Cryptocurrencies: What Is Blockchain?

This is the second installment in the Cryptocurrenices series. It explores how blockchain technology works and how it could augment, transform, and disrupt an array of economic sectors. The first edition examined the rise of decentralized money.

Blockchain technology is the “engine” that powers cryptocurrency networks and it is rapidly gaining recognition among businesses.

But what exactly is it? How does it work? And how does it generate economic value?

What is blockchain?

In essence, blockchain is a cryptographically secured ledger that tracks transactions on a decentralized network. Decentralized networks, like those of bitcoin, Ethereum, Cardano, etc., are a collection of computers that are self-managed by a consensus mechanism — a set of rules that dictate how data is recorded, shared, and synchronized throughout the network.

How does blockchain work?

Blockchain’s theoretical foundation fuses mathematics, computer science, game theory, and cryptography. There are several key components that together make blockchain tick.

1. Hash Function: Cryptographic hash functions are central to blockchain technology. They are used to “chain-link” blocks. The hash function has two important features that help it maintain the security of blockchain.

A. Hash functions are one way, or asymmetric. They compress an input, or message, of any length into an output of a predetermined length, or hash value. The hash value of an input is easy to calculate, but it is impractical to decipher the input from the hash value.

B. Hash functions are deterministic. For a given input, there is exactly one resulting hash. Changing any single character in that input changes the hash value. The same input always produces the same output. (This online hash function demonstrates the process).

2. Public Key Cryptography: Cryptocurrency networks use private and public keys to generate spending transactions and verify their validity. A private key is a value randomly generated by a digital wallet. It serves as a unique password or authorization code. A public key is the equivalent of an account number. It is generated together with the private key and is mathematically linked to it. A public key or its hash value is known to the entire network.

Every time users conduct a transaction, their wallet cryptographically signs for it using their private key. These digital signatures serve like fingerprints, cryptographically connecting the transaction with the holder of the private key. The network verifies each transaction using the combination of public key and the digital signature. If these match, the network approves the transaction, which then gets added to the blockchain. The public key cryptography allows the network to ensure that only the person with the private key can spend the funds associated with a particular digital wallet.

3. Blockchain:  A self-propagating ledger that resides on a network. Every block on the ledger consists of a header and a set of transactions that are validated by the network at predetermined time intervals. Each block has its own hash signature connecting it to a previous block. The network constantly updates and checks the validity of all these blocks. Changing any single character in that block invalidates it.

4. Mining: Mining is the process of validating blocks on a network that uses proof-of-work (PoW) as its consensus mechanism. Participants on these networks are incentivized to earn cryptocurrency by helping to include transactions through the process of mining. Mining requires time and computing power to solve a difficult mathematical problem through trial and error. The output of mining is easy to verify but imposes steep costs on bad actors who seek to tamper with legitimate transactions. Campbell Harvey offered a helpful technical presentation on how the mining process works.

Blockchain technology uses hash functions to cryptographically link and secure blocks, public key cryptography to authorize and verify transactions, and a consensus mechanism to synchronize its network.

While the first version of blockchain appeared on a permissionless network, this is not a strict requirement for blockchain technology to work. Blockchain-based networks can be run by private consortia and can have limited access/membership. Hyperledger, for example is an open-source project hosted by Linux Foundation that encourages various industries to adopt blockchain technology. IBM and Microsoft are two other important players in this space with similar enterprise-level offerings.

How does blockchain generate economic value?

Blockchain’s fundamental value stems from its two critical properties: persistence and decentralization. These allow blockchain to record transactions on a cheap, accurate, auditable, and secure network that is always open. These combined qualities not only can reduce economic friction in value chains, they can also replace some economic intermediaries, as their functions are taken over by these networks.

So what sectors are likely to experience significant blockchain-driven change?

Banking: Despite its fairly nascent stage, blockchain has already rendered the old model of cross-border money transfers obsolete. Blockchain-powered money can cross the globe in seconds while traditional methods can take days or weeks. The slowest blockchain network can take up to an hour to confirm transfers, the fastest take 4 to 5 seconds. For reference, ACH transfers take three business days, while domestic wire transfers require several hours and can cost $15 or more. Compare that to the Litecoin network, which took 2.5 minutes to send the equivalent of $99 million to the other side of the world for just $0.40 in fees.

Blockchain could also disrupt commercial banking. From a consumer perspective, blockchain eliminates the need for traditional banks since users can hold, accumulate, and disperse capital without an intermediary. Blockchain networks are cheaper to use than those set up by Visa or Mastercard. With blockchain banking apps and fiat-backed, low-volatility cryptocurrencies on the horizon, traditional banking may be facing an existential challenge.

My prediction? Sooner or later banks will become nodes on a decentralized network run by the US Federal Reserve.

Real Estate: Blockchain is a perfect technology to keep track of property titles. A national database of property titles could benefit consumers, expedite real estate transactions, shrink transaction costs, and potentially reduce insurance and interest rates.

Health Care: The health care industry employs a hodgepodge of IT systems that barely talk to each other. While care providers and insurance companies work with the same patient data, data portability is a huge issue. Often patients have to re-enter the same information at different health care service locations. This system is highly inefficient and fragmented. Blockchain could streamline this process by giving each user access to their records. As the need arises, patients could share their data on the network. SimplyVitalHealth is one of many start-ups in the space that are offering blockchain-based health care solutions.

Government/IT Security: The growing severity of cyberattacks demonstrates that our data remains exposed to hackers and other criminals. Cyberattacks are expected to cause $6 trillion in damages by 2021. The Equifax data breaches put the identities of most Americans up for sale without their consent. Blockchain empowers individuals and could improve security, transparency and auditability in government.

More broadly, blockchain could become the backbone of many government functions, including elections, procurement services, car registration, identity management systems, record keeping, and social security.

Transportation: Maersk and IBM recently announced a joint venture that will use blockchain to streamline the shipping process. Morgan Stanley estimates that block chain-related revenue opportunities could reach $500 billion.

Challenges

Regulation is the major hurdle to mass blockchain adoption. Blockchain’s properties, including its open architecture, make it difficult to define it within our traditional legal systems. Custody of assets is a big challenge.

There may be legal challenges, but they are not unsolvable even if their solutions may require some innovative thinking. Blockchain pushes the boundaries of capital formation and allocation across the globe. New laws are required to realize its potential without compromising the fundamental principles that govern the current financial system. Once the full economic importance of blockchain is grasped, sensible new regulations will likely follow.

Bitcoin requires considerable energy resources to power its network, consuming 62.24 terra-watt hours — enough to power all of Switzerland. Such steep energy requirements have evoked criticism, but the space is exploring less costly alternative consensus mechanisms. One potential fix may be proof-of-stake (PoS), a less-energy intensive consensus mechanism.

Conclusion

We live in a world with increasing digitization, a world where our personal data is stored on someone else’s computer, where ideas can reach millions at the speed of thought, and where fake news can easily undermine or overwhelm reputable outlets. In this world, trust is in short supply but of incalculable value.

Blockchain empowers the individual. Through a permanent, auditable, and tamper-proof ledger, blockchain can provide that trust and that value.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: ©Getty Images/Panuwat Sikham

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