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What is a blockchain? What is the blockchain?

What is a blockchain?

Many people have heard the word “blockchain” – it seems to be the financial buzzword of the year.

But, when you ask people “What is a blockchain?” then other than knowing it is the underlying technology behind cryptocurrencies, most people have no idea what a blockchain is or why its important.

The simplest way to describe what a blockchain truly is, is to call it a “decentralized public ledger.”

Before we can get into the nuance of how a blockchain applies this in a technical sense and what the advantages are, let’s get on the same page about what these terms mean.

Let’s start off by stripping away the “decentralized” part, and focusing on what a “public ledger” is.

If English is your first language, you probably feel you have a decent grasp of that concept just from the two words alone. “Public” accessible to everyone. “Ledger”, a book or record of financial information. But, I’d still ask that you follow along with our analogy below, because there is important nuance we’ll unpack when applying this concept to the blockchain.

What is a public ledger?

To better understand what we mean by a “public ledger” I’m going to take you through a story that I’ve shared with my students over the years to help them understand the blockchain.

The Village Ledger

What is a blockchain?

I want you to imagine a little tropical island village.

A lush paradise with a series of huts, surrounding one large middle structure.

This tropical island paradise is home to five different families. For simplicity sake, we’ll simply refer to them by number such as “Family #1.”

Our society lives in a pre-modern civilization. They are a simple farming community. They can read and write, and have iron tools – but, they don’t have electricity, and haven’t even begun to use things like oil or coal for fuel.

This simple farming community spends their year harvesting coconuts. They tend to them throughout the spring, harvest them in the summer and then in Autumn, they trade the coconuts with a more advanced society on the mainland in exchange for supplies to get through the winter.

The Island Problem

Early on in this societies existence, they realized they had a problem. The families small huts couldn’t act as storage for all the coconuts that each family had harvested.

They needed a better place to store the coconuts, so the families came together and built a large structure at the centre of the village where all the coconuts would be stored. And, at the end of the season, the community would just trade all the coconuts at once.

Since certain families were larger than others, they both contributed more coconuts to the collection, and needed a larger share of the supplies to get through the winter, and so they needed to come up with a way to track contributions for each family.

The Island Ledger

What is a blockchain?

To solve their problem of tracking how many coconuts each family contributed, the inhabitants of our island decided to create a ledger book and put it on a shelf outside the coconut storage hut.

On the front page of this ledger was a list of each family’s name, and the amount of coconuts they owned in the storage unit:

Family #1 — 100 Coconuts
Family #2 — 85 Coconuts
Family #3 — 115 Coconuts
Family #4 — 125 Coconuts
Family #5 — 75 Coconuts”

On the internal pages of the ledger, there were a series of transactions, at first these were just families adding coconuts:

Family #1 added 3 Coconuts – June 22nd

Family #2 added 4 Coconuts – June 25th

But, the families then realized something else. They now had the ability to trade among one another without physically exchanging coconuts. They could instead just update the ledger. So now we have transactions that read:

Family #1 traded Family #3 5 Coconuts for 2 quarts of milk

Then “Family #1” would lower their balance of coconuts from 100 down to 95, and “Family #3” would raise their count of coconuts from 115 to 120.

This public ledger allowed the families to know if individuals truly had the money without seeing it. It also allowed them to trade assets between them without having the items in physical proximity, and it created very rudimentary forms of debt and credit (as technically a family could be negative in coconuts and owing to another family.)

This system works fairly well except for one caveat – trust.

The Trust Problem

What is a blockchain?

Our islanders have known one another for generations, and the five families trust one another. They know that the information in the book is updated by people they trust, and so they don’t need to ask for proof when looking at the numbers.

However, one day, a new family moves to the island and sets up a home. The islanders are quick to welcome “Family #6” and teach them their ways. A few of the families even donate a couple of coconuts to the new family to help them get started and they update the ledger to read:

Family #6 – 20 Coconuts

The next morning “Family #6” goes to “Family #1” and offers to buy their cow. “Family #6” says they are willing to pay 300 coconuts for it. In disbelief, “Family #1” goes to consult the ledger and see how many coconuts the new “Family #6” has.

When they look at the ledger they see a transaction from last night that reads:

Family #6 added 700 coconuts – June 28th

And the balance of at the front of the book now shows:

Family #6 – 720 Coconuts

Now the Island ledger system is broken, because the community has one “bad-actor” that they can no longer trust.

Back to the Blockchain

What is a blockchain?

Ledger systems have been around for a long time, but, they require “trust”. We  either trust all the individuals in the system, like our island community did or we have to trust middlemen like banks, who often charge large fees.

This becomes a huge challenge, especially in the digital space. This is why there is an important difference between a ‘public ledger’ and a ‘blockchain’.

It’s a weird concept to wrap your head around, but everything on the internet is essentially a file on a computer. Like a .jpeg picture file that you might have sitting on your desktop. (Yes, this is an oversimplification, but, for the non-technical among us, it is accurate enough to understand the concepts at hand.)

If I have a picture on my desktop and I send it to you, there is no way for me to know what you do with it. Even if you send me the picture back, you could have duplicated the file and still have a copy. To send you a digital file, I require either the ability to:

  1. Trust that you will handle the file to my specifications.
  2. Or, not care about what you do with the file as it will have no negative impact to me.

If I can’t trust what you will do with a file, how can I trust you to report the right amount of money (or coconuts!) to me?

Creating Internet Money

What is a blockchain?

In the early 90s, when the internet was fairly new, there was a lot of discussion on how to use the web for payment systems.

There were even multiple attempts of people creating an “internet currency.”

These services all faced a number of challenges.

Challenge #1 – Centralization Cost and Adoption:

Some of these services that popped up required you to pay huge transaction fees. If I wanted to send $100 to my friend across the globe, they might only receive $80 by the time all the fees are taken.

To make matters worse, my friend already had to have signed-up for an account with this service in order for me to send them money.

Challenge #2 – Centralization Trust and Existence:

Furthermore, if I was using a centralized service, I had to both trust the service was reporting the real amount of money (and not going to steal my money) – but I also had to trust that the service was going to be around for a while.

Many of these services operated like an early PayPal. But, because they were transacting in non-federally regulated currencies they weren’t insured or held to any standard. If I had bought $100 worth of e-Gold in order to transfer it to my friend, and the e-Gold service shut down, then I lost my $100 and there was nothing more that I could do.

Challenge #3 – Decentralized Trust:

Around the time of these scammy services, there was a lot of discussion of if you could create a “decentralized” service in which there was no central server, or administrator. The responsibility of the service would be shared by the community – much like our Island Ledger.

Every attempt to create such as system was met with the same challenge. No matter how much they screened their members, eventually a bad actor got into the system and greed took over ruining it for everyone else.

The Advent of the Blockchain

What is a blockchain?

The internet had failed on a few occasions to bring us a public ledger system that could operate without us needing to trust all of the participants. That was until the 24th of May 2009, when a mysterious individual named Satoshi Nakamoto posted an academic paper called “Bitcoin: A peer-to-peer electronic cash system

Not a lot is known about Satoshi Nakamoto, in fact, to this day no one is sure of his real identity. No one has ever met him, and in 2010 he left the Bitcoin project and stopped communicating with anyone through his online handles. Since then his fortune of over 1M Bitcoins (at their peak worth $20B) has remained untouched.

No one knows who Satoshi Nakamoto is/was, or if it was even a single person. What we do know is the Bitcoin “whitepaper” introduces the first concept of a digital blockchain aimed at allowing a decentralized public ledger system that is “trustless.”

The basics of Bitcoin’s blockchain

What is a blockchain?

Since Bitcoin was the first blockchain ever created/implemented, we’re going to talk about a number of the features in terms of Bitcoin’s blockchain.

It’s important to remember that while blockchain’s differ in features, the core of what makes it a blockchain is that it is some sort of “trustless” “decentralized public ledger.”

We’ll start with a high-level overview of Bitcoin’s blockchain, which may sound very technical, but after that we’ll break down each part so it is easier to understand.

Bitcoin’s Blockchain – A high-level overview

Bitcoin’s blockchain is very similar to our public island ledger. “The Blockchain” itself is a public record of balances and transactions that exist between users.

Instead of tracking the exchange of coconuts however, this blockchain tracks the balances of Bitcoin.

Instead of a ledger having listings for each family like “Family #1” each user has a “wallet.”

Wallets are given their own unique “public key” and “private key” that are used to manage the wallet and allow the user to send transactions.

The ledger is used to keep track of how many “Bitcoins” each wallet has. (Although just like in our coconut example, bitcoins never actually move to different wallets, they only update the numbers in the ledger.)

The ledger (the blockchain) is a big data list of transactions, balances and events, that are split into small chunks called “blocks” and copies of it are stored on thousands of computers around the world.

Whenever a wallet makes a transaction the decide the amount to send “sign the transaction” with their private key and send it to the network.

Then every computer that is connected to the Bitcoin blockchain by “mining” checks their local copy of the ledger and validates if the user has the balance, if their “private key signature” matches the public key, and if they’ve signed the transaction. If they have the “node” (mining computer) validates the transaction with a “Yes” vote.

As long as more than 51% of computers agree that the transaction matches with their record, then the transaction is approved and takes place, because they have reached “consensus”.

All the computers who were “mining” split up the transaction fee as a reward.

Where is the ledger stored?

What is a blockchain?

Unlike in our island ledger example, the ledger is actually not one physical ledger. It exists as copies across thousands of computers around the world. These “Bitcoin Blockchain Nodes” store the entire history of the ledger. Anyone can download a copy of the blockchain (ledger) and become a node.

How is information stored in the ledger?

All the transactions and balances of a blockchain are stored in data chunks called “blocks”.

If we were on our island ledger, this would be the equivalent of one page in the ledger. We fill up a ledger page with transactions and then move to the next page.

In Bitcoin, one block is produced every 10 minutes, and it is filled with the latest transactions. That information is sent out to all the computers connected to the network.

What are wallets?

Instead of having line items in the ledger for each family, users instead have “wallets” which are their entry in the ledger to store their Bitcoin.

These wallets are identified by a “public key” which is also known as their “Bitcoin Address”

What is a public key?

A public key is a bit like an address, if I want to send you a letter, I need to know an address where you live.

In Bitcoin, wallet addresses are random strings of letters and numbers. For example:

1A1zP1eP5QGefi2DMPTfTL5SLmv7DivfNa” this address was the first one ever created (referred to as “The Genesis Address”) and is owned by Satoshi Nakamoto.

Public keys/addresses aren’t very user friendly when presented as random strings, but, it’s actually very important that these strings exist because they interact with private keys.

What is a private key?

What is a blockchain?

A private key is kind of like a password for accessing and controlling your wallet. It’s something that only you know, and you can’t ever share.

Unlike passwords, private keys cannot be changed.

The public key and private key are actually linked together through a complicated mathematical function that creates both of them.

When you have a private key you can use it along with the math function to produce the public key, but it is mathematically impossible to use the public key to figure out the private key.

This is what allows us to “sign” transactions. Using our private key our wallet creates an encoded string (such as turning “ABC” into “123”). This string, when created by the private key, can be decoded by the public key (although the encoding/decoding can’t work the other way around).

This allows us to prove “this transaction was indeed signed by the person who owns this public address” even though we don’t know the key.

The equivalent for our island ledger would kind of be like each family having a wax seal to stamp their transactions with. Perhaps each stamp had a very unique feature that only that family knew how to create. This means that even though you didn’t see them apply the stamp to the paper, you know it must have been them who stamped the page.

Private keys are complicated stamps, that are impossible to duplicate or trick and will always match the public key.

What is a node?

A node is any computer system connected to the blockchain network. Nodes monitor and help to validate transactions through a process called “consensus”.

What is Consensus?

What is a blockchain?

Each node has the ability to vote on a transaction. In blockchain technology there are a number of methods of counting votes and deciding how nodes agree on transactions. These are called “consensus mechanisms” – essentially “how do the computers reach consensus” or “how do we decide when enough of us are in agreement.”

On our island ledger, this would be like letting each family vote on whether they believe the transactions to be real/true, and only counting the transaction if enough of the families voted yes.

The main point of consensus mechanism is to decide three things:

  1. How do we decide who gets a vote?
  2. How many votes do they get?
  3. How many votes minimum are required to approve/deny a transaction?

If we look at our island example this might break down something like:

  1. Do all members of the village get individual votes or do only the families get to vote?
  2. Should family get more votes if they have more family members? Should their vote hold more weight if they contribute more coconuts?
  3. Is a transaction real if 3/5 families agree? Or do 5/5 families have to agree?

For the Bitcoin blockchain the model they use is called “Proof-of-Work.”

What is Proof-of-Work?

Proof-of-Work is the consensus mechanism for the Bitcoin blockchain.

Some people advocated that each “wallet” should simply have one vote on a blockchain. The challenge with this becomes it costs nothing to make a wallet, and it costs no resources to run a wallet.

If I was a bad-actor, I could simply make 1M fake wallets, tell the blockchain I was sending a big transaction and have all my fake wallets say it was true. Then your wallet would believe I had sent you the bitcoin, even if I didn’t have any to send.

To solve this problem Satoshi Nakamoto suggested the method of Proof-of-Work, in which computers must partake in “mining” in order to have a vote in the network. Because of the way mining works, its resource intensive and you can only have one mining program open on one computer.

This creates an economic cost for voting, and proves some level of identity, making it so that people can’t cheat the voting system.

What is mining?

What is a blockchain?

Mining is basically using your computer to solve a complicated math problem. A random number and a “hashed” encryption string of letters and numbers is also generated.

Your computer needs to randomly generate numbers until it finds one that, when combined with the other number the blockchain gave us, that it produces a matching hash string. (Hashed strings are when you take any letter and number combination and change it based on a set of rules. Very similar to secret codes or “decoder rings” that you might have had as a child – except these rules are complicated algorithms)

This description is a bit confusing, so here is a simple example. Imagine I give you the letters:

ABC

And the encoded string:

234ZAB

You don’t know the method I used to encode the string, all you know is that you have to randomly guess three numbers. When you have a guess you can ask me if is right and I will say “Yes” or “No”.

You have to keep guessing until I say “yes.”

In our simple example, the method of encoding might be “-1”

So I may take the numbers 3, 4, 5 and subtract one from each of them, so they become 2, 3, and 4.

Then I may take the letters A, B, C and subtract one (or move one letter back in the alphabet for each) and have them become Z, A, B.

As we know, your computer needs to guess a string to put in front of “ABC”. In this case we need “345” so that when it is combined with “ABC” it becomes “345ABC”. When we pass it through our “hashing function” of “-1” it becomes the encoded string “234ZAB”.

This is a super simplified version of how the computers are randomly guessing numbers to check against a secretly encoded string.

What is the purpose of mining?

Actually, nothing. It’s pointless. The numbers are entirely random and not used for anything.

The only goal of mining is for it to take time and be hard. You essentially get more voting power on the blockchain the more guesses per second your computer can produce.

While mining, these nodes also verify transactions by checking that someone’s “signed transaction” matches with their “public key” but this process is trivial for computers and takes fractions of a millisecond.

In our island ledger concept, this would be similar to the process of the family creating their unique wax seal. It is something tedious and challenging that ensures the work is genuine because the effort required to try and cheat the system outweighs the benefit of tricking the system.

What is a blockchain?

Why do people mine?

Mining is a common method of distributing cryptocurrency like Bitcoin. Since  you need to provide an economic incentive for people to use their computers resources in mining, they are rewarded with Bitcoin.

In the beginning of Bitcoin, Satoshi Nakamoto decided that there would be 21M Bitcoin produced. To help randomly and fairly distribute them, they would be awarded to users who find the solution to the next block puzzle when mining.

Each 10 minute block consists of the “block prize” and the total transaction fees from users who sent transactions during that 10 minute time window.

The first set of blocks yielded 50 Bitcoins each as a block prize, and that amount gets lower over a set time period (roughly every 4 years). The goal is eventually that, once all 21M coins are mined, that the fees earned from transactions will be enough that miners will continue to mine for Bitcoin and help secure the network.

What does it mean to say a blockchain is “trustless”?

“Trustless” or “Trustlessness” are new concepts. Right now, we think of systems, communities, groups of people and individuals as “thing we trust” and “things we do not trust”.

It is ultimately a scale between 0% – 100%. I can 100% my bank, or I can 30% trust my bank (which ultimately means I don’t really trust them.)

Trustlessness, or trustless systems, are (usually economic) systems which exist without the need for trust. I don’t need to trust or not trust other nodes on the blockchain. It is literally impossible for them to successfully lie to me or manipulate my transaction. If I own some Bitcoin, no other person in the world can take that away from me. It’s not like a bank or PayPal who can freeze my funds. I have trustless access to those funds, and trustless control over them.

What does it mean to say a blockchain is “decentralized?”

What is a blockchain?

A decentralized system is one that has no central point of failure or control.

For example, PayPal is a single corporate entity in the United States. If PayPal Inc, goes out of business, you will no longer be able to use PayPal to hold or transfer your funds. If PayPal inc, decides to freeze your assets, you no longer have any opportunity to reclaim them except through interacting with PayPal.

A blockchain, however, is decentralized. There is no “Bitcoin Inc” or any other company that runs Bitcoin. Bitcoin cannot be shut down or destroyed.

The public ledger is decentralized because copies of it exist on tens of thousands of computers all over the world. If I turn off my computer, it doesn’t shut down the Bitcoin blockchain. The blockchain keeps progressing and in the morning when I turn on my computer again, it will just catch up with the ledger by downloading the latest blocks.

Blockchain vs Public Ledger

So we now understand that the key differences between our classic “public ledger” system and a blockchain boil down to:

  1. Decentralization: Everyone has a copy of the ledger.
  2. Trustlessness: Impossible to fake validation methods (private/public keys) mean that the data we see in the ledger must be true.
  3. Consensus: Everyone in the system gets a vote when it comes to validating the data.

Bringing it Back to the Island

So if our island was to implement many of these features we would now have a system where:

  • Each family earns votes based on how many coconuts they produce.
  • Each family stamps transactions they are part of with a special wax seal that only they can make.
  • Each family votes to decide if they believe the stamps to be real and genuine in each transaction and at least 51% of the families must agree or the transaction is removed from the ledger.
  • Each family keeps their own copy of the ledger, and updates it by asking other families for the latest updates and only recording the transactions if more than 51% of families agree on the transactions.
  • In exchange for helping to validate transactions, each of the families are rewarded with a small cut of the transaction as a fee.

That’s it. That’s essentially a blockchain without electricity, without the internet, without any technology at all. Blockchains seem big and scary, but, when we think of them on our little tropical island it’s pretty straight forward.

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Metcalfe’s Law

Unless you work in the telecom industry, you may never have heard of “Metcalfe’s Law.”

And rightly so, as Metcalfe’s law is a simple and obscure mathematical observation relating to the impact/reach of a telecommunications network.

The law states that the potential of a network is simply the number of nodes squared, or mathematically:

n2

All this means, in its basic form, is that the network is more valuable the more people that use it.

For example, if you had a phone that could only call one other phone, then that network has a low value, as there are only two possible connections. Phone A can call Phone B, and Phone B can call Phone A.

If you add an extra phone to the network (for a total of 3 phones) then your total number of connections doesn’t just increase by one. Instead, if you have phone A, B and C you can now have connections:

  • A calls B.
  • B calls A.
  • A calls C.
  • C calls A.
  • B calls C.
  • C calls B.

So whereas a network of two phones had 2 connections, a network with 3 phones has 6 connections. This compounding growth curve is represented on a graph by the equation. The growth of value in a network scales exponentially, giving us what we call “the network effect.”

How does this work outside of telecom?

While it may make sense for a telephone network (or computers on the internet), how do we apply this to systems outside of telecoms?

My favorite example involves currency and gift cards. But before we dive into that example, we need to define a few terms. When we think about the world of gift cards, there are two types: “closed-loop” and “open-loop.” They get their name from broader concepts which can be applied to financial systems.

Closed-Loop Financial Systems

Closed-loop financial systems are ones in which the flow of money is controlled and can only be earned or spent in certain places.

For gift cards, this is like buying a gift card for a specific company such as McDonald’s.

You give $10 to McDonald’s, they give you a gift card valued at $10, and they know you can only spend it at McDonald’s.

Another example would be something like tokens in an arcade. You’ve purchased the tokens, which are the closed-loop currency, and can only use them in that arcade. Outside of the arcade they have very little value.

In fiat economic systems, we don’t really have any examples of a 100% closed-loop financial system. The closest we come is the Chinese Renminbi/Yuan which is a controlled currency. The Chinese government works hard to prevent Yuan from leaving the Chinese financial system, although it still does leak out through various black market channels.

It’s important to remember that closed-loop (and open-loop) aren’t categories. They are a sliding spectrum.

Open-Loop Financial Systems

On the other hand, open-loop financial systems are when money can be entered into a system that is not controlled. The most open example of this is any national currency, when you buy into it you are free to spend it anywhere in that country and can often find places around the world to easily accept and exchange your currency.

But, when we talk about gift cards, “open-loop” refers to a gift card that can be redeemed at multiple locations. One such example might be a gift card you can redeem at any store in your local shopping mall, or, if we want an even more open-loop card we’d use the example of pre-paid Visa gift cards, which can be redeemed just about everywhere.

Once again, as we can see, there is no example of a financial system that is 100% open, and there are multiple levels of “openness.”

Applying Network Value to Gift Cards

Now, let’s assume that I have four different financial instruments in my possession:

  1. A $5 bill.
  2. A $5 gift card to Einstein Bro’s Bagel Co.
  3. A $5 gift card to Starbucks.
  4. A $5 Visa gift card.

At first glance, if we were asked which of these is the most valuable, it might be tempting to say “Trick question! They are all worth $5!” But, given what we now know about how networks are valued, we may take a different approach.

When we think about selling these items, we instantly know that the $5 is the most valuable, because we would never sell a $5 bill for anything less than $5. The underlying reason for this is a $5 bill can be used anywhere and so we don’t discount it at all.

As for the rest of the cards, let’s take a look at what they are worth on second hand networks. If we go over to GiftCardGranny.com, we can look up the value of the different cards.

Einstein Bro’s Bagel Co.

When we look up the gift card at Einstein Bro’s Bagel Co. we can see that the average giftcard for their store is selling at a 35% price discount:

This means if we attempted to sell our $5 Einstein Bro’s Bagel Co gift card, we’d probably only get $3.25 for it.

Why? By exchanging $5 of an open-loop currency for a closed-loop currency, we are restricting the number of places we can spend it, which makes it less valuable. So the supply and demand of “people who want Einstein Bro’s Bagel Co gift cards” and “people who have Einstein Bro’s Bagel Co gift cards” is out of balance, and thus, sellers must compete on price discounting to get their money back into the open-loop.

Starbucks

So, by this same logic then, we may expect to see that our $5 Starbucks gift card is worth about $3.25 as well, right?

Instead, the average Starbucks gift card is only 13.56% discounted, meaning our $5 card is worth about $4.32.

Why the difference? When we look at these cards as “networks” we have to remember how we apply Metcalfe’s law – the number of nodes matter.

For gift cards, these nodes are:

  1. Starbucks locations.
  2. Number of people who want Starbucks.

Simply put, there are more Starbucks than Einstein Bro’s Bagel Co locations, and more people who prefer Starbucks to Einstein Bro’s Bagel Co. Therefore the network has more nodes and is more valuable.

Visa Gift Card

At this point, I think we all know what to expect:

The average Visa gift card trades at a discount of only 0.75%, making our $5 card worth roughly $4.96 – because it has a wider network with more nodes. More freedom for spending, more demand for buying.

The Value of Our Cards

So that makes our final value list:

  1. The $5 bill (Worth $5)
  2. The Visa gift card (Worth $4.96)
  3. The Starbucks gift card (Worth $4.32)
  4. The Einstein Bro’s Bagel Co gift card (Worth $3.25)

Applying the Law to New Economic Systems and Crypto

Now that we have an understanding of Metcalfe’s Law, it would seem to suggest that we could simply count the number of nodes or transactions within an ecosystem and accurately get the price of a currency, right?

Many folks who are far better economists and mathematicians than I am, have tried (with varying levels of success) to apply this model to cryptocurrencies; and while many models fit backtests [Read: Issues with Backtesting], they fail to accurately predict the growth of a cryptocurrency based on either its number of nodes (users) or the number of transactions moving forward. (Although many of them are really awesome models).

Why is this?

There are two main reasons for this:

  1. The original Metcalfe’s Law is designed to only measure the maximum potential value of a network. It does not measure the current or actual value.
  2. The original Metcalfe’s Law is designed to measure all nodes within a system at an equal value.

So while the general trend of “Network Transactions2” is historically true, this is more likely a matter of correlation, and not causation.

Different Transaction Values:

As we saw in our gift card example, not all nodes are of equal value or strength – and this is especially true of transactions in a financial network.

For example, here are four transactions:

  1. I transfer $5 worth of Bitcoin between two wallets.
  2. I transfer $500 worth of Bitcoin between two wallets.
  3. I purchase something worth $5 using Bitcoin.
  4. I purchase something worth $500 using Bitcoin.

We can’t assume that these transactions have all added equal value to the network. In fact, we could debate if the first two added any real value at all.

The two remaining purchases were value within an ecosystem, but, at very different scales.

Different Node Values:

If we want to think of nodes in terms of network services/participants rather than transactions (which would be useful if you are applying the model to something like the Kin Ecosystem) then we can look at a different case.

Imagine two developers add Kin into their app:

  1. “Developer A” has 1,000 daily active users (DAU) who love using their product, have an emotional connection to it and think it is an important part of their daily lives.
  2. “Developer B” has 500 DAU. They find the product useful, but in a solely functional manner.

In looking at Metcalfe’s Law we couldn’t equally weight these two systems, in fact because of the emotional component it wouldn’t even be fair to count the 500 DAU as 50% of the 1,000 DAU, as users with a strong emotional connection will pay more for something than those using it solely for function.

How do we solve for this?

That’s something I don’t have the answer to, and never will – at least not as a concrete formula. Metcalfe’s Law simply isn’t designed to predict the future price of a currency or network, primarily because to do so requires us to do complicated weighting and individual investigation for each node that makes it prohibitive.

How would we approach it? For us to evaluate the worth of a network I think we need to take into account:

  • The number of nodes.
  • The weight of that node compared to others within the system.
  • The value added by that node’s transactions.
  • The emotional weight users have to that node, measured by engagement KPIs.
  • The number of users on that node.

So, if Metcalfe’s classic law of n2 gives us the upper-bound value score of a network, then what we need to do is weight each node on some form of distribution and discount or increase the value of each node from there. In the end, we should end up with something that is a fraction of n2.

For a cryptocurrency like Kin, this might end up being something like:

((N1((f)(a)/2)+N2((f)(a)/2)+…+Nnth((f)(a)/2))2

Where:

  • Nnth is each individual node, represented by a count of N=1
  • f is the bell curve score of each node based on the value added to the network (solved as f(x) = y1 + ((y2-y1)/(x2-x1)) (x-x1)).
  • a is the bell curve score of each node based for user engagement, based on user engagement over number of users. (Same bell curve scoring as above).

 

Walking through the challenges

In this model, we take each node and give it a starting score of 1.

We then take their scores for “user engagement” and “value added” and grade them on a bell curve against all other nodes, giving us a weighted score for each. We then get the average of those scores. For example:

If N1 was the best node for “value-add” then it gets 100% or “1” and if it was a leading node for “user engagement” then it may get an 80% or “0.8” score for that.

We take the average of those two values and we get 0.9. We then discount the value of N by multiplying it by that weight. In this case, since the node started at “1” it is now a score of “0.9”.

We repeat that process for every node within the system and then we add up the final scores, after this we then square the sum of our result.

That will leave us with a number that is some sub-fraction of the classic n2 rule that is probably a more accurate predictor of the value of our network.

Does this really work? Is it accurate?

No, not at all. There are probably a number of issues with both my assumptions, and with the actual math equation. I’m not a mathematician. The point here is more to illustrate that in order to adapt Metcalfe’s Law, we would need to come up with complicated weighting mechanisms which makes it unrealistic to accurately predict the value of a currency.

The math gets very complicated very quickly, and the needed variables become almost impossible to measure.

Wait, so you are saying that we can’t predict the price of a crypto with Metcalfe’s Law?

Yes. Sadly, the goal of this article is to help you realize that Metcalfe’s Law is a mental model designed to help us think about measuring and growing value. It’s not something that we’ll likely ever be able to adapt and apply as a predictive tool.

At best, we’ll be able to adapt it in a way where we can accurately backtest/backfit data within acceptable bounds, but it likely won’t be a good indicator of raw price.

At the end of the day, Metcalfe’s Law won’t tell you the future price of your currency, but, understanding the principle of more nodes in a network equaling more value is important.

While many folks have created very complicated variants of Metcalfe’s Law to try and apply it to cryptocurrency and other financial systems, the only thing that has remained true is the simple n2.

Metcalfe’s Law is a theory. It’s a guideline to help you understand that networks grow value in a compounding and non-linear fashion. It wasn’t designed to predict the price of a network – the only thing you need to takeaway from Metcalfe’s Law is that if you want your cryptocurrency to be worth more, then adoption of earn and spend opportunities are the key.

TL;DR:

Metcalfe’s Law is about how “network effects” create compounding value. It will never be usable as a forward looking price predictor. But, it’s an important concept to understand in economics.

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One of the great debates in blockchain centers around what it means to be decentralized, whether it’s a necessary trait for the application you’re developing, and how a blockchain’s centralization should affect the regulatory status of the cryptoasset(s) running on top of it. While many followers of the blockchain space would identify as decentralization ‘maximalists,’ touting the utopian anarchic virtues of their favorite project, others would argue that centralization is a sliding scale, and that none of the major blockchains in production today are truly as decentralized as they claim to be. Take Bitcoin, for example, where the world’s longest-running and most valuable blockchain has one-third of its hashpower consolidated under one mining pool operator, Bitmain, nearly putting one multi-billion dollar entity in control of the protocol.

Or take two of the other top 10 cryptocurrencies by market capitalization, XRP and Stellar, which have been criticized relentlessly since their inception, for adopting federated Byzantine fault-tolerant models of consensus, as opposed to the more popular ‘trustless’ Proof-of-Work (PoW) or Proof-of-Stake (PoS) models. Where PoW grants power and incentives to the users that run the most powerful machines supporting the network, and PoS grants power and incentives to the wealthiest users supporting the network, federated models optimize for network efficiency by employing ideas like flexible trust and quorum slices. While I’m not savvy enough to go much deeper into consensus theory, the short story is that decentralization maximalists typically aren’t fans of consensus models that require ‘trust’ in any specific node on the network, regardless of the blockchain’s application.

Consensus and Kin

So when the development team behind the Kin cryptocurrency, the Kin Foundation, announced several months ago that it would ‘fork’ the Stellar blockchain to use in parallel with the existing ERC20 token, and that the ONLY node operator at the outset of the new blockchain’s production network would be Kik, the chat app that launched the cryptocurrency, the crypto community’s negative reaction didn’t come as much of a surprise. While Foundation (and Kik) CEO and Founder Ted Livingston later clarified that this wouldn’t be a problem for the blockchain’s end-users because they already trust the app’s developers, and that the network would grow to be more decentralized as additional apps and partners joined the ecosystem, the maximalists didn’t want to hear any of it.

Fast forward five months, after the maximalists and some pre-sale investors have exited a large portion of their Kin position, bringing down the value of the Kin token in conjunction with an extended bear market, and the topic of nodes has surfaced once again. After the release of the atomic swap between ERC20 Kin and the token on the new blockchain was indefinitely delayed, despite already having the technical procedure developed and audited, the project’s followers wondered why. And in recent updates posted by Livingston and community manager Yoel Rivelis, it was revealed that the atomic swap won’t be cleared for release by the Foundation’s legal team until the Kin blockchain federation has assembled at least seven full nodes (operated by independent entities) to run the network. In other words, the Foundation has come to the conclusion that based on their blockchain’s consensus model, they can’t reasonably claim that the blockchain is decentralized enough to link to the ERC20 token until they have seven nodes. I’ll say more on why that probably is, in a moment.

This revelation, which comes at the tail end of a Q3 which saw several major announcements from the Kin Foundation, including the launch of the Kinit survey rewards app, the launch of Kin inside of beauty app Perfect365, and the hiring of former Twitch exec Matt DiPietro as CMO, may also explain other undelivered promises from the project.

The Liquidity

For example, a recurring problem for early adopters and followers has been the available market liquidity of the Kin token. During the token’s “distribution event,” community staff assured prospective investors that they had received indication from multiple exchanges that planned to list the token shortly after launch. The Jaxx wallet even formally announced they would support Kin (and presumably, would offer it on their built in Shapeshift exchange as well). And in the year following those statements, the largest exchange overall that has listed the token, HitBTC, only offers one trading pair, and they aren’t even Kin’s largest exchange by volume.

While Livingston claimed that the Foundation had de-prioritized listing the token on exchanges until there was a call to action for developers and advertisers to buy and sell the asset, according to the community staff, it had become a priority as early as late July. And yet, two months later, the token remains unlisted on any additional major exchanges, despite the project’s high profile and connections to various exchanges at the board of directors level.

While many high-volume cryptocurrency exchanges, both in the United States and around the world do not have very strict criteria for asset listing, other than substantial application fees (to the tune of millions of USD), others hold themselves to a high standard of eligibility based on the project’s fundamentals. Perhaps the most sought-after exchange, for its retail customer base and direct pairs to fiat currency, Coinbase publishes strict eligibility criteria (which they call the Digital Asset Framework), which include concepts such as decentralization and token utility. While the ERC20 version of the Kin asset is fully decentralized (at least, as far as the industry at large is concerned), without at least seven nodes, the Kin blockchain is not. And without the aforementioned atomic swap, the ERC20 Kin asset has arguably zero utility, as it isn’t connected to the app ecosystem where Kin is earned and spent.

The Regulators

Coinbase isn’t the only organization involved in crypto that has a problem with tokens that lack the combination of decentralization and utility. The Securities and Exchange Commission of the United States (SEC) regulates the sale of securities assets to and from citizens of the US. The SEC has recently developed a greater interest in enforcing securities laws in the cryptocurrency space, particularly with respect to tokens sold in an initial coin offering event (ICO), which is how the Kin Foundation raised their development funds. After issuing guidance on non-compliant token sales such as The DAO, and taking enforcement action against sales in-progress like Munchee, and completed token sales like Centra, the SEC has been intensely deliberating amongst themselves and other US regulatory bodies to develop a better framework for how the laws should apply to crypto assets.

https://steemitimages.com/0x0/https://cdn.steemitimages.com/DQmesqJsffFW5afTEKJk3thtZJDEGrB1MyFkwF6BKmpxvJa/image.png

William Hinman, SEC Head of Division of Corporation Finance

In June, the head of the SEC’s Division of Corporation Finance issued an unofficial statement that Bitcoin and Ethereum are not securities, and that the decentralized status of their blockchains was a key determining factor in reaching his conclusion. The SEC, which has had an open investigation into Kin’s token sale since shortly after the conclusion of the sale (alongside investigations into dozens of other tokens), is keeping a close eye on how the Kin Foundation conducts itself, and may be watching how it proceeds towards decentralizing its blockchain, and whether it succeeds in providing meaningful utility to the Kin token. Exchanges based in the US, such as Coinbase, Gemini, Bittrex and others, are likely to be wary of listing assets that may fit the SEC’s fuzzy criteria for a security token. And even if the atomic swap were achieved with only one node running the Kin blockchain, the utility of the token would remain limited to that centralized chain, therein not qualifying the ERC20 asset for real utility.

The Partners

Kin has also had a hard time onboarding major partners, as well as smaller developers in the absence of any programmatic incentives for integrating their cryptocurrency. It is plausible that some app companies, who likely follow the crypto space to some degree, aren’t sold on the idea of implementing a currency over which so much power is held by one or two entities, or which is still lacking so many of the fundamental infrastructural features necessary to make it all ‘work.’ This presents something of a ‘chicken and egg’ scenario, in which exchanges, regulators, apps and investors are hesitant to partner with a blockchain so centralized and feature-incomplete today, which means they won’t run nodes for Kin, which means the blockchain won’t become decentralized enough to unblock those missing features.

Naturally, the ‘seven nodes’ requirement raises several key questions, the first of which we (at NuFi) feel we already know the answer to.

So, why does Kin need at least seven nodes?

I’ll defer to Adam to comment on this:

While it’s important that Kin not be recognized as a security, it is also important that the network not be recognized as a Money Services Business (MSB) by FINCEN.

As we noted within “How Does the Kin Consensus Protocol (KCP) Work?” the Kin network will need a series of federated validator nodes within the network to create balanced quorum slices who can ultimately ensure >66% accepting votes in a network consensus.

So why seven?

Having 7 nodes ensures that no entity controls more than 20% of the vote. Which seems to be the magic number the Kin Foundation believes results in the network not being considered a money services business.

What is so special about 7 nodes and the 20% number?

For the Kin Consensus Protocol to successfully validate a transaction, the network must reach a consensus of >66% of votes. These votes are voted on by overlapping quorum slices, where within each one of those quorum slices a >66% or greater vote must take place.

Since members who follow a quorum slice can have their vote changed by the quorum slice they follow, it actually takes significantly less than 66% of voting power to influence the network.

In fact, if a single actor (entity or user) were to control 20% of the votes in a Federated Byzantine Agreement network (like Kin or Stellar), and all quorum slices within that network overlapped, that it is almost mathematically impossible for the network to vote the same way as the actor who controls 20%. In order to defeat the vote of the 20% actor, every other tangential quorum slice would have to cast their primary vote against the vote of that actor. If any single node within the network that is in a tangential quorum slice were instead to vote in favor of that vote, or vote to accept that vote, or to fail to vote, it would create a domino effect of quorum slices changing their votes due to the level of influence this node has.

The only other way around this would be to isolate that node (or those nodes) in a specific quorum slice, which runs the risk in turn of leaving us with disjointed quorums which result in a broken network.

Given this, anyone who controlled more than 20% of the federated nodes that were default to a Federated Byzantine Agreement network would have the power to:

  1. Always get their vote approved even if it was the initial minority vote.
  2. Hold the network hostage with fractured quorum slices.

In any scenario in which a minority entity (or entities), or a minority of the voting nodes can exercise control over the majority, the network is no longer decentralized and therefore can not be considered exempt as a money services business.

At 7 federated nodes, we are able to create interdependent quorum slices, where no one node has excessive voting power and the majority favor always plays out within these votes.

Who is running a node today?

As mentioned above, the only confirmed node operator to date is Kik Interactive, developers of the Kik chat app (and current parent company of the not-for-profit Kin Foundation). It’s possible that the two other apps that have partnered with the project, IMVU and Perfect365, are also running (or planning to run) nodes, but we aren’t clear on that.

Who will run nodes in the future, and when?

It’s possible that the Foundation has stipulated in its terms of partnership with apps like IMVU and Perfect365 that they are to run full nodes for the network as soon as they’re ready for integration, but this has never been stated. As for smaller developers and followers of the project, the Foundation hasn’t yet made it clear what the operating costs to run a node will be, and they also haven’t published all of the code necessary to get a full node running on the new blockchain. A preliminary documentation FAQ uncovered on Github a month ago estimated a cost of upwards of $2000/month for Kin blockchain nodes. So, in the meantime, Kin may need four additional major app partners to run nodes in order to achieve their goal of seven.

Other blockchains have thousands of nodes. How does the Kin blockchain have fewer than seven nodes after a whole year since raising $100 million and beginning development?

While Kin started raising funds over a year ago, they didn’t shift blockchain strategy to forking Stellar, thus needing to build their own network of nodes, until May. And because these nodes need to be sufficiently independent of each other in order to truly decentralize the network, they can’t just buy Amazon AWS instances around the world and claim decentralization. They also may be bound by what incentives or funding they can offer node operators, as the Foundation paying for others to run nodes could easily raise eyebrows over the threat of collusion. Still, with nearly five months behind them, and a major fundraise completed, it is concerning that the Foundation hasn’t yet been able to onboard more than just two apps to participate in the ecosystem, and presumably, in consensus as well.


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Missed the rest of the series? Check out “Part #1” “Part #2“, “Part #3” and “Part #4

When I first started this series critique number 5 was “The Kin team hasn’t done anything since the ICO.” A lot has happened since then, including the launch of the Kinit app, and so we’ve heard less and less of this critique over time.

Instead, a new negative narrative has surfaced that we’re going to combat, one that I call “the two blockchain problem.”

It seems whenever Kin related news gets shared around cryptocurrency communities we consistently hear:

Kin can’t decide which blockchain they’re on.

Kin keeps flip-flopping on blockchains.

There are two subtle points that people are misinterpreting here, that we should clear up.

Critique #1 – “Kin Can’t Decide Which Blockchain They’re On!”

At first, when I heard users complaining about this decision, I thought it was in reference to the migration from the Ethereum blockchain to the Stellar blockchain, and then to their own Kin blockchain. However, after taking the time to have in-depth discussions with these users, I’ve realized instead they are (surprisingly) upset that Kin is a token that lives on two blockchains.

While cross-chain projects like ChainLink and Bitcoin-to-Ethereum Atomic Swaps have been celebrated, people seem to think that Kin’s chain-duality is a negative, rather than a positive.

The Case for Two Blockchains

Ethereum Scaling

When Kin first launched, they were focused on the Ethereum blockchain, as most new ICOs and blockchain projects from 2017/18 were.

At the time, Ethereum was yet to face some of the platform’s worst scaling challenges, such as the CryptoKitties craze, and the upper bounds of Ethereum’s transactions-per-second capacity had been mostly untested.

Shortly after Kin’s launch, the Ethereum network was hammered by the launch of CryptoKitties. Seeing how few transactions were needed to clog the Ethereum network, Kin realized that they could not possibly implement their project on Ethereum blockchain in the short term.

They even went as far as to calculate what would happen if Kin were to ‘airdrop’ a little bit of Kin to each Kik user, and realized that if they did this, they would take down the Ethereum network for days.

Rock and a Hard Place

At this point the Kin Foundation knew they had to explore other options, including their own blockchain.

The challenge became that moving to your own blockchain means:

  • Losing out on existing Ethereum infrastructure like web wallets, hardware wallets and decentralized exchanges.
  • Exchanges have less incentive to list your coin, as they now have to run a node of your blockchain rather than just add a smart contract token.
  • Increased overhead, as you now need to create your own software wallets and node tools.
  • Decreased security at the initial launch of the network, as you lose access to Ethereum’s global network of validators.
  • Decreased liquidity for investors, as they can no longer easily move tokens within the Ethereum network.

We’ve seen examples of these challenges faced by other popular projects. Consider RavenCoin, a mine-able community token that launched around the same time as Kin. They’ve faced a tremendous uphill battle with their token, and even though they have a large and highly involved community, they are only listed on a few small unknown markets, have a market cap of only $39M and get less than $600k/day in daily turn over. Beyond that, a significant portion of the developer’s time is spent upgrading and maintaining software wallets, which takes away resources from their main vision.

The Decision

The Kin Foundation, realizing that they didn’t want to put their users in that position, decided to do something new. They decided that they would continue to explore other blockchains while still keeping the Kin token available on the Ethereum network, so that users could take advantage of the existing ecosystem for liquidity.

While this introduced significant confusion, especially in messaging surrounding “KIN1” and “KIN2” (Read: “What the heck are KIN1 and KIN2?“)

Critique #1 – Conclusion & TL;DR

Kin isn’t split between blockchains, and they don’t have two tokens. The Kin Foundation is focused on building the Kin Blockchain, a highly-customized fork of the Stellar blockchain that supports 0-fee transactions and high-rate TPS.

Since Kin knew that moving to their own blockchain might result in reduced liquidity for token holders, they allowed Kin to remain active on the Ethereum blockchain for trading.

Kin is not building tools to support the Kin token being used on the Ethereum blockchain. Their tools are focused on the Kin blockchain, and users will be able to move their tokens over via Atomic Swaps.

Critique #2 – “Kin Keeps Flip-Flopping on Blockchains!”

In recent years, especially in political-spheres, changing your mind has been demonized with the word “flip-flopping.”

Before we get to the Kin Foundation specifically, let’s first clear this up.

  • “Flip-Flopping” is changing your answer to a question, or your position on an issue without substance (or without meaning), primarily to take advantage of a current benefit. (i.e. lying to a crowd for votes).
  • Changing your mind is what happens when you learn new information that disproves your previous position. It is not flip-flopping, it is not bad, it is actually the most healthy thing to do when presented with new information. (In startups this is often called a “pivot.”)

To that end, the Kin Foundation has never once “flip-flopped” on which blockchain they are going to use. Instead, they’ve learned new information as time went on and changed their minds.

Leaving Ethereum

As we mentioned earlier, Kin’s decision to leave Ethereum was based on challenges around scalability.

The inability for the Ethereum blockchain to scale to the level that Kin needed for integration into their own Kik app, let alone into multiple enterprise partner apps, meant that they simply couldn’t complete their vision on the Ethereum blockchain.

While Ethereum is rapidly moving towards scaling solutions, even optimistic estimates put these as being implemented sometime in 2020, which would delay Kin’s timeline far too long.

This initially lead to Kin exploring Stellar.

Aside: Ethereum Vs Kin

It’s worth noting, that many have argued that if Ethereum won’t have scaling before 2020 then there is no way Kin will be able to create their own blockchain that will have scale.

The important distinction here is that Ethereum is trying to create a scaling system on a live blockchain, while managing a number of existing features, none of which were designed for this scaling system.

Kin, on the other hand is trying to implement scaling by building a blockchain of their own, and only having the features they want/need within it. They are two very different products, with different challenges.

Leaving Stellar

After leaving the Ethereum blockchain, the Kin Foundation began to explore Stellar’s blockchain as an alternative, due to its focus on high scalability and low cost fees. Stellar achieves those goals by using a more efficient consensus model and removing the overhead of a “Turing Complete” smart contract language, like Ethereum has.

While Stellar proved to be advantageous from an underlying technology perspective, it introduced a unique set of challenges in terms of user experience.

To create a new wallet on Stellar, a user must first fund the wallet with at least 1 Lumen (Stellar – XLM), and whenever they send a transaction the user must burn 100 Stroops (0.0000001 of a Lumen).

This meant that in order to use Kin, users would first need to purchase and load their wallets with Stellar, and make sure they have a balance of Stellar in their wallet at all times in order to make transactions.

Since most users would be using Kin via third-party apps, they wouldn’t be aware of background processes like this, and certainly wouldn’t be familiar with how to use exchanges to purchase Stellar and load it into their wallet.

This would drastically increase either the financial load on developers (requiring them to spend around $0.50 for each new account activation) or increase the education friction on new users. Either of these options would ultimately lead to less adoption in the Kin ecosystem.

This finally led the Kin team to decide they needed to pursue their own blockchain.

The Kin Blockchain

Kin obviously wanted to avoid making their own blockchain to start, as building a blockchain from the ground up is a tremendous cost and comes with its own headaches.

But, given that no other blockchain technology was ready to perform at the scale they needed without sacrificing user experience, the Kin team pivoted and decided to build their own based on a fork of Stellar.

Building their own blockchain comes with a lot of advantages. It will allow them to create the exact infrastructure that they and their partners need without worrying about third-party developers and other complications.

It also means that Kin has the potential to expand beyond their initial ambitions and offer other features in the future including smart contract support (like we learned in their recent Engineering AMA).

Critique #2 – Conclusion & TL;DR

Kin didn’t flip-flop. They learned new information, and pivoted in response.

They had to do this twice. It wasn’t their initial plan to build their own blockchain, but, now they are doubling-down on that, and this brings a lot of benefits.

They aren’t going to be changing their blockchain again.

A Final Note

There has been a lot of fuss about Kin’s journey with multiple different blockchains, especially in the messaging around KIN1 and KIN2. The fact that the Kin Foundation is a blockchain company that is willing to change course when learning new information is a good thing.

Adaptation is key to success in startups. Far too many blockchain projects seem to worry that admitting you were wrong is a point of weakness, and so they cling blindly to their statements. In the end, that will be the downfall for a number of these companies.

If there is one thing Kik has proven they are good at, it is evolving to stay in the fight. For the last decade they’ve had to continually evolve to stay relevant, and that’s something that’s foreign to most blockchain startups.

I personally believe that Kin should go all in on their new blockchain, building it first as a platform for themselves, then supporting other projects that want to live within the ecosystem, because Kik is one of the few companies with the expertise to help deliver on a project at this scale.

Whatever lays ahead for the Kin blockchain, I think it’s clear that their decision to change blockchains was the right choice for them and that many of the critics who disliked that choice were kind of like baseball fans refusing to cheer for anyone other than the home team.

There is a lot that Kin hasn’t done right to date, but, the project has an incredible potential and has shown they have the ability to bring real partners into the fold and help make crypto adoption mainstream – and in the end, that’s why we had to examine “What Critics Fail to Understand about Kin.”

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