Blockchains: An introduction to blockchain technology

Posted on
This article examines blockchain technology, the reason for its emergence and highlights some of its possible applications. In a later article we will explore the legal issues associated with the use of blockchain technology.

What is blockchain technology?

A blockchain is a type of distributed ledger which was invented by Satoshi Nakamoto in 2008 to underpin the peer-to-peer cryptocurrency Bitcoin[1]. Ledgers have for a long time been used to record assets and financial accounts. Traditionally a ledger has always been controlled by a single entity, such as a bank (the bank has complete control over recording the debits and credits on a bank statement). In a typical financial marketplace, institutions use trusted third parties such as clearing houses to verify and record transactions between buyers and sellers of financial investments. The main function of the clearing house is to maintain a centralised ledger to record the details of every transaction that has been processed.


 

Instead of relying on a centralised ledger, blockchain technology uses a distributed ledger where an exact copy of the ledger is shared between every buyer and seller on the financial marketplace network. Each computer on the network is known as a “node” and each node holds an exact replica of the distributed ledger meaning there is no need to rely on a trusted third party to maintain a central ledger. When a new transaction takes place the details of the transaction are distributed across the network and each node will then simultaneously update its own ledger. 

The ledger in a blockchain network is made up of electronic records of different transactions which are grouped together to form blocks. Each block contains details of a predefined amount of transactions and link together in chronological order to form a time related chain. This chain shows a record of all of the transactions that have taken place since the blockchain was created. 

Benefits of blockchain technology

Removing the reliance on a trusted third party to maintain a central ledger has the following benefits:

  • Faster transaction times. A transaction between banks can typically take days for clearing and may be reliant on when the banks are open for business. A blockchain transaction is distributed across the network in minutes and will be processed at any time throughout the day.
  • Cost saving. Trusted third parties will often include an intermediary fee when handling transactions whereas blockchain technology has no such costs associated with them.
  • Security and resilience. Maintaining multiple copies of the ledger across every node in the network means that the blockchain is better able to withstand attack. Even if one node was compromised by an attack, the blockchain would be maintained by every other node. In theory this means that an attacker would need to take control of every node simultaneously in order to corrupt the ledger. This is not the case for traditional ledger where an attack on a single trusted third party could bring down the record of transactions.
  • Immutability. This is seen as one of the key benefits of blockchain technology. As changes to the public ledger are seen and verified by all the nodes simultaneously across multiple ledgers the transactions cannot easily be altered or deleted.
  • User anonymity. Buyers and sellers use anonymous and unique address numbers to process the transaction. Whilst this has been criticised for giving rise to the use of cryptocurrencies in illegal online market places such as Silk Road, it could be seen as an advantage if used for other purposes, for example, electoral voting systems.

How is a transaction processed?

When a node is used to create a blockchain account the node is allocated a unique address number consisting of random letters and numbers. This is the public identifier for that node. At the same time as the address is created, the node is also assigned a private key which is a different set of numbers and letters generated using a complex algorithm from the node’s address number. This private key is kept confidential from other nodes and is used to digitally sign a transaction request to ensure it is authentic.

In order to process a transaction the buyer will transmit a transaction request message to all of the other nodes which it has digitally signed. This message also contains the details of the requested transaction and the public keys of both the buyer and seller. The other nodes apply an algorithm to both the digital signature and the public address which authenticates the digital signature as originating from the buyer, but without ever being able to reverse engineer the private key. This provides an authentication process without ever compromising the private key. When a transaction has been verified it will be grouped into a block for entry into the digital ledger.  

Proof of work concept

In a public blockchain, such as Bitcoin, each node on the network is capable of grouping together transactions into blocks ready for distributing to the other nodes on the blockchain network. In order to prevent multiple versions of the same block being entered onto the chain at the same time, the blockchain requires the nodes to carry out a proof of work concept to determine which node’s version is entered onto the chain. This is achieved by setting a mathematical competition in which nodes are required to solve a complex algorithm, with the node that solves the algorithm first having its block verified and accepted onto the chain.

Nodes that participate in grouping transactions into blocks are known as miners. Miners use brute force computing to solve the answer to the puzzle, often utilising large amounts of computing resources in the process. As an incentive to mine the blocks, miners are rewarded with a coin in the relevant cryptocurrency when they add a block to the blockchain. The expenditure required by miners on computing resources also serves to give a real world value to the cryptocurrency.

Other applications

Whilst financial marketplaces have been the most widely used application for blockchain technology to date, this is not the only type of transaction that it can be applied to. The development of the use of blockchain technology for wider applications is often referred to as “blockchain 2.0” and its use has been explored in many areas, including:

  • domain name registries
  • smart contracts
  • intellectual property registers
  • voting systems

The most interesting application from a legal perspective is that of smart contracts. Smart contracts are computer programs that contain codified versions of the contractual obligations, benefits and penalties that you would usually see in a traditional legal document. When the smart contract is executed the computers on the network will automatically perform the contract in accordance with the programmed code. As the code is being executed by the computer and does not have the same scope for interpretation as written English, the outcome of the contract is much more certain than with a normal contract, meaning there is less scope for contention.

The pre-programmed nature of a smart contract does mean however, that smart contracts are only suitable for contracts that have clearly defined obligations at the outset and will not be appropriate for more complex commercial contracts. This is at least until computer AI is further developed to understand the nature of changing commercial relationships.

A blockchain may be used to distribute a smart contract across multiple parties with the execution of the contract and the monitoring of compliance with its terms being recorded across every ledger. For example, it has been reported that the use of blockchain smart contracts is being explored as a possible solution to streamline digital rights management in both the software and music industries, with copyright ownership and licensing arrangements being recorded on the ledger and royalty payments being made automatically between parties in real time[1]. A similar application has been explored by Verizon, the multi-billion pound telecommunications company, which has recently filed a patent in the US for a “passcode blockchain”, designed to maintain and monitor issued passcodes for use of digital content.

Is it as good as it sounds?

As the use of blockchain becomes more commonplace for lucrative financial markets there has been increased scrutiny regarding their security. In June, the crowdsourced venture capital fund known as the DAO had $60 million worth of cryptocurrency stolen after it had raised over $160 million in the cryptocurrency “ether” from 11,000 investors. The investment fund was recorded on a decentralised blockchain stored, where it was recorded until members of the DAO voted on how they wanted to invest the funds.

One individual exploited an error in the coding of the “withdraw” function in the blockchain software which was designed to allow DAO token holders to remove their investment. The error allowed the individual to call this function multiple times and remove ether currency far beyond the value of their actual investment. It should be noted though this was only possible because of an error in the coding on that particular blockchain rather than as a weakness in blockchain technology generally.

The response from The DAO was to perform a hard fork in the blockchain, rolling back the system to a day before the withdrawal and return the stolen ether to the original owners. This was possible because the DAO is a “permissioned” blockchain, which means it is managed by designated administrators under agreed governance rules. Permissioned blockchains are most commonly used in private networks. Whilst this action was necessary to correct an obvious illicit act, the decision to roll back the blockchain has been criticised as it goes against the immutable nature of the blockchain.

A further threat to undermine the immutable nature of blockchain technology is the creation and recent patent by Accenture of a blockchain editing tool. Whilst Accenture states that the editing tool is only intended to be used in permissioned blockchains and only then “under extraordinary circumstances to resolve human errors, accommodate legal and regulatory requirements, and address mischief and other issues, while preserving key cryptographic features...”[2], the decision to create this tool has again been criticised by blockchain purists[3]. This tool is though seen as essential by many to make blockchains practical for the financial services industry where editing to resolve errors in financial records is necessary.

Whilst the risk to the immutability of a blockchain is most prevalent for permissioned systems, it should be noted that permissionless blockchains can also be mutated if someone is able to take control of 50% or more of the hashing power of all of the nodes on the network. Whilst this is unlikely due to the large amount of computing resources required for such an operation, it would allow that person to win every proof of work competition to insert new blocks into the chain and potentially create a chain of fraudulent transactions.

Summary

There is no doubting the potential of blockchains to revolutionise how transactions and marketplaces are managed and operated in a range of sectors. Commercial blockchain solutions are already being adopted throughout banking and financial markets with an estimated 65 percent of banks expecting to have blockchain solutions in production in the next three years[4]. With this anticipated growth and development there will be a need to ensure that legal issues are considered and in the next article we will explore some of the legal issues associated with blockchain technology.

 



[1] http://www.businessinsider.com/blockchains-promise-to-content-creators-2016-9?IR=T

[2] https://newsroom.accenture.com/news/accenture-debuts-prototype-of-editable-blockchain-for-enterprise-and-permissioned-systems.htm

[3] http://fortune.com/2016/09/20/accenture-blockchain/

[4] http://www-03.ibm.com/press/us/en/pressrelease/50617.wss