Why were Blockchains Invented?
Bitcoin was engineered using a combination of pre-existing technologies in order have a monetary system without a centralized authority. The types of events that the Bitcoin protocol allows to be recorded onto its ledger are simple — they are transactions made either as payments between users, fees for use, or as rewards for miners that help to make the network and protocol infrastructure work. The Bitcoin software was built on a simple programming language in order to ensure its security and reliability.
Once Bitcoin proved itself as a viable monetary system, many started to ponder over the possibility of using Bitcoin’s design principle to build new applications for the provision of services beyond the monetary realm. Efforts were directed towards designing new blockchain platforms to deliver more elaborate services such as decentralized finance, tokenization, gaming or governance.
In order to undertake the above-mentioned innovations, it was necessary to write computer programs — known as smart contracts — that would execute more elaborate functionalities than those that could be executed in the Bitcoin platform (for example, automate interest rate payments, tokenize gaming assets or define voting processes). Smart contracts are open source, they can be audited and verified by users and since they are hosted on a distributed network of computers, they cannot be censored by a government authority.
New blockchain platforms such as Ethereum allowed developers wanted to use more expressive code in order to provide more elaborate services. When a user wishes to interact with a smart contract, for example, to request a decentralized loan, users can execute the code for a fee paid to the network. Thus, with smart contracts, developers can build and deploy arbitrarily complex user-facing apps and services such as: marketplaces, financial instruments, games etc.
Before we move forward, it´s important to distinguish between permissioned and permissionless blockchains:
Permissioned/Enterprise Blockchains: are distributed ledgers that are not publicly accessible. Corporations experiment with these to allow stakeholders to ensure that data hasn´t been tampered but they are subject to censorship by desidn.
Permisionless blockchains are built following the goals that had made Bitcoin successful:
- Censorship resistance: The smart contracts and ledger are copied among a network of computers.
- Open: User accounts are handed out using asymmetric cryptography.
- Execute programs with no central authority: Consensus mechanism to secure the network and incentive honest behavior.
- Money supply: Own money supply schedule.
- Governance: New governance models were put forward.
In this article, we will focus on the use of permisionless blockchains, which are the truly revolutionary idea.
Blockchain Use Cases
- Token creation: We use tickets, coupons, stock and bond certificates, vouchers, food stamps, deeds, and a variety of other bearer instruments because they entitle the holder to different things. Rather than do all that with various pieces of paper, or notations on a centralized database, why not make tokens that people can control with their smartphones and whose authenticity can be verified by on an open peer-to-peer network?
So a blockchain token can hypothetically represent anything that can be digitized. And because blockchains are censorship-resistant, any entry added to a blockchain can be thought of as an immutable record online.
- Financial system: The banking cartel often mal-invested funds leading to bank runs, suffered hacks or sold the private data of their customers.
Decentralized finance (Defi) would look to build decentralized software for the provision of financial services. The spirit of Defi is to trust smart contracts instead of private financial institutions that are subject to corruption and incompetence.
- Exchanges: Exchanges often have high barriers to entry, are nation dependent and can occasionally suffer from corruption. (e.g. the gamestop shorting ban).
Decentralized exchanges could allow open, borderless, censorship resistance trading.
- Social media corporations: Censored and deleted user accounts, advancing their own ideological interests.
A decentralized social network could enforce a set of rules that the community agrees upon.
- Gaming: Gaming companies could manipulate, add payment woes, confiscate in-game digital assets, or even shut down the game against the will of its users.
Decentralized games could enforce property rights over in-game assets and allow players to vote on the development of the game.
- Corporate governance: Governance legal contracts and enforced by a legal system which is subject to the underlying governing law of the country they reside in. If anything goes wrong, or someone does not stick to their obligations, the legal contract will define who can be sued for what in a court of law that is vulnerable to corruption.
DAOs might allow for governance principles that are self-enforcing, open-source and immutable. Blockchain can take community governance mainstream. Same believe DAOS might even replace governments in the provision of certain public goods.
Engineering Blockchain Platforms
As we saw in the previous article, the Bitcoin platform was built on a complex system of incentives that ensured the workings and security of a decentralized monetary system.
Bockchain projects are built upon Bitcoin’s design principles, however, they introduced modifications and incentive structures in an attempt to bring more elaborate smart contracts and deliver improvements in scale and throughput. In order to allow for the deployment of smart contracts and other functionalities, new block-chain systems face their own set of challenges.
In this section we will make use of the analytical framework presented in the analysis of Bitcoin to explore the design principles of blockchain technologies:
Hopefully, this framework will help us identify potential benefits, drawbacks and compromises in the design of different blockchain projects.
Traditional applications are normally built over a client-server model; where the front-end of the application runs on the clients device (for example a cellphone) and the back-end of the application (which includes the application’s logic and database) is executed on a centralized server hosted by the owner of the application.
In the present article, we will study advancements in blockchain technology that endeavor to build applications which, like bitcoin, don’t rely on a trusted third party and cannot be censored or closed down by a centralized authority. In order to avoid censorship, blockchains distribute a copy of the software through a network of computers.
Blockchain systems are compromised not just of a ledger showing the balance of each user but also smart contracts. When a smart contract is uploaded, a copy of it is uploaded to each node and whenever it is executed, the events are recorded on every computer on the network. In order to prevent bloating, smart contracts contain only the back-end or basic logic of the software, where as the user interface is executed on the client side such as a computer or a phone terminal.
Since the key components of the software — the back-end and the database — are copied in a network of computers, there is no central server that can be shut down by a government to stop the application.
Hand out accounts
Like Bitcoin, Blockchain technology uses asymmetric cryptography to grant access to the system. In this way it attempts to offer permissionless, borderless and open access to decentralized applications.
Recall that any blockchain technology does the following: it will allow connected computers to reach agreement over shared data. For Bitcoin, that shared data is a list of bitcoin transactions and Nakamoto consensus ensures that the chain with the most work is the only valid version of the ledger. Bitcoin’s consensus mechanism uses massive ammounts of energy which make it unfeasible to change the order of transactions.
Nakamoto consensus works because miners are forced to commit a scarce resource (computational power) in order to validate transactions. In this way, the censoring of transactions is disincentivized and all participants can rely on thermodynamics to determine the valid version of the ledger (instead of trusting an external source).
Nakamoto Consensus works and so far it has proven to be an effective tool for solving the Byzantine General’s Problem. However, it has some apparent drawbacks:
1-High energy intensity of the network.
2- High transaction fees
3- Low transaction throughput
Innovators in the blockchain space wanted to find ways to achieve consensus in a decentralized system without the above-mentioned drawbacks. Some of the alternative mechanisms that have been explored include:
- Proof of Stake: Validators must lock up or “stake” a certain amount of the blockchain’s native currency in order to validate transactions. Validators are rewarded in transactions and they lose their stake if they undermine the network.
- Delegated Proof of Stake: Users can lock up their coins and vote for a third party to validate transactions.
- Proof of Capacity/Space: Digital storage space is used as a requirement to validate transactions. (Chia Network)
In essence, all consensus mechanisms are compromised by a Sybill Resistance Mechanism + a consensus rule.
1- Security (Sybill resistance mechanism): If it was free for anyone to deploy any type of application on the blockchain the system would quickly become overloaded. Also, if people could freely write applications that endlessly looped, consuming more and more system resources each cycle, they’d be able to easily crash every computer connected to the network.
The crux of a Sybil resistance mechanism is that it requires each node to have some form of “𝐬𝐤𝐢𝐧-𝐢𝐧-𝐭𝐡𝐞-𝐠𝐚𝐦𝐞” in order to have a voice in the system. Security is guaranteed by requiring validators to put at risk some valuable resource that is 𝐡𝐚𝐫𝐝-𝐭𝐨-𝐟𝐨𝐫𝐠𝐞 which they will lose if they don´t act in accordance with the rules of the system.
- Proof of Work: Energy and computational hardware
- Proof of Stake: Opportunity cost of locked capital
- Proof of Capacity: Disk space (e.g. Filecoin)
- Proof of Identity. Approved identity (e.g. Binance Smart Chain)
2- Consensus Rule: Allows users to agree on the correct version of the distributed system without a trusted third party. If there is a trusted third party, it is an attack vector for somebody wishing to manipulate or censor the system.
The crux of a consensus rule is enable users to agree on the correct version of the blockchain. In the case of Nakamoto Consensus, Proof of Work is used both for sybill deterrence and as a consensus rule.
Other blockchains are experimenting with modifications to this rule that could lead to less decentralization and potential attack vectors:
- Proof of Work: Energy expenditure serves both as a deterent for dishonest updating of the ledger and to determine the valid version of the ledger.
- Proof of Stake: POS select the chain with the most stake as the valid version of the ledger. This is a problem for PoS since there’s no proof of work (or a time-intensive operation) required to rewrite a very long chain. Ethereum 2.0 introduces checkpoints by validators that have been continuously on-line to determine the valid version of the chain which could undermine the systems security and decentralization.
- Voting: Some consensus mechanism include voting mechanism, where skaters vote on the valid version of the chain.
Decentralized systems, by definition, do not have a single source of truth. Proof of work is trust-less because it doesn’t rely on external third parties to determine the order of transactions, instead, it relies on a thermodynamic proof that energy was spent. Satoshi’s breakthrough was to build a system that allows all participants to zero in on the same truth independently.
Other blockchains use internal mechanisms to prove the order of transactions which are political and could be subject to manipulation. It remains to be seen if these alternative mechanisms are effective at making it unfeasible for adversaries to manipulate blockchain ledgers to their own advantage.
By now it should become apparent how blockchains that don´t have a valuable token can´t be secure. Ensuring sybill resistance needs to be incentivized with a valuable reward. If a blockchain doesn’ have a token or it’s token is worthless, there will be no incentive for validators to secure the network and it will become very cheat to spam or even gain most of validation power and censor users or double spends.
Open Blockchains need their own valuable, native token in order to secure the network and maintain its decentralization. A blockchain without a coin is just a database that is run by those who benefit from the system, just like in any other centralized system. In other words blockchains are monetary innovations. they are not computers. they need credible monetary policies or they will collapse into operational centralization, zero value, or both.
Thus, most blockchains copy Bitcoin’s principle of issuing a token with some sort of supply cap. Satoshi created a pre-defined schedule that hasn´t been modified, other blockchains have more flexible monetary policies that are arbitrarily modified by their founders — for instance, the Ethereum foundation has altered the supply of Ethereum. Future alterations of ether’s supply schedule could further undermine the decentralization and value of its token.
Governance of Blockchain systems can be made both on-chain and off- chain.
1- Off-chain governance: Off chain governance refers is somewhat anarchic, proposed changes to the protocol require stakeholders to persuade everyone else to support their cause. There is no clear hierarchy or rule, rather a number of key stakeholders with certain power limitations:
- Developers propose changes to the protocol.
- Node operators decide which protocol upgrades they deploy.
- Exchanges decide which coins they admit to trading.
- Investors and traders give value to a certain tokens
- Validators verify or reject transaction blocks.
Networks like Bitcoin and Ethereum have off-chain governance models where there is a balance between their own set of stakeholders.
2- On-chain governance: Consists of a more structured governance mechanism in which voting power is assigned by objective parameters such as number of tokens staked, or duration of stake, limits etc.
On-chain governance gives users the ability to vote directly to change the underlying protocol in blockchain governance. The duty of controlling protocol updates, upgrades, and bug fixes is delegated to the community rather than a centralized party.
On-chain governance is more flexible but could lead to vulnerable do centralization, plutocracy or a great number of hard forks and chain splits in the cases where there is no consensus over how the system should develop.
Bitcoin was conceived with a clear goal: to separate money and state. The engineering took place over the shoulders of giants and was made possible thanks to the careful combination of existing technology giving place to incentives that ensure the systems security and decentralization.
Blockchain innovations try to break Bitcoin apart and improve and change some of its moving parts in order to deliver improvements of efficiency and more complex smart contracts.
So far, these platforms have delivered on some of their promises and we are seeing a wave of innovation in the blockchain space such as; stablecoins, tokenized assets, gamefi, DAO’s, decentralized finance etc.
It remains to be seen whether these systems can scale to the degree that they promise whilst remaining decentralized and secure.