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The Blockchain 101: Cryptography & Trust
Trust is the core value proposition of blockchain technology. Middlemen have made a lot of money by guaranteeing trust when two unknown parties transact.
Trust is the core value proposition of blockchain technology. Historically, middlemen have made a lot of money by guaranteeing trust when two unknown parties transact. Now it is possible for two parties with zero trust to have almost absolute faith that the transaction will go ahead as agreed. As discussed in our last instalment, the issues that our public ledger faces are twofold.
How can you ensure someone only spends what they have? And how do you stop someone from spending the same coins twice? In the real world, this is not a problem, once I hand over cash to a store owner, there is no getting it back, the money has been spent. For online transactions, the bank keeps a record and ensures you always have enough money to pay for what you buy, so you don’t double-spend. But if there are no banks, and the currency is run by the people of the internet, how do you prevent someone from buying two things at once with the same coin? The short answer is cryptography. By using cryptography, people can be certain that others can only spend what they have once.
The next issue is if anyone can post transactions to the ledger, how do we stop people from falsely claiming they are owed money. Again, cryptography comes into play.
It works like writing a cheque and using your own written signature. As you are the only person who can write your signature, when anyone sees a cheque with your unique signature, they know it is authorised even without you being there. But everyone knows you can forge a signature; this is where the cryptography comes in.
Imagine if every time you signed a cheque, you were required to use a different pen. And each pen would change colour based on your fingerprint. One Mont Blanc pen might go red, and one Parker pen might go blue. The same pen would change to a different colour in the hands of different people.
Every time you send a cheque the receiver sees your signature and the pen you used to sign it. But still, no one else knows your fingerprint.
Can someone forge your signature with this system? Well, you could still copy my written signature, but when you use the same pen, it will go a different colour because your fingerprint is different. This means you are exposed as a fraud. But if people don’t know our fingerprints, then how would they know what colour is meant to be unique to us?
To answer it, let’s add another element to the analogy. The paper the cheque is made from is pretty smart. It knows just from the colour of our signature and the type of pen, if it was our fingerprint, without ever knowing what our fingerprint looks like. It just knows that the combination is either true or false. So, if you imitate my signature with the Mont Blanc, when the pen goes red, it will know it is false. But when I sign it, with the exact same pen, the pen goes blue, and the paper knows it’s me.
To protect me, the paper takes a step further by automatically setting itself on fire whenever the signature and pen do not match the fingerprint holder This is essentially how encryption works.
But why is any of this important? For the first time in human history, two parties who have zero trust in each other can transact online without an intermediary. Trust is no longer required as cryptography guarantees the validity of each transaction. Signatures cannot be forged. The ramifications are profound. Markets will come into existence that were previously impossible and existing ones will become significantly more efficient as expensive middlemen or inefficient processes are cut out of the picture.
Take, for example, cross-border payments. The legacy system is inefficient, it’s faster and in some cases cheaper to physically take cash with you on a plane to another country. To trade from Aussie dollars to Nigerian Naira, requires the following levels of trust:
Trust in the Aussie bank
Trust in the intermediary bank that holds funds from my bank
Trust in the destination Nigerian bank that credit’s the money to the end customer
And the cost of all the middlemen providing trust? Fees and terrible exchange rates. Now enter stablecoins, a cryptocurrency pegged to a fiat currency, which can be used for international remittance with zero trust required. Aussie dollar and Nigerian Naira stablecoins could be exchanged without the price risk of Bitcoin and without the cost of legacy finance, and it’s settled almost instantaneously.
But this cryptographic trust has more far-reaching consequences.
Two interesting use cases which spawned due to this new layer of trust are:
Complex Two-sided Marketplaces:
Most marketplaces with a buyer and a seller are fairly straightforward like Ebay or Uber. Traditional finance works well for these business models. But some marketplaces are infinitely complex — they involve millions of users distributed around the world where the service being offered occurs in real time and could be stopped at any moment by a malicious supplier. The security offered by cryptography allows these types of businesses to flourish while the complexity of the services offered can increase further. Examples include Web 3.0 marketplaces that sell spare computer space or peer-to-peer 5G networks.
Most people trade crypto in centralised exchanges such as Coinbase, Binance or eToro. Centralised exchanges take custody of your cryptocurrency whereas Decentralised exchanges or DEXs allow you to keep custody of your own funds even when you are trading. Incredibly DEX’s require no KYC and are executed as smart contracts where trust between the buyer, seller and liquidity provider is irrelevant as it is secured by cryptography.
The ledger allows value to be moved around and cryptography ensures that everyone can trust additions to the ledger. Our next article will explore consensus and why Bitcoin wastes so much power.
This article was written by Eric Tran, Associate at Aura Ventures, and originally appeared on Medium. You can follow Eric for more articles regarding blockchain, Web3, and funding here.
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