Blockchain Technology Explained

November 7, 2018
Over the last 20 years, there have been significant technology advancements in the financial markets. Most recently, the interest in blockchain has been huge. The blockchain technology platform is a distributed ledger technology system that allows multiple parties to have simultaneous access to a constantly updated ledger that keeps a record of all transactions between participants. The block of transactions make up the chain, hence the name blockchain. This new technology has the potential to redefine operations and improve the efficiency, security and economics of the financial industry. It is time for financial institutions to change and benefit from the possibilities of distributed technologies.
 

Distributed Ledger

In its simplest form, a distributed ledger is a digital record of transactions, shared instantaneously across a network of participants. The ledger may be used to register any transactions involving the exchange of something valuable, such as rights to payment or ownership of property. It is “distributed” because the transaction record is held by each of the users of the network and each user’s copy is updated with new information simultaneously.
 
The term “ledger” is a familiar concept in everyday banking. Bank statements set out the history of transactions on an account and summarise any outstanding amount owed by either the bank or the customer. In a distributed ledger, the accuracy of the database is confirmed by reconciling each individual version against all existing copies within a computer network. A “consensus” is reached to establish the true record, thereby avoiding the need for duplication as well as expensive and time-consuming reconciliation. This consensus process allows parties to immediately identify any instances of unauthorised tampering. Due to the distributed nature of the ledger, by construction, the distributed ledgers are not vulnerable to a single point of failure.
 
Blockchain is a distributed ledger that records digital transactions in a secure, transparent, immutable and auditable manner, without necessarily using a trusted third-party intermediary to perform these transactions. Here we illustrate a few selected characteristics:
 

Digital Distribution: A blockchain distributes data recording and transaction execution across the different computing nodes within a given network. There is no central authority, such as a central bank or clearinghouse, to act as a central data warehouse and intermediary.

Cryptographic Algorithm: Blockchain uses highly sophisticated and mature cryptography to ensure the reliability and security of data and transactions across the different computing nodes and information sharing amongst network participants.
 
Consensus: To validate information and accept new transactions, blockchain requires some or all of its nodes to reach a consensus. This consensus, which varies amongst different blockchain protocols, eliminates the need for a central authority to confirm and maintain a ledger of all transactions.
 
Resilience: A distributed database is, by its nature, more resistant to accidental failures or malicious attacks than a centralised system. Specifically, if one or more nodes on a blockchain fail or are hacked, the rest of the system can still function reliably.
 

Immutability: Blockchain bundles transactions into “blocks”. Each block contains the previous block’s “hash” or digital signature, so that each block is linked to the one prior to it and, together, they interlock to form a chain. It is extremely difficult to change one block without changing the others that preceded it, making each block and the data it contains immutable. This immutability property helps to create the trust necessary for different parties to conduct business safely over the blockchain network.

 

Time-stamps: Blockchain time-stamps every new transaction or data entry in its block header, thereby allowing easy tracking and verification of information.

 
Security: Under the distributed nature of blockchain, a hacker can only corrupt a blockchain by initiating a 51% attack on the network. Encryption and multistep verification procedures add protection, as do time-stamped transactions, data that cannot be altered without trace and the need for consensus to accept transactions.

Blockchain

A blockchain is a technical component of a distributed ledger and refers to the chain of transactions that reside within the ledger. Transactions are grouped into “blocks” and as they are verified, a new “block” is added to the chain of previous transactions. The ledger is updated instantaneously, permanently and irrevocably for all users to reflect the new status of the ledger with the additional new block. Therefore, the blockchain is an accurate record of the history of the entire ledger. Not all distributed ledgers use blockchain technology, though the terms are often used interchangeably.
 
 
Bitcoin is the first generation of blockchain, a public ledger consisting of blocks that holds time-stamped batches of recent, valid transactions. In a nutshell, Bitcoin has two main components: miners that solve computational problems using special-purpose chips through proof-of- work and full nodes that store the blockchain. These nodes relay and validate transactions and blocks that miners build. 

An Example of Blockchain

 
Blockchain is generated through mining, which is a record-keeping service. To be accepted by the rest of the network, a new block must contain a “Proof-of-Work” (PoW). The PoW requires miners to find a number referred to as a nonce, such that when the block content is hashed along with the nonce, the result is numerically smaller than the network’s difficulty target (difficulty is a measure of how difficult it is to find a hash below a given target). This proof is easy for any node in the network to verify, but extremely time consuming to generate (i.e. for a secure cryptographic hash, miners must try many different nonce values before meeting the difficulty target) [3]. Furthermore, the PoW system, alongside the chaining of blocks, makes modifications of the blockchain extremely hard, as an attacker must modify all subsequent blocks in order for the modifications of one block to be accepted. As new blocks are mined, the difficulty of modifying a block increases as time passes, and the number of subsequent blocks increases. [1], [3], [4].

Taxonomy of Distributed Ledger Platforms

In Figure 2, we categorise distributed ledger platforms into two types: “permissionless” and “permissioned.”
Permissionless blockchains are public and open for anyone to read, write transactions to and participate in the consensus process. Key benefits of permissionless blockchains include: complete disintermediation, as entry costs for new participants are minimal, and that no participant has exclusive control over the blockchain network. However, permissionless blockchains provide limited data privacy. This is a serious problem for most financial services applications.  Permissionless, public shared ledgers are protocols associated with Bitcoin, Litecoin and Ethereum.
 
Permissioned blockchains only permit consortium members access to information and transaction history. Examples of permissioned, private shared ledgers are Corda and Hyperledger. 
 
Permissioned vs Permissionless Distributed Ledger Technology
 

Introducing Smart Contract 

Many blockchains are taking advantage of “smart” contracts. A simple way of looking at a smart contract is as a logical if-then statement, i.e. if a condition is met, then a result is executed.
A traditional contract is a promise between two or more parties that are legally binding. For instance, Alice promises to pay Bob money in return for use of Bob’s house. In the tenet of distributed ledger technologies, a “smart” contract is one where conditions are both evaluated and executed by computer codes making the transaction trustless. The “smart” rental contract between Alice and Bob would lock Alice out of her apartment if she fails to pay.
 
Once participants agree to terms, conditions, and outcomes, the smart contract is coded and recorded on a distributed ledger. The code typically contains references to external data sources that the smart contract needs to work. Once a smart contract is recorded, it cannot be modified without the participating parties’ permission, therefore, ensuring the fidelity of contractual terms. Current smart contract development efforts are mostly focused on three areas: security, accessibility and legal certainty.
 
Smart contracts are digital contracts allowing terms contingent on decentralised consensus that are self-enforcing and tamper-proof through automated execution. By enabling the use of smart contracts, blockchain technology can increase contractibility and enforceability in contingent contracts that facilitate exchanging money, property, shares, service or anything of value in an algorithmically automated and conflict-free way.
 
There are three popular blockchains using smart contracts: Ethereum, IBM Hyperledger Fabric and R3 Corda. These are good examples of distributed ledger platforms as described in the previous section. Table 1 gives a comparison amongst the three blockchains. 
 
Comparisson of Ethereum, Hyperledger Fabric & Corda

Ethereum

Ethereum is a decentralised platform that runs smart contracts. It uses a blockchain to synchronise and store the system state along with a cryptocurrency called ‘ether’ to meter and constrain execution resource cost [7-9]. From a computer science perspective, Ethereum is a deterministic, but practically unbounded state machine with two basic functions: a globally accessible singleton state and a virtual machine that applies changes to that state [9]. 
 
Ethereum shares many common elements with other open blockchains (e.g. bitcoin blockchain): a peer-to-peer network connecting participants, a consensus algorithm for synchronisation of state (PoW), a digital currency (Ether) and a global ledger (the Blockchain) [9]. From a practical perspective, the bitcoin blockchain is a distributed consensus state machine, which tracks the state of units of bitcoin and their ownership. Ethereum is also a distributed state machine. But instead of tracking only the state of currency ownership, it tracks the state transitions of a general-purpose code and data store. For example, it can load code into its state machine and run that code, storing the resulting state changes in the blockchain. Ethereum state changes are governed by the rules of consensus, and the state is distributed globally on a shared ledger.
 

IBM Hyperledger

Hyperledger is an umbrella project of open source blockchains [10]. As depicted in Figure 3, there are five frameworks beneath the umbrella [11], including:
1. Hyperledger Fabric: designed as a foundation for developing applications or solutions with a modular architecture; 
2. Hyperledger Sawtooth: a modular platform for building, deploying and running distributed ledgers; 
3. Hyperledger Iroha: designed to incorporate into infrastructural projects requiring distributed ledger technology; 
4. Hyperledger Indy: purpose-built for decentralised identity; 
5. Hyperledger Burrow: a permissionable smart contract node that handles transactions and executes smart contract code
 
To facilitate these frameworks, there are five major modules to facilitate development [11], including:
1. Hyperledger Caliper: a blockchain benchmark tool for measuring the performance of a specific blockchain implementation; 
2. Hyperledger Cello: brings the on-demand “as-a-service” deployment model to the blockchain ecosystem; 
3. Hyperledger Composer: collaboration tool for building blockchain business networks. Accelerates development and deployment of smart contracts; 
4. Hyperledger Explorer: can view, invoke, deploy or query blockchain information; 
5. Hyperledger Quilt: offers interoperability between ledger systems.
 
Hyperledger Modular Umbrella Approach

R3 Corda

Corda is an enterprise-grade blockchain platform developed by a distributed database technology company called R3 [13]. It was originally built for recording and processing financial agreements. Corda enables institutions to transact directly using smart contracts, whilst ensuring high levels of privacy and security [14]. Similar to Ethereum, Corda runs inside a relatively powerful virtual machine and can contain complex logic. 
 
Similar to Hyperledger Fabric, consensus in Corda is reached at transaction level by involving parties only. However, Corda has been consciously designed for the financial services industry. Most notably, it takes the highly regulated environment into account by augmenting smart contracts with legal prose. Its sole focus on financial services transactions simplified its architectural design and can be seen as a complement to Fabric [6].
 

Closing Thoughts

Distributed ledger technology (DLT) has gained a lot of attention lately. It has caught the attention of many firms, including those active in payment, clearing and settlement, for its potential to disrupt financial services by making them more efficient, secure, transparent and reliable. DLT could bring a number of benefits to the market, notably enhanced reporting and data management capabilities, more efficient and streamlined post-trade processes and reduced costs. 
 
Blockchain is the most recognised form of distributed ledger. Blockchain based DLT, which was first applied as the underlying technology for virtual currencies such as Bitcoin, has a number of possible applications within finance. For example, DLT could be applied to digital record keeping, smart contracts, digital currencies and digital assets. 
 
DLT represents a promising source of future innovation in financial markets as it is starting to prove itself beyond just cryptocurrency. The opportunities arising from blockchain are vast, there are however many challenges to contend with before the full potential of the technology can be realised. It will take few years for DLT to make its way into the mainstream, however, there is no doubt that it will have a significant impact on the global financial markets.
 
 
References
[1] Satoshi Nakamoto, “Bitcoin a peer-to-peer electronic cash system,” 2009 
[3] Matthaus Wander, “How Bitcoin Works,” https://www.vs.uni-due.de/wander/20110629_Bitcoin_ Wander.pdf 
[4] Bitcoin, https://www.bitcoin.com 
[6] Martin Valenta, Philipp Sandner, “Comparison of Ethereum, Hyperledger Fabric and Corda,” FSBC Working Paper, June 2017 
[7] Ethereum Project, https://ethereum.org/ 
[8] Ethereum, Wikipedia, https://en.wikipedia.org/wiki/Ethereum 
[9] Andreas M. Antonopoulos and Gavin Wood “Mastering Ethereum,” O’Reilly, December 2018 
[10] Hyperledger, Wikipedia, https://en.wikipedia.org/wiki/Hyperledger 
[11] Hyperledger Official Website, https://www.hyperledger.org/projects 
[13] R3, Wikipedia, https://en.wikipedia.org/wiki/R3_(company) 
[14] R3, Official Website, https://www.r3.com/technology/