If we take as a reference point in history the end of the Gold Exchange Standard in the 1970s, we can observe that since then, several changes have occurred in the society. A general optimism and a vision of the future characterized by increasing scientific discoveries and technological advances aimed people about possibilities never thought possible before, such for instance the realization of automated robots, or the possibility of making a journey in space. The hardware and software development has continuously risen after the invention of computers, indeed, these years could be traced to the birth of modern computers and microprocessors, along with the invention of floppy disks and the development of the gaming and audio-visual industries.
However, the vision of the future of the seventies and later, had foreseen space travel but had not been able to foresee the advent of the Internet, mobile telephony and the digital revolution, which took together, can be referred to a wider Information revolution. Initially, the development was slow, but over time and with the growth of interconnections of these machines and people, the possibilities of applying new means to the social and economic activity grew exponentially, changing people's behavior to the point of perceiving software as an extension of "the self" [1].
Belk analyzes five main changes in the information age which at different degrees affect the self perception: the dematerialization of analogic items, the reconstruction of these items in digital terms, the presence of a distributed memory between participants, the collaborative construction of software and finally sharing, as the prominent way of exchanging. These factors combined have created a permanently connected world that transcends national borders, time differences, and geographic distance, allowing for the extension of the "collective self".
The revolution in I.T. has not only changed our social behavior but also how people consume these goods and services. With the internet, today we find ourselves in a situation where digital resources are abundant and available to everyone. The utilization of information does not diminish the availability for others, because of the nature of digital information to be immaterial. Indeed, data is a long series of zeros and ones, that grouped form bits, which implies that the data is perfectly reproducible and transferable with near-zero marginal costs all around the world. Therefore the Internet, being a large pool of information accessible to anyone and downloadable for free, has facilitated the old universal sharing methods.
This fundamental characteristic has eased the share of the distributed and tacit knowledge between people, which in turn has allowed the agglomeration of groups with the same interests, the flourishing of new ideas and has enhanced the number of possible transactions in a large scale, with blogs, forums, chat, and social networks.
Participation, therefore, favored the construction of an aggregate sense of self through feedback and comments. In this way, consumers of digital services become part of the production process through the "collaborative consumption", making the border between producers and consumers more imperceptible. Another relevant way to cooperate in the digital realm was made possible with the birth of open-source systems, where the source of the code is made public by the authors and made available to everyone. In these systems, the license gives the rights to favor the modification, the study and the redistribution of the code, allowing independent programmers to make changes and extensions. This phenomenon has benefited greatly from the Internet because allowed distant programmers to coordinate and work on the same project otherwise considered impossible to build singularly.
Indeed, more complicated problems require the cooperation of a large number of participants and heterogeneous minds, where sharing information necessarily becomes the more efficient way to manage decentralized knowledge inside the whole complex system.
This way of thinking is supported by the research of J.Bessen and E.Maskin [2], nobel prices, which observe that if tech innovations are both sequential and complementary. By sequential, we mean that each successive invention builds on the preceding one, and by complementary, we mean that each potential innovator takes a somewhat different research line and thereby enhances the overall probability that a particular goal is reached within a given time [2]. In this industry certainly are, patent protection may reduce overall innovation and social welfare, instead of the contrary.
Defenders of patents may counter that, with stronger property protection, these industries would have been more productive in economic activity.
Instead, the two researchers found evidence of the contrary:
The software industry in the United States was subjected to a revealing natural experiment in the 1980s. Through a sequence of court decisions, patent protection for computer programs was significantly strengthened. Far from unleashing a flurry of new innovative activity, these stronger property rights ushered in a period of stagnant, if not declining, R&D among those industries and firms that patented most. [...] For industries like software or computers, there is a good reason to believe that imitation promotes innovation and that strong patents (long patents of broad scope) inhibit it. Society might be well served if such industries had only limited intellectual property protection. Moreover, many firms might genuinely welcome competition and the prospect of being imitated [2].
Furthermore, in open-source systems, it was then revived a new sense of community, in which participants, helping others directly with their contributions, increased their sense of belonging to the group and increased the moral benefit due to actively support others for bigger projects. This further allowed new ways of sharing, for instance, in the case of the peer-to-peer networks (P2P), where files are distributed and exchanged directly between users. These new ways of sharing slowly changed the way business operate, while raising ethical questions concerning digital forms of ownership.
The internet led to very rapid growth in the demand for international communication systems on the world wide web such as e-mails and chats. Therefore, programmers were required to handle illustrations, maps, photographs, and other images, plus simple animation, at a rate never seen before, which in turn led to the construction of few well-known methods to optimize the image display quality and the storage's efficiency.
Then, the increase of browser usage, running on the HyperText Markup Language (HTML), changed how information-display and retrieval were organized. The widespread network connections led to the growth and prevention of international computer viruses on Windows computers, and the vast proliferation of spam e-mail became a major design issue in e-mail systems, flooding communication channels and requiring semi-automated pre-screening [3]. Interestingly, these problems led people to search for a solution which was then found in cryptography, another maturing field parallel to computer science, that has never stopped to grow since the rise on concerns on privacy and data protection. In the next picture, it is possible to see all the most relevant innovation in cryptography in those years.
In this context, every business in every sector was impacted by the Internet, economically and sociologically, even though the effects were not immediately visible. Indeed, at the beginning of the 1990s, the most famous brands in the world belonged to companies that produced goods or processed raw materials, today, at the top of the rankings of the best-known brands in the world we find companies such as Google, Apple, Yahoo, etc., all involved with the digital world. Hence, it has become actually difficult, if not impossible, to live inside the economy without using the Internet one way or another. As a result, the Internet has definitely changed the ways in which people understand ownership. The confusion generated has brought out difficult questions about intellectual property and rights, by transforming the paradigm of possession in the digital age. Consequently, it has also changed the perception of the monetary system, that more than ever, becomes immaterial and intangible.
A "New" concept of hard cash
The convergence of these factors and the expansion of transactions on the web lead to a series of attempts to create a new type of currency, which can only exist on the Internet. But before tackling the ways in which these coins are developed, let's take a step back, looking at the reasons why they were born. As we have seen, few improvements were made in the fiat monetary system, the base layer of the current money.
Issuers of paper money are constantly battling the counterfeiting problem by using increasingly sophisticated papers and printing technology. Physical money addresses the double-spend issue easily because the same paper note cannot be in two places at once [4].
But for digital money this is not possible, indeed, the facility of exchanging and duplicating data carried out not only problems concerning property rights, but also technical problems on how this data is transferred. That is, if an object is easily duplicable, its monetary value tends to zero.
Since the 1990s, some forms of e-money have been experimented which proposed to solve the problem of the protection of personal data when transacting and the more concrete problem of double-spending. In particular, in the middle of the 1990s, it was born a competing approach to the intermediary architecture called SET, which avoided the need for customers to send the credit card information to merchants and the need for the user to enroll with the intermediary.
In the SET architecture, when one made a purchase, the browser passed the view of the transaction details to a shopping application on the computer which, together with credit card details, was encrypted in such a way that only the intermediary could decrypt it. Hence, the buyer could send the data to the seller knowing that was secure, while the seller blindly forwarded the encrypted data to the intermediary. Then, the intermediary decrypts data and approves the transaction if the views of buyers and sellers coincide. SET was a standard developed by VISA and MasterCard, involved together with many other technologies such as Netscape, IBM, Microsoft, Verisign, and RSA [3].
Another company that implemented the SET protocol was called CyberCash, one of the few companies which obtained a special exemption for their software from the Department of State of the US. Indeed, at the time, there were government restrictions on the development and export of cryptography, which was considered a weapon. Nevertheless, CyberCash later suffered from a critical bug, that caused their processing software to double-bill some customers, and their bankruptcy. Later, their intellectual property was sold to Verisign and the acquired by Paypal, founded in 1999, where it lives today [3].
The SET system initially did not work because it had a fundamental problem with certificates, that is a way to securely associate a cryptographic identity, a public key, with a real-life identity. These certificates are now the backbone of our secure Internet and they protect sensitive information as they travel across the world's computer networks; they are essential for protecting websites, even if they cannot handle sensitive information like credit cards. In that period, however, they were unpractical and not used by users for monetary purposes.
Meanwhile, after the reawakening of the Austrian school of Economics, and in concomitance with the development of cryptography and computer science, it started to be recovered the concept of hard money. In previous articles, we compared commodity money - cash - and credit, noting that a cash system need to be "bootstrapped" in some way, but the benefit is that it avoids the possibility of a buyer defaulting on his debt. Cash offers two additional advantages, that are becoming of fundamental importance in the digital age.
The first is better privacy. Since a credit card is issued along with a personal name, the bank can track all the spending. But when one pays in cash, the bank doesn't come into the picture, and the other party doesn't need to know who made the transaction. Second, cash can enable offline transactions where there's no need to phone home to a third party in order to get the transaction approved [3]. For these reasons, through time, several attempts were made to create a monetary system that might be more resilient to devaluations but also with the aim to protect privacy and prevent double-spent. The earliest idea of applying cryptography to cash came from David Chaum in 1983, with the invention of digital signatures.
He has found a way to replicate digitally - and way more precisely - the meaning of the analogic signature, on which checks have been based for several years as a payment system.
Note that the same applies to banknotes, where the signature, in this case, could be thought as the "stamp" or the promise that the intermediary would pay back, so based purely on trust. The same concept can be applied to e-money with digital signatures, even if it comes out again the annoying problem of double-spending. A possible solution to the duplication of data was to put a unique serial number into each note issued. When one receives that note from someone else, he can check the signature, but he has also to request to the central authority whether that unique note has already been spent. The problems here, in addition to the little practicality, are the trust that should be placed to the intermediary and that this money could not be anymore considered cash, since it is not anonymous - that is, the controller can associate the serial number to each identity.
This is where Chaum's innovation comes in. He figured out to both keep the system anonymous and prevent double-spending by inventing the digital equivalent of the following procedure: when I issue a new note to you, you pick the serial number. You write it down on the piece of paper, but cover it so that I can't see it. Then I'll sign it, still unable to see the serial number. This is called a 'blind signature' in cryptography. It'll be in your interest to pick a long, random serial number to ensure that it will most likely be unique [3].
This was the first serious digital cash proposal that worked, even if it still required a server run by a central authority, such as a bank, and for everyone to trust that entity. Nevertheless, what achieved was that every digital coin issued to someone, encoded his identity in such a way that neither the user or the bank could decode it. So Chaum commercialized his idea and formed a company in 1989 called DigiCash, one of the first companies that tried to resolve the problem of online payments at its roots. He had several patents on Digicash technology, such as the blind-signature scheme that it used, which was controversial for the open-source community, stopping other people from developing ecash systems that used the same protocol [3]. The main problem of DigiCash was that it was not able to persuade the banks, the users and merchants to adopt it, also because it was really centered on the user-to-merchant transaction rather than user-to-user.
Simultaneously, many other companies tried to use electronic cash systems based on tamper-resistant hardware. For instance, Mondex, a company founded around this idea, was later acquired by Mastercard, while Visa also had their own variant called VisaCash. Systems like Mondex worked similarly to cash, that is, if you lose the card or if it is stolen, the money's gone. "Worse, if there was some sort of malfunction with the card, if the card reader wouldn't read it, there was no way to figure out if that card had a balance on it or not and Mondex would typically eat the cost" [3], making the business unsustainable.
Other systems such as e-Gold, put a pile of gold in a vault and issued digital cash only up to the value of the gold. Another company called Digigold wasn't fully backed by gold, but only had partial reserves. It was more and more clear that scarcity was one of the several issues to resolve to have the Internet's money. In the digital realm, one creative way to achieve scarcity is to design the system so that minting money requires solving a computational problem (or puzzle) that takes a while to crack. "The basic idea, that solutions to computational puzzles could be digital objects that have some value, is pretty old. It was first proposed by cryptographers Dwork and Naor as a potential solution to email spam back in 1992 [3]". Initially, the goal was to make it difficult for spammers to sent out thousands or millions of emails all at once, because before they have to solve a small puzzle for each email sent, which becomes unfeasible after a certain number.
These computational puzzles, to protect from spam e-mails, require three properties. First of all, it should be impossible for an attacker to find the solution and attach it to all the e-mails he sends. Second, the receiver should be able to easily check the solution without redoing the computational work. Finally, each puzzle should be totally independent of others, in the sense that solving one puzzle does not decrease the amount of time it takes to solve any other puzzle [3], which implies that puzzle solutions should be adjusted according to technological development.
These properties can be achieved by using cryptographic hash functions to design the puzzles, a mathematical tool refined since 1993 by the National Security Agency (NSA) and published as a federal standard by the US government. A similar idea to these computational puzzles was later discovered independently by Adam Back in 1997 and applied to money in a proposal called Hashcash. Another key component discovered separately a few years before, by Haber and Stornetta, was the architecture of a general blockchain, a method for secure time-stamping digital documents.
The goal of timestamping is to give an approximate idea of when a document came into existence. More importantly, timestamping accurately conveys the order of creation of these documents: if one came into existence before the other, the timestamps will reflect that. The security property requires that a document's timestamp can't be changed after the fact [3].
So when the server receives a document, it signs this document together with the current time as well as a link to a pointer to a previous document, issuing a "certificate" of this information. As we will see more in detail in other articles, the pointer in question a special type pointer that links to a piece of data instead of a location. That means that if the data in question changes, the pointer automatically becomes invalid, ensuring the integrity of the previous document. This mechanism could be also applied recursively:
[...] each certificate essentially fixes the entire history of documents and certificates up until that point. If we assume that each client in the system keeps track of at least a few certificates - their own document's certificates, and those of the previous and following documents - then collectively the participants can ensure that the history cannot be changed after the fact. In particular, the relative ordering of documents is preserved [3].
This finally led to another proposal with an efficiency improvement: instead of linking documents individually, they can be collected into blocks, then blocks can be linked together in a chain with a tree structure instead of linear. This invention is called Merkle-Tree and allows efficient and secure verification of the contents of large data structures while decreasing the amount of checking needed to verify that a particular document appears at a particular point in the history of the system, so very suitable for sharing blocks.
These new developments started other two proposals that are relevant in the creation of digital cash. The first was called b-money, and it was designed by Wei Dai in 1998. In b-money, anyone can create money using a hashcash-like system, where each node maintains the LEDGER in a peer-to-peer network, so each node has its own ledger of what it thinks everyone's balance is. The second and similar proposal was called Bitgold, created by Nick Szabo in 1998 and commercialized only in 2005.
Nevertheless, in those proposals, computational puzzles were used directly to mint currency, so anyone could solve a puzzle and be rewarded. Moreover, these systems relied on timestamping services to preserve the order of transactions, which made it not clear how to resolve disagreements if they occurred. "Letting the majority decide seems to be implicit in both the author's writings, but since anyone can set up a node - or a hundred, hiding behind different identities - these mechanisms were not very secure, unless there was a centralized gatekeeper who controlled entry into the network [3]".
Most of these forms of digital money were forced to shut down their activities, due to a multitude of events. On one side, regulations increased restrictions over transactions and financial instruments, also because of legal troubles due to money laundering and the increasing targeted hacker attacks. On the other side, the following dot-com bubble, in a recession phase of the market, forced a lot of business to close. These companies, all had a common thread: they were all centralized and thus subject to a single point of failure, because they have always to rely upon a third party to resolve disputes about properties. Only a few companies survived, one example is PayPal, which gradually shifted its business core from cryptographic payments to online payments, making a fortune.
In this framework, the final result at the beginning of the 2000s was that was proven empirically and scientifically the impossibility to coordinate a network in a decentralized way. The general belief was then that the only solution to maintain the integrity of the register was inevitably to trust a third party. The Bitcoin protocol solves this problem through an injection of game theory.
The White Paper
The 31st of October 2008, appeared in a cryptographic mailing list, a document that declared to have found a way to solve the double-spend problem without having to rely upon a central authority. The document, titled "Bitcoin: A Peer-to-Peer Electronic Cash System", was signed by Satoshi Nakamoto, whose then was discovered to be a pseudonym. While the identity of Satoshi remains a mystery, he (There is no particular reason to think that he is male, except for the name itself) communicated and worked extensively in Bitcoin's project early days, until the 3rd of January 2009, it was released the first genesis block of the Blockchain.
In this first block it was appended the title of the New York Times: "Chancellor on brink for the second bailout for banks, a sentence that is going to remain there for a long time.
Satoshi maintained the source code in conjunction with other developers, fixing issues as they arose, but by December 2010 he stopped to communicate with them saying that he was busy with other projects, while leaving the maintenance of the Blockchain to the community. Then, he disappeared without leaving traces. "Another interesting quote from Satoshi suggests that he might not be an academic [3]. This is because most academic researchers think about ideas and write them down immediately, before they build the system. Satoshi said that he took the opposite approach; he first had to write all the code to see if it worked, then he released the paper. The abstract of the White Paper presents itself in this way:
A purely peer-to-peer version of electronic cash would allow online payments to be sent directly from one party to another without going through a financial institution. Digital signatures provide part of the solution, but the main benefits are lost if a trusted third party is still required to prevent double-spending. We propose a solution to the double-spending problem using a peer-to-peer network. The network timestamps transactions by hashing them into an ongoing chain of hash-based proof-of-work, forming a record that cannot be changed without redoing the proof-of-work. The longest chain not only serves as proof of the sequence of events witnessed, but proof that it came from the largest pool of CPU power. As long as a majority of CPU power is controlled by nodes that are not cooperating to attack the network, they'll generate the longest chain and outpace attackers. The network itself requires minimal structure. Messages are broadcast on a best effort basis, and nodes can leave and rejoin the network at will, accepting the longest proof-of-work chain as proof of what happened while they were gone" [5].
In this document, Satoshi makes some references to basic cryptography and probability theory. He also cites most of the mechanism that we saw earlier, so it's very natural to think that he based the design of the Blockchain on these references, since the similarities are so apparent. Then, he also cites b-money, and subsequently Bitgold on a website that he made up at the beginning. However, "Bitcoin uses a completely different decentralized model and so there's no compelling reason to dwell on old centralized systems that failed [3]".
When a system is decentralized it means that resources and activities are distributed away from a central group. In these systems, the data is chopped in small pieces and shared through peers in a way such that to close the system one has to shut down every node containing that file. Everyone can download the core software, check what it can do and what it cannot do and participate in the system to use it or improve it.
In the ecosystem that Satoshi created, there are numerous stakeholders with imperfectly aligned interests, which collaborate to open protocols to find a consensus on the rules. This environment is very similar to the architecture of the Internet where improvements are made by upgrading standards. For example, the BIP process (Bitcoin improvement proposal) is reminiscent of the RFC (Request For Comments), which is a type of standards-setting document for the Internet. The good news is, as claimed in the paper, that Bitcoin "doesn't require a central server, instead relies on a peer-to-peer network which is resilient in the way that the Internet itself is [3]".
Differently from B-money and BitGold, Satoshi explained a mechanism to automatically adjust the difficulty of the puzzles periodically, in which solutions constitute money in a more complex way. B-money and Bitgold did not include such a mechanism, which resulted in problems tied to monetary value. That is, when coins become trivial to create they will lose their purchasing power through time. Moreover, these two currencies relied on timestamping services that sign off on the creation or transfer of money.
Differently, Bitcoin doesn't require trusted timestamping; in essence, it "tries to preserve the relative order of blocks and transactions, combining the idea of using computational puzzles to regulate the creation of new currency units with the idea of secure timestamping to record a ledger of transactions and prevent double-spending [3]".
As a final thought, Satoshi can be though of as an innovator because he took different pieces of different inventions and he assembled them to construct viable decentralized money, looking carefully at the hard-code constraints of the environment. Moreover, "Bitcoin was able to build up a community of passionate users as well as developers willing to contribute to the open-source technology. This was a markedly different approach than previous attempts at digital cash, which were typically developed by a company, with the only advocates were benefits for the company itself. Bitcoin's current success is due in large part to the vibrant supporting community who pushed the technology, got people using it, and got merchants to adopt it [3]".
Nevertheless, as the word suggests, cryptocurrencies make heavy use of cryptography to prevent tampering and equivocation, as well as to encode the rules for the creation of new units of the currency into a mathematical protocol. In the next chapters we are going to look at these cryptographic instruments that are used up in the White Paper.
Index:
- Cryptocurrencies for friends who don't care about cryptocurrencies
- 1 - Bitcoin and money
- 2 - The history of money
- 3 - Characteristics of money
- 4 - A glimpse into the Austrian school of Economics
- 5 - The history behind Bitcoin and cryptocurrencies
- Building blocks of the blockchain
- The Nakamoto consensus
- Some crypto-economics
References:
[1] - R.Belk. Sharing.
[2] - James Besse and Eric Maskin. Sequential innovation, patents and imitation.
[3] - E. Felten et all. Bitcoin and cryptocurrency technologies (Princeton)
[4] - A. Antopolous. Mastering Bitcoin: unlocking digital currencies.
[5] - S. Nakamoto. The Bitcoin White paper.
