Cryptosphere—Unraveling the Mystery Part 1: Blockchain: A Ledger for the Modern Era

By September 15, 2018Other
bitcoin

Cryptocurrency has quickly become one of the most notorious buzzwords in the financial world. The extreme market volatility of some of the most well-known cryptocurrencies, paired with the potential for fantastic returns on investment, has captivated many people—from seasoned investors to individuals whose primary interaction with financial markets is the accidental launching of the Stocks app on their iOS device. Unlike the early United States dollar, this new form of currency is completely digital; and, perhaps even more surprisingly, it is not backed by any tangible collateral asset. This article focuses exclusively on the basic underlying technology that brought cryptocurrencies like Bitcoin into existence: blockchain. For a detailed explanation of cryptocurrencies or Initial Coin Offerings (ICOs), please see our articles Cryptosphere—Unraveling the Mystery Part 2: Overview of Cryptocurrencies and Cryptosphere—Unraveling the Mystery Part 3:  Initial Coin Offerings.

What is blockchain technology?

A blockchain is a database ledger. The blockchain technology we are most familiar with today was originally created for Bitcoin, but that same technology is now being integrated into the financial markets through cryptocurrency, digital contracts, and other asset records. According to Autonomous Research, an independent research provider for financial companies across the globe, a blockchain is “a database or ledger that maintains a continuously growing list of data records or transactions.” Based on that definition, you may be thinking a blockchain sounds quite like a Microsoft Excel spreadsheet—and you would not be entirely incorrect. However, Autonomous listed five key features of a blockchain database that differentiate it from the familiar Excel spreadsheet: (1) shared publicly, (2) decentralized, (3) secure, (4) trusted, and (5) automated.

Before explaining these principal features, it may be helpful to walk through the process of adding a transaction entry to the ledger. Although blockchain technology seems complex and futuristic, it all boils down to a fundamental financial tool we are well acquainted with: a ledger. Unlike the current digital ledgers most companies and organizations use, a blockchain ledger is not owned or controlled by a single entity or user; rather, this ledger is shared with all servers, or “nodes,” within a network. Much like how the IT infrastructure within a company allows employees to access files on the corporate server, a blockchain network is accessible only to those with valid credentials. A company can choose to create its own private network, or it can join an existing blockchain network. All nodes within a network have complete, unfettered access to the ledger because each node has a complete copy of the ledger on its server. This is where blockchain’s claim of “trusted” comes into play. Once an “on-chain” transaction (i.e., a transaction between two or more parties who are within the existing blockchain network) is initiated, the details of that transaction are broadcast to every node on the network. Each node then independently verifies the transaction and updates its respective copy of the ledger. Once the transaction is verified and updated on every copy of the ledger in the network, the verified transaction becomes a ‘block’ that is added to the blockchain. Included below is a Blockgeeks1 graphic that depicts the process flow of such a transaction on a blockchain.

 

Blockchain Infographic

According to Autonomous Research, there are four main components of a block:

  1. The unique hash. The hash is the consensus identifier for each block. It consists of a random set of encrypted numbers.
  2. The unique hash of the previous block. Including the hash from the previous block on the current block allows the system to place the blocks on the chain in chronological order.
  3. The transaction(s). Each transaction has its own ID hash, and each block can contain one transaction or thousands of transactions.
  4. The public key. Identifies the sender and receiver of each transaction.

The system of hashing is an element of public-key cryptography. Public-key cryptography uses a pair of keys—one public and one private—to encrypt and decode the message. A message that is encoded with a private key can only be decoded with its paired public key, and vice versa. With blockchain technology, you are not required to, nor should you ever, reveal your personal private key (e.g., the private key associated with your cryptocurrency wallet), because once it is released, it is no longer secure. That is, anyone can now do anything they want with any of your information and transactions. The private key acts as a unique signature on the transaction. Holders of the paired public key use the public key signature on the transaction to verify that it originated with the true owner of that private key. In theory, a hacker cannot create a fraudulent transaction because the private key cannot be easily forged. As will be discussed in a later section, each key is a hash sequence; so, absent an incredible amount of computing power, the random sequence of letters and numbers cannot be cracked. Once joined with the blockchain, a block cannot be changed or deleted. The transaction is then executed, and the assets are transferred between the parties.

Now that we’ve established a base understanding of how a blockchain transaction works, let’s dive into the five distinguishing features of blockchain systems as listed above.

Shared publicly

Blockchain technology allows for complete transparency among all users in a database because each user has his/her individual copy of the entire ledger. This allows anyone in the network to audit a given transaction and ensure an asset’s value by looking through the ledger for all entries related to that asset. Further, as noted throughout the entirety of this article, although the transactions are publicly viewed and verified, the blockchain network can be designed to allow a transaction’s participants to remain completely anonymous. Such anonymity is accomplished by the public/private key pairing—if the participants wish to remain unidentified, they will use the public key as their unique digital identity.

Decentralized

Today, there are three ways a transfer of assets can be conducted: (1) through a system of trust in which all involved parties trust that each other party will transfer the assets as originally agreed, (2) through a traditional contract, and (3) through an intermediary. Even with a contract or through the involvement of an intermediary like a banking institution, there is no guarantee that the assets will be transferred in full or without additional costs. If one contracted party does not comply, the other party (parties) will likely need to spend additional resources in the form of legal fees to enforce the contract, while the use of a financial intermediary creates “friction” by adding costs and time needed to complete the transaction. Unlike most asset-based transactions occurring in the markets today, blockchain technology does not need an intermediary or an external contract to execute a transaction. Because it is a decentralized system in which the entire network must confirm a transaction for it to occur, transacting parties can engage on their own terms without the traditional added costs.

Immutable

Perhaps the claim people take issue with most is the immutability of a blockchain transaction. The premise that the blockchain cannot be hacked is purportedly inherent to its function—once a verified transaction is added to a block and that block becomes part of the chain, it cannot be changed or altered by any party. The inability to change transactional data contained in a block is tied to the unique hash. A good hash (a) makes it difficult to reverse-engineer the original data from the hash alone, and (b) changes in an unpredictable fashion in response to any change in the underlying data 2. On a very basic level, you can think of a hash as a simple language code you may have made as a child. For example, you could write out the numbers 1-26 on a piece of paper and assign every third letter of the alphabet to each number.

You could then share that code with another person, and you two would then be able to write each other ‘secret’ messages that only you would understand. Hashing works much the same way—just on a far more complex scale. Unlike the simple encryption example above, hashing is a one-way function that relies on algorithms to translate the original data into a single, complex string of letters and numbers. Where standard encryption is a two-way function that can be solved with the proper code (like the piece of paper explaining your coding system you gave to your friend), the password for a good hash cannot be reverse-engineered. The decoding process is initiated when the recipient of a hashed file submits an ID and password to the authentication server. The server first translates the password into a hash using the same algorithm that the original file’s hash was created with, and then matches the password hash to the file hash, thereby decrypting the file and granting the user access.

Because a good hash will respond to a change in the underlying data in an unpredictable fashion, a hacker would need to know the precise algorithm by which the hash was originally created to match the data file’s new hash to the corresponding password. Further, that new hash would be immediately visible to the network users because the block would no longer fit in the blockchain—recall that each block contains the original hash of the block that comes before it in the chain.

Although these features establish further levels of security than a traditional transaction, it is important to remember that the blockchain is still susceptible to the ordinary security vulnerabilities companies currently face. Such vulnerabilities include social hacks like email phishing scams and scammers within the company, unsecure access to the physical servers, and lack of protocol for protecting server logins and passwords. Companies or individuals that utilize blockchain technology must be vigilant in their efforts to protect their private keys and other access points onto the chain.

There is a corresponding dark side to immutability. Although the distinctive feature is a significant security measure, it also means that any illicit, or otherwise offensive, materials attached to a blockchain are also irremovable.

Trusted

As previously discussed, a blockchain transaction cannot be executed without verification by all servers within the network—creating trust even between unknown parties. In conventional transactions the risks of transacting with an unknown party are significantly increased because there is no guarantee that the unknown party’s assets are in the claimed condition or amount, or that the party even possess the asset(s) at all. Because of the decentralized nature of the blockchain ledger, ledgers can be shared between contracting parties—allowing for complete transparency regarding the assets in the transaction. Remember that blockchain ledgers can record more than just cryptocurrencies—these ledgers can be used for a wide variety of assets from inventory, traditional currencies, marketable securities and options, and land and buildings. Accordingly, you, and every other node in the network, can verify that the other party does in fact have the assets they claim to possess. During a panel discussion at Brigham Young University’s Blockchain Summit on February 16, 2018, this feature of blockchain technology was explained through a comparison to a standard credit card transaction. With a credit card transaction, there is a delay between when a seller gives up goods and when the buyer makes good on his promise to pay. At the time of the transaction, the seller does not know if those funds are good (i.e., the buyer has sufficient funds and won’t default on the payment). Within the blockchain, asset transfers can be executed with greater speed and reliability. Because each participant’s ledger is viewable (auditable) by every node in the network, a transaction can only happen if there are sufficient assets available to transfer. In other words, every node in the network must either be conspiring together or have been compromised and under the control of a malicious single party for an individual to make a transaction that is invalid or nefarious or to alter a previously validated transaction.

Automated

The blockchain software not only prevents conflicting or double entries from being permanently written into the ledger, but also is capable of automatically executing transactions. Some of the drawbacks to a traditional contract are the additional fees and intermediaries needed to both draft and enforce the contract. In the spirit of blockchain technology’s limited use of resources off the chain, ‘smart contracts’ are contracts written directly into the blockchain. These contracts don’t require an intermediary because, although the participants are kept private, the contract itself is part of the public ledger. The terms of a smart contract are immediately executed when a triggering event, as detailed in the contract’s code, occurs. For instance, in a real estate transaction, once ownership is confirmed, the title is transferred, and escrow is released. Or, shares of stock are purchased/sold/transferred once a pre-determined strike price is reached.

Is blockchain the future?

From seasoned investors and financial analysts to members of the general public, opinions on blockchain technology and its implications for global financial markets fall along the spectrum of whole-hearted enthusiasm to extreme distrust. Blockchain enthusiasts claim that blockchain systems allows for ‘trust through technology’ by allowing complete strangers to enter into asset-based transactions with one another and have full confidence that they won’t be cheated. Panelists at the BYU Blockchain Summit also explained the impact the technology can have especially in third-world countries where access to funds through financial institutions is limited at best and asset records are not the most reliable (or are non-existent). With blockchain technology, members of third-world countries can establish government-like asset registries which could then be used to verify available collateral for loans.

Even with the proposed benefits of blockchain technology, there remain significant downsides that must be considered—including the computing power required and the previously mentioned dark side of immutability. The sheer amount of computer processing power necessary to hack into and fraudulently alter the blockchain is so high because the computing power needed to establish the blockchain in the first place is immense. Organizations that choose to implement a blockchain system must address considerable changes and additions to their IT infrastructures.

Additionally, blockchain could revolutionize how accounting professionals perform their jobs2. Auditors could use the blockchain as an intermediary in a triple-entry accounting system to automate transaction storage and verification, as well as develop internal control mechanisms for the blockchain-related functions and applications. The blockchain can also be used in taxation to make transfer pricing more transparent. The key in all of this change is for regulators to understand the entire blockchain ecosystem and to develop new measures and practices that allow the accounting realm and the entirety of the financial markets to adapt.

As cryptocurrency values skyrocket and plummet seemingly overnight, it is reasonable that people would be hesitant about the underlying technology. However, Stockchain Global CEO and BYU Blockchain Summit panelist, Ben Beasley, expressed that blockchain technology should be separated from cryptocurrencies because there will be many crypto crashes. He went on to state that conflating the volatility of Bitcoin with blockchain technology is like treating the dotcom bubble and the internet as one and the same.

For many, blockchain seems like a complex, foreign technology that has the disruptive potential to fundamentally change how the global economies operate. While there is still much to learn about the security and proposed implementations of blockchain, we hope this article provided you with a better basic understanding of this new technology.



 

Resources Consulted

 


 

Footnote

  1. https://blockgeeks.com/guides/what-is-blockchain-technology/
  2. Julia Kokina, Ruben Mancha, Dessislava Pachamanova. Fall 2017, Vol. 14 Issue 2. “Blockchain: Emergen Industry Adoptions and Implications for Accounting.” Journal of Emerging Technologies in Accounting 91-100.
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Author Alexia Jentgen

Alexia was born and raised in Vacaville, CA. When she is not studying accounting, Alexia loves running, dancing, and training her dogs, Mickey and Daisy. After graduation, Alexia will be joining the Deloitte Audit team in San Jose, CA.

More posts by Alexia Jentgen

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