Week of December 14, 2020
Bitcoin, Cryptocurrencies, and Blockchain
Time’s glory is to calm contending kings,
To unmask falsehood, and to bring truth to light,
To stamp the seal of time in aged things,
To wake the morn, and sentinel the night,
To wrong the wronger till he render right.
Shakespere, W. , The Rape of Lucrece, 1594
I wanted to take a different tack this week and address cryptocurrencies and blockchain technology. Cryptocurrencies like Bitcoin and Ethereum have made headlines over the past few years. As financial professionals, friends and clients often ask our opinion of Bitcoin. Previously, I conducted a light dive into crypto/blockchain. However, I decided to do a deeper dive in order to have a fundamental understanding of what this technology is and what it means for the future. My hope is to address this over the next few weeks, explain it in a simple manner, and lay out the possibilities. Although Bitcoin and Ethereum are the “hot” blockchain technologies of today, I believe cryptocurriencies are just the tip of the spear when considering the long-term disruption capabilities of blockchain
The Dawn of Blockchain
I find that for my mind, it works best to go back to the genesis of a story - to follow its history and original intent and bring it into the light of today. Blockchain as an idea was born in 1991 when two employees at Bell Labs, Scott Stornetta (a physicist) and Stuart Haber (a cryptographer) wrote a whitepaper titled “How to Time-Stamp a Digital Document”. Bell Labs at that time encouraged open projects. They would accept anything you wanted to work on as long as you stated what and why. What Stornetta and Haber saw was a future world in which, “all text, audio, picture, and video documents are in digital form on easily modifiable media. . . We propose computationally practical procedures for digital time-stamping of such documents so that it is infeasible for a user to either to back-date or to forward-date his document.” The why was a story Stornetta had heard about a widely published biology research report that was later found out to be based on lab reports that had been altered after the fact. Although this report was in physical written form, Stornetta and Haber foresaw the digital storage of records and they wanted to ensure the immutability of those records.
Stornetta and Haber wanted to create a world where digital documents could be time-stamped and held by a trusted third party. Then the document could not be changed after it had been time-stamped without it being obvious that the altered document is not the same as the original time-stamped document held by the trusted third party. Four overlapping issues arose out of this solution:
- Privacy – Consider a trade-secret document. The information contained in the digital file could be intercepted digitally and/or the trusted third party would have access to the trade-secrets.
- Storage – Digitally sending and storing a large document would require huge hard drives.
- Incompetence – The digital file could be corrupted in transmission, it could be incorrectly time-stamped, or it could be corrupted while being stored at the trusted third party.
- Trust – How much can you trust the trusted third party?
They proposed solving the first three issues using existing cryptographic solutions. First they advanced hashing the data to keep the information private and easy to store. Hashing is key to blockchain technology today. Think of an Excel spreadsheet. You can type a lot of data into one cell. Hashing that data involves an algorithm that regardless of what you type in a cell, the output is a defined fixed number of characters. So you might type in “the quick brown fox” and the output would be FXJ0098456. If you typed in “The quick brown fox” you would get TRE9275434. Just changing one character produces completely different output characters but the same length regardless of how much data is in that one cell. So the privacy of the information and the size/storage of the information are satisfied by hashing. To protect against incompetence, Stornetta and Haber recommended using digital signature algorithms. Once the trusted third party receives the hashed values they can affix a time-stamp, sign the hashed document and return it to the client. The client can check the hash, the signature, and the time-stamp; thus ensuring that the trusted third party received the hash and time-stamped it correctly. This left one issue to solve: How to prevent the trusted third party from intentionally issuing an incorrect time-stamp?
Stornetta and Haber wanted to create a system, “which guarantees that no matter how unscrupulous the (trusted third party) is, the times it certifies will always be the correct ones, and that it will be unable to issue incorrect time-stamps even if it tries to.” They theorized on two different systems to create a trusted third party that could not issue false time-stamps. The first system would embed or link (chain) previously timestamped information (blocks) into the current certificate. That way the trusted third party cannot front-date a time stamp without changing all the previously embedded time-stamps. Nor can the trusted third party backdate a time-stamp without changing all the embedded time-stamps that follow the time-stamp in question. The flaw in this scheme is that if there are not continuous transactions, then there is a delay between the time-stamps and the data could be compromised during that delay. Additionally, at least one of the parties must store the certificates. Their other theorized option was to create a shared or distributed ledger of transactions. When one client wants a time-stamped document, they would send that request out to all the other clients on the system. The other clients would individually return a time-stamped certificate (this time stamp would be a computationally randomly generated number that the other clients would have to solve for in order to match the requesting clients id). The beauty of this system is threefold: First, the sharing of the certificate and request to time-stamp across multiple users would expose any time-stamp that was inaccurate. Second, in order to create a false time-stamp, it would require more than half of the clients to act dishonestly. Otherwise, the output of the honest clients will outweigh the output of the dishonest clients and the dishonest time-stamp would be discarded (say there are 11 clients on the system. If 6 of them are honest and 5 are dishonest in their time-stamp, the 6 would outweigh the results of the 5 and those would be discarded thus providing a valid time-stamp). Finally, there would be no need for a centralized power to monitor and approve transactions. All approval would come from the client members.
The authors of this whitepaper left it up to future generations to figure out the best solution between linking previous data (blockchaining) or a distributed ledger. It would take nearly two decades before someone came up with a practical solution using much more powerful computers than were available in 1991 when Stornetta and Haber wrote their paper. In 2008 a person or persons going by the pseudonym Satoshi Nakamoto wrote a whitepaper suggesting a blend of linking and a shared/distributed ledger. The name of that whitepaper? “Bitcoin: A Peer-to-Peer Electronic Cash System”. Bitcoin, and blockchain, had a working model.
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