On the Bitcoin Blockchain: Looking Under the Hood

On the Bitcoin Blockchain: Looking Under the Hood

More than a year ago, the Capco Institute Journal of Financial Transformation (Journal) ran a “critical assessment,” by Robert Sams, of bitcoin blockchains as a means of distributed clearing. With both bitcoins and blockchains newly in the news, Sams’ informed assessment is worth another look.

Two years ago, Nasdaq announced a project that was to use not just a blockchain, but the bitcoin blockchain, the grand-daddy of blockchains, with the idea as the press release put the point that this would facilitate the “issuance, transfer, and management of private company securities” on their private market platform.

Chris Skinner, founder of The Financial Services Club, and a writer with much to say both about the banking industry and blockchains, wrote soon thereafter that bankers are confused about the cryptocurrency simply because most of them “haven’t looked under the hood.”

What is Distinctive Here?

Sams proposes, then, to look under that hood. He begins with an explanation of what was distinctive about the bitcoin blockchain when Satoshi Nakamoto introduced it in 2008.  It wasn’t a new discovery that the combination of cryptographic signatures and public keys can be chain-linked in a way that makes documentation self-validating, replacing the notary. All that, says Sams, is “rather obvious.” What was new was the use of a peer-to-peer network to replace any “trusted third party” to maintain the ledger.

Nakamoto (actually Craig Stephen Wright, or perhaps a composite of Wright and the late Dave Kleiman) said that the true chain will always be the longest chain, which by its length “serves as proof of the sequence of events witnessed [and] that it came from the largest pool of CPU power.”

I send you a bitcoin because I don’t want to write you a check. I don’t want to write you a check in part because the check has to be cleared by a trusted third party, and there is no analog in the bitcoin world. Why do I not want to trust a third party?   Sams, channeling Nakamoto, says that this distrust will protect me from shenanigans by that third party, but even more cogently it will protect me from those who have power over that party, whether the government or a private hacker (or presumably hackers sponsored by a foreign government, a possibility suggested by recent headlines).

We don’t need any of that because (and now we are deeply engaged in looking under the hood) the bitcoin network “timestamps transactions by hashing them into an ongoing chain of hash-based proof-of-work….”

Cryptography

Nakamoto uses the word “hash” twice in a short compass there, once as a gerund and once as part of a compound adjective. This is a cryptographically savvy reference to “hash functions,” that is, functions that process data in such a way that whatever data goes in, a pseudo-random number of determinate length comes out.

For example, using the SHA256 hash (which the bitcoin protocol does in fact use) the phrase “Goldman Sachs” leads to this output:

b0aad912e3a3d9c1be503c154c0580531709862a

The cryptographic significance of hash is that a very small change in input can lead to a great change in output. So, again through SHA256, the input “Goldman Suchs” yields a0b9a202da83ea581e0306f28115b7c6e10c8483.

The two outputs are only similar in that they are of the same length. Otherwise, there is no pattern.

For the bitcoin blockchain, then, Nakamoto’s insight was that a hash function could accept as input the number of transactions already on the chain, and the hash of the previous block, and the arbitrary number N. The output of that function would then be self-validating proof-of-work, that is, proof that the most recent recipient of a bitcoin was in fact the most recent recipient, and so the holder of that amount of value within the private monetary system.

The Critical Assessment

Sams’ explanation of all this, his look “under the hood,” is admiring in tone. So why is the paper called a “critical assessment”? Because he wants to make the point that there is much that such a blockchain can’t do, or won’t do without inefficiencies and unnecessary complexity. Blockchains of this design aren’t good for “security interests and other property titles.” Bitcoin works on a possession-equals-ownership principle. A vendor accepting bitcoin simply adds a new link onto the chain, and need do no due diligence into whether previous links involved, say, fraud. This is (by design) akin to the situation of a vendor who accepts paper Federal Reserve Notes. He is taking physical cash and does no due diligence into its history.

Where property titles are at stake, due diligence is of the essence, and the designers of a system have to be willing to put a governance system “over the validators that is far more resistant to attackers than proof-of-work can ever be.”

 

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