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The Revolution Of Digital Currency

Nov 05, 2019
byNDAX Labs

The Revolution Of Digital Currency

When people think of digital currencies, most might think of cryptocurrencies like Bitcoin.

However, Bitcoin was not the first attempt at creating a digital currency. In fact, many different people have tried to create digital currencies in various forms for nearly 40 years. The earliest efforts to create a digital currency go all the way back to the early 1980s.

Many of the ideas and concepts that led to the creation of Bitcoin came directly in response to the many failed attempts at creating digital currencies in the past, and by finding solutions to the problems that caused many early digital currencies to fail. In this blog, we look at the history of digital currencies that came before (and would later inspire) the creation of Bitcoin.

Computer scientist David Chaum is regarded as the first person to release a white paper on digital currency in 1982. The paper titled Blind Signatures for Untraceable Payments proposed a new digital currency in response to a sharp increase in electronic transactions at the time. The article was also the first to conceptualize an anonymous digital currency. In 1990, Chaum launched DigiCash. DigiCash made its first electronic transaction in 1994 using a new digital currency called eCash.

DigiCash was the first to use protocols such as public-key cryptography and blind signatures to ensure a user’s anonymity. By using these protocols, third parties did not have access to personal information contained in online transactions. Advancements in both public and private key cryptography allowed the electronic payment system to become untraceable by a bank, government, or third party. However, the system of blind signatures that allowed users to remain anonymous required a central authority such as a bank to ensure that the funds were not spent twice.

Although DigiCash was the first to introduce many of the ideas that would later serve as the framework for future cryptocurrencies, the company did not have much commercial success. Only one US bank implemented the currency. DigiCash filed for bankruptcy in 1998 and was eventually sold off for assets. Other electronic cash systems such as First Virtual Holdings and Cybercash were created around the same time and suffered a similar fate.

One of the most significant problems with the early electronic cash systems is that they relied on centralized organizations like financial institutions to partner in the process. Relying on banks also created a single point of failure for early digital currencies, meaning that if a bank was to go out of business then the digital currency that the bank partnered with would go down with it.

Early digital currencies also suffered from the problem of governments shutting them down overnight, rendering many early e-cash solutions useless. Government intervention ceased operations for several digital currencies such as E-Gold and GoldMoney over concerns that the criminal underworld was using the currencies to launder money and facilitate illegal transactions.

The problem of government regulation intensified following 9/11 as governments tried new ways to stop the transfer of funds to terrorist organizations. The perception that central authorities could suspend digital currencies simply by enacting new legislation gave the public a good reason to be reluctant in adopting them.

Nick Szabo, a cryptographer and computer scientist, was the next to introduce ideas around creating a decentralized digital currency with Bit Gold. Bit Gold never came to fruition, but it is essential in the history of digital currency as many of Szabo’s ideas would go on to become critical in the creation of cryptocurrencies. Bit Gold aimed to create a trustless transaction model tied to gold. The US Federal Reserve’s central bank broke the standard of having the money supply of US dollars tied to gold in 1971.

Bit Gold was the first digital currency to implement a proof-of-work (PoW) consensus algorithm. Using proof-of-work, cryptographic puzzles are solved using computational power. Each puzzle solution is broadcast on a peer-to-peer network. A cryptographic hash is created to link the solution of each puzzle to the next puzzle. In this model, all the users on the network need to agree on the previous puzzle’s answer before a new puzzle is generated. This method of consensus would be used to secure groups of transactions that would all be linked together using cryptographically hashed solutions.

Unlike Bitcoin, Szabo was unable to solve what is known as the double-spending problem. An example of the double-spending problem is spending $100 on goods and services and then using the exact same $100 to make additional purchases at another point in the future. Szabo wanted to mimic the characteristics of gold (which has intrinsic economic value) and to prevent fraud or mismanagement by centralized third parties. Up until the creation of blockchain and cryptocurrencies, centralized organizations were solely responsible for maintaining and updating the account balances used in financial transactions.

British cryptographer Adam Back created the digital currency Hashcash in 1997. Back wanted to introduce a system that could prevent spammed emails by restricting the amount of internet resources each user can spend per email.

Back’s solution to spam email required that users spend a small amount of computing power to solve a puzzle before they would be able to send emails. For regular emails, the amount of computational power to solve each puzzle would be tiny, and it would only delay an email by a few seconds.

However, someone trying to send spam email would be prevented from doing so by making it almost impossible for them to have the computational resources to send out thousands of emails all at once. It would also prevent spammed email by requiring that the senders pay for the electricity costs necessary to use a vast amount of computing power. Hashcash was referenced in Satoshi Nakamoto’s Bitcoin white paper. According to Nakamoto, a proof-of-work system similar to Hashcash would be needed in the blockchain that would be used to create Bitcoin.

Computer engineer Wei Dai proposed another digital currency with the paper, "B-money, an anonymous, distributed electronic cash system" in 1998. The first protocol outlined in the article proposed using Hashcash’s proof-of-work consensus algorithm to create money. In the proposed system, transactions would be broadcast to everyone on the network to keep a balance of all the money in each account.

In the second protocol, only a small subset of the network’s participants would be used to keep the balance in each account. He set out to create a punishment and reward system by having each server deposit a certain amount of funds in an account to be used as fines or rewards for proof of misconduct.

To fully understand the development of digital currency, one must understand the story of the Cypherpunks. Cypherpunk is the name given to an activist that advocates for social and political change by using privacy-enhancing technologies such as cryptography.

A small group of cryptographers met in the San Francisco Bay area and adopted the name Cypherpunks in 1992. The Cypherpunks mailing list was created later that year, acting as a forum for discussing computer science, cryptography, math, politics, and philosophy.

The core Cypherpunk philosophy is that individuals should have the power to reveal their identity only when they choose to reveal it, and that neither governments or corporations can be entirely responsible for protecting that right.

Satoshi Nakamoto cited several Cypherpunks in his original article. He first announced his white paper and the genesis block creation for Bitcoin through the Cypherpunk mailing list. Many of the early Cypherpunks went on to become developers for Bitcoin.

With the creation of Bitcoin in 2009, Nakamoto was able to solve many of the problems that plagued his predecessors. By using a decentralized peer-to-peer network of computers that continually updates and maintains a public ledger (known as the blockchain) the problem of double spending is eliminated.

Nakamoto explained this process in his 2008 white paper by stating, “Digital signatures provide part of the solution, but the main benefits are lost if a trusted party is still required to prevent double-spending. We propose a solution to the double-spending problem using a peer-to-peer network. The network timestamps transactions by hashing them into an ongoing chain of hash-based proof-of-work, forming a record that cannot be changed without redoing the proof-of-work”.

Said more simply, for someone to double-spend funds they would have to deceive the entire network into thinking that it was a legitimate transaction. New coins cannot be faked or copied and every transaction in the history of a cryptocurrency can be found on the blockchain. Making it nearly impossible to spend the same money twice.

Nakamoto referenced the ideas first proposed by Szabo, Back and Dai in his white paper. The proof-of-work consensus algorithm outlined by the previous three authors defined the process over the creation of new Bitcoins.

Bitcoins are issued to users on the system who help process transactions on the network. This is known as Bitcoin mining. Releasing a known and fixed number of coins over a given period of time creates an environment of scarcity for the currency, leading to the coins having value. This removes the need for Bitcoin to be tied to some other asset that has an intrinsic economic value such as gold.

Nakamoto also found a solution to the problem DigiCash experienced of needing to rely on financial institutions in the transaction process by having a decentralized network that holds all of the transaction information in a public blockchain.

With Bitcoin, there is no central authority or financial intermediary to regulate or attack. Solving the problem of other early digital currencies such as E-Gold and Gold Money that were essentially shut down overnight by new government regulations. No government or third-party can censor or shutdown a cryptocurrency like Bitcoin. Bitcoin does not have a single point of failure.

To summarize, Bitcoin is not the world’s first digital currency. Attempts to create a digital currency goes back to the 1980s with key players such as David Chaum, Nick Szabo, Adam Back, Wei Dai and the original Cypherpunks all playing significant roles. However, many of the earlier attempts at creating digital currencies informed and inspired Satoshi Nakamoto in the creation of blockchain and Bitcoin.

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