While Bitcoin technology has been hitting the headlines over the last few years, Blockchain is the essence that underpins it. But what is Blockchain? It’s essentially a ledger which logs transactions between two parties. Yet while most ledgers are kept in banks or accounting departments, Blockchain is a distributed ledger in which copies are kept at several computers or nodes (under different owners). Each block represents a financial transaction and comprises a set of transactions, which have been captured as a sequence based on time. Every new block/transaction has to be approved by a set of computers to be added to the chain.
Blockchain and its use for Bitcoin transactions – five key factors
One of the reasons for the hype surrounding Blockchain is that it solves a number of digital transaction issues, including:
- Privacy: The identity of the individual is a public-key (a string of alphanumeric text) which is available to everybody, much like an email address. This public key is mapped to a private-key known only to its owner. The combination of private-key and public-key usage gives the individual access to his/her funds, providing privacy and security.
- Peer-to-peer (P2P): The exchange of money between two individuals happens directly without an intermediary, like a bank. For example, a Whatsapp call is an example of P2P exchange (using the Internet) whereas a cellphone call depends on a telecom provider and is not peer-to-peer.
- Distributed ledger: All peer-to-peer transactions are logged in a ledger; in the Blockchain world, a copy of this ledger is present on many computers in the ecosystem, hence the term ‘distributed’. The blocks/transactions in the ledger are non-reversible by design. So this distributed ledger which is visible to everybody becomes a permanent record of cash and digital transactions. This key element adds a trust factor to the system.
- Proof work by nodes: Every new transaction that is added to the ledger is approved by a set of computer nodes. The nodes have to solve complex mathematical problems to be eligible to approve (and get a small commission for) this work. The system is designed to prevent computer nodes from colluding to rig the overall system.
- Digital coins: The Bitcoin ecosystem started with a fixed number of coins with rules deciding when coins could be issued. The issued coins can be bilaterally exchanged by users, with each individual’s balance or coin wallet determined by traversing the blocks in the Blockchain tree.
Blockchain can claim seemingly endless capabilities and advantages, including:
- Preventing double spending – Previously, when sending digital currency from one person to another there’s always the issue of ‘double spending’ one’s digital cash. For example, anything digital like a photo or file can be copied and duplicated, yet currency notes in the real world can’t be used again. Blockchain solves this problem through the immutable ledger that’s visible to everybody.
- Self-monitoring – The mechanism that ensures that the distributed ledger is immutable follows a ‘proof of work’ system. Though the ledger is available to everybody, it can’t be hacked by a collusion of nodes. Every transaction is approved with a foolproof method before it is captured in the ledger. Essentially, this provides the distributed ledger with integrity without the need of a central authority.
- Global platform- Since the currency is digital and not tied to a country, it is useful for cross border money transactions. There aren’t any costs for foreign exchange conversion, correspondent banking fees and other delays. Plus, the time for a new Blockchain transaction is typically just minutes, whereas current cross-border transactions can take hours or even days.
- Cross border trading of goods- Typically, currency conversion comes with certain implications; the cost of imports or revenue from exports can significantly impact companies. These swings in revenue aren’t related to the quality or performance of underlying products or services – a globally accepted digital currency could help to solve this problem.
- No single point of failure – In a central authority based system, all trust rests, rather unsurprisingly, with the central authority. So if the central authority fails, the entire system collapses. In the Blockchain model, where the ledger copy is kept at several nodes, this can’t happen.
Blockchain beyond digital currency
Could Blockchain store something else besides currency? Anything that can be captured as digital text can be stored. There are several ideas currently being explored but many are still in their early stages of maturity. For example, storing intellectual property rights, where Blockchain could identify the owner of the right, the time of IP/node creation and IP contents at the time of filing. It could be used for trade settlement; overseeing the settling of trades between two counterparties and the security of that transaction. Blockchain could even be used in a rewards program, for closed user-group membership points and rewards management.
It’s too early to predict the wholescale success of Blockchain technology; it hasn’t been tested adequately in terms of volume of transactions, variety of usage scenarios and mass user-experience. But as the world moves to a global economy which is digital and mobile driven, there is a need for a global payment platform which doesn’t rely on any individual government. Blockchain seems to tick all the boxes as the best example of such a platform. But the success of a product is also determined by mass adoption and consistent behavior over a period of time. Given the potential and limited alternatives available, it is one of the best financial innovations in recent times.
The article was originally published on Financial IT Magazine on Oct 23, 2015 and is re-posted here by permission.