If you are a beginner on Blockchain and curious to know where to start and what are the key concepts of blockchain then you are at the right place. Don’t worry I was also perplexed about key terminologies like Bitcoin, Blockchain, Ethereum, Miner, Wallet, Consensus, Hyperledger, etc.
There are tons of articles on each individual but as a beginner, I think it is always good to start the discussion with storytelling, real-world examples, and easy to understand case studies.
In this part, I will discuss the invention of the bitcoin protocol, why bitcoin was introduced as a digital currency, and why blockchain was so important in bitcoin transactions.
The financial crisis of 2007–2008
The financial crisis was the worst economic disaster since the Stock Market Crash of 1929. It started with a subprime (high risk) mortgage lending crisis in 2007 and expanded into a global banking crisis with the failure of investment banks of the USA in September 2008. Huge bailouts and other measures meant to limit the spread of the damage failed and the global economy fell into recession.
Cause of financial crisis
Double Spending: Loans (in the form of mortgages) were given to borrowers with poor credit histories who struggled to repay them. These high-risk mortgages were sold to financial experts at the big banks, who packaged them into low-risk public stocks by putting large numbers of them together in pools.
Effects of financial crisis
Trust, the ultimate adhesive of all financial systems, began to disappear in 2008. The regulations have since changed to prevent similar circumstances from arising, but it was clear that there was a need for autoregulation of trust between counterparties and transparency into their ability to enter any type of sales contract.
Centralized authority, who had failed to monitor the ecosystem. This type of pooling would work when the risks associated with each loan (mortgage) are not correlated. The experts at big banks hypothesized that property values in different cities across the country would change independently and therefore pooling would not be risky. This proved to be a massive mistake.
Bitcoin is a peer-to-peer electronic cash system, with no trusted third party. At the early stage, it was a protocol named Bitcoin protocol. This protocol was introduced to overcome the economic crash in 2008.
Three of those ideas and the components have been introduced for the complete Bitcoin protocol:
1. Hashcash for proof of work
2. Byzantine fault tolerance for the decentralized network
3. Blockchain to remove the need for centralized trust or central authority
Hashcash for proof of work
The rationale behind Hashcash was to attach some computational cost to sending e-mails to limit e-mail spam with the first-of-its-kind Proof-of-Work (PoW) algorithm.
Byzantine General’s problem
The key is that every general agrees on a common decision because a tepid attack by a few generals would be worse than a coordinated attack or a coordinated retreat. The crux of the problem is that some of the generals are traitorous. They might cast a vote to deceive the other generals and ultimately lead to a suboptimal strategy. Let’s take a look at an example: In a case of odd-numbered generals, say seven, three support attacking and three support retreat. The seventh general might communicate an agreement to the generals in favor of retreat, and an agreement to attack the other generals, causing the whole arrangement to fall apart.
The attacking forces fail to capture the city because no intrinsic central authority could verify the presence of trust among all seven generals.
Byzantine fault tolerance for the decentralized network
Byzantine fault tolerance can be achieved if all the loyal generals can communicate effectively to reach an undisputed agreement on their strategy. If so, the misleading (faulty) vote by the traitorous general would be revealed and fail to perturb the system as a whole.
For the Bitcoin protocol, to enable Byzantine fault tolerance was to create a peer-to-peer network with a ledger that could record and verify a majority approval, thereby revealing any false (traitorous) transactions.
This ledger provided a consistent means of communication and further allowed for the removal of trust from the whole system.
The blockchain is primarily a recording ledger that provides all involved parties with a secure and synchronized record of transactions from start to finish. A blockchain can record hundreds of transactions very rapidly and has several cryptographic measures intrinsic to its design for data security, consistency, and validation.
The central purpose of the Bitcoin protocol is to allow transactions to occur over the network between users in a decentralized manner.
Blockchain was introduced to make bitcoin transactions in a secured and trusted way to eliminate the risk of double spending.
That’s all for part 1. In the next part, I will discuss the foundations of blockchain.