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This is a chapter from the book Token Economy (Third Edition) by Shermin Voshmgir. Paper & audio formats are available on Amazon and other bookstores. Find copyright information at the end of the page.
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Blockchain networks use various cryptographic tools paired with economic incentives to trustfully identify and authenticate all network actors and guarantee the correctness of token transactions. Understanding the role of these tools and mechanisms is key to understanding why and to what extent blockchain networks are more decentralized than current Internet infrastructure.
Cryptography focuses on the creation of secure and secret communication and collaboration systems that are resilient against eavesdropping or manipulation. Early cryptographic systems were analog, designed to ensure that a piece of information (plaintext) would be converted into unintelligible text (ciphertext) and could only be deciphered with the corresponding cipher. The term “cipher” refers to a pair of algorithms that define both encryption and decryption processes. While the history of cryptography and cryptanalysis dates back to the advent of handwritten texts, it has evolved significantly in the computer age. The most notable game-changers were the Enigma machine, which was used by the Germans in World War II, and the emergence of Turing-complete electromechanical computers in response. While computers made classical ciphers more vulnerable to brute-force attacks—where computers test all possible combinations to crack the cipher—they also enabled the development of more robust cryptographic systems designed to resist such attacks. Today, modern cryptography extends far beyond text encryption, as it can encrypt any computer file—text, image, or video.
The emergence of the Internet as a computer-to-computer network was another significant game-changer in the 1960s. These early computer networks primarily focused on connecting stand-alone computers, creating addressing mechanisms, and establishing data transmission protocols. Secure communication, however, wasn't a priority in the early years. Systems for more secure communication between stand-alone computers were eventually developed, but initially for military purposes only. They later made it into the commercial Internet.
Secure communication algorithms are generally designed to be incredibly difficult and expensive to break—requiring an infeasible amount of computational effort, time, and resources. Security in this context is a relative term that relies on computational hardness assumptions. As computing technology advances and hardware becomes cheaper, cryptographic algorithms must evolve to maintain their resistance by increasing complexity and difficulty—creating a cryptographic arms race.
Today, cryptographic tools are increasingly used to secure day-to-day applications such as e-banking, e-commerce, identity verification, authentication, rights management, digital signatures, and secure computation. However, cryptographic tools have also raised many legal and ethical questions along the way. Some governments have classified them as weapons, restricted their use, or required individuals to disclose encryption keys for investigation purposes. Political debates around these issues intersect with broader discussions about privacy in the digital age, particularly as encryption becomes central to safeguarding constitutional rights and, more broadly, digital human rights in an era of potential mass surveillance (read more on this topic in the chapter “Token Privacy”).
Bitcoin’s system architecture did not emerge out of thin air but was built on decades of research and development in cryptography, P2P networks, and numerous attempts to create digital cash systems. Key inspirations included Adam Back’s “Hashcash,” Wei Dai’s “B-money,” Nick Szabo’s “BitGold,” as well as the broader cypherpunk movement. Cultural influences, such as sci-fi author Daniel Suarez, also played a role. Its technological origins date back to the 1970s.
In the early 1970s, Ralph Merkle laid the groundwork for secure communication over the Internet when he developed a “collision-resistant” cryptographic hash function and the concept of a Merkle tree for efficient data verification. In 1976, an academic paper introduced mechanisms for secure cryptographic key exchanges over public networks, setting the stage for the development of digital signatures, and in 1978, the RSA algorithm was developed. All these innovations became cornerstones of Bitcoin’s decentralized Public Key Infrastructure. In 1991, an academic paper on cryptographically secured chains of time-stamps was published—another essential concept that inspired Bitcoin’s system architecture.
In the early 1980s, David Chaum advocated privacy-preserving digital signatures and launched “Ecash,” an early form of cryptographic electronic money. Ecash was commercialized through his company, “Digicash,” and was used as a micropayment system at one US bank from 1995 to 1998. However, its system architecture could not defend against Sybil attacks and required some form of centralized coordination. Ecash was shut down in 1998, possibly because it was ahead of its time—e-commerce applications were not yet widespread—as well as due to regulatory scrutiny.
In 1997, Adam Back created “Hashcash,” which was the first proof-of-work system designed to limit email spam and denial-of-service attacks by requiring computers to perform computational work before sending a message. The original idea was proposed in an academic paper by Cynthia Dwork and Moni Naor in 1992. The concept of proof-of-work was also adopted as a mining mechanism in “B-money,” a proposal by Wei Dai for creating an “anonymous, distributed electronic cash system” in 1998. The idea was proposed on the “cypherpunk mailing list,” which represented a group of activists advocating the use of strong cryptography and privacy-enhancing technologies over the Internet. However, B-money was never deployed in practice. It did, however, lay the groundwork for Bitcoin’s proof-of-work.
In 1998, Nick Szabo designed a mechanism for a decentralized digital currency—“BitGold”—where he implemented many of his prior ideas around smart contracts and added a proof-of-work-based consensus algorithm. Like B-money, BitGold was never deployed, possibly because the proposal had not resolved the problem of double-spending in a fully decentralized, Sybil attack–resistant way. Szabo, however, was speculated to be behind Bitcoin’s anonymous creator, Satoshi Nakamoto—a rumor he always denied.
The late 1990s and early 2000s were also significant, marking important developments in P2P networks, highlighted by music-sharing applications like “Napster,” where users could upload their music files and share them with others who could, in turn, download them. Napster was designed as a decentralized file-sharing network independent of the Internet's physical structure. Even though its system architecture reduced the need for centralized coordination, it still relied on a central indexing server, making it prone to shutdowns by governments. Gnutella” in 2000 and later “BitTorrent” further developed decentralized file-sharing architecture by eliminating central points of failure and using distributed hash tables to enhance privacy and security. However, the greatest challenge that remained was the lack of incentives for network contribution and the resulting free-rider problem. Most of the early file-sharing networks eventually collapsed, either because they could be shut down by regulatory action or because their users consumed network services (downloading music and video files) without contributing to the network (uploading music and video files). Hal Finney’s “reusable Proof-of-Work” system, proposed in 2004, tied token value to real-world resources, hinting at a mechanism to incentivize network contributions—an idea that likely inspired Bitcoin’s reward mechanism.
The Bitcoin white paper, published in 2008, was groundbreaking because it resolved the lack of incentives in early P2P networks by proposing a Sybil attack–resistant incentive mechanism for network contributions. It solved the Byzantine Generals' Problem by uniquely combining cryptographic methods (hashing & public-private key infrastructure) with economic anti-spam mechanisms (“Hashcash”), alternative data architectures (a chain of timestamped transaction blocks), and network incentives (block rewards). The cryptoeconomic system architecture of Bitcoin and the subsequent blockchain networks that emerged later have pushed cryptographic tools deeper into the infrastructure layer of the web.
In blockchain networks, hashes are a key cryptographic building block used for many network operations. A hash is a mathematical algorithm that transforms input data of arbitrary size—such as a human-readable text, a picture, or a video—into a fixed-size text that is unintelligible to a human reader. It is not a cipher used for encrypting or decrypting but rather a one-way mathematical function (aka “trapdoor function”) that is easy to create but hard to reverse. As a result, small changes in input data lead to drastically different outputs, making hashes ideal for detecting even minor modifications to the original text or digital file. A document’s hash value can, therefore, serve as a cryptographic twin of the file, which is why it is often referred to as a “digital fingerprint.” Different forms of hashing algorithms exist: cryptographic hash functions and non-cryptographic hash functions. Cryptographic hash functions are designed to be secure against tampering and collisions, while non-cryptographic hash functions are usually designed for other purposes without cryptographic security. Blockchain networks use public cryptographic hash functions, such as SHA-256, to convert any input into a fixed-size string. Anyone can use these public algorithms to produce a hash with online tools. Here is a practical example:
Hash of the sentence “How to buy Bitcoin?” using SHA-256: 156aedcfab1d49f73abddd89faf78d9930e4b523ab804026310c973bfa707d37