What Blockchain Is and Is Not

One of the most frequent topics we are reading and hearing about these days is blockchain technology. The articles run the gamut on how it will affect the financial industry, but very few articles explore what it really is and is not, and how it works. To many, blockchain is a magic box where things are recorded or registered, and that is supposed to help…maybe…somehow, something in the transaction process.

The first step is distinguishing between Bitcoin and blockchain. Bitcoin is a cryptocurrency that uses blockchain technology to work. It is not uncommon to conflate the two, but that would be a mistake. Bitcoin is often accused of being a means for drug dealers to do business. But, true or not, that does not make the blockchain technology it uses “bad.” That would be akin to saying cars are bad because moonshiners used them to smuggle alcohol during prohibition. So, while blockchain technology underlies cryptocurrencies, blockchain is not itself a cryptocurrency.

So what is a blockchain?

At its most fundamental level a blockchain is a cryptographically secure distributed ledger system. Taking the last part first, a distributed ledger system is just what it sounds like. For instance a bank keeps a ledger of its transactions. You deposit money, take out money, get a loan, etc. and it all gets recorded in the ledger. Each part of the ledger depends on what goes before it. So if you want to take out money the ledger needs to show you already have that money in the bank and then your new balance is recorded after the withdrawal.

But how do we know that ledger is correct?  What if the person recording transactions wrote down the wrong amount or moved a decimal place (either by accident or fraudulently)?  We have to have faith in the business or people we are transacting with and it is for this reason that banks (as one example) have extensive procedures in place to make sure everything is recorded as it should be. It is also why there are delays in the system. The delays allow more time to be certain all is as it should be. Even with all that, mistakes and fraud still occur.

This is where the cryptographic part comes in. While we usually think of cryptography as a means to hide secrets, in this case cryptography is a means to ensure that each entry into a ledger cannot be changed once it has been recorded.

The math used to calculate a block can only be done in one direction. In other words, you can get an answer but you cannot discern the prior pieces that got you to that answer. So my secret number I used to encrypt the data cannot be guessed by looking at the result it produced.

In a blockchain, each block incorporates the cryptographic hash of the previous block. That makes it nearly impossible (or at least exceptionally difficult) to go back in the chain and change something. All the blocks are dependent on the ones that came before. Change even one, no matter how long the chain, and everything after that change will have incorrect values, making it immediately apparent something was altered.

That alone, though, does not make the system secure. If only one person has the ledger, they could change something in the chain and recalculate the whole chain after that so it all looks fine. To stop this is where the “distributed” part of the “distributed ledger” comes in. Again, it works just like it sounds. Instead of one ledger there are many, many copies distributed among a large group of people. Since they all have a copy of the ledger they all have to agree on what the correct ledger looks like. As transactions occur the whole network agrees on what are legitimate transactions and everyone has a record of that transaction (and if there is a conflict the whole network votes on which transaction is the right one).

Now, putting it all together you can see the blockchain in action. Everyone has a copy of the ledger, each entry in the ledger is a “block”, everyone agrees that each transaction is legitimate, and if one person tries to change the ledger fraudulently,  the rest of the network will disagree because the cryptographic hashes will be wrong compared to the rest of the network. Each transaction depends on the block before it and thus, by extension, the entire chain all the way back to the beginning.

So the “blocks” are really Bitcoins when all is said and done, right?

Nope. Not at all. Bitcoin was just the first and most high profile use of blockchain technology. Bitcoin is a cryptocurrency which basically posits that each block has an inherent value that can be used for transactions akin to money. There is much debate about whether it constitutes a real currency, or is a scam, or is only for criminal activities. None of that is in the scope of this article or is relevant to the function of blockchain.

That said, it did not take people long to realize the possibilities of the underlying blockchain technology that Bitcoin uses. Basically, a “block” can represent anything you want. It can be a currency, ounce of gold, a piece of artwork or other property. Indeed the art world sees blockchain as a means to firmly establish the provenance of artwork in the future. A block could represent most anything you can think of that you would want to trade.

However, each such system would have to be distinct from the other systems, completely separate and (probably) not even running the same implementation of blockchain technology. So you could have a blockchain for trading private securities, another for bonds or OTC trades and others related to clearing and settlement. Given the number of blockchain initiatives and cooperative organizations such as Digital Asset Holdings, R3 and the Hyperledger Project, there are likely to be multiple versions of blockchain technology in the future.  And with competition for blockchain solutions, there exists a real danger of Balkanization.

Are blockchains inherently safe?

Not necessarily. It really depends on the implementation. For instance, there are private blockchains being developed. The “distributed” part of the distributed ledger will only be given to parties that the originator agrees to. Is that safe?  Might be, might not be. You have to trust the people running it not to try to mess with the transactions for their own purposes.

Bitcoin maintains the security of its ledger by being public and so widely distributed that it is near impossible for any one person or group to control the system. Private blockchains of course do not have that same distribution.  The fewer entities it is shared with the easier it is for someone to fiddle with the system.

Even so, there can be some great uses for a private blockchain. When used internally within an organization they can make sense. For example the Federal Reserve or a bank might want to use a private blockchain system internally among their own branches for transactions between each bank. If you can’t trust yourself who can you trust?

So why use blockchain?  Why not?

The current system that banks and companies use to track transactions is slow and cumbersome and has a potential for errors and possibly fraud. Blockchain allows transactions to occur much more quickly and with potentially greater reliability than they do now. Inherent in that reliability is less chance for fraud as well.

Even so, there may be reasons someone would not want to use it. Public blockchains are, well, public, and that is not always desirable. Private blockchains may allow for non-public transactions but then you are back to having to trust that it is all going as it should.

Also, many companies make a lot of money ensuring transactions and dealing with the current complex process. There is a real chance that blockchain technology will eat into that business.

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