Blockchain 101

Articles Written by Ravi de Fonseka (Partner), Simin Yang

On 12 January 2009, Satoshi Nakamoto mined Block 0, Bitcoin’s ‘genesis block’, marking the first issuance of cryptocurrency and implementation of blockchain technology. A purely peer-to-peer version of electronic cash, cryptocurrencies have since burgeoned, currently accounting for a total market capitalisation of over $12b across a plethora of competing cryptocurrencies.  However, the world is fast realising that the real value of Bitcoin’s mint may very well rest in its machinery – not the virtual currency it produces. 

So what is a blockchain?

At its essence, a ‘block’ is simply a set of transaction data.  Each block contains a record of a recent transaction or transactions, along with a timestamp, digital signature and fingerprint reference to the immediately preceding block. A ‘blockchain’ is a chain of transaction data, recorded and aggregated in these blocks, which are linked by an algorithm to an immutable and linear chain stretching all the way back to the genesis block.

The UK Government Office for Science compares a blockchain to a distributed ledger – an asset database that can be shared across a network of multiple sites, geographies or institutions.  Originally created to support Bitcoin, blockchain technology is now being adapted to accommodate other asset types, including securities, contracts, intellectual property rights, physical assets and more.

How does a blockchain work?

  • Blockchain algorithm: The operation and purpose of a blockchain is determined by its underlying algorithm. For Bitcoin, the blockchain algorithm has been designed to accommodate a public, decentralised system for transactions based on cryptographic proof instead of trust (allowing parties to directly transact without the need for a trusted intermediary). However, blockchain algorithms are not limited to Bitcoin’s public ‘permissionless’ format and  can be adapted to accommodate private, centralised ledgers (or hybrid systems) where transactions are no longer anonymous and where only approved administrators have the power to verify transactions.  

  • Miners and nodes: A public, decentralised blockchain is not controlled by any one individual but by all the participants (or ‘miners’) in the network on a peer-to-peer basis.  An individual becomes a miner by downloading a ‘node’ which connects them to the blockchain network (i.e. a software program that the miner runs on their computer). These nodes download the entire blockchain to date, and check in real-time each new block and transaction against the rules set by the blockchain’s algorithm. Nodes also allow miners to take part in transactions on their blockchain.

  • Adding a block to the chain: A miner can take part in transactions on a blockchain using their node software.  Each transaction is digitally signed and protected by cryptographic encryption using a public and private encryption key issued to the miner upon downloading their node.  The order in which transactions are recorded on the blockchain is determined by the consensus of all active miners (rather than one or more trusted intermediaries). This process is unique to each blockchain technology. In the case of Bitcoin and other public, decentralised blockchains, miners must solve a system-generated, proof-of-work puzzle (including a ‘hash’ or one-way function) in order to make a transaction.  

  • Verification of blocks: Once a miner considers a transaction to be complete, the miner will broadcast the block containing the transaction data along with the hash (also containing a timestamp) to all the other miners in the network, who collectively verify the contents of the block. If verified, miners will update their respective nodes to include the new block of transactions.

    A pictorial representation of this blockchain process is set out below:

The beauty of blockchain technology lies in its simplicity and its security through multiple node verification. Any attempt to cheat the system (e.g. artificially including a block containing false transaction data) will create a ‘fork’ in the blockchain where two chains (and two accounts of events) will run side-by-side. Blockchain protocol dictates that in such a case, miners must work off the chain containing the most amount of blocks. Since verification of transactions is done by way of consensus across all nodes, a blockchain is resistant to unauthorised change and malicious tampering in a way centralised, legacy systems are not.

So what are some of the challenges?

Lack of regulation: As is the case for many new technologies, blockchain technology is not currently specifically regulated under Australian financial services, healthcare, privacy or other relevant legislation.  This creates some uncertainty as to whether the deployment of blockchain technologies in an organisation’s businesses will comply with applicable law.  Organisations should carefully consider the proposed deployment of blockchain technologies (whether public or private) in their businesses against the regulatory regime in which they operate.

No trusted intermediary: The blockchain technology underpinning Bitcoin is a true decentralised system in which all nodes host, maintain and verify the database (without the need for a trusted intermediary).  However, a trusted intermediary will inevitably still be required in many other blockchain applications.  Before designing or deploying blockchain technologies, organisations should first consider whether blockchain technologies are actually the most suitable technologies for addressing their particular business needs. 

Anonymity: The anonymity and ease of decentralised blockchain transactions, the fact that nodes may join and participate in decentralised blockchain technologies with limited or no Know Your Client / Anti Money Laundering requirements and the lack of a trusted intermediary raises potential security, money laundering, tax evasion, governance, enforcement, and other legal issues.  Organisations should conduct detailed due diligence to identify and understand the key risks associated with any blockchain deployment and ensure that appropriate measures are put in place to mitigate those risks.

Privacy and confidentiality: While decentralised blockchain applications offer the promise of anonymity, sophisticated data analytics technologies may enable block information to be processed against other information databases to garner details about blockchain transactions and the transacting parties. This may have significant privacy and confidentiality ramifications if savvy operators are able to use the publicly available information to compromise otherwise private and confidential transactions.  To protect against this risk, organisations will need to ensure that blockchain technologies deployed in their businesses contain robust measures to protect block information against unauthorised identification, access, use and disclosure.

Security:one of the inherent benefits of blockchain technologies is its security through cryptographic verification by a distributed network of peer to peer miners.  However, we have already witnessed the high profile hacking and theft of US$60 million from The DOA – the first venture capital fund operating through decentralised blockchain technologies.  Instead of relying solely on the inherent security of blockchain technologies, organisations may need to use a number of additional, and more traditional, security technologies which may be challenging in the context of a decentralised network.

Where to from here?

Given the transparency, security and simplicity of blockchain’s distributed ledger technology, it is easy to see why it has potential applications across a broad range of industry sectors, from financial services, to power and utilities, technology licensing, smart contracts, health care, real estate and more.  Numerous industry leaders are already beginning to embrace new blockchain technologies in their businesses:

  • the ASX and major banks are already rolling out payment systems using blockchain technologies;  
  • prominent investment banks are aiming to use the Ethereum blockchain to build fully automated bonds;
  • the R3 CEV banking consortium has been testing blockchain-based algorithms to replace costly and complex processes for post-trade settlement and asset transfer;
  • the privately funded SETL is developing a specialist blockchain technology that will facilitate settlement of securities transactions for financial market participants on a peer-to-peer basis, streamlining the costly and risky settlement process into a real-time process;
  • Provenance is using blockchain technology to make supply chains more transparent by tracking the source and movement of physical goods; and
  • Everledger, a permanent ledger for diamond certification, runs on blockchain to assure the origin of diamonds by providing insurance companies and law enforcement agencies with access to diamond certificates, policy and claims information and police reports. 

One thing is for certain, blockchain technology is a powerful, adaptable and disruptive tool that is here to stay. 


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