Basics of blockchain

Blockchain technology has been around since 2008, but what exactly is it?

• In simple terms, it is a database.
• In technical terms, it is a list of records or blocks managed in peer-to-peer networks that uses the internet as a platform. But, unlike normal databases, nobody is in charge – there is no central administrator and no clearing house.  

The key difference, then, is that the blockchain system is managed and controlled by its users as a decentralised (or distributed) digital ledger which is duplicated across a worldwide network of computer systems.

In the first of two blog posts on blockchain for the Institute Paul Ford has outlined the fundamentals of blockchain to give you an idea of the technology behind this increasingly influential digital system.

How it works and terminology

• Blockchain systems may be open (public) without access restrictions or closed (private) systems with set permissions criteria. The most well know open system is Bitcoin, the cryptocurrency.
• A ledger is replicated in a large number of identical databases, each hosted and maintained by different approved users. 
• Every new ‘block’ in the chain is timestamped and consists of a record of transactions.
• When a block is filled it becomes immutable and part of the recorded timeline or chain, and all ledgers are updated simultaneously.  
• As further transactions occur, more blocks are added to the chain.
• Transactions are verified using cryptographic keys and a proof protocol demonstrating that some computer resource was expended to create the block (‘proof-of- work’).
• This process of verifying transactions (known as ‘mining’) secures each block.  Once a computer begins mining, it becomes a ‘node’.
• Alterations require the consensus of over 50% of the nodes. Blocks cannot be altered retrospectively without altering all subsequent blocks (i.e. immutability).
• The larger the network of participants, the less vulnerability to fraudulent tampering of records (theoretically).

If a block in the chain is altered without also altering all subsequent blocks, the unique identifying string of enciphered text (‘hash’) of the following block will no longer match, making the tampering on the blockchain detectable. If the information in the block is financial (e.g. purchase of shares) or identifying information (e.g. due diligence identity information), then fraud is, in theory, easily detectable.

Distributed technology – is this new?

• This is not a new concept.
• The World Wide Web is based on TCP/IP (transmission control protocol/internet protocol) adopted by ARPANET (Advanced Research Projects Agency Network, the predecessor to the internet) in creating email. Before TCP/IP, telecommunications architecture was based on pre-established connections between two computers systems connected by an exchange.
• Open source software operates on similar principles with licensed users and indeed is utilised in blockchain projects.
• The ‘vision’ for blockchain champions is to remove the need for intermediaries in transactions.

For instance, a typical stock transaction can be executed within microseconds without human intervention. Legal transfer of ownership however is much slower as a series of intermediaries (i.e. lawyers, bankers, brokers) are needed to verify ownership and the right to transfer. Ledgers are then individually updated. Advocates suggest that if a stock transaction took place using blockchain technology, settlement would be simultaneous with execution.

Does the technology have integrity?

• The longer the chain of blocks, the more complex the encryption sequence.
• The proof-of-work protocol serves to deter denial-of-service attacks and spam but may result in high energy use which may prove a practical deterrent to smaller organisations.
• The proof-of-stake protocol seeks to overcome the energy usage issue by limiting the mining power to the proportion of bitcoins or other value held only.
• Use of smart contracts which automatically execute transactions negates the need for these protocols but requires pre-determined conditions to be met.
• In theory, this all makes it harder to hack or corrupt blockchain systems.

However, if miners obtain 51% of the mining process, they can create a second fraudulent version of the blockchain (known as a ‘fork’) which may enable:

• Double spending (where one bitcoin is spent for two or more goods or services before the sellers realise). This occurred with Bitcoin Gold and Ethereum Classic in 2018; and/or
• fraud. If the system is based on the ‘longest chain wins’ protocol, making the fork chain longer will ensure all innocent participants will build on the fraudulent fork, thus undermining integrity. This occurred also with Bitcoin Gold in 2018. 

The double spending risk is why traditional currency transactions use clearing houses and the 51% risk should only be a realistic possibility in smaller networks.

These, then, are the basic principles involved in a blockchain system. Stay tuned for my second blog post on the topic, which will look at the potential ways blockchain might be used going forward and the huge impact this could have on the world.

Paul Ford

Paul is an Associate member of The Chartered Governance Institute UK & Ireland