The October 31 issue of The Economist featured the blockchain in its cover: “The Trust Machine: How the technology behind Bitcoin could change the world.” Its two articles on the subject explain what blockchains are about, as well as why we should care about an exotic technology that involves concepts from cryptography, game theory and distributed computing.
Right up front, the Economist distinguishes between three different notions that are often muddled up when discussing blockchains:
- Bitcoin, the best known and most widely held digital currency, whose users can transact directly with each other with no need for a central authority, - be it a bank or government agency, - to certify the validity of the transactions.
- The blockchain architecture underpinning bitcoin, whose protocols were specifically designed to control the creation and transfer of bitcoins.
- The general concept of blockchain, a distributed database architecture with the ability to handle trust-less transactions where no parties need to know nor trust each other for transactions to complete.
Bitcoin has had a mixed reputation, due to its wild fluctuations in value and past links to illicit activities. And, bitcoin-specific blockchain concepts like mining might well be perceived as too wasteful of computing power and energy by all but the most libertarian of bitcoin supporters. But the advanced technologies and architectures underlying blockchains are being increasingly accepted as having important implications far beyond bitcoin and other cryptocurrencies.
The blockchain holds the promise to revolutionize the finance industry by bringing one of its most important and oldest concepts, the ledger, to the Internet age. Beyond finance, the blockchain “offers a way for people who do not know or trust each other to create a record of who owns what that will compel the assent of everyone concerned. It is a way of making and preserving truths.”
Ledgers constitute a permanent record of all the economic transactions an institution handles, whether it’s a bank managing deposits, loans and payments; a brokerage house keeping track of stocks and bonds; or a government office recording births and deaths, the ownership and sale of land and houses, or legal identity documents like passports and driver licenses.
The earliest ledgers likely hark back to ancient Mesopotamia, where writing first evolved thousands of years ago enabling people to keep track of financial records. The modern ledger, based on double-entry book-keeping, was first developed among the merchants of renaissance Italy as commerce and banking flourished.
Starting over 50 years ago, institutions have been transforming their paper-based ledgers into highly sophisticated IT applications and data bases. But while most ledgers are now digital, their underlying organization has not changed. Each institution continues to own and manage its own ledger, synchronizing its records with those of other institutions as appropriate, - a cumbersome process that often takes days.
This is not surprising. There is often a fairly long time lag between the emergence of a disruptive technology and the development of the processes and institutional organizations that are required to properly leverage the technology. For example, when electric motors were first developed in the late 19th century, they were deployed to replace big steam engines as a source of power. It took several decades for factories to realize that instead of having one central source of power, they could now fit small electric motors in each machine in the plant floor, thus leading to far more productive and flexible manufacturing processes.
In the early years of the IT industry, different vendors brought to market their own proprietary networking systems, such as IBM’s Systems Network Architecture and Digital’s DECnet. These worked quite well as long as all communications were within the same company using the same vendor’s architecture. But, going across companies and vendors was quite cumbersome. Just sending an e-mail using an IBM application to another user in a different institution using another vendor’s application was quite cumbersome.
The Internet changed all that. Once the Internet was widely embraced in the 1990s, it became no harder to send an e-mail between companies as within a company. Everyone was using the same standards, including open source implementations of key protocols. Rather than developing their own proprietary networks and struggling to interconnect with those of others, institutions now collaborated on developing the common Internet architecture, - and Internet-based applications like e-mail and the Web, - that they all now used.
A similar story played out with UNIX. In the 1980s, UNIX became a popular operating system for technical workstations, supercomputers and a number of other applications. The problem was that every vendor had developed its own version of UNIX, - IBM’s AIX, Sun’s Solaris, HP’s HP-UX, and so on, - and they were all somewhat different and incompatible with each other, making it difficult to port applications across different flavors of UNIX. Various attempts to unify UNIX were not successful, mostly because the vendors didn’t trust each other. Finally, Linux emerged in the 1990s as a UNIX-like operating system that over time was embraced by just about everyone. And, as was the case with the Internet, it was the outside-in, collaborative governance of Linux that helped it succeed in essentially unifying UNIX where previous efforts failed.
A 2014 report by the Bank of England argues that the time might well have now come for the ledger to now follow the collaborative, distributed, standards-based approach of those earlier innovations. The classic ledger, - “a process that has not changed since the 16th century,” - may now be evolving toward a blockchain-based distributed ledger, a major technological innovation not only for payment systems but for the finance industry as a whole.
“The approach used in the modern banking system, which emerged as a computerised replication of earlier paper-based records, is for specialised entities (usually banks) to maintain master ledgers that act as the definitive record of each individual’s money holdings,” notes the Bank of England report. “In turn, they hold accounts recorded in the ledger of one central body (typically the central bank). Those holding the ledgers have the ability to prevent any transaction they deem to be invalid. In order to use the system, people must trust that these centralised ledgers will be maintained in a reliable, timely and honest manner.”
“An alternative approach is to implement a fully decentralised payment system, in which copies of the ledger are shared between all participants, and a process is established by which users agree on changes to the ledger (that is, on which transactions are valid). Since anybody can check any proposed transaction against the ledger, this approach removes the need for a central authority and thus for participants to have confidence in the integrity of any single entity.”
Why should the finance industry embrace such a shared, distributed public ledger that everyone can inspect, but which no single entity controls? Why not continue to rely on centralized institutions like banks, clearing houses and government authorities to certify the trustworthiness of the proprietary ledgers they each manage?
Beyond the general decline in trust in governments and banks in recent years, the Bank of England cites several risks that are inherent in our current banking system:
- Credit risk: “a paying bank may become insolvent with a large amount of money owed to other members of the system.”
- Liquidity risk: “a bank might be fundamentally solvent but may not have the funds to settle a required payment at a particular moment in time.”
- Operational risk: “one of the banks involved in a payment transaction may cease to function (either temporarily or permanently) because of some event, such as an IT failure.”
In a distributed financial system, payments are made directly between payer and payee, thus removing the credit and liquidity risks. The main responsibility of the institutions involved is to oversee the trustworthiness, security and efficiency of the distributed ledger system, ensuring that the cryptographic technologies and protocols have been properly implemented. And, like the Internet, such a distributed system should be significantly more resilient than our current banking systems, given the large numbers of redundant blockchains and pathways in the network.
Ledgers have been widely used to keep track of valuable economic assets besides money. Similarly, blockchain-based distributed ledgers will likely have much broader applications beyond payment systems. Financial institutions can use them to keep track of stocks, bonds, loans and similar such assets. Governments can use them to record the ownership of land, houses, cars and other valuable physical assets, as well as birth certificates, passports, and other forms of identities. The rapid growth of the Internet of Things requires the kinds of capabilities offered by blockchain technologies, - distributed peer-to-peer architectures, near unlimited scalability, privacy, security and the ability to efficiently handle myriads of trustless transactions.
Blockchains enable institutions who don’t know or trust each other to build highly secure and scalable ledgers of all sorts. It’s a worthy companion to the Internet, with which it shares many architectural characteristics. And like the Internet, it might well lead to many innovative applications that we can barely imagine today.