Demystifying Blockchain

What is Blockchain?

Blockchain is a revolutionary type of accounting system. It is a decentralised, public ledger that is distributed and replicated across computers around the world. Conceptually it works as a chain of blocks, where each block represents an accepted ‘state of the world.’ Blocks are added chronologically when transactions are verified. Each time a block is added, currency is released, and the security of the chain increases – the existing blocks cannot be altered.

Blockchain is based around two values: consensus and incentivisation. Everyone must agree for a new block to be created. Those who maintain the network and validate transactions (called ‘miners’) use computing power to ‘solve’ the network and receive a reward. In bitcoin, bitcoin is the reward or ‘token’; on the Ethereum platform it is ether.

If I want to use bitcoin to send a payment, I broadcast this on the network. A group of people recording incoming transactions will perform basic validations: that I have the bitcoin to send and that I send it only once. Miners then race each other to solve the equation of how the system will look after the transactions have settled. If they win, they can create a new block and propose it to the network. If it is accepted, it will join the chain and they will get a reward.

How is Blockchain different from a traditional database?

Databases have owners, whereas blockchain does not. A useful comparison is emailing attachments (the ‘database’ model) versus a collaborative system like Google Docs (the ‘blockchain’ model). In the former, an original file is sent to participants and many different versions of it might subsequently exist. In the latter, only one version of the document exists and everyone works on it to modify it and keep it current.

What type of transactions are going on?

Bitcoin transactions are usually fairly simple, eg payments. In order to send and receive money, every user creates a ‘wallet.’ This wallet has an address (or ‘public key’) and a password (or ‘private key’). The information recorded in the blockchain is the different amounts of bitcoin held in the different addresses, eg a ledger of who owns what. To receive money, a user gives the person making the payment their public key, and use their private key to log in to their wallet. Individuals are responsible for the security of their private keys – there is no central authority to ask if the key is forgotten or lost. Ethereum is more sophisticated; it is a platform which enables other types of applications. In Ethereum you can code ‘smart contracts’, or pieces of code that will execute in certain conditions.

What kinds of application can blockchain have?

Bitcoin can be useful for making payments in countries with volatile currencies, or where people lack bank accounts, or trust in the traditional banking system. Bitcoins circumvent capital controls; no one can prevent them being sent anywhere in the world. Payment is sent rapidly, regardless of the amount, and so far, a bitcoin transaction has never failed. The blockchain technology provides an extra level of security and accounting over traditional accounting systems, as multiple users verify every transaction. This also reduces the potential for errors. It is proving useful in industries where there are multiple stakeholders using different systems – eg shipping or financial exchanges.

What are the disadvantages?

Blockchain’s decentralised nature can be a weakness; governments and central banks may be reluctant to cede control over currencies. Bitcoin has also attracted criticism for its role in the ‘dark web’ – it lacks censors or controls. But one could level the same criticism at the internet. The idea that bitcoin is completely anonymous is another misconception. The blockchain can be viewed online via sites called ‘block explorers,’ where any public key is searchable, and every transaction can be viewed. While public keys are anonymous, as soon as a user connects it to their real identity, they can be traced. The same is true any time money is transferred from bitcoin into ‘real’ money.

In many cases, a standard, centralised system can prove a better solution than using blockchain technology. Visa and SWIFT payment systems are faster; they are easy to use and for the most part, people trust them. Security and ‘knowing your client’ are easier. There are no checks on who opens a bitcoin account. 

“I like blockchain, but I don’t like bitcoin”

This is a popularly used phrase, based around a misconception. In blockchain, miners check each other’s work and arrive at single answer – an agreed ‘state of the world’. They are neutral parties that perform the function in return for payment. This token of value is necessary– without bitcoin or an equivalent, the blockchain technology could not work.

What about ‘private blockchains’?

These are also called ‘permissioned blockchains,’ but both terms are misnomers . Both involve centralised ownership, with a group of users ‘permissioned’ to validate transactions or blocks. Blockchain is by definition decentralised, so private/permissioned blockchains are essentially databases. 

How is Blockchain evolving?

Currently, the method used by miners to validate transactions is called “proof of work.” Multiple confirmations that the solution is correct are needed before the result is finalised and a block is added. This slows down the system. Platforms such as Ethereum are now moving from “proof of work” to a validation method called “proof of stake”, which can speed things up considerably.” Here, a miner might stake 100 bitcoin as proof that they will propose a valid block. If they don’t succeed, they lose the stake.

Are ICOs a new model for corporate fundraising?

‘Initial Coin Offerings’ (ICOs) are similar to Initial Public Offerings (IPOs), but involve a company raising funds by releasing its own digital currency, typically in exchange for bitcoin. In late 2017 and early 2018, there was an explosion of such sales. What was happening was a form of ‘over-tokenising’: issuing new forms of securities (which sometimes provided liquidity to essentially illiquid assets), but without much of the regulation behind traditional securities.

ICOs have since changed radically, following a regulatory crackdown. Such offerings are now subject to securities offering rules, and roughly half of the projects which raised ICO funding during the ‘bubble’ in 2017 have largely failed. When we talk about ICOs today we are increasingly talking about registered and regulated security tokens. For many start-up companies, the traditional venture capital route may still be the more suitable one to take.

Lombard Odier does not invest in cryptocurrencies; nor does it recommend clients do so. This article represents the views of the external participants only.

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