This article does not cover any of the technical aspects of the blockchain or cryptocurrencies. The objective of this introductory article is to introduce the basic concepts of the blockchain, cryptocurrencies, and tokens as well as touch on why we’re on the cusp of something big. It is the first of a series of articles that are an amalgamation of concepts and ideas of various industry pioneers; I try to give a comprehensive beginner’s reading list at the end.
How and why
For the majority of people, the concept of a blockchain remains enigmatic. That is OK, because as much as SMTP, HTTP, or TCP/IP are a mystery to everyday users, they interact with each other using those protocols on a regular basis by sending emails, browsing the web, or exchanging any sort of data over the internet. The advent of the blockchain is no less revolutionary than those legacy computer protocols.
The rapid development of the blockchain today is akin to the early days of the internet in the 80s and 90s in a foundational sense. The foundation blocks of tomorrow’s digital infrastructure are being built today on blockchains. To many, the blockchain is fulfilling the original promise of the internet, a peer to peer distributed network controlled by no one and available to anyone. A public good, that any person may utilize equally and fairly.
Today, personal data on the internet is mostly controlled by a small handful of internet companies, such as Facebook, Twitter, or Google. Internet service providers are throttling bandwidth to select sites, and governments are outright blocking access to information they believe harms them. Furthermore, banks and payment networks control financial information and central banks indirectly control the value of money. The internet brought us closer to freedom, security, and control over our own lives, but the networks and systems that connect us remain centralized. Personal data is still stored by entities who one would only hope they look out for our best interests.
Cypherpunks are obsessed over the dangers of an internet where data is centrally controlled by corporations and governments. It is a almost a four-decade old movement that calls for a world where user data is cryptographically protected to maximize privacy and control. The biggest breakthrough came when Satoshi Nakamoto, an unknown individual or group of individuals who founded bitcoin and released the bitcoin whitepaper, built the framework for a decentralized, distributed, and immutable public database that no individual or entity controls, and required no third party’s trust over user data. That idea was termed ‘distributed blockchain’. The first mainstream use of that blockchain is Bitcoin, a digital ‘cryptocurrency’ that is deflationary in nature and is not controlled by any central bank or government by design.
Currencies, smart contracts, and Dapps
Cryptocurrencies come with the promise of trust-lessness, security, anonymity, and utility with low transaction fees that fiat currencies and banks cannot offer today. It takes three or more days for a wire transfer to clear, while Bitcoin transactions settle in an hour or less. Fees charged for cross border remittances by traditional institutions like Western Union average about 10 percent of a transaction’s value, while Bitcoin transactions cost less than one percent. There is also a finite number of bitcoins that will ever exist, capped at 21 million, which makes it a deflationary currency and allows for price to be determined entirely by supply and demand, while central banks are able to manipulate prices of fiat currencies by printing more money. Cryptocurrencies are trustless in that no central entity controls them. Users do not need to trust a third party to conduct transactions or exchange data. Instead, thousands of distributed nodes operate to maintain the integrity of a cryptocurrency public ledger, or blockchain, making it virtually impossible to alter previously verified transactions.
A blockchain is a chain of discrete blocks, each containing data about transactions between users. New transactions are contained in new blocks. They’re added to the chain in a process known as mining. The data is secured using cryptography, and the encryption mechanism is built in a way to ensure that any slight tampering in data will significantly affect the integrity of that data. The chain is simultaneously run on multiple independent nodes so that if some of the nodes are compromised, it will not affect any of the other nodes. Blockchains are effectively ultra-secure databases, and in cryptocurrencies, that database is the ledger of all transactions that ever took place using that currency.
Cryptocurrencies have no intrinsic value, just as there is no intrinsic value to a US dollar since the abolition of the gold standard. Bitcoin is a medium of exchange which value is determined by the market. The surge in the price of the Bitcoin indicates its demand. The more the users deal in Bitcoin, the more valuable and redeemable against other goods or services it will be. It benefits from network effects, like any other currency. There is no value to a USD if you are the only person on the planet using it. Today, Bitcoin is the standard digital settlement currency, but other cryptocurrencies do exist like LiteCoin, Dash, and Monero, among others, each with their own unique characteristics.
As society moved from a barter-based economy to a unified currency for all transactions, there was a decoupling of value from utility. The medium of exchange is also the utility in a barter transaction. I may exchange three chickens in return for five pounds of salt. The salt is both the currency as well as the utility in this case. I am willing to accept salt as a form of payment for my chickens because I want to use the salt myself. Currencies, on the other hand, are just mediums of exchange. They are only valuable if they can be converted into other services or products. Barter economies are inefficient because it was difficult to standardize value of certain goods. It was also impractical because not only did it require a party to be willing to give up a product, but they must be willing to give up the product in exchange for another particular product. That must be matched with another party who is willing to take up the first offer’s party, and within a specific timeframe. Currencies allowed for seamless exchange, using a standardized value, that are redeemable at any point in time. That decoupling of value from utility was the primary driver of global trade.
Cryptocurrencies are virtual and the internet operates around the clock, which means the impracticality of holding multiple physical currencies is diminished. You are now able to hold various currencies, each with their own set of use cases. Some will be more appealing for small value instantaneous transactions, others will work better for larger amounts that requires anonymity and security. Furthermore, a currency can now also contain a set of rules that allow for exchange to only occur in case these rules are met. That is known as a smart contract. A smart contract is simply a contract between two or more parties that will be executed if and only if certain conditions are met. These conditions can be programed into the token itself and is often open-sourced, to allow users to view and audit the integrity of the code.
Smart contracts could eliminate the need for trusted middlemen by ensuring that a transaction between parties is only executed if and only if certain criteria are met. For example, a contract could be programed so that a property’s title deed is transferred to the buyer if the seller receives the full payment, thereby eliminating the need for an escrow agent. Another contract could be programed so that there is absolute transparency in the usage of funds, ensuring that a taxpayer dollar is not utilized in a corrupt manner. Those conditions can be programed into the cryptocurrency itself. The implications of that are enormous, as contracts replace centralized middlemen as policing authorities. You can trust the contract because it is auditable and immutable.
A simple example of a smart contract is ‘multi-sig’. These transactions are only executed if multiple signatories sign off on it. Many smart contracts today contain an element of multi-sig, over and above other conditions to be met by parties, like time-based or deliverable-based release of funds.
Smart contract applications would have their own token with their own value, but not necessarily their own blockchain. Think of those blockchains as open, anyone can build tokens or coins that run on that blockchain as long as they fit that blockchain’s protocol. In return, transacting parties must pay fees in that blockchain’s default currency. Though Ethereum is the largest and most popular blockchain, others exist like EOS, Tezos, Qtum, and NEO, each with its own unique offering. A token can be built on the Ethereum blockchain with its own set of rules programed, its own name, and its own value, but transacting parties must pay fees in Ether, Ethereum’s ‘gas’, or default currency. The more the Ethereum blockchain is used, as a result of more applications built of the Ethereum blockchain, the higher the value of Ether. These types of protocols can be considered Decentralized Applications, or Dapps. Dapps are applications that allow users and providers of a service to connect directly without a middleman or compromise on trust. Dapps are usually open sourced projects, with public blockchains. The ecosystem is incentivized to maintain integrity and keep the blockchain up to date through transaction fees and mining rewards. Ethereum is a form of a Dapp, in that a community of developers maintain Ethereum’s code and submit proposals for upgrading the protocol, miners constantly mine blocks and are paid ‘gas’ for it, and any two parties can use Ethereum without the need for involving an organization or corporate entity to be an intermediary.
Utility versus security tokens
While cryptocurrencies are tokens or coins that derive their value from supply and demand, tokens in this industry are usually split into two forms. Utility tokens which are redeemable against a service or a good, and tokenized securities, such as tokens that represent ownership in an asset, like shares, fiat currencies, or commodities.
Tokenizing securities is valuable because it creates public and immutable records of ownership that cannot be manipulated or hacked, ensuring that owners of these securities are under no threat of loss. These tokens have the potential to disrupt the existing model of custodianship of assets. They can also help increase liquidity in assets by processing transactions instantaneously by programing rules and restrictions into these tokens that are today exercised manually, like KYC and AML checks, minimum net-worth authentication, or geographic restrictions. These restrictions can be programed into a token’s smart contract layer. A great project in this space is Jibrel Network, founded by Yazan Barghouthi, Victor Mezrin, and Talal Tabbaa. Jibrel aims to tokenize traditional financial assets on the Ethereum blockchain while keeping the assets in custody with banks. This can allow for increased liquidity, lower fees, and faster transfer of assets between parties.
When it comes to utility tokens, think of an airline loyalty points system. The points can go towards flights, upgrades, or purchases in retail outlets, or think of cellphone minutes that can be used against calls, data, or SMS messages with carriers.
Coin offerings or token sale events are essentially companies, teams, or foundations offering tokens for public purchase. Most coins offered for public purchase are utility tokens.
I will dive into tokens and token sales in more detail in another post, but for now, think of token sales as an ecosystem-building event. Tokens are expected to increase in value the more valuable stakeholders believe the ecosystem is, similar to equity but much broader in coverage. The lines start to blur between what is a utility token and what is a tokenized security when studying these ecosystems and token sales events, which are changing the very foundation of corporations and their relationship with stakeholders. In short, tokens have the potential to distribute value to different stakeholders in an ecosystem in a way that is not possible today.
Some examples of popular tokens:
Augur- a prediction market token built on the Ethereum blockchain.
Golem- the world’s first decentralized supercomputer, utilizing underused computation power of idle machines that collectively acts like a super computer.
Civic- Blockchain-based identity management system.
Basic Attention Token- An advertising exchange network based on the Ethereum blockchain.
Tether- Issues tokens that are supposedly tethered in value to fiat currencies
Monetizing the protocol layer
A smart contract is in a sense a form of a protocol in that it dictates what is and is not allowed to take place over a certain network. The difference between legacy protocols and today’s tokenized protocols is that the exchange of data using a protocol is now monetizable at scale. Fred Wilson from Union Square Ventures, wrote a great blog post about this here. In summary, while legacy internet protocols brought enormous value to users, it was only at the application layer that that value is being captured. Facebook, Google, and Twitter exist because the internet is ubiquitous, but the internet itself and the ecosystem around it do not directly benefit from the usage of these products. Most of the value is captured by Facebook the company, Google the company, and Twitter the company. This ability to allow monetization at the protocol layer is a massive change that can lead to a radically different approach entrepreneurs and programmers will take when building new technologies.
Fred further elaborates on the points he brings up in the above mentioned article in a more recent post he published titled ‘How to Value Crypto Assets’ in which he argues that it is erroneous to value a cryptocurrency in the same way a traditional company is valued because a lot of these cryptocurrencies are platforms in which the protocol layer is worth more than the sum of the applications built on top of them.
I will leave the discussion on the topic of valuing a cryptocurrency or token for another time, but in sum, it is erroneous to value a cryptocurrency or token, especially platforms, in the same way companies or products are valued today because these protocols and ecosystems are to applications what the internet is to tech companies, the foundation on top of which everything is built. How do you value the internet?
The implications cryptocurrencies and utility tokens can have on traditional industries are massive. The more obvious ones are the financial industry and venture capitals, as cryptocurrencies begin disintermediating the banks and replacing fiat currencies and commodities as the standard exchange medium, while ICO and token sales disrupt the fundraising process startups currently undergo with VCs. On a deeper level, the trustless mechanism of smart contracts and Dapps has the potential to impact almost every industry and social order from supply chain management to voting and public governance. The impact on large internet companies will also be felt as decentralized marketplaces and social networks begin to acquire market share. It is easy to overstate the opportunity and understate the challenges ahead. Is it only a matter of time before smart contracts and digital assets replace legacy social contracts or is it a matter of if they will at all?
I have added suggested further reading material below. If you are just curious to learn more, consider investing in Bitcoin and Ethereum, or even try to venture out and purchase some alternative coins (you can use ShapeShift for that). BitOasis is the best place to buy Ethereum and Bitcoin if you are based in the GCC. Take a cryptography class online and learn more about cryptocurrencies at a more fundamental level.
We are still at the infrastructure and protocol building phase. Do not assume that consumer adoption is an indication of success or failure at this stage. The primary objective at this stage is to increase adoption, build infrastructure, and improve security and stability of blockchain technology.
In the next article, I will talk about how ecosystems built around Dapps and cryptocurrencies are nothing less than a paradigm shift in the way we think about building companies, products, or applications, and how value of networks and ecosystems can potentially be distributed to all stakeholders more fairly than traditional corporate models that exist today.
In a world where transparency, authenticity, and integrity of data are both achievable and tremendously valued, the blockchain brings with it the promise of a more efficient world with more equality.
Suggested further material