We’ve all heard about it, but what is one and why does it exist? Hopefully, this abstract yet simple explanation will shed some light on the most curious technological breakthrough of the modern era.
You and I are stood next to each other, and I give you a document. You accept the document. The transfer of the document was verified because we both saw it and accepted the transaction. The document was only mine (because I physically owned it), but now it is only yours (because you took physical ownership of it).
Now, what if it had been a digital document like a word file?
I give you the digital document. But, how do you know it is only yours? How do you know I haven’t copied the document, given one to you and kept one for myself? Or worse still, copied it a dozen times and give it away to anyone I can find?
As you can see, digital exchange is problematic (known as the double spending problem). It doesn’t work the same as a physical exchange.
A ledger would solve this problem, right? Someone creates and manages a ledger of all the digital transactions in a given computer network so that no unit is double spent. Brilliant.
But, what if the person or people managing the ledger decide to fiddle with it, maybe give themselves a couple more digital documents. It’s not like when I gave you the document when the exchange was witnessed and verified physically from me to you. There are lots of digital transfers on this ledger from lots of different people in different places. It would be impossible for each person to witness their individual transfer to their recipient. So, a third party must verify all the transactions on the ledger.
Third party verification. Problem solved.
But wait, there must be a better way to do this. It would be so much better if I could just give you the digital document in the same way as when we were stood next to each other, right? No risk of double spending and no third-party verification needed. Sounds much more efficient, but how would we do that?
The answer is actually very simple in theory.
Give the ledger to everybody! Instead of someone managing the ledger centrally, it lives on everyone’s computer who wants to utilize this system of transacting digital documents. All the transactions of digital documents in all time will be recorded on it. Every time a transaction occurs, everyone’s computer synchronizes to the new record added to this distributed ledger.
No-one can cheat it. I can’t send you digital documents I don’t have, because then it wouldn’t sync up with everybody else in the system. Nor can you fiddle how many digital documents you received, because the number I sent will have synced on everyone else’s computer. It is decentralised because no one entity controls the ledger.
The rules of the transaction system are set up from the beginning. To change them means everyone in the system has to agree.
New participants can join the system too, putting the ledger on their computer and updating it when transactions occur. What’s more, the system pays you in digital documents for doing so. In fact, this is how new digital documents are created (you might have heard the term mining before?).
A digital transaction system as described above was invented in 2009, named the Bitcoin Protocol. Bitcoin is essentially a decentralised payment system, a distributed ledger which is neither owned nor managed by any single person or entity.
In reality, there are what we call full nodes and light clients on the Bitcoin Protocol. Full nodes are those people in our example that download the ledger on to their computer to power and verify the updating of the transactions (the miners). Light clients are simply those people with a Bitcoin wallet who wish to send bitcoin to someone else with a Bitcoin wallet. They power nothing and actually pay fees (a fraction of a bitcoin) to the miners in order to make a transaction.
Now, when I give you a digital document everyone in the system knows, certifiably, that it left my possession, and was received by you. This wasn’t possible before, but now it is. The ledger is updated and verified by everyone in the system and the transaction occurs.
No third party is required to oversee the transactions to ensure I didn’t make a copy, or that you fiddled the number you received. The bigger the system, the better.
Now our transaction of a digital document is exactly like when I gave you the document in person. It behaves exactly the same way and is actually even more secure because there are thousands of others in the system that recorded it. In fact, it is believed to be virtually unhackable, yet no single person or organization manages it or needs to protect it.
Pretty clever, right?