Back on the Chain Gang – Part 2
In the winter edition of the Artisan, we provided a high level overview of Blockchain technology and why it continues to attract attention in the financial industry. In this edition, we will delve into the inner workings of the technology. We use the word ‘attempt’ here, as this can be a particularly challenging topic, plus the technology is evolving every day. We hope to provide a framework to highlight a few of the opportunities to apply Blockchain and some challenges being debated as it matures from its infancy.
As a brief review, Blockchain is a distributed open ledger that can store and update records without the use of a trusted third-party. The ledger itself is decentralized and is accessible to all network members, who have the right to update and maintain it. One of the most prominent questions is how users can be assured that the ledger gets reliably updated, or if fraudulent records and transactions could be slipped in. After all, this is why we require a trusted third-party in the first place. To put it simply, how can the ledger be trusted? The easiest way to explain exactly how this works is by detailing an example of a Blockchain transaction using Bitcoins, keeping in mind that the fundamentals of the process can be applied to any type of transaction. The first step of our hypothetical transaction is to get set up on a network for the transaction to take place (in this case, the Bitcoin network). After installing the appropriate software and purchasing some coins you now have a “cryptocurrency.” The cryptocurrency, which consists of digital Bitcoins, are stored in a digital wallet. The Bitcoin itself is not actually "stored” in a wallet but rather a private key (secure digital code known only to you and your wallet) is stored that shows ownership of a public key (a public digital code connected to a certain amount of currency). Your wallet actually stores these private and public keys and thereby allows you to send and receive coins, and also acts as a personal ledger of transactions.as a sequence of bits in the form of an address that is unique to the holder.
The second step is the fun part – spending those Bitcoins! After some online browsing, one may find that a coveted item is now on sale, and with luck, the online seller accepts Bitcoins as payment. Now the Blockchain technology takes over. By purchasing the item, software sends a digital message along with a signature over the network, stipulating that Bitcoins are being sent in exchange for the item. The party receiving the Bitcoin payment has its own unique address and becomes the new owner of the coins. Using Blockchain technology, which actually is the ledger, each party involved in the transaction can easily validate it. This is simple to do because Bitcoins are marked with unique addresses that are not associated with any other Bitcoins. The next question to address is how do we know that hackers can’t write some code and deceive the system about Bitcoin ownership?
The Blockchain holds a record of every single transaction that has ever existed on it. Each transaction gets grouped into a “block” and is verified by the network. Each block of transactions gets linked to the block before it, forming a digital “chain”, hence the name Blockchain. A new block can only be added to the chain if all of the transactions within it have been verified (remember this is traditionally done by a trusted third-party). Since new blocks are verified based on each previous block, the more blocks that are added strengthens the chain and therefore the reliability of accurate information. In order to fraudulently add in a transaction, a person would have to alter every single block of the chain from the very beginning.
Blocks in the chain are verified through the process of “mining”. All of the users, or “nodes”, on the network are involved in the mining process. They become “miners” when they participate. Mining is the key to this entire technology and is based on a proof-of-work concept. Miners compete to update the ledger (or add a new block to the chain), and have incentive to do so because they receive rewards for their work. For their work, miners receive Bitcoins. The “work” involves solving complex mathematical problems that can only be achieved using computational force. If a hacker wanted to alter the entire chain back to the very first block of transactions, it would require unprecedented levels of computer power, which would also be extremely cost-prohibitive. This cost combined with the added challenge of making these spurious changes faster than all of the other miners competing to update the latest block effectively puts hackers back to square one. Although Blockchain continues to face obstacles such as privacy, integration, and compliance, it is expected that we will hear a lot more about this technology in in the years to come.