This article has been previously published in Global Corporate Venturing and is reproduced with permission.
Blockchain and distributed ledger technology offers significant and scalable processing power, high accuracy rates, and apparently unbreakable security at a significantly reduced cost compared to the traditional systems the technology could replace, such as settlement, trading or accounting systems. The most visible current use of blockchain technology is to run the Bitcoin cryptocurrency but blockchain technology has many other potential uses. Angus Champion de Crespigny of Ernst & Young recently noted that "blockchain technology has the potential to streamline and accelerate business processes, increase cybersecurity and reduce or eliminate the roles of trusted intermediaries (or centralized authorities) in industry after industry.” This year many companies have started to implement solutions based on blockchain technologies, such as the announcement by Citi and NASDAQ Private Markets that they would use blockchain in the sale of private securities on the NASDAQ Private Markets. The state of Delaware is using the blockchain to track the filing of corporate documents with the implementation of “smart UCCs” (UCCs are filed to give notice of certain rights, such as security interests) being targeted for this year. Like all new technology however, it poses challenges for suppliers and customers. This article will summarize critical technical issues and subsequent articles will address three other uses of blockchain technology: smart contracts, decentralized autonomous organizations and initial coin offerings.
In its simplest form, blockchain is a decentralized, distributed ledger on which transactions are anonymously recorded. The transaction ledger is maintained simultaneously across a network of unrelated computers or servers called “nodes”, like a spreadsheet that is duplicated thousands of times across a network of computers. The ledger contains a continuous and complete record (the “chain”) of all transactions performed which are grouped into blocks: a block is only added to the chain if the nodes, which are members in the blockchain network with high levels of computing power, reach consensus on the next ‘valid’ block to be added to the chain. A transaction can only be verified and form part of a candidate block if all the nodes on the network confirm that the transaction is valid; the method of determining this issue is called the “consensus” protocol. Currently, the most common consensus protocol is Proof of Work (PoW) in which nodes run by “miners” compete to solve a highly complex algorithm to verify it. Blockchain technology is implemented by a variety of technologies: Bitcoin and Ethereum are the two most commonly used blockchain technologies. Under PoW, the first node to solve the algorithm and validate the block should be rewarded – on the Bitcoin blockchain this reward takes the form of Bitcoins and in the Ethereum blockchain, this reward takes the form of ether. The Ethereum Foundation has announced that it will change to a new consensus protocol, “Proof of Stake” rather than PoW.
A block generally contains four pieces of information: the ‘hash’ of the previous block, a summary of the included transaction, a time stamp, and the Proof of Work that went into creating the secure block. Once information is entered on the blockchain, it is extremely difficult to alter: a blockchain network lacks a centralised point of vulnerability for hackers to exploit and each block includes the previous block’s ‘hash’ so any attempts to alter any transaction with the blockchain are easily detectable.
In other words, blockchain is a self-maintaining database which typically has a “functionality wrapper”, or app development platform, on top. Blockchain can be thought of as an operating systems for which useful applications or “smart contracts” can be written. Assets and information about transactions can be stored and tracked without the involvement of a typical intermediary, such as a bank, or a central authority or some other trusted third party.
A blockchain network may be public and open (permissionless) like the internet or structured within a private group like an intranet (permissioned). The blockchains that have captured the imaginations of many financial institutions are known as “private” or “permissioned” blockchains because only certain pre-approved participants may join them. These blockchains use a variety of means to ensure the identity of parties to a transaction and to achieve consensus as to the validity of transactions. The entities creating the “private” blockchain agree on rules that govern how entries are recorded and under what circumstances they can be modified. Only specific authorised participants are given access and are known within the network.
Critical technical issues
The key advantages of blockchain technology is its reliability and immutability. Most blockchain technologies use a combination of cryptography, the distributed nature of the ledger and game theory to minimize the possibility of the alteration of the records in the blockchain. The security and immutability of transactions will depend on the security of the blockchain and its susceptibility to various forms of attack. Under PoW, a miner (or more likely a “mining pool”) desiring to “modify” entries in the blockchain would need more computing power than at least half the nodes in the blockchain. Other security issues include protocol governance and user anonymity. Protocol governance includes dealing with problems in the implementation of the blockchain. An example protocol governance arose last year in the Ethereum blockchain: a group launched a decentralized autonomous organization, the DAO, to act as an automated venture capital fund to support Ethereum projects. The DAO was launched with US$168 million in crowd funding from 10,000 investors in May 2016., but a month later, a hacker found a flaw in the code implementing the DAO and US$50 million in cryptocurrency was siphoned off by the hacker. However, Ethereum developers reversed the US$50 million transaction by implementing a “hard fork” of the Ethereum blockchain.
Blockchain technologies vary on the speed on which blocks (and, thus, transactions) can be processed. This speed depends on the number of blocks that can be submitted and the average time for the block to be processed. This speed can be critical for applications such as security transactions. The performance is also effected by the scalability of the system which can be effected by the number of nodes on the system, number of users and its geographic dispersion.
The average period for a block to be validated will vary depending on the number of users and transactions and this characteristic is described as “latency”. The “latency” may vary over time and the variability of latency is another important technical criteria.
Blockchain does have the potential to become an integral part of the operation of many businesses, offering scalability, security and computing power at a lower CAPEX and OPEX. But, as is true with most new technologies, companies need to carefully consider both the technical and legal risks prior to adoption.