Distribute and conquer
One of the most important characteristics of payment systems in force to date is information centralization. During the transfer of funds from buyer to seller, it is necessary to verify the availability of funds so the transaction can be completed. Customarily, this is done by consulting a single centralized database under the responsibility of a bank, credit card issuer or entity in charge of the means of payment infrastructure.
The most important concept introduced by blockchain technology is precisely the change in the way information is stored. It can be applied to any kind of information, but for now the best known application of this technology is associated with cryptocurrency, a topic we discussed here. Instead of using a centralized database, by adopting the blockchain exact copies of all information are distributed to every participant. The information is not only decentralized but also equally distributed across all computers that are part of the system. When a new transaction takes place, it is validated and added to all existing copies.
The name “blockchain” references the way information is stored. Each data block is part of a chain arranged chronologically and protected by cryptographic techniques and sophisticated mathematical functions — for a new record to be added to the blockchain it must be validated by all (or at least some) computers that are part of the network, making fraud or changes to stored data nearly impossible feats (excluding bugs in the programming). This means that in addition to distributing information, which eliminates the risk of an attack on a central point collapsing the entire network, blockchain technology also eliminates the need for an intermediary as a transaction “trusted party”: the community itself is responsible for keeping the system intact and robust.
Cryptocurrencies — such as bitcoin — make use of the blockchain structure to make what was once impossible now possible: transferring funds from one party to another without any kind of intermediation. Boston Consulting Group estimates that in 2014 banks processed more than $400 trillion in transfers, collecting about $1 trillion in fees for the service provided. With the increasing use of new payment models via mobile phone and card (both still requiring some type of intermediation), this figure should continue to increase. PayPal, Apple Pay, Samsung Pay, Google Wallet, Stripe, and Square have increased the number of money transfer options but have not significantly changed the transfer processing basic structure. Even when sensors are used to let a particular store know that you bought an item, the way the money leaves your account and reaches the store’s is still the same as always.
The fact is that we have become used to dealing with digital content in a variety of situations. Sending and receiving letters was the most common form of written communication between people just two or three decades ago — but you will hardly remember the last time you posted a handwritten letter. Movies and TV series, previously consumed through videotapes and then DVDs or BluRays, are now available on demand through streaming services (in which the content is transmitted directly to the requesting device). Our favorite songs are no longer stored in vast CD collections, but in digital files, as well as our books, arousing heated discussions between those who prefer the traditional sensory experience of handling a few hundred pages and those who extol the convenience of carrying a library in their pockets.
Money has also begun its irreversible migration into the digital world. Our financial life is no longer tied to how much money we have saved at home, but rather how much is displayed by the bank on a device screen. The rapid growth in the use of credit and debit cards as well as payments through mobile phones reduces our handling the banknotes we still insist on carrying.
The latest stage of money digitization comes in the form of cryptocurrency, which is not issued by any Central Bank or backed by gold deposits. The convenience associated with the phenomenon of communication, movie, music, and book digitization advances on one of the earliest symbols of civilized society. Now, sending money is as simple as sending an email. Such ease did not come easily. Due to the importance and sensitivity of the subject, it was necessary to wait until a new technology could bring security, robustness, and transparency to the process — and this technology is the blockchain.
To illustrate how the process works, we will use an example in which you want to transfer five bitcoins (currently about $35,000) to someone. By using an application on your mobile phone containing a unique electronic signature associated with you and this particular transaction, you simply have to enter the transferring sum and account. This instruction will be transmitted to the network, which uses encryption techniques to validate that you are in fact the sender of the message and have sufficient balance to perform the transaction (querying the distributed database to obtain your total balance data). Assuming you have the amount required to complete the transaction, your balance will go down by five bitcoins and your counterpart’s will increase by five bitcoins. One of the most important characteristics of the blockchain is the way this validation occurs. Since the system is completely decentralized and distributed, the responsibility for processing transactions taking place in the network lies with volunteers called “keepers.”
When a new transaction is performed, every keeper receives this information, which means that the balance of all system participants is available not only on a central database but on the numerous copies scattered around the world. These copies need to be synchronized to avoid discrepancies. Just picture a situation in which your balance equals ten units. You then make a payment of eight units and, before your balance is updated, you make another payment of four units. The system cannot allow this and must prevent people from spending funds they do not have. In fact, all copies remain intact through a voting process: as transactions are validated, a complex mathematical function is re-assessed (based on stored transactions’ history) and then compared with the results obtained by other keepers. When the network reaches a consensus, stating that the new transaction is valid, all balances are synchronized, avoiding fraud and misuse of funds.
But apart from cryptocurrency, blockchain technology has many other uses. The areas impacted by this new paradigm are our next topic. See you then.