What is Blockchain?
Cryptocurrencies, blockchain.
These are the terms that are in the headlines daily all over the world.
Blockchain is the underlying technology which came to prominence with the launch of Bitcoin in 2009, but what is blockchain?
Blockchain combines two long-standing technological developments.
On one side, distributed ledger technology, and on the other, cryptography.
If we look at Bitcoin, if we look at cryptocurrencies, cryptocurrencies at their base are blockchain systems combining distributed ledger systems and cryptography.
Distributed ledger system, what is a distributed ledger system?
For a system like Bitcoin, the distributed ledger means that the information in the system are not stored in one single place.
Rather, they exist in multiple locations, multiple identical ledgers throughout the users of the system.
So, if we think about this idea of ledgers, the traditional example is to think of something like a bank.
A bank is a place where a certain amount of money is stored, it is a single place, it is a silo, and it is a single ledger.
At the other extreme, are distributed ledgers.
Distributed ledgers mean that there is no single place where the information, the valuables, the data are stored, rather they are stored across a variety of identical locations.
In between these structures of centralised and distributed, we also have network-based structures where perhaps you have a single centralised structure and a variety of spokes, a hub and spoke structure whereby the individual spokes connect to the hub.
So, distributed ledger technology combined with cryptography.
Cryptography is a technology that involves the secure storage, the encryption of information.
It has a very long history with important points going back to code breaking, particularly in the Second World War.
If we combine distributed ledger technology with cryptography, we have a system of secure distributed ledgers where entries have to be proven, proven through the use of a variety of structures which then encrypt the data into blocks.
So, transactions 1 through 50, packaged in a block, encrypted together.
The next set of transactions build on that first block, transactions 51 through 100 encrypted as a second block.
This structure provides a number of very important attributes to a blockchain-based system.
In particular, it provides for security.
The layers of cryptography across multiple blocks make it very hard, but importantly not impossible, to necessarily break those blocks making blockchain potentially a highly secure system.
Second, it’s a permanent system.
In other words, each of those transactions is recorded permanently in each of those blocks.
That means that there is always a traceable history of all of the financial transactions going back to the very beginning.
So, with each Bitcoin, you can trace back the life of that Bitcoin from its creation and into each account that it has been transferred to over time.
And finally, transparency.
Transparency means that the combination of visibility allows you to see what is happening in the blockchain.
This combination of security, permanence, transparency, makes blockchain a potentially very powerful platform technology across a number of areas.
Now, if we look at blockchains, within this general structure we will often have a third level added.
So, DLT plus cryptography plus smart contracts.
What are smart contracts? Smart contracts are automated systems that on the occurrence of pre-determined actions something else happens.
If I provide A, you provide B we pre-agree that A and B will be added together to create a new C, and this occurs on an automatic basis, this is a smart contract.
There is an old joke that smart contracts are neither smart nor contracts, they are not smart because they are automated, they happen automatically, on the occurrence of something / events.
And they are not necessarily contracts, but that is a more complicated legal question for later.
Within this idea of blockchain, we can also add in a second important determination.
Blockchains can either be permissionless, or permissioned.
A permissionless blockchain, like bitcoin, means that it is open, anyone can participate that downloads the software.
You download the software, you become a node, you’ll have a full picture of the ledger, that distributed ledger is distributed to your node, anyone can enter.
But, we also have what are called permissioned blockchains.
A permissioned blockchain, involves requirements or governance structures or restrictions on entry.
In other words, only individuals or organisations or computers or devices which have been pre-approved can join into the network, can access the information and can potentially contribute transactions.
Now, when we think about blockchain, it may or may not involve cryptocurrencies.
A cryptocurrency will involve a blockchain, but a blockchain does not necessarily involve a cryptocurrency.
In other words if we think of a blockchain based system at its base, it is a distributed ledger which is encrypted, maybe with an additional layer of smart contracts on top.
Those individual data entries, can be anything.
The communications between those data entries do not necessarily involve any sort of currency.
One of the most interesting and powerful applications for this sort of thing, is in production processes, the food market where the providence of a chicken, or a bottle of whiskey can be proven by the blockchain system from its creation, its history, its movements documented throughout that system.
So, any eventual possessor can document both the origin as well as the lifespan of that particular chicken, bottle of whiskey, diamond, and artwork, whatever it may be. And that is the real power of blockchain. To build systems which are potentially highly secure, permanent and highly transparent.
But, blockchain is not the solution for every problem, why? Because not every blockchain is created equally…not every blockchain is necessarily secure.
Big blockchain systems like Ethereum or Hyperledger or R3’s quarter, or bitcoin, these are highly secure.
But if I create a blockchain in my basement, probably not that secure.
Just because it’s a blockchain, doesn’t mean it’s secure.
Second, from the standpoint of permanence and transparency, this raises two problems.
One, is the garbage in, garbage out problem in other words if you put that information in, it’s in there forever, and that is a big problem in the context of building histories, building information, the permanence problem.
And finally, privacy concerns. If information goes into, a permissionless public blockchain that information may be permanently on public display and access, and this can create all sorts of problems in that not necessarily do we want every piece of information permanently on view.
So, looking at blockchain, and this is something that we talk about a great deal throughout this course, and in other courses.
Blockchain is a very important technology, being used across all aspects of the financial sector and beyond.
But it’s not the solution for every problem, but it is giving us an excuse to re-look, to reconsider many of our existing systems and infrastructure to build better systems.
(Professor Douglas W Arner is the Kerry Holdings Professor in Law at the University of Hong Kong (HKU); Director of the Faculty of Law’s LLM in Compliance and Regulation; and Project Coordinator of a major five-year project funded by the Hong Kong Research Grants Council Theme-based Research Scheme, titled “Enhancing Hong Kong’s Future as a Leading International Financial Centre”. He is a member of the Hong Kong Financial Services Development Council, an Executive Committee Member of the Asia Pacific Structured Finance Association, and a Senior Visiting Fellow of Melbourne Law School. Professor Douglas has served as a consultant to, among others, the World Bank, Asian Development Bank, Asiapacific Economic Cooperation (APEC) and European Bank for Reconstruction and Development, and has lectured, co-organised conferences and seminars and been involved with financial sector reform projects around the world)