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March
18
2017
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Enter, the Blockchain
This week, we are going to look at another disruptive technology: the inevitable and imminent adoption of the blockchain, and its impact on a wide range of transactional industries, including banking, investing, and everyday commerce. I am in an Argentine frame of mind, having worked the last two mornings in a winery sorting and crushing grapes. Therefore, as the Parade rolls into sight, I’m listening to the classic tango, Por Una Cabeza by Carlos Gardel. As I understand it, the song is about a man lamenting about how his life coulda, woulda followed a happier path if only the horse he had bet on many years ago hadn’t lost by a head. And with that, it’s on to the Parade, with special thanks to Stephen McBride and cybersecurity expert Pete Kofod, president of The Sixth Flag, for their considerable contributions to the article that follows. Enter, the Blockchain In a 2016 report, the World Economic Forum stated, “Blockchain will fundamentally alter the way financial institutions do business around the world.” The “Davos clique” aren’t the only ones excited about its future. Goldman Sachs, JPMorgan, IBM, and Microsoft, among others, are pouring millions into blockchain research. So, what is “blockchain”? We can’t do a better job at defining it than Bettina Warburg, the co-founder of Animal Ventures. Blockchain technology is a decentralized database that stores a registry of assets and transactions across a peer-to-peer network. It’s basically a public registry of who owns what and who transacts what. The transactions are secured through cryptography. Over time, that transaction history gets locked in blocks of data that are then cryptographically linked together and secured. This creates an immutable, unforgettable record of all of the transactions across this network. This record is replicated on every computer that uses the network.
Mining—Auditing the Blockchain for Fun and Profit To better understand how a blockchain works, consider a financial institution’s general ledger. It is typically comprised of a chronologically sequenced set of books, each book representing all transactions for a given financial period. Once that period is complete, the book is closed, audited, and a new book is opened to record all financial transactions for the next period. In this instance, the financial institution’s trustworthiness, and therefore long-term survival, is directly related to the rigor and integrity with which it enforces internal controls, including auditing its books. The blockchain is quite comparable to a financial institution’s general ledger. It is made up of blocks, each of which is analogous to the book of a given financial period. Like the book, a block on the blockchain contains all transactions for a given period. Why the Miners Matter Unlike a financial institution, however, the blockchain does not rely on a central auditor to assure the integrity of the blockchain. Being a trustless system, the blockchain relies on distributed participants to perform this critical task of integrity assurance. These participants are known as miners, a group of entrepreneurs who use computational power to cryptographically audit the integrity of each sequential block. Mining involves something of a mathematical Easter egg hunt, in which all the miners in the world continuously attempt to guess the “signature” of the block. This process, regardless of how many miners are participating in blockchain mining, takes approximately 10 minutes. Once a miner successfully guesses the block’s signature, the block is considered “closed” and the miner is rewarded for their efforts. In bitcoin, currently that reward is 12.5 bitcoins (btc), at prevailing prices worth about $15,300. It’s important to note that each auditing process not only audits the current block, but all previous blocks as well. As such, in order to place many eyes on the same block over time, a block is not considered “fully audited” until it has been successfully audited 12 times. The idea is that the probability of 12 independent auditors incorrectly auditing a block (either on purpose or by accident) is extremely low. For the sake of this article, miners must wait for all 12 audits to be completed to receive their reward. But if the blockchain has such high integrity assurance protocols built in, how could documented hacks of Mt. Gox and Bitfinex occur? In each of these cases, it was not the protocol that was vulnerable. Rather, it was the systems that protect customers’ bitcoin balances. It’s like a gold repository failing to protect the gold it stores, and thieves successfully absconding with customers’ assets—that does not suggest an inherent weakness in the underlying asset. Blockchains are also “permissioned.” Everyone involved in a blockchain is permissioned to have a copy of every recorded piece of data. Every transaction that is added to the blockchain is subject to the distributed auditing performed by miners. Fraudulently tampering with the blockchain appears to be a futile endeavor as the transaction won’t stand up to cryptographic scrutiny. Recall that every transaction is subject to auditing indefinitely. As such, the blockchain is tamper resistant and highly secure, basically eliminating the risk of fraud. On the blockchain, you can store and record any type of transaction. It’s very much like a traditional database, except the “blocks” are linked together cryptographically. An example of this in action today is how it’s helping stop the spread of “blood diamonds.” Having looked at how a blockchain works, what is its potential? The Great Disruptor The real value of blockchain is that it renders intermediaries obsolete. Intermediaries make a living off being a third party that establishes “trust” between parties unknown to each other. Blockchain replaces these middlemen. It does so by offering a vast global distribution ledger on which every type of asset can be stored, managed, and exchanged. This technology has the ability to transform contracts. In fact, it’s doing so right now. Blockchain company Ethereum has created self-executing “smart contracts.” These contracts handle enforcement, management, performance, and payment. Therefore, there is no need for trusted middlemen.
This is the reason the world’s biggest firms are investing in blockchain. They are trying to become the disruptor, not the disrupted. Today, around 80% of banks are developing their own blockchain technology. In September 2016, Barclays carried out the world’s first trade transaction using blockchain. In doing so, they cut a process that normally takes 7–10 days down to less than four hours. IBM is working with the government of Dubai to develop smart contracts that can facilitate all trade that passes through its port. This is huge, given $344 billion worth of goods passed through the port in 2016. Dubai’s government said it plans to shift all transactions to blockchain by 2020. Nasdaq is also in on the action. In December 2015, it used its Linq technology to execute the first blockchain securities transaction. In January, it also used Linq to successfully complete a test to run proxy voting on its Estonian exchange. As Harvard Business Review points out, blockchain is a foundational technology like the Internet. A big system on top of which you can build applications. The parallels between blockchain and TCP/IP, the groundwork for email are clear. Just as email enabled bilateral messaging, blockchain enables bilateral transactions. TCP/IP unlocked new economic value by lowering the cost of connections. Similarly, blockchain will drastically reduce the cost of transactions. To give you a better sense of the thing, here’s just a smattering of existing businesses that could find themselves on the wrong side of the proverbial ledger. What Industries Could Blockchain Disrupt? Financial Services. Banks are essentially secure storehouses and transfer hubs for money. Blockchain’s secure, decentralized, and tamper-proof ledger addresses this function—at a fraction of the cost. A company called Thought Machine has already created a “blockchain bank.” As every type of asset can be exchanged securely on the distributed ledger, blockchain has the potential to render the international money transfer industry obsolete. Clearinghouses and stock brokers are also in the firing line, for the same reason. Voting. In future elections, votes could be cast through a blockchain. Blockchain’s audit trail would authenticate voters’ identity and keep track of votes while allowing anyone to verify no votes were altered. This would make fraud virtually impossible and ensure there is no question of electoral foul-play. Music Streaming. Music streaming is great—well, maybe not for the musicians. It’s estimated that artists lose up to 86% of the proceeds from their music because of illegal downloading. Blockchain is making it possible for artists to earn royalties on their music without going through a record label. Grammy-winning artist Imogen Heap has created a blockchain-based streaming platform called MYCELIA that is facilitating this. Real Estate. When most people think of buying and selling property, they think copious amounts of paperwork, a long, drawn-out process, and high agent fees. Using blockchain, anyone can manage, track, and transfer land titles and property deeds—no need for intermediaries. A firm called Ubitquity is providing this service right now. Supply Chain Management. The transfer of goods requires a lot of middlemen. Middlemen take time, add costs, and every now and then make mistakes. The creation of smart contracts means there is little need for these intermediaries. Smart contracts basically function as a traceability system—recording, managing, and enforcing contracts in a secure and transparent manner. UK company Provenance, which facilitates “transparent and traceable” trade, has been one of the most successful blockchain-based companies so far. These uses are just scratching the surface of the many areas in which blockchain technology will upset apple carts. With the world’s most successful companies pouring millions into blockchain, big breakthroughs are likely near. While it took more than 30 years for the Internet to transform the economy, today more than 50% of the world’s most valuable firms are Internet-driven. Given the fast pace of technology, a blockchain-based economy could be closer than we think. For further reading, here’s a PDF of a presentation Pete Kofod recently gave to a group of high-level law enforcement officials on the topic of blockchain technology. It is definitely a good time to learn more, because the rise of blockchain technology is only just getting started. Want to read more? If you haven’t done so already, sign-up for your free subscription to The Passing Parade from Garret/Galland Research. It’s a rousing weekly romp on economics and markets, with a dose of politics and other follies. It’s free and you can cancel at any time. Click here now to start your subscription today!
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