Asking for a Friend: What’s a Blockchain?

And should I buy Bitcoin? What’s NFT?

A primer in case you have seen these terms for a long time and by now are too embarrassed to ask.

Here’s the core fact to know: Blockchain enables digital scarcity.

The fundamental difference between the pen lying in front of me on my desk and a digital rendering of that pen is that my pen is provably, ineluctably on my desk. I am 100% sure that this pen is not somewhere else right now. And if I give it to someone, there is a 0% chance that I can give that same pen later to someone else. None of this is true of my pen’s digital cousin.

That fundamental thing-ness inherent to physical objects was impossible to recreate online. Until blockchain.

We perhaps didn’t notice that this thing-ness was missing from our digital lives because we spent most of our time dazzled by the opportunities enabled by the elimination of scarcity. A billion people can watch the exact same Billie Eilish video, unbounded by geography, for what feels like free, and without any degradation of quality. We can share, distribute, and duplicate almost anything.

Even before blockchain, there were some digital representations of physical items with enforced scarcity, most notably money. If I send $10 to someone else on Venmo, that money is gone from my account and in the recipient’s account. But the success of that non-duplication of that $10 is really only based on the ability of Venmo’s engineers to enforce it. I, and we, have to trust that Venmo isn’t going to screw up and somehow accidentally zero out our account (or maybe hope that somehow a few extra zeroes get added to our balance.)

So this brings us to what blockchain is. It’s nothing more, or less, than a secure database. Depending on the configuration, it’s between mildly and extremely inefficient, but the design brings an extraordinary benefit: Once a blockchain has been set up, it is essentially impossible for an outside party to change any of the records in that database. And the crucial fact is that, in a blockchain, everyone is an outside party. There is no Venmo engineer who has God-view access to the system and might one day mess with the system. You can participate in building a blockchain, but any attempt to tamper with the data is immediately obvious to the algorithms running the blockchain, and will be rejected by the system.

So, to elaborate on the opening statement of this article: Blockchain enables secure, publicly-verifiable digital scarcity.

How does it do that? I won’t get deep into the mechanics, but a blockchain is a database that stores information as, surprise, a chain of blocks. Each block is made up of a number of data entries that are interlinked with complex math so that information stored with each item before it and each item after it is calculated based on the information of the item itself. Therefore, any change to any of the items would immediately cause a cascade of changes to all the items around it, and become glaringly visible. Each block is connected to the previous and subsequent blocks in an analogous way.

So that’s the structure of the database. The next piece of magic comes from the number of copies the system makes. Anyone can make and maintain a copy of a blockchain like the one that tracks Bitcoin. It is estimated that there are currently about 80,000 active copies of the Bitcoin blockchain around the world. Each one is 330GB of data. Permission to add a new block to the Bitcoin database, which currently happens about every 10 minutes and contains about 500 transactions, is granted to the winner of a global competition to solve a series of mathematical challenges. This is called “mining” and is rewarded with some Bitcoin. Then there is an automated, democratic vote among all copies of the blockchain whether to accept the new block. This competition and democratic voting forces fair play.

A few things stand out from this structure:

• Since there are so many copies, mathematical safeguards, and incentivized competition, the blockchain is extraordinarily secure. All the Bitcoin out there are worth over $1T, and although there is no traditional security or secrecy around the database, the chain has never been hacked. (This isn’t true of some of the exchanges, where Bitcoin are stored and exchanged, but I’ll leave that aside for now.)
• There actually is one very public way to “hack” the Bitcoin blockchain. If you controlled 51% of all the copies of the blockchain, you could vote in any number of fraudulent transactions onto the chain. However, the system design has made it so practically and computationally expensive to control that many copies that no one has ever succeeded.
• No one controls the blockchain. You can’t appeal to some board of directors to propose an improvement (which is both a strength and, as we’ll see, a big disadvantage), and there is no customer service number to call if you forget your password (it’s estimated that ~20% of all Bitcoin are inaccessible because the owner lost the password keys; that’s over $200B).
• The system is incredibly—incredibly!—inefficient. The Bitcoin blockchain consumes more energy than a midsize country.
• This system is SLOW. If a new block with 500 transactions is added every 10 minutes, that means that Bitcoin processes less than one transaction per second, which is about 72,000 in a 24-hr period. To put that in perspective, well over 4 billion shares trade hands on the NASDAQ each day. There are over a billion credit card transactions per day. The Visa network alone processes 1,700 transactions per second.

Let me dwell on that last point for a bit.

Currently, markets have decided that Bitcoin is very valuable. But it is staggeringly inefficient, which renders it essentially unusable for transactions of any volume. Imagine every US Dollar was a 50lb boulder. We might all still agree that dollars are still valuable, but they would be decidedly awkward to use to buy your morning coffee. Instead, we might just sit at home with a pile of boulders and count ourselves wealthy. A Bitcoin is the digital equivalent of a 50lb boulder. The Bitcoin blockchain would struggle to handle the volume of the Mongolian stock exchange, not to mention pretty much any financial market in the developed world. And, by design, the Bitcoin blockchain is effectively impossible to upgrade.

There have been extraordinary improvements in blockchain design and functionality since the Bitcoin blockchain was launched. Modern blockchains use them. But because there’s no one in charge over at Bitcoin, you can’t improve on that particular blockchain. That ship has sailed, and there’s no captain.

So the only thing Bitcoin has going for it is first-mover advantage. It is worth a trillion dollars solely because it got there first.

The Money Myth

Lots of people still think that Bitcoin, blockchain, and cryptocurrencies in general are all kind of the same thing. This conflation has proven extraordinarily valuable (so far).

Money is perhaps mankind’s grandest mass delusion. We simply agree to agree that certain pieces of paper that say 20 on them are twice as valuable as others that say 10, and that any of them are worth anything.

Fiat currencies are called into existence by countries, which transfer their reputation and strength into their money. That endorsement sells the myth of the money. Then step 2 happens: we all start to use the money, and it begins to become closely associated with intrinsic value. Things of value are bought and sold with that money. The money develops utility—value—from being used.

Because of its inflexible 50-lb-boulder design, Bitcoin can never achieve that. It also has no government or military endorsing it. The only thing it has is that it got there first.

It’s hard to imagine that the first-mover advantage of Bitcoin won’t fade as other blockchains—ones that power actually useful cryptocurrencies—build their own track record. As those currencies become used to exchange things that have value outside of the blockchain, that currency represents real value. This concept is embodied in what’s known as “gas fees.” If you want to use the Ethereum blockchain to complete an extrinsically valuable transaction, you have to transfer some of that value to the owners and operators—in other words, the currency holders—of that blockchain. Extrinsic value creates intrinsic value.

One of the most promising blockchains is called Provenance, built (but no longer now controlled) by a fintech named Figure. The idea is that a cryptocurrency gains real value by adding value to already valuable transactions. There are a fixed number of Hash tokens in the Provenance blockchain. (Whether you should think of these “tokens” as a currency, like Bitcoin, shares of a company, or something else, is an expensive and complicated legal question, but for our purposes here it’s irrelevant.) The important thing to understand is that every time users of the Provenance blockchain pay a dollar in fees to use the blockchain (for example to transfer a share of stock from one person to another), then a portion of that dollar is paid out pro rata to every Hash holder. Suddenly owning Hash is like owning a bond. The more money each Hash holder gets each year in payouts, the more owning that Hash is worth. That’s provable value. And Figure is on its way to providing services to substantial portions of the financial industry.

Will Bitcoin retain value? It might, driven by the same nostalgia that stamps and baseball cards rely on. But it will be dwarfed by the real, usable value created by other blockchains. And while a Mickey Mantle card evokes a certain myth and history that will resonate for a long time, I predict that Bitcoin nostalgia will be a tough sell if you start thinking 10, 20, or even 50 years out.

The Bigger Picture

Cryptocurrency is an obvious application of digital scarcity, but far from the only one.

Let’s talk about what kind of items a blockchain can track. They fall into 3 concentric circles:

• Blockchain-native items. Cryptocurrency is the simplest example. A token like Bitcoin is an inextricable part of the design of the blockchain—there’s no way to separate the two. Digitally-issued items like shares in a company, or pretty much any financial product, can be resident inside the blockchain. That’s what Provenance is doing. The data inside the blockchain IS the item.
• Digitally native items. This is where all this NFT (non-fungible token) art comes in. An NFT is an ownership registry of a digital item which is elsewhere on the internet. We’ll get to that in a second. But the thing to keep in mind is that there already is a link outside the blockchain itself—the name of the owner of that digital owner is on the blockchain, but the item itself resides elsewhere. Often, unlimited copies of that item exist across the internet.
• Real world items. You may have read about people selling fractional ownership in a Lamborghini via blockchain. There’s nothing wrong with that in theory, but keep in mind that it’s essentially a matter of trust that the actual, physical Lamborghini truly exists (and is still in good shape, hasn’t been sold elsewhere, etc). There has to be some person or company that has the car on its lot and issues a guarantee, backed perhaps by insurance, that the car is there and is fully pledged to the owners listed on the blockchain. Nothing inherently wrong with that. But since we’re back to trust, you could also argue why use the inefficient blockchain structure for tracking the ownership stakes? You can use any database to do that, cheaper and faster.

Let’s talk about NFTs

You may have read the news that somebody bought a piece of art by Beeple for $69m. All that meant is that the buyer’s name is now registered on a blockchain along with a link to the file stored elsewhere. That same file is accessible to others as well (you see a copy with every article describing the sale). The digital art has no thing-ness to it, and can be freely copied. What has achieved thing-ness is the record of the buyer’s name on the blockchain attesting that this person has ownership rights to that digital file. That’s it. Perhaps it will bring some bragging rights, a few legal rights, maybe some as-yet-undefined royalty revenue. Maybe a greater fool will pay $100m to change the name on the blockchain.

Before you laugh off this development as absurd, let me make 3 points:

1.    Someone paid $450m for Leonardo da Vinci’s Salvator Mundi a few years ago. You can find an infinite number of high-resolution digital copies of this painting online. In fact, I’ll include one here with this article, just because I can, for free. While I’ll grant you that it would be kind of cool to hold the actual canvas that the actual painter used to make the actual painting, is it a half-billion-dollars better than commissioning a ridiculously good copy and putting it in a frame? Most of the difference between those two options is conceptual, including the rarity factor of the “real” painting. In other words, we made the leap long ago of valuing non-tangible aspects of tangible items, so why wouldn’t we value non-tangible aspects of non-tangible items?

2.    It is not hard to imagine that extracting ongoing revenue streams from digital assets will become easier and more standard. When Bob Dylan sold his music catalog for $300m (or more) recently, it emphasized the growing ability of online systems like streaming services to measure and extract royalties every time we listen to a song. Song catalogs typically sell for 10-20x annual royalty revenue. It’s not hard to imagine a future where a band puts ownership of their song catalog on a blockchain and allows fans to buy in. Soon, maybe that friend of yours who always reminds you of when he saw some national act when they were just playing fraternity parties will instead tell you about the incredible return he got from buying a piece of their catalog after seeing them play Lambda Lamda Lamda. So while I have no idea how the buyer of a $69m Beeple digital file will make money, unless some richer person takes it off his hands, the concept of monetizable NFT investments is very realistic.

3.    Never forget: humans are collectors. We collect the most ridiculous stuff. Just because the world is going virtual doesn’t change that fundamental desire. My son plays Fortnite and has a huge collection of virtual outfits for his avatar. He keeps buying more. There is absolutely no rational reason. It provides zero utility. I would shake my head and blame it on “the youth of today,” but then again, look inside your closet, or almost anyone’s—there is way more stuff than we need, much of it just because we imagine other people will think you look good in it. So why not the same with digital goods? Add scarcity and you have a digital version of the multi-billion dollar sneaker collector’s market, which is as ridiculous as it is real.

The key fact is that blockchain brings the concept of digital scarcity, of thing-ness, to digital stuff that humans want to collect. That begets value.

So Where Does This Leave Us?

Blockchain is an extraordinarily valuable invention because it finally introduced scarcity to digital goods. In fact, it’s arguably even better than physical scarcity. About this pen on my desk, which I said I couldn’t give away twice—well, if it was actually worth money, I might buy a box of them and pretend to sell the same one 10 times. This counterfeiting and general subterfuge is as old as commerce and money, and all of the courthouse records and holograms and watermarks haven’t eliminated it. The Bitcoin blockchain proved that this fundamental characteristic can be reproduced, and perhaps even improved upon, in the digital world.

I remember in the early 2000s, shortly after the dot com crash, when my mom asked me what the internet was so great for, really, other than perhaps selling used stuff on eBay? I can forgive her for thinking that the internet at that point was pretty much just about sock puppets selling pet food and overhyped stocks. But then in the lull of the 2000s the hard work got done. Now we can’t imagine the world without the internet. The Bitcoin blockchain might be the sock puppet of blockchain, but it also blew the starting whistle to a remarkable phase of development of the digital world.

About the Author: Otto helps startups with their communications and messaging. He has worked with enough blockchain and fintech startups to get questions about blockchain one too many times, and hopes this article will help.