You've no doubt heard of blockchain, but you probably haven't heard a good answer to the question, "What is it?" or for that matter, "What is it good for?" In this two-part series of articles, I'd like to provide my answer to both questions:
- Why do we need blockchain?
- What is a blockchain?
Another way of framing these questions might be, "What problem does it solve?" and "How does it solve that problem?" Because in the media frenzy around the price of Bitcoin, hackers, money-launderers, and NFTs it can be lost that this new technology does in fact solve a real problem.
While I hope you come to understand what a blockchain is and how it works, my ultimate goal is for you to see blockchain as the logical next step in the exchange of value in the global economy.
That's a big goal, so let's get started.
The History of Accounting
The history of accounting is really the history of the placement of trust. When economic activity expands, new mechanisms are created that shift how and where people place their trust.
Early trade was relatively easy because economies were small. Think of your friends and family: you keep track of who owes what to who, whether that's a drink at happy hour or help the next time someone moves, without an advanced system of record. The same was true for early trade. You can easily keep track of who lent who what in a small tribe and you can do it all without the need for record keeping or strict enforcement. You exchange with someone because you can place your trust in them directly. If that fails, you trust the rest of your community to step in and apply pressure in case of a default.
At some point though, the size of the group hits an inflection point and you can't intimately know all of your trading partners. When this happens, your community needs a way for everyone to keep track of who traded with who. This is why early record keeping systems developed and what lead to the birth of both writing and arithmetic. In early bookkeeping systems, someone recorded transactions on tablets or papyrus. We placed our trust in the record keeper and their records to honestly track what was bought and sold.
A single record-keeper works when that record-keeper is trustworthy and manipulating the records is difficult. It's hard to go back and edit a stone tablet and, for a while, the amount of exchange was small enough that someone would likely have been caught anyway. But as trade between parties continued to increase in volume and distance it grew beyond the capabilities of such simple record keeping.
If a record of what is sold is kept in Venice, it's really down to the Merchant's trustworthiness when they bring the goods to Rome. This makes it hard for people to trust the merchant, so something new is necessary once again. Enter double-entry bookkeeping. Two identical records are kept up to date. If they're ever out of sync, you know someone is lying. Our trust shifted from the bookkeeper to the system of bookkeeping.
There have been many growth spurts of trade followed by shifts in where we place our trust. Most recently, bookkeeping became digital in the form of a database. And the internet introduced new ways to exchange goods, new types of goods to exchange, all while greatly increasing the amount of exchange. Once again, we're at an inflection point where the old system doesn't work and a new one is necessary.
Why Do We Need Blockchain?
The internet has sped up the pace of trade while also significantly increasing the volume. We’ve established that when this happens, the old system breaks down and is replaced by a new one. So, how is the old system breaking down?
First, current standards of bookkeeping aren’t enough to police the bookkeeper. In 2007, Lehman Brothers reported $4.2 billion in profit and then declared bankruptcy less than 12 months later. How is that possible? They lied about their books. They moved debt and losses around to paint a rosy picture of their business. It worked for years, before the piper called for payment.
Second, centralized systems are too easily compromised. Major centralized institutions get hacked so frequently that I can say with absolute certainty that your personal, private information is public on the internet. Don't believe me? Check for yourself.
All that is to say, we're at yet another inflection point in the history of exchange where the old system doesn't work anymore. The volume of exchange is too high while the pace of exchange is too fast and where you place your trust is in question.
Can you trust that your bank is doing everything possible to prevent your account getting hacked?
In short, no.
Because your bank is holding every account's records in a centralized system, they'll always be at risk no matter what measures they take. By having everyone’s information stored in a centralized system, the incentive will always be too high for hackers to be one step ahead of institutions.
Additionally, the stakes are so high and the amount of information so large that the incentive for shady behavior becomes high while the odds of getting caught are relatively low.
What's the solution?
In the early days of the internet, there were attempts to develop a triple-entry bookkeeping system. The third bookkeeper didn't record transactions like the first two, it recorded every action of the other two bookkeepers. But there's a fundamental law of the internet which is that things don't grow linearly, they grow exponentially because the internet has network effects.
When someone shares a post on Twitter, TikTok, Facebook, or any other platform, they share it to all their friends or followers, some of whom share it with all of their friends or followers, and so on. Something going viral online is a factor of it spreading throughout a network and growing exponentially along the way.
Given that things grow exponentially on the internet, why incrementally increase the number of bookkeepers? Why not go straight to n-entry bookkeeping where n is some exponentially large number of bookkeepers?
In its simplest form, that is what a blockchain does: n-entry bookkeeping where n is the number of participants in the system, also known as nodes in the network.
So how do we exchange goods and services online in this new era? For most things, the answer is blockchain.
A distributed ledger (i.e. n-entry bookkeeping) that uses some relatively simple cryptography to effectively make it unchangeable and unhackable. And, it's an internet-native solution to the placement of trust problem.
The next article in this 2-part series will breakdown how blockchains work and how, specifically, they solve this problem of trust. I've established that the existing system will be replaced by blockchain-based systems. But the next logical question is, why blockchain? What is it about blockchains that solve this trust problem?
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