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Crypto-currencies, block chain and distributed ledgers.

Nigel Morris-Cotterill

This ultra-simplified explanation clarifies the absolute basics of a subject that has become shrouded in myth and mystery.

The blockchain, crypto-currencies (or cryptocurrencies) like bitcoin, distributed ledgers and smart contracts are, actually, stuff you already know..


Leaving aside, for a moment, the way they are created, there is no magic to a crypto-currency: it simply uses all of the above to do what it does which is to sit in an account and to disappear from that account and reappear in a different, specified, account when it's told to do so. To understand that, let's look at how banks developed. To do that, we have to go back to when money was physical, before, even, notes and coins.

Banks have two primary functions: the first is to act as a warehouse, a place where people store their money and to keep records of who owns what. This means it's more than a deposit box but not much more. When people wanted to pay for things, they went to the bank, took out their asset and gave it to the other person who, then, put it into his own bank or gave it to someone else. This was messy and time consuming and people didn't want to carry valuables around all the time. So a system developed where two people could go to the bank and one would ask the bank to make an entry in the ledger that a set value should be transferred to the account of the other. Remember that: in many ways, it's what crypto-currencies have reverted to.

The next step was the creation of the cheque (it's spelled "cheque" because it's derived from the word "exchequer" and "check" isn't) The cheque is a form of I.O.U. or, to give it its proper name, a promissory note but it does something else: it's an acknowledgement of a debt and it's an instruction to the debtor's banker to pay the amount specified to the creditor. The banker then makes an entry in his books to debit the account of the debtor and to credit the account of the, er, creditor. But what if the debtor and creditor used accounts in different banks?

There were two choices: first, the creditor could go do the debtor's bank and collect the value. That, however, resulted in exactly the problem people were trying not to have i.e. carrying valuables. The second choice was that the creditor went to his own bank and handed over the cheque. What happened next is exactly the opposite of what happens in crypto-currency transactions. The creditor's banker would wait until the next morning and he would take the note to a centralised meeting point where the bankers would exchange the notes they had each received from their customers with the banker for the payers. The banker for the payer would take the note back to his office, check (haha) that the account held sufficient assets, and send, usually within a day or two, the required value to the creditor's banker. This system required the daily movement of frequently large amounts of assets, in physical form, between banks which, of course, created a large security risk. Later still, banks adopted a system where they would do an inter-bank clearing periodically and only the difference between what one bank's customers owed another bank's customers would be moved. An alternative system developed, that of the Central Bank in which all the commercial banks (that is the banks that did business with actual customers) deposited their customers' assets with a state-owned institution which became the bankers' bank and physical movement of moneys, insofar as they were necessary at all, took place within the vaults of the Central Bank. That, for those that are interested, is why the City of London is so closely clustered around the Bank of England: several commercial banks provided depository facilities for smaller, private or trade, banks and through them the money was deposited in the Bank of England's vaults. Instead of pushing carts loaded with gold around the City, tunnels were constructed from the head offices of the major banks directly into the Bank of England. The Bank had branches in other major cities and tunnels are in at least one of them, too.

There was another problem: what if the depositor had lodged with the bank a gold bar but the value to be paid was less than the value of the whole bar. In this way, we ended up with coins: originally, the coins would be, literally, worth their weight in gold but later coins would be tokens that represented their weight and later still, bank-notes for larger quantities. The ability to "split" bars into coins meant that money could become universal - even poor people might have a "farthing," which was a quarter of a penny and a penny was one-two hundred and fortieth of a pound. Why? Dunno, don't care, it just was. The history of money, as we've known it for a couple of thousand years is fascinating but we don't need more of it here. The important thing is this: anything that people believe has value can be used as money. Anything, even if it has no physical form or, as we've seen with crypto-currencies, no legal basis (which doesn't mean it's "illegal," incidentally).

The material difference with crypto-currencies is that the instruction is not like a cheque in that it does not create any admission of a debt. It is one thing only: an instruction to transfer x value. That transfer is done by truncating all of the above steps and by the making of two ledger entries with no physical movement because there is nothing physical to move. So, it's essentially a banking app for distributed ledger (albeit one that does a load of complicated stuff in the background).

So, in principle, there's nothing new. The only material complexity is now to get hold of it and how to store it and transact in it. That's what "wallets" are for and each one follows its own rules but essentially, they are your personal store of value: you keep your own value under your own control, like before the days of banks. But you still need clearing and that's what exchanges do: they accept your instruction, debit your wallet, plus charges (which can be significant) and then pass the nett amount (again, often taking charges) to the recipient's wallet. That places records on both wallets across the network (remember the delay for propagation) and so the entire blockchain knows that that transaction took place and, except in very limited circumstances, it cannot be reversed.