Mar 04, 2019
Blockchain – truly transformational in its potential
“First you dismiss it as unimportant, then you embrace it, then you try and kill it. Then you become it.” David Crosbie, School of Engineering, Penn State on new technology
Many of us were first introduced to blockchain as the underlying technology behind the cryptocurrency Bitcoin, although we knew little of what that meant. Equally misunderstood, Bitcoin jumped on to the scene by virtue of its spectacular investment returns of 1400% in 2017, and equally spectacular collapse last year. While it is fair to say that Bitcoin’s future as the de facto world currency was probably a bit overhyped, there is a growing consensus that blockchain technology is truly transformational in its potential. With that in mind, we thought it might be helpful to provide a simple (as possible) explanation as to what this means and why it is important.
“What is Bitcoin?” was one of the most commonly asked questions on Google in 2018.
Imagine on Election Day you have the option of casting your vote on your tablet or smartphone, knowing that your identity is secure and getting confirmation that your vote was counted. How about eliminating the risk of fraud or counterfeiting in an online transaction, or musical artists receiving the correct royalties without depending on the honesty of their record label? Imagine knowing with certainty that the steak you are eating was grass fed in Wyoming. These and many other transaction-related developments are coming, enabled by a relatively new technology called blockchain. Blockchain has grown in its visibility as a powerful new technology that promises to change the way transactions are made and how records are kept. In the business world, that’s a big deal.
One of the first questions someone might ask is, “Even if this technology develops as expected, do I really need to understand the mechanics behind a transaction?” For most people, the answer is no, which may be reason enough for some to stop reading here. For others, there may be a mild curiosity what all the fuss is about as blockchain becomes more prevalent in news stories and references. Most of what we address will be at this level. For the few who are fascinated by new technologies, we have included an appendix of more technical commentary.
What is blockchain?
Blockchain is a digitized, decentralized public ledger for financial and other types of transactions. It is a permanent record and leaves an immutable historical trail that is publicly accessible. Digitized means a transaction is in the language of computers, enabling it to be shared electronically. A decentralized public ledger means that the record of a transaction is kept on multiple sites that can be visible to anyone in the blockchain network. In contrast, the recording of a transaction under traditional methods, such as a credit card or cash purchase, is an isolated entry on the card company’s or merchant’s ledger.
Blockchain technology also leverages many asymmetrical cryptographic methods to code and decode the underlying transactions, all of which are continually verified, authenticated and reconciled. At a high level, each transaction that is broadcast over a blockchain network is grouped in a “block” with thousands of other transactions. Once these blocks are mathematically verified and authenticated by administrators in the network, they become accepted and are linked to the “chain”, or ledger, and everyone in the network receives a copy. If any of the data is manipulated, the links change and the chain becomes invalid.
So why does it matter where these records are kept, and why would anyone else care to see them? Though the answers are not intuitive, the ramifications are significant. We will provide several explanations as to why this matters and how this potentially groundbreaking technology can be disruptive to many entrenched businesses.
But before we get there, we will revisit the history of blockchain technology and the concepts of Bitcoin and other cryptocurrencies. While blockchain has multiple potential applications beyond cryptocurrencies, this is a good place to start.
Cryptocurrency and Bitcoin
A cryptocurrency is a currency in digital form only. It remains in digital form until it is exchanged for a fiat currency such as a dollar, Euro or Yen, or for goods or services. However, unlike a fiat currency, a cryptocurrency has no physical form like the dollar bill in your pocket. Also, unlike fiat currencies, there is no central bank to create, regulate or influence its value. Like a fiat currency, a cryptocurrency’s value is determined by willing participants to exchange it for goods, services or fiat currency.
The idea behind cryptocurrency and blockchain, the technology that makes it possible, came into focus in 2009 in a whitepaper written by an unidentified source named Satoshi who envisioned a currency with no central authority—a libertarian’s dream. He envisioned coins created by “miners” who employed customized software designed to solve a specific mathematical equation. Bitcoin, the most widely recognized cryptocurrency, was instantly popular among the tech-minded, and soon among speculators, blackmailers, money launderers, and other black hats who wanted to transact anonymously.
“Crypto” refers to the encryption used to ensure that the currency cannot be stolen. The process is similar to the encryption codes credit card companies use to protect your card during an online transaction. In this case, when you type your credit card number on a protected website, it is encrypted and digitized; that is, it is changed into a very long series of ones and zeros—the language of computers. Unless you possess the encryption formula, it is virtually impossible to decipher the number.
The credit card company then decodes the number and reveals it to the merchant who then debits your card. Similarly, the owner of a cryptocurrency account who wishes to spend her currency uses her “private key” to encrypt the transaction. However, this time, the transaction is verified by a small army of administrators on the web, called miners; after which it is posted to a distributed ledger. The administrators are called miners because they receive a reward in cryptocurrency for their effort, thus creating additional currency. The private key used by the originator of a Bitcoin transaction has a public key match that is used to decode the transaction.
The number of coins in circulation increases as more currency is mined. Normally, more supply means less value, but in this case, its value may not diminish because mining becomes more difficult as the number of coins increases. There is an upper limit to the number of “blocks” (units of bitcoins) that can be created (approximately 21 million) over a specified period of time.
Fans of cryptocurrencies believe they will supplant fiat currencies someday; however, they will have to overcome several major hurdles before they hope to be accepted as a medium of exchange and a store of value. The first challenge is scalability—the ability to handle tens of millions of transactions daily. For example, Visa can handle more than 15 million transactions a day. Second, it must be accepted by most vendors. Third, its exchange value must be stabilized. Beyond speculation, an unstable currency is useless.
There are also plenty of critics. One observer compared Bitcoin’s recent decline to “a bunch of drunk teenagers falling down a long escalator while discussing the future of capitalism.” Instability is one reason sages like Warren Buffet and Jamie Dimon have dismissed Bitcoin as a “fraud.” Paul Krugman takes it further by calling it “evil.” We’ll pass on moral judgments, but either way, it is hard to foresee just when cryptocurrencies become a credible alternative to traditional currencies.
Are cryptocurrencies a threat? A national digital currency would be cheaper and easier to manage. Sweden and Singapore are testing the waters, planning to issue their own digital currency. Indeed, a total of 15 countries’ central banks so far are considering digital currencies. If central banks gain control of digital currencies, Bitcoin and others on the market today may not survive.
Modern Cryptographic Methods
We generally associate cryptography with coded messages. As we have all learned from spy novels, encryption keeps the message a secret until it is deciphered by the intended recipient. Historically, one would simply substitute one word for another so that the message looks like nonsense. With the advent of computers in WWII, messages became numbers which were then scrambled by special formulas or algorithms. Modern encrypted messages are breakable, in theory, but not in reality with current technology.
So how do modern cryptographic methods work? Imagine hundreds of coins in a row, randomly some are heads, some tails. Now imagine this binary row of heads and tails as a sequence of ones and zeros, digitized. This row could be a digitized version of your credit card number, for example. However, the number represented by this row is encoded when it is combined (possibly multiplied) with the second number to create a new number. This new number can be transmitted without fear of eavesdroppers discovering the original constituents because of the enormous number of possible combinations.
A hacker might try to guess by using brute force computing (sort of like repeatedly flipping coins in both rows and combining them in the hopes of getting the same product), but that could take decades. This is the concept behind the cryptographic function used to encode your credit card transactions and to transmit cryptocurrencies. Of course, the credit card company has the key to decode it at the other end of their transaction, while cryptocurrencies have separate key holders and miners that serve as public auditors.
Cryptographic transactions are also tagged with a digital signature. We know that traditional banking transactions require your written signature to verify your intent to transfer cash from your account to another. Distributed ledgers, like Bitcoin, are more secure because the signatures are encrypted and cannot be copied. As these digitized transactions are verified, the distributed ledger, held in many locations, keeps a record and a running balance for each account.
What happens when you pay with bitcoin? First, you’ll need a Bitcoin app that lets you receive, hold and spend bitcoins. You make the payment directly from the app, which broadcasts it publicly on the web. Then agents or miners, listening for such transactions, rush to verify your transaction and post it to the blockchain, or communal ledger. Multiple verified transactions are next arranged in blocks by miners that broadcast the results so that others can see this work. Successful miners are rewarded with new Bitcoins. The current award is 12 ½ coins, each worth approximately $4,600. New blocks of bitcoin transactions are processed and rewarded about every ten minutes.
Mining is an energy-intensive arms race, requiring advanced technological tools and, as with any race, speed is key. Speed comes with a high price tag. To compete as a miner requires a large investment in expensive processing equipment, using advanced Graphics Processing Units (GPUs) built by Nvidia or Bitcoin-specific ASIC chips.
Disrupt: “to throw into disorder; to interrupt the normal course or unity with new technology.” Merriman-Webster
“…blockchain technology has the potential to revolutionize the financial services industry, the U.S. economy and the delivery of government services, and I am proud to be involved with this initiative,” Mick Mulvaney, Acting White House Chief of Staff
“Blockchain technology creates a single, shared version of the truth, that no one member or entity owns or controls. That leads to increased trust and integrity in the flow of information among participants. More simply, it’s an entirely new operating system for trust, upon which all sorts of innovation can spring.” Ginni Rometty, IBM [source: www.nxtbook.com]
Blockchain technology offers many advantages over traditional record-keeping methods, such as cost savings, speed, accuracy and security. It eliminates the middleman and provides a mathematical basis for trust. Intrigued with its possibilities, companies across industries are investing in resources to further explore potential benefits and uses. In the private sector, several major companies are planning to implement blockchain projects in 2019, including retail goliath Walmart. Venture capitalists and tech titans are investing tens of millions of dollars in blockchain startups. And according to Fitch Ratings, “Companies are actively incorporating it into their capital spending plans.”
Blockchain is already changing the financial landscape. One of Europe’s biggest securities settlement systems is set to welcome a blockchain-based depository after Setl, a UK fintech group, received a license from French regulators, according to the Financial Times. The potential cost savings alone of blockchain will attract multiple businesses to look at potential applications. For example, blockchain will be instrumental in streamlining the current payment verification process, saving time and expense. Banks currently charge steep fees to verify international transactions, which are especially cumbersome and time consuming. Blockchain would allow banks to instantly validate participants and their accounts.
According to the Financial Times, more than 75 of the world’s largest banks are turning to blockchain to fight the competitive threat of new payment rivals. This race to create the banking industry’s first mutually-accessible ledger, the Interbank Information Network, is currently being tested by JP Morgan and the Royal Bank of Canada. Developers expect it to improve the international exchange process, currently bogged down by faulty records, wrong addresses and missing data. With a distributed ledger, resolution would be almost instantaneous. Accurate records would reduce disputes between trading partners seamlessly and ease a major source of trade friction.
Blockchain technology also promises to disrupt other industries such as retail, food, education and healthcare. Even in the last year, several companies have made strides to incorporate blockchain-based technologies. For example, Walmart announced plans to implement blockchain farm-to-store tracking of food. In oil, Chevron, Total and Reliance Industries backed a new digital platform for crude oil trading based on blockchain, joining a consortium of investors that includes British Petroleum. Five of the world’s largest container-shipping groups are joining forces to create new IT standards for the industry that could allow them and ports to use digital technology such as blockchain. Air France-KLM said it was exploring ways to use blockchain-based technology to cut costs for flyers and increase profits for suppliers by cutting out middlemen. The Financial Times predicts that insurance companies could save 30% or more by making the claims process more efficient. And not surprisingly, Facebook, Google and many others have teams of engineers dedicated to developing this technology.
Blockchain is attracting new entrepreneurs, too. Startups, like Provenance and Fluent, are developing blockchain’s potential to improve supply chain management; documenting and tracking inventory securely and transparently, verifying authenticity at every point in the chain. On the healthcare front, startups Gem and Tierion are developing blockchain software for hospitals to secure their data and improve the accuracy of diagnostic records. The real estate industry is plagued by bureaucracies with inaccurate or fraudulent public records that frustrate the transaction process. Here blockchain would be able to ensure accuracy, reduce paperwork, and speed up transactions. Startup Ubitquity is working on these platform solutions.
It is estimated that there are currently 15 billion devices communicating with each other. Tech giant IBM has committed 1,000 employees and $200 million to the development of blockchain-powered Internet of Things (IoT).IBM and Samsung are working on blockchain applications for IoT that will allow decentralized communications between devices, eliminating a central controller, to make the devices more difficult to hack.
According to Gartner, the world’s leading technology research firm, blockchain is involved in proof-of-concept trials that include digital diplomas, verifying an idea or invention as unique, registering copyrights, patents, reducing resume fraud and streamlining transfer processes between institutions, states, countries, student payments and academic publishing. Eventually “smart contracts” may disintermediate lawyers, accountants and bankers.
Figure 1: Potential Blockchain Applications
Trust and security are essential to modern economies. Compromising our financial system through the destruction of credit records and bank accounts is far cheaper than conventional weapons and just as devastating. Western governments do not have the capacity to protect all its citizens and institutions from cybercrime. Some governments are passing legislation to make cybersecurity compliance mandatory. Indeed, Gartner warns that by 2021, private organizations that bypass privacy requirements or lack enough protection will pay 100% more in compliance costs than protected competitors. Blockchain can strengthen the security of cloud storage provided by Google, Amazon Web Services, and others.
Besides being a somewhat difficult concept to understand, most Chief Information Officers remain skeptical. So, implementation will come slowly, in a measured evolution. However, skepticism will eventually give way to fear of missing out. Accenture, McKinsey and Gartner are introducing the new technology to organizations worldwide, convincing doubting CEOs that additional security will add to the bottom line. Gartner believes blockchain will create $3.1 trillion in business value by 2030. Little wonder that blockchain startups have raised over $1.3 billion from venture capitalists in 2018 according to Crunchbase, a business information firm.
Figure 2: The Blockchain Ecosystem
A DEEPER DIVE – HOW BLOCKCHAIN WORKS
“The blockchain does one thing: It replaces third-party trust with mathematical proof that something happened.” Adam Draper, Boost VC [source: https://www.mercurynews.com/2016/11/11/whatever-happened-to-bitcoin-adam-draper-has-the-answer/]
The cryptography that serves as the foundation of blockchain technology is what enables the technology to be incorruptible. Transactions are encrypted, transmitted and decoded using a multi-step process that ensures transactions are both immutable and verifiable. This is achieved through the use of hashing algorithms, digital signatures and a process known as “proof-of-work”. Transactions are further protected by the decentralized, consensus-driven and transparent nature of a blockchain network.
Blockchain Cryptography: Hash Functions & Digital Signatures
When a sender decides to transmit a message, or initiate a transaction, the cryptography process begins with a tool called a “cryptographic hash function”. A hash function is an algorithm that maps data of an infinite size to a bit string of fixed size. Applying a hash function to the original message, or input data, creates an encrypted output known as a “hash”, or digest. This hash is what is transmitted to the blockchain network, added to a chain and later deciphered by the intended recipient with the same hash algorithm.
Figure 3: The Hash Function
Source: 3Blue1Brown – YouTube
Each hash serves as a unique identifier, and any attempt to change the original message, or input, changes the hash unpredictably. And, as we’ll discuss later, this in turn changes the integrity of the entire chain. Furthermore, the cryptographic hash function is asymmetric, making it impossible to compute in the opposite direction. The message can only be verified using the same hash function. For example, Bitcoin uses the hash function SHA256. It is these properties associated with hashing that make messages sent using blockchain technology immutable.
Figure 4: The Hash Function Avalanche Effect
Source: YouTube, 3Blue1Brown
Before a hash is transmitted to the blockchain network, a digital signature is applied by the sender. Digital signatures are used to verify that it was the sender who sent the digital message and the sender cannot repudiate the message. An encryption algorithm creates a public key and private key pair at random. The encryption process is asymmetric, meaning the algorithm used to combined the public and private key pair and encrypt the message is a one-way function. Therefore it cannot be computed in reverse using the public key to obtain the private key. A separate algorithm is used (typically by miners) with the public key to either accept or reject the signature as valid, without revealing the private key. Once the hash is created, the sender “signs” the encrypted message with his private key and a digital signature is created. The message is then decoded by the intended recipient with the sender’s public key. In essence, the sender’s private key is used to encode the message while the sender’s public key is used to verify who the sender was.
Each key is represented as a very long series of bits—1s and 0s. Currently, 2,048 bits are used for asymmetric algorithms. Of course, a private, or secret key, should be kept secret. In fact, some coins have been lost because the owner forgot the private key, most famously as reported by the Financial Times: “QuadrigaCX announced its 30-year-old founder, Gerry Cotten, had died in December, and this week revealed that no one else has the passwords needed to unlock at least $150m in Bitcoin and other assets”. After it is transmitted, or broadcast, the public key is used at the other end to decode the transaction, sort of like the way you use your passcode and comparing the hash digest computed before to determine whether any changes have been made.
Figures 5 and 6: Public and Private Keys
Because it is infeasible to recreate the private key, the recipient is able to verify the authenticity of the message. Lastly, as an additional layer of security, transactions are “time stamped” so each transaction is unique.
Creating the Chains: Miners & Proof-of-Work
Signatures and hashes must be discovered before they can be verified. Discovery begins when the originator broadcasts her proposed transaction to everyone in the network. The blockchain network is made up of administrators, known as “miners”, who listen for these transactions with the goal of recording them in blocks and eventually adding the blocks to the chain, or ledger. Each miner has a copy of the chain, making the network transparent and decentralized.
In order to be added to a block, the hash and digital signature of each transaction must first be verified. In competition with each other, miners race to build and release larger and larger blocks. For this effort miners earn a reward in Bitcoin. A block may contain 2,000 or more transactions, and new blocks are broadcast in the hopes of being accepted and added to the chain. A completed block means the transactions are verifiable. If the majority of other miners in the network accept the new block, it is added to the ledger. But which new block should they trust? Miners will trust the block with the most “proof-of-work” since those blocks would be the least likely to have been altered.
Miners discover these blocks and race to solve a “cryptographic puzzle”, meaning they attempt to correctly guess the original input. Importantly, the only way to find the input data from the output hash is to use brute (computer) force—requiring serious computing power—to try billions of possible inputs. However, due to the enormity of possibilities, discovering the entire input is impossible with today’s technology. But by applying the hash function, for example SHA256, a miner can discover a partial match, such as a predetermined sequence that begins with 50 zeros. This predetermined partial match is enough for validation as “proof-of-work”, and good enough to register a ‘True’ signal. Importantly, the sender’s private key is validated but not revealed during this process. (How this software computes this is beyond the scope of this paper.)
Figure 7: The Cryptographic Puzzle
Validation requires knowing the full history of a transaction. For example, to be able to transfer currency, the sender must have a positive balance (overdraft is not allowed); therefore, validation requires access to the whole ledger in order to view the full history.
This first miner to solve the cryptographic puzzle adds the new block to the chain by attaching the cryptographic hash from the previous block. We now have a chain of blocks that consist of valid transactions. Chaining the blocks ensures the blocks of transactions follow an immutable sequence. Tampering with a block would change the hash and break the chain, making all the following blocks in the chain invalid. A hacker might try to recalculate all the hash tags in the chain, but this would require recalculating the entire history. A fraudster would have to stay a step ahead of an army of racing miners. So, it’s the longest blocks—the ones with the most computational work behind them—that are the most trustworthy. These long blocks would require the most effort to change. Changing the contents of a large block requires too much work in addition to continuous updating. So, if miners discover two ledgers that don’t match, they would trust the ledger that has the longest, most proof-of-work. The updated chain becomes the newly revised ledger of verified transactions and is distributed with everyone in the network.
Figure 8: Blockchain Simplified, The Economist
Bitcoin blocks are getting longer, requiring more work. Therefore, newer cryptocurrencies attract new miners because they require less work. In its infancy, anyone with a desktop computer, access to the internet and the software could create a Bitcoin. But today, mining requires a room full of servers, consuming huge quantities of electricity which in turn creates heat. Electricity and hardware costs can be as much as 25% of the rewards. Many experts believe that most bitcoins are mined in China. However, with its geothermal energy and cold temperatures Iceland is becoming the new center for bitcoin miners.
Figure 9: A Bitcoin Mining Operation
Source: Google Image
Like many new technologies, blockchain is quickly challenging the status quo. Blockchain’s potential extends across industries, with Bitcoin and cryptocurrencies representing just the tip of the iceberg. Your credit card and bitcoins remain a safe way to transact, for now. But quantum computers are coming, and they are a game changer. Hiding information with encryption schemes will be impossible, whether it’s distributed ledgers for credit cards, stealth fighters or submarines. This is the subject of a future paper.