We’ve all been there. At some point in the Christmas supper, maybe between the roast turkey and the mince pies, Aunty Hilda or Granda Joe inadvertently starts a heated debate around this “bitcoin thing.” There may be a tech-savvy cousin who tries to come to the rescue and explain how blockchain works or why people value jpegs on the internet, to no avail.
This year the Etherbridge team thought we would do a holiday special titled “Crypto At The Christmas Table” so you are fully prepared to handle any blockchain conversation that may arise. So let’s dive in.
So what is this blockchain thing anyway? – Uncle Jack
A blockchain is a ledger; a ledger is simply a tool people use to understand who owns what and how much of it they own. Ledgers also exist to record other things like events; examples include when you purchase a sweet at a store or when you buy a home. People rely on ledgers to tell them whether something is true or not.
The “blocks” of a blockchain are like pages of a book that contain a record of transactions. Each page only has a certain number of lines and, therefore, a limit to how much can be written. Every time a page fills with writing or information, we need to start a new page.
The “chain” of a blockchain is like a reminder of what was written on the previous pages; this reminder is always written in the first line of the new page. This reminder links the current page to all the pages that came before it.
Okay, cool cool cool. So why do we need a blockchain if I’ve already got my own ledger? – Uncle Jake
Our current ledgers are controlled by centralised parties. This means you have to place enormous trust in the fact that these parties will keep the ledger honest and accurate. We have a few ways of trying to ensure this, such as audits; nevertheless, we have seen how these control measures often come short, think Enron, WorldCom or Lehman Brothers.
Blockchain proposes an alternative. Instead of using closed, centrally controlled ledgers, what happens if we used ledgers where anyone could validate for themselves if the information is true and accurate, all in near real-time?
This sounds great, but when an open ledger is distributed across the globe, and anyone can contribute to it, how does one determine what is true and false? This is achievable through something called a consensus mechanism.
A consensus mechanism? Sounds like something from Star Wars. – Great Aunt Cathy (after the third glass of wine)
Consensus mechanisms are like rules to a game. You can play the game as long as you are willing to follow the rules. In this game, the points that you score only count if you follow the game’s rules which are “reffed” by nodes. If you decide not to follow the rules, the other players wouldn’t want to play with you anymore, and you will need to find new players willing to play by your new rules.
There are a variety of rules or consensus mechanisms that exist, and that is what we are talking about when we mention Proof of Work or Proof of Stake.
Proof of Work?? I’ve proved I’ve worked my whole life. You don’t see me bragging about it – Uncle Harry
Proof of Work was initially created to help reduce spam emails. The idea behind it was that computers were required to perform a small amount of computational work before sending an email. This would be trivial for any computer sending a few emails at a time, but it would be impractical for those sending a large number. However, Satoshi Nakamoto first applied it in a large-scale commercial sense to digital money.
In Satoshi’s system, individuals could buy expensive computational hardware and direct it towards mining. At its most basic, mining is expending computational power to propose valid blocks (or pages of the book) that meet the rules of the network. This is proof of the “work” you are doing in the system. If the nodes of the network agree that it is, in fact, a valid block and it meets the rules of the network, they will accept it and add it to the chain and blocks that have come before. If the new block doesn’t agree with the consensus rules (which is easy to prove), you forfeit your chance to receive the block reward.
As you can probably guess by now, Proof of Stake differs in the “proof” you have to provide to the network. Proof of Stake was created to address some of the perceived shortcomings within a Proof of Work system.
As described above, miners in a Proof of Work system have to purchase expensive computational hardware and expend electricity to secure the network. In a Proof of Stake system, miners or “validators”, as they are known, use their crypto holdings as collateral and must put it up as a “stake” to earn the chance to validate blocks according to the network’s rules. Just as miners in Proof of Work broadcast the new blocks to the network, and they are checked against their consensus rules by the nodes, so too are the blocks in Proof of Stake. However, in this system, if you are found to be “lying” about the transactions within the block by the network’s nodes, you get your stake or collateral “slashed” or taken away.
These financial incentives inspire people to act honestly in the system; they have rules enforced by code that means at any point in time, it is in your best interest to contribute positively to the system as a whole. This is what makes it possible to keep an open ledger true and accurate without any centralised coordinating entity, something not possible before Satoshi’s creation.
These all sound like gimmicks and fancy words. Crypto is just used by criminals – Grandpa Joe
All money is used in some way, shape or form to finance illicit activities, yet it doesn’t make money inherently bad. It is estimated that 90% of all dollar bills in circulation have trace amounts of cocaine on them.
Does that mean the dollar is bad? Not necessarily.
Bitcoin and other crypto are no exception, and for a long time, it was a convenient form of internet money that criminals could use to fund operations across the globe. However, they have since realised it’s actually highly problematic, and this is due to the nature of their open ledgers. Many criminal rings were brought down due to the fact authorities could very easily trace them.
Chainalysis is the leading blockchain analytics company in the world when it comes to risk and compliance, working with governments, banks and businesses across the globe. Every year they publish an annual crypto crime report that gives an overview of the criminal activity in the blockchain industry. They started tracking the illicit share of all onchain crypto transactions in 2017, when it sat at 1.42%; as of 2021, it sits at 0.15%, which equates to a total of $14 billion a year.
Okay, so an open ledger is incredible, but what can we do with it? – Cousin Blake
Well, that really is up to the imagination. Like our current ledgers, these open ledgers can record anything we want. However, because they are codified, they can not only record information but also automatically run any business logic.
Projects such as Ethereum are what we call Turing Complete. If a computer is Turing Complete, it means that given enough time and processing power, it can solve any computational problem, no matter how complex it is. This means that Ethereum is a general-purpose platform that has the capability to understand and implement any agreement you may think of; the only limiting factors are your imagination and the cost associated with it (the more complex, the more expensive the agreement will be).
It’s important to remember that there are also Turing Incomplete blockchains such as Bitcoin. This limits what Bitcoin can do; however, this is because Bitcoin serves a very specific purpose and reduces the number of problems that may be encountered. Keeping it simple allows developers to accurately predict how it will operate in a finite number of situations.
Okay, okay, okay, enough about how it works. Why did everyone lose so much money this year? – Uncle Jake
This year was a challenging time for markets in general. In fact, it has been the worst in over 50 years. There was nowhere to hide, and both stocks and bonds fell together, breaking the usual diversification benefits one gets from investing in both. Crypto has been no exception to this. But why has this been the case?
Well, a few factors have contributed to it, but it began with inflation. Inflation emerged as a result of central bank policy decisions, supply chain constraints and a Europen energy crisis.
When Covid-19 hit, central banks worldwide started using the two tools at their disposal to prop up the economy: lowering interest rates and increasing the money supply. As a result, the stock market recovered quickly, taking around 140 days for the S&P 500 to return to previous highs; nonetheless, they maintained these low-interest rates until early 2022.
Due to global lockdowns, supply chains were put under extreme pressure, and when combined with China’s zero Covid policy, they were stretched even further, making it hard to produce and distribute goods globally.
The final factor was the beginning of the war in Ukraine that kicked off a European energy crisis, making living and manufacturing more expensive. While there are definitely more factors to consider, these were the main three that resulted in an aggressive rise in inflation, which had repercussions across the globe.
As inflation started rising and central banks began to realise that it was not “transitory”, they needed to use the same two tools that they used to prop up the economy during Covid again; however, it was now the opposite way around: increasing interest rates and lowering the money supply. This combination is not good for stock or bond markets, and people started to get scared, often choosing to hold cash or other assets instead. Assets perceived as risker also often get sold off first, and crypto was part of this bucket, unfortunately.
Well, I heard that Jane’s son Roy lost all his money on FTX. Was that the same? – Aunt Hilda
The story of FTX was very different to the general market conditions. FTX went bankrupt because they were committing fraud, they didn’t run on a blockchain, and the clients had to trust the people at FTX to accurately record and maintain a record of who owned what. They are an excellent example of why using codified, open ledgers is a better alternative to placing trust in centralised parties.
FTX formed part of a greater debt crisis that the industry experienced in 2022, which also put further pressure on the industry in general. However, it definitely could be viewed as a positive longer-term theme for the industry as we learn from our mistakes. These include designing better blockchains that aren’t as susceptible to debt spirals and realising that if people had used DeFi, many of the credit issues that arose could have been avoided.
If I don’t want to end up like Roy, how can I protect my crypto? – Great Aunt Alison
Well, that comes with a bit of responsibility. If you don’t want to trust a centralised institution to look after your crypto, it now comes down to you to protect your wallet’s private keys.
Crypto wallets store your private keys and are how you interact in the blockchain world. A wallet allows you to have a unique identity, use different blockchain networks, and they are where you ‘store’ your assets.
What is important to remember is that, unlike a regular wallet where you can hold cash, a crypto wallet doesn’t technically store your crypto. Your crypto stays on the blockchain; instead, your wallet contains the private keys that allow you to prove ownership or ‘unlock’ those assets and make transactions.
Many different types of wallets exist, and choosing a wallet will depend on your specific needs and the level of security you want. Etherbridge wrote a piece explaining how to protect your private keys, which is a good place to get started.
Okay, what about those NFT things? The next-door neighbour’s daughter, who had so many, had to move back in with them. – Uncle Al
NFTs, at least the ones that are spoken about most often, were highly speculative in nature. And yes, they were just jpegs on the internet. People made and lost hundreds of millions of dollars, with most holding no value in the end. While some will always have some form of residual value because of what they signify, most don’t. The NFT craze has now come and gone, but it has managed to leave behind some very useful tools.
NFTs can be used to represent more than just ownership of an image on the internet. They can be used to represent anything unique, from title deeds to your social media persona.
Over 2021 and 2022, critical infrastructure was built to support the further development and use of these types of tokens, including exchanges, wallets, development tools and new token standards. This will pave the way for other NFT use cases to be adopted and used, which is really exciting.
Crypto at the Christmas Table
Crypto offers the opportunity to create a new, better version of the internet where value can be created and transferred. Nevertheless, crypto and blockchain aren’t for everyone, which is okay. Everyone is entitled to their own opinions and thoughts.
What crypto does provide is the opportunity to engage in thoughtful debate and potentially challenge one’s world views. It also offers an alternative way to think about the systems we use today and challenges some of the assumptions we hold regarding them.
Crypto’s journey has just begun, and we are in a multidecade trend that still has to play out. As it finds a fit in the world and adoption continues to increase, these conversations may change to focus more on the positive than the negative.
Being an early adopter of new technology can often be a difficult road to walk, yet at the end of the day, the rewards are greatest for those who take risks and challenge the norm. Blockchain can change the world for the better, and we need people to continue flying the flag, even if it means explaining cryptographic hash functions to Aunt Hilda for six hours on Christmas.
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This is not financial advice. All opinions expressed here are our own. We encourage investors to do their own research before making any investments.