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Blockchain: Separating Hype from Substance

“Blockchain” has been a popular term in the financial industry over the last four years. Countless articles have been written about its benefits, how this innovative technology can change the way business is done and what it means for the future.

Given the abundance of information and commentary out there, how do you separate hype from substance? What’s the actual end benefit of blockchain technology and does it have any value beyond Bitcoin?

This two-part series cuts through the noise, deconstructing what a blockchain is at its most fundamental level and exploring the technology’s uses in the financial services industry. Part one examines the Bitcoin blockchain and identifies inherent blockchain properties that add value for data integrity, privacy and security. Part two (due out in February) will dig deeper into the benefits of blockchain technology independent of Bitcoin and what a blockchain-like database with systemic integrity can bring to a business.

 

Blockchain Anatomy 101

Blockchain is often introduced as the technology behind Bitcoin. Though true, this simplified explanation obscures the fact that blockchain technology is a rigorous system that creates certain desirable properties and has a variety of potential applications beyond Bitcoin.

At the most fundamental level, it’s easiest to think of a blockchain (also referred to as a distributed ledger) as a subset of a database, or a data store with special characteristics. In the case of Bitcoin, the basic unit used in the blockchain are transfers of value called transactions. Transactions in this context are similar to the common English usage of the term, that is, an asset (in this case bitcoins) being transferred from one owner to another.

These transactions almost always require signatures which add easy-to-prove authorization. This is done through the use of public-key cryptography, and in Bitcoin’s case ECDSA (Elliptical Curve Digital Signature Algorithm). Such signatures are near-impossible to forge as they require immense amounts of computation (think every computer in existence for millions of years) to create without the private key.

Transactions are grouped into what are called blocks. Blocks are the mechanism by which the data store can be checked for consistency. This is done through two mechanisms.

First, all blocks point to a previous block. This allows them to be well-ordered and is the inspiration for the term blockchain. Each block extends a chain of blocks with the obvious exception being the first block, which is called the genesis block. Having an ordering of blocks allows for an ordering of transactions. This is important for auditing and validation purposes.


Standard composition of a blockchain, from newest block to the genesis block

Standard composition of a blockchain, from newest block to the genesis block


Second, each block must not only be self-consistent (no conflicting transactions within the block) but also consistent with the network rules (no conflicting transactions with transactions in previous blocks in the chain). This allows anyone with access to the entire blockchain to check that the rules of the network are respected. In addition, any capable machine can check that each new transaction (and thus, each new block) is consistent with all the transactions that came before. In short, any machine on the network has the ability to check the integrity of the database with respect to the network rules.

 

Bitcoin: The First Decentralized Digital Payment System

The blockchain, combined with something called proof-of-work, gives Bitcoin an extremely desirable property. Because the complete record of every transaction is shared publicly, decentralized and well-ordered through blocks, nobody can cheat by spending bitcoins they don’t have (double spending) or creating bitcoins that don’t exist. There’s a whole network that enforces which blocks/transactions are valid without a central authority. Essentially, Bitcoin is a digital payment system that eliminates the need to trust a third-party intermediary to execute transactions.

Think about that for a moment. Most digital payment systems require you to trust third-parties like banks and credit card providers. Conversely, in-person methods of payment like cash, gold or barter do not require trusted third-parties but they are non-digital and cumbersome in nature. Bitcoin has combined the best characteristics from both worlds.

Eliminating third-party intermediaries from the transaction process, as Bitcoin does, is valuable for three key reasons. First, third-parties have to make money and traditionally, they do this by adding cost to the system. For example, credit card providers take up to 3% of the transaction as fees for their service. Second, using a third-party intermediary adds risk. This may not be apparent when using reputable companies like Visa or Paypal, but the payment space is littered with companies that have gone bankrupt, had accounts seized or hidden insolvency by cooking the books (see Flooz, E-gold or Pay by Touch). Finally, the involvement of third-parties reduces privacy. An In-person cash transaction is nobody’s business but the two people involved in the exchange. When a third-party enters the picture, they gain access to sensitive personal and financial information.

In addition to its strengths as a decentralized digital payment system, the Bitcoin blockchain is also valuable in that due to proof-of-work, the ledger is immutable (for all practical purposes). That means no one can go back and change numbers around to make things look different. This is great for auditing and ensuring systemic integrity.


Blockchain and the Global Financial System of the Future

It’s important to remember that third party intermediaries aren’t present only in consumer transactions like buying groceries with a credit card. Thousands of times every second, third-parties help execute the buying/selling of stocks, derivatives, currency, precious metals and other assets. In short, most transactions today require both a third-party intermediary and centralized infrastructure that adds cost, risk and privacy-loss to the transaction.

The question, then, isn’t about the utility of blockchains in financial transactions, but whether it is possible to use blockchain's properties to increase privacy while decreasing cost and risk when executing these transactions. When discussing the financial applications of blockchains, there is less interest in the technical specifics as they pertain to Bitcoin. Rather, the excitement is in how blockchain technology’s inherent desirable properties can be applied to modernize how assets (beyond bitcoin) move through the global financial system.


Part two, set for release in February, digs deeper into the benefits of blockchain technology (digital exchange of assets without a central authority, practical immutability) without the mechanisms of Bitcoin and what a blockchain-like database with systemic integrity can bring to a business.

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