What is blockchain?
Blockchain is a technology/software protocol that is generally a distributed database, meaning a ledger of transactions. This database is structured differently to typical databases. Instead of tables, the information is stored in blocks. These blocks are verified by the miners, otherwise known as nodes, then cryptographically sealed rendering it permanent and unchangeable. The blocks are then distributed across a network of computers making it accessible in the network.
What is bitcoin?
The Bitcoin (BTC) protocol was released in 2009 as an open-source payment software project intended to be an electronic form of physical cash without the use of third parties. Anybody could download the software, become a ‘node’ on the network, and ’mine’ for bitcoin.
Mining is the process where the transactions are collected and validated then entered on the blockchain then sealed crypto graphically.
Bitcoin can be viewed as a cryptocurrency that is built on its own protocol, which defines how its transactions are created, validated and granted finality.
This was the first of the current batch of cryptocurrencies. Some other forms of crypto that came afterwards are mere copycats as the source-code is open and viewable to all. They have taken lessons learned and built new, exciting features.
More than 10 years have passed and many new protocols have been developed. It is clear to see that cryptocurrencies and blockchain are here to stay.
This protocol was released in 2015 and is considered the leader in programmable blockchains. The protocol allows smart contracts to be executed on the blockchain. From this ability to program, a lot of innovation has been developed using the application layer sitting on the Ethereum blockchain. Blockchain based applications that are trying to remove unnecessary third parties. I’ll talk about Decentralised Applications later in the article.
Cryptocurrency ecosystem expanded: Layer 1, 2 & 3
Like the technology used for the internet there are distinct layers for using this new technology to the fullest. Under the hood of the worldwide web, we have the internet layer, transport layer and application layer. Below I’ll run through the current landscape for blockchain.
Layer 1 Solutions:
Layer 1 is the main blockchain, which are transactions that have been confirmed or ‘signed’ and sent peer to peer, or address to address, and confirmed in a block, which is the list of records of transactions.
Ordinary Bitcoin transactions are utilised with layer 1, this is the underlying BTC blockchain with its properties of the protocol. In other words Layer 1 on Bitcoin includes the actual ledger of BTC transactions, the network nodes (miners), and the block verification mechanism known as Proof of Work (PoW).
Layer 2 Solutions:
What’s Layer 2 trying to solve?
Transaction speed and transaction cost
Layer 2 is a higher network that sits on the first layer, for example Lighting, which is a state channel, and is the 2nd layer solution for Bitcoin. This has been publicly used by Twitter and the US company Strike.
State channels explained – layer 2
A state channel is a two-way communication channel of transactions between participants (of cryptocurrency), which enables them to conduct interactions, which would typically occur on the blockchain, now away from the blockchain.
Taking this away from the blockchain speeds up the transactions as you are no longer dependent on the blockchain confirmation.
This is how a state channel works:
A portion of the blockchain is sealed off via multi-signature or some sort of smart contract (agreed mechanism for the process), which is pre-agreed by the participants. Then the participants can directly interact with each other without submitting anything to the blockchain for validation.
When the entire transaction set is over, all the balances are settled to the accounts/addresses then these values are added to the blockchain and mined/confirmed. This allows cheaper, faster transactions within a smaller network but with the same assets.
Nested blockchains (side chains) – layer 2
A nested blockchain is a child blockchain connected to the parent blockchain. The parent blockchain sets parameters for a broader network, while executions are undertaken on an interconnected web of secondary chains. The parent blockchain delegates work to child blockchains that process and return it to the parent after completion. The parent blockchain does not take part in the network functions of children blockchains unless dispute resolution is necessary.
The design principle of plasma (this is the Ethereum solution) is pretty straightforward:
The main, parent blockchain lays down the ground rules of this entire system. It will not directly take part in any operations unless it needs to resolve some disputes.
There will be multiple levels of blockchains sitting on top of the main chain. These levels will be connected to each other to form a parent-child chain connection. The parent chain delegates work amongst its child chains. The child chains then execute these actions and send the result back to the parent chain.
Not only does this solution significantly reduce the load in the root chain, but, if executed properly, it will increase scalability exponentially.
Layer 3 is represented by blockchain-based applications as it is used in hosting Decentralised Applications (DApps) and the protocol that enables the apps, such as decentralized finance (DeFi) apps, games, or distributed storage apps. Many of these applications also have cross-chain functionality, helping users access various blockchain platforms via a single app. This adds to the usability of the application as it’s not bound to one protocol.
What lies ahead?
The cryptocurrency market has grown from nothing to a high of 3 trillion USD. There has been a large correction so far in 2022, but there is no doubt continued institutional interest will continue to change the market landscape. The large hedge funds have all dipped their toes in, with Brevan Howard recently announcing their crypto division BH Digital. Fidelity have been offering institutional BTC custody and publishing educational pieces since 2014. Similarly State Street and Citibank are now publicly discussing this new asset class with their clients. Companies like Jump Trading, DRW and Virtu are actively trading and building in the decentralized finance (DeFi) ecosystems. KPMG Canada has also added Bitcoin and Ethereum to its corporate treasury.
Decentralized finance is a little bit of a misnomer, but it’s stuck and it claims to be saving us from Traditional Finance (Trad-Fi). Whereas Trad-Fi is built on a system controlled by trusted parties, De-Fi allows peer to peer interactions which are governed by the protocol eliminating the intermediary.
With centralized intermediaries there’s a consolidation of the risk and control at the centre of these systems, which have proven on occasion to be unfit for such responsibility. Providing an automated system that relies just on code and logic is a refreshing change.
Some well-known projects that I suggest readers to review for their understanding of this new thriving space:
- Decentralized Exchanges (DEX) such as UNI,
- Decentralized lending and borrowing, COMP
- Stable tokens, MKR and DAI
- Asset management, AMPL
This new industry has a long way to go but I believe it’s on the right path to achieving a revolution in financial services. Is this the end of third-party systems and brokers? I don’t think so but there’s now a solution to a lot of the legacy systems that have reduced economic efficiency despite the fact we’re in the electronic age.