Bitcoin, blockchain, ICO and smart contracts explained in a very simple way

Bitcoin, blockchain, ICO and smart contracts explained in a very simple way

This text is the translation of an original article by Nicola Di Marco, co-founder of Dexlab.io, an international group of open source developers working to accelerate the adoption of blockchain technology by providing user friendly products. All technology explained here, one day will be more accessible and intuitive thanks to Dexlab.io.

The concept of cryptocurrency is generally hard to explain due to the fact that most people have no idea how “normal” currency works, as well as the stock exchange, the relationship between the economy and the currency and in general what is speculation or investment.

I will try to explain some concepts to clarify some ideas.

Legal currency (fiat)

What is the money?

Money is everything that is generally accepted as a means of payment for goods and services or for the repayment of a debt. The main use is therefore the means of exchange and preservation of value.

The reason is quite simple: in an economy based on bartering it is too difficult, if not impossible, to measure goods that are, by their very nature, heterogeneous and not comparable.

Imagine being a producer of watermelons and wanting to buy a house:

• How many watermelons are equivalent to a house?
• Which house owner would accept to be paid with thousands of watermelons as compensation for the property (the house) sold?
• Should these watermelons be transferred from one owner to another at the same time? Would all the necessary watermelons be produced and available at the same time? Where would you imagine?

Aristotle, about 350 years before the birth of Christ, addressed the theme of money and summarily defines it as follows:

• Money is a tool that makes things measurable and therefore comparable
• In this way, any good or service can match a universally recognized equivalent in money

Starting from these assumptions defines what is a currency:

• It must be durable, it must not lose value over time. A coin retains its value for a much longer time than a watermelon, which would deteriorate after a few days and lose its value.
• It must be easy to maintain, transport and exchange. It is obvious that it is not convenient to bring 100 watermelons to pay for a dinner at the restaurant.
• It must be divisible. Imagine being a jewellery manufacturer and wanting to buy an apple: you cannot certainly exchange it with a whole necklace because the value of the necklace would be much higher than the apple and you cannot exchange it with a quarter of a necklace because the necklace would lose its characteristics main and consequently its value
• It has an intrinsic value, ie it has a value given by the cost of materials, work etc.
  Historically the only means that satisfied all these requirements was the gold that, besides being easily transportable and divisible, also has an intrinsic value given by scarcity (the gold existing on earth is not infinite) and difficulty in finding (you have to identify the mines and work hard to extract it).

Given the difficulty of managing a coin with intrinsic value, it was preferred a tool with a nominal value, such as paper banknotes or coins of non-precious metal, where the value is not given by the cost of the material and work but from other factors:

• Authenticity: because issued by institutions such as Central Banks
• Guaranteed by the law
• Recognized by users: all citizens recognize and accept the nominal value of a given currency

But things start to get complicated when you need to exchange large amounts of money (for example, to buy a house you would need to use hundreds of thousands of coins or banknotes) or when you need to transfer currency to far places (another city or continent) and over time (future payments or debts).

Contracts
The easiest way to exchange large sums of money or at significant distances is through a contract. But what is a contract?

The contract is a voluntary obligation between two parties.

The basics of a contract are:

• The definition of the parts (Tizio X, Tizio Y)
• The execution time of the obligation (before: o day x)
• The object of the bond (the transfer of the sum X in exchange for the asset Y)

Contracts are a very powerful technology that has enabled, for millennia, a whole series of abstractions and dynamics that would have been impossible in any other way.

But who guarantees that the contracts will be respected or who guarantees that after giving 300,000 usd in November 1st to Mr. John Doe born in New York on 11th March 1970 he will give me his house?

I introduce to you the mediator-guarantor.

The most widespread form of mediator-guarantor today is the bank. The bank verifies that I actually have this money supply and transfers the requested amount to Mr John Doe’s account. Then register and keep this transaction as evidence.

If then John Doe does not sell his house I can appeal to another guarantor (the judge) who will analyse the terms of the contract and the evidence (the transaction registered by the bank) taking (hopefully) an appropriate decision.

The mediator-guarantor is necessary because it enables the dynamics that otherwise would be impossible (or almost) to make (for example transport a suitcase containing $ 300,000 to the landlord who is 10,000km away) and assures us that the pacts are maintained .

The more complex the contracts, the more the number of mediators-guarantors grows (as well as the commissions that the contractors will have to pay).

Although this method has been valid for centuries we also know that the mediators-guarantors have too much power (who guarantees on the guarantor?), are too expensive and not always safe (the mediators-guarantor are corruptible).

The stock exchange

Here things get interesting.

One of the advantages of money is that you can lend or anticipate for a profit. For example, this earnings could be given by a percentage of interest on the loan or a percentage of a company’s profits.

A trivial example: the company “Apple” needs a liquid investment (money that can be spent immediately) and to collect this money it sells contracts that represent portions of potential future earnings. This contract then says: give me 100 usd today and tomorrow you will be entitled to 10% on the earnings we make.

This contract is an action and is also authentic, guaranteed, recognized, wearable. It has a nominal value (because the shares are only paper contracts, so they have no intrinsic value) given by the valuation of the company that issues them or how much people are convinced of the company’s ability to produce profits and consequently how much the buyers are willing to pay to possess the aforementioned action.

Stock exchanges are highly regulated institutions to which it is not easy to access, either for a legal issue (license) or for an economic question (minimum investment limit accepted).

Blockchain

Let’s take a step back and talk about contracts again.

So far it has been virtually impossible to cut costs and take responsibility for the contract directly without losing the guarantees given by central institutions (banks, courts, etc.) acting as mediators.

Where is the problem?

• Control: governments and central banks can strongly influence the value of money. Think of financial crises, hyperinflation, Greece, Zimbabwe, and Venezuela.
• Mediation costs: a monetary transaction, for example with WesternUnion, can cost up to 10% of the sum sent. An immigrant worker who wants to send 100 euros earned with sweat to his family in the country of origin will have to give 10 to WesternUnion
• Costs of the guarantor: if a contract, for example a mobile service, is not respected you have to pay lawyers and taxes to make the judicial machinery work and often unfortunately it’s not worth the risk given the high costs
• Corruption: think about a will. It is always possible to try to bribe a notary to turn the tables
• Security: centralized infrastructures are easy to hack and once hacked you have access to all the data of all users (and these things happen very often)
• Limits: banks have on average 10% liquidity (depending on the countries and established by law), the rest is only virtual budgets. This means that if you go to the bank and you want to withdraw your million dollars you cannot do it because the bank does not physically own it.

How Blockchain works:

• There is a network of thousands of computers that make up the infrastructure without the need for a central government
• Everyone has a private key
• Transactions are encrypted, legible and valid only if you have the private key
• There is a log of all transactions that is shared by the entire network
• Transactions are validated by a minimum number of computers that are part of the network
• The management decisions are taken in a democratic way, that is with 51% of the network
• Each member of the network has a monetary incentive to keep the network running
• This incentive is decided democratically, and this guarantees transaction costs infinitely lower than those of banks. We are talking about 0.05% or less against 2/10%, the average we are used to today.

Benefits of blockchain

• Completely anonymous transactions
• No one can trace or alter a transaction without 51% consent
• This makes the infrastructure impossible to hack unless at least 51% of computers are hacked. Cost estimates have been made and it would take more money than they would be able to steal.
• Management costs, security, infinitely lower transactions
• You are your bank, no one owns your codes, no one can make any movement in your wallet against your will even if ordered by the CIA. You can access all your money and do what you want immediately and without asking for permission

Bitcoins also, unlike legal currencies, have an intrinsic value calculated in plus or minus $ 1000 which represents the cost of mining (it is a parallel with the cost of gold mining but in this case represents a cost in hardware + electric energy).

Monetary transactions are a type of contract in which coins are transferred from the account X to the account Y, but blockchain enables a whole series of transactions called “smart contracts”. A smart contract is a coded, encrypted and automatically executed contract.

I give a trivial example. In my will I have arranged to transfer 50% of my Bitcoins to my son and 50% to my daughter. Normally my children have to contact notaries, lawyers and banks, provided that everything happens peacefully.

A smart-contract instead would happen in an immediate and automatic way: when I die the amounts move from my wallet to them in percentages established by me. Point. No notary costs, banks, lawyers, litigations. Anything.

Crypto Economy

Bitcoins are the first example of blockchain-based success, but as we have seen, there can be a myriad of different operations.

The concept is to transfer any type of contract (therefore any possible interaction) in an encrypted transaction through the network-blockchain that makes it possible, secure, private and economic.

For this reason, a whole series of companies that use blockchain are not born to build financial instruments but for other types of applications, for example:

• File storage / sharing: instead of storing and sharing files by a company that keeps them on a central server, files can be encrypted and broken into a global network. Only the owner of the key can read them and no one will ever be able to steal or delete them
• Internet of things: devices that interact with the Internet, such as a smart door or a car, can now be easily hacked.
  Furthermore, companies that offer these services acquire our data deliberately. Also in this case blockchain would guarantee a cheaper and safer service.

Also in this case the members of the network have an economic incentive and very often this consists of a currency for internal use (a credit) different for each company. This second generation coins are called Altcoin and there are already a myriad of them and the number continues to grow as the market in which these Altcoins are traded continues to grow.

ICO

Before explaining what an ICO is, it is perhaps useful to understand what an IPO is.

An IPO (Initial Public Offering) is the phase in which a company that wants to be listed on the stock exchange, sells some shares at a reduced price or exclusively to investors who arrive for first. This type of fundraising is incredibly regulated and has very high access costs: only accredited institutions can participate, we mere mortals can then buy back the shares (even in that case with very high access limits, for example 20,000 usd) to an already increased price.

The Ethereum blockchain (the second largest currency after Bitcoin) has enabled a very similar system to IPO which is called ICO (Initial Coin Offering).

A company that wants to develop a product based on blockchain can activate a fundraiser with the characteristics above (privacy, independence, security, minimum costs).

2017 was the year of the ICOs, with a volume of loans that has already surpassed that of Ventur Capital and Global Angel.

Once the ICO phase has been completed, the shares (which in this case are called tokens) can be sold and bought on trading platforms, with the same dynamics of stock exchange shares but with the difference that everything happens independently, without the need for crazy transaction costs, accredited traders and minimum investment capital: everyone can access it by investing only a few pennies.

Many (token) shares were sold at very low prices during the ICO phase, for example $ 5 cent and resold at $ 50 within a few days in trading platforms.

Many of these companies are taking advantage of this mechanism without having a solid team or product but only to collect money (sometimes they managed to raise 40 million dollars in 6 hours) but the game is still worth the candle because at the moment it is easy to speculate or buy when the price is low and resell as soon as it grows to an acceptable percentage given that there is a lot of interest to many new users entering.

The most sensible (and ethical) way to invest anyway is:

• Studying team and company and believing in the quality and possibility of success of the proposed product
• Keeping tokens for a long time in the belief that you can make a good x100 in a year or two instead of just an x3
• There are now dozens of ICOs every month and dozens of exchange and evaluation platforms in which to engage in trading without the need for special skills.

The market is crazy

Right now, that cryptocurrency looks like the goose that lays the golden eggs: it keeps growing and it’s easier to make money than lose it, especially if you buy tokens during ICOs, but this situation will not necessarily last long.

The market, equally if not worse than traditional exchanges, is very emotional and easily influenced: just a buzz news, even if fake, sensationalist or imprecise, to make the price of a token skip or fall, especially in the short term.

It has already happened to see the price of Bitcoins fall by 50% a few days after news like “China wants to ban cryptocurrencies”.

This situation is particularly disadvantageous for speculators (as opposed to investors who count on keeping the tokens for a long time, convinced of the soundness of the companies in which they invested) because they can lose significant percentages within a few hours.

The situation, now that the crypto world has become too big to ignore it, seems to change: many governments are trying to regulate dynamics and taxation and many financial and banking groups are adopting these technologies or offering cryptocurrencies in their investment portfolio.

Future developments

Privacy (anonymity) and autonomy are a threat to governments that have so far had exclusive rights over these things. This is potentially a good thing, but it also represents enormous risks. Let us not forget that governments are, up to now, the only subject able to redistribute wealth in a more or less equitable way (from the rich to the poor) and can do so thanks to taxes (that is, to the exclusive control of our data and our goods).

Another scary trend is to turn every human interaction into an economic transaction on blockchain. This would make everything much cheaper, safer and more efficient, but on the other hand it would push everything towards better performance, leaving aside a whole range of activities, differences, weaknesses that would not work well in this economic system but still represent an important part of human identity.

Ans Mdr Crypto (original italian article by Nicola Di Marco)