DEMYSTIFYING BLOCKCHAIN: FROM CRYPTOCURRENCY TO SMART CONTRACTS

Transcription

1 DEMYSTIFYING BLOCKCHAIN: FROM CRYPTOCURRENCY TO SMART CONTRACTS 1. DEMYSTIFYING BLOCKCHAIN Blockchain is an emerging technology that promises to revolutionize digital transactions. However, blockchain is not well understood and confusion exists as to the different associated terms. This whitepaper aims to demystify the technology and to provide insight into potential future applications. At its core, blockchain is a public ledger technology that uses cryptography to provide an authoritative record of secure transactions. The technology is deemed disruptive in that it eliminates centralization, which uses a trusted third party. A trusted third party is a middle man facilitating a transaction between two parties. This centralized architecture underlies the brunt of transactions today. Trusted third parties like banks and payment providers, dominate the financial services industry. Blockchain threatens to disrupt this model. The technology leverages mathematics (digital signatures, cryptographic hashing, and consensus mechanisms) to enable untrusted parties to transact directly in a secure manner, without having to deal with a middle man. This type of transaction is known as trustless trust, and it is paving the way for a radical transformation of established industries, notably in the financial services sector. In addition, blockchain technology could impact emerging markets, such as those forming around the Internet of Things (IoT).

2 Before diving into how blockchain can transform industries, it is important to dig into what makes it an innovative technology. Blockchain has three primary transformative features: immutability, transparency, and autonomy. The transactions, once verified and accepted, are cemented into blocks and appended to a chain. After synchronized replication across all the distributed nodes, the blockchain provides not only an immutable record of the transactions, but also transparency, as the data (current and historical) are viewable to all. Without the requirement of a centralized authority to manage transactions, blockchain users enjoy a level of independence previously unattainable in many services, including legal and financial. Bitcoin is the first (and most) successful commercial application of blockchain technology. Incepted by one or more parties under the pseudonym of Satoshi Nakamoto in a 2008 whitepaper entitled Bitcoin: A Peer-to-Peer Electronic Cash System, it made its practical debut in cryptographic circles in January For a few years, the reputation of Bitcoin was more infamous than respectable, with many use cases tied to the darknet, illegal transactions, and cybercrime. However, it was immensely popular as a technology within techno-libertarian and crypto-anarchist circles. Continued use and growing popularity saw Bitcoin outgrow disrepute to become a formidable success. As of 8 August 2017, 1 Bitcoin was valued at US$3,482. The origin story of blockchain is, therefore, in Bitcoin, and the associated terminology is best understood from this source. Without going into technical detail, the figures and table below attempt to provide a snapshot of the various components of blockchain. BLOCKCHAIN BLOCK BLOCK # 1 BLOCK # FROM: A TO: B FROM: A TO: E FROM: E TO: F FROM: E TO: S FROM: R TO: S FROM: R TO: Y HASH HASH OF THE PREVIOUS BLOCK 56857CFC709D3996F057252C16EC4656F HASH HASH OF THE PREVIOUS BLOCK 35D91262B3C3EC8841B C97F7745RY7H CFC709D3996F057252C16EC4656F JUNE JULY BLOCK BLOCKCHAIN BLOCK # 1 BLOCK # BLOCK # BLOCK # BLOCK # BLOCK # BLOCK # FROM: A TO: B FROM: A TO: E FROM: C TO: B FROM: C TO: A FROM: B TO: Y FROM: A TO: R FROM: E TO: R FROM: E TO: F FROM: E TO: S FROM: E TO: D FROM: R TO: M FROM: S TO: A FROM: C TO: E FROM: R TO: T FROM: R TO: S FROM: R TO: Y FROM: E TO: A FROM: E TO: D FROM: A TO: C FROM: D TO: A FROM: A TO: E HASH 56857CFC709D3996F057252C16EC4656F HASH 35D91262B3C3EC8841B C97F7745RY7H4 HASH 2D86C4246F3C0EB516628BF324D6B9A3GREWGRK HASH 4FB319211B2E85CACE04E F024GROJGJOIR HASH FF6626C69507A6F511CC R74H2UH3 HASH 56857CFC709D3996F057252C16EC4656F HASH E0D123E5F316BEF78BFDF5A HASH OF THE PREVIOUS BLOCK HASH OF THE PREVIOUS BLOCK 56857CFC709D3996F057252C16EC4656F HASH OF THE PREVIOUS BLOCK 35D91262B3C3EC8841B C97F7745RY7H4 HASH OF THE PREVIOUS BLOCK 2D86C4246F3C0EB516628BF324D6B9A3GREWGRK HASH OF THE PREVIOUS BLOCK 4FB319211B2E85CACE04E F024GROJGJOIR HASH OF THE PREVIOUS BLOCK FF6626C69507A6F511CC R74H2UH3 HASH OF THE PREVIOUS BLOCK 56857CFC709D3996F057252C16EC4656F JUNE JULY JANUARY JANUARY FEBRUARY JUNE JULY Bitcoin A cryptocurrency application of blockchain technology. Blockchain A distributed database consisting of blocks, which, as a chain, form an authoritative record of transactions. Block A block contains a set of recently recorded transactions, a hash of the previous block, a time stamp, and a nonce. 2

3 Cryptocurrency A digital currency that works using cryptography to secure transactions and create further units of currency. Cryptographic Hashing Decentralized Autonomous Organization (DAOs) Digital Signature A one-way unique hash value is created for every transaction (for Bitcoin, using SHA-256 encryption), then bundled with others in a Merkle tree. A resulting aggregated hash value is created. The consensus mechanism requires that the calculated value for a hash must be equal to or smaller than a certain given value. AI-based autonomous agents. They can be a party to a smart contract, and are best defined as a class of long-lasting smart contracts. DAOs can be used to implement more complex governance structures, such as owning, exchanging, and trading resources, interacting with other parties (human and machine), and executing pre-defined tasks. Blockchain makes use of PKI. By applying the concept of public and private keys, the blockchain assures the authenticity of participants sending transactions within the system. Distributed Consensus Mechanism All participants have to calculate the hash value continuously by using different nonces until the target is reached. When one node obtains the relevant value, all other nodes must mutually confirm whether the value is correct or not. Distributed Ledger A type of database spread across multiple sites, based on consensus of replicated, shared, and synchronized digital data. Blockchain is one type of distributed ledger. Mining Process of adding blocks to the ledger through the proof of work process. Participants are incentivized to mine through the receipt of a cryptocurrency when a correct hash value is calculated and the block is successfully validated by other miners. Node Any computer connected to the blockchain network and relays transactions to other nodes. Nonce The mathematical problem of the proof of work concept; nonce is a value starting from 0 and increasing for each hash calculation. Proof of Work The original consensus mechanism strategy (used in Bitcoin) using complex computational process for authentication. Proof of Stake An alternative consensus mechanism strategy using various solutions: randomization to predict the next generator, or coin-based age selection, or priority to generate blocks according to stake. Smart Contract A software-based contractual agreement between two or more parties that can release funds, communicate information, record and embed data, or even make purchases; all this in a pre-programmed, self-executing, autonomous manner. BLOCK BLOCKCHAIN SMART CONTRACT BLOCK # BLOCK # BLOCK # SMART CODE TO BE EXCUTED SMART CODE TO BE EXCUTED SMART CODE TO BE EXCUTED if(condition #1){ if(condition #1){ if(condition #1){ //do something //do something //do something }elseif(condition #2){ }elseif(condition #2){ }elseif(condition #2){ //do something else if condition 2 is met //do something else if condition 2 is met //do something else if condition 2 is met }else{ }else{ }else{ //do something else //do something else //do something else } } } DATA Electronic medical records DATA Logistics and supply chain information DATA Electric vehicle charging stations HASH 56857CFC709D3996F057252C16EC4656F HASH OF THE PREVIOUS BLOCK HASH 2D86C4246F3C0EB516628BF324D6B9A3GREWGRK HASH OF THE PREVIOUS BLOCK 56857CFC709D3996F057252C16EC4656F HASH FF6626C69507A6F511CC R74H2UH3 HASH OF THE PREVIOUS BLOCK 2D86C4246F3C0EB516628BF324D6B9A3GREWGRK JUNE JUNE JULY

4 The evolution of blockchain since its Bitcoin origin almost a decade ago has moved beyond digital payments using cryptocurrency. Business logic can now be programmed through smart contracts, and contractual agreements can be automatically executed peer to peer. This provides a new level of autonomy to users, beyond the abstraction of payments from a centralized authority. Blockchain is, therefore, a type of distributed ledger technology, but not all distributed ledgers are effectively blockchains. Later iterations of blockchains have moved to private, permissioned formats, which are in stark contrast to their public, open cousins. Cryptocurrencies can be viewed as the first generation of blockchain, with very limited characteristics as they pertain to distributed ledgers. While the definition of distributed ledger technology is still debatable, the current dominant position is that they essentially require a legal identity with permissioned nodes to validate transactions. Furthermore, while cryptocurrencies are based on blockchain technology, it does not necessarily flow that distributed ledgers are all blockchains. They can simply be distributed databases or computing platforms. As such, there are a number of enterprises labeling their offerings as blockchain, but in reality, they are just distributed ledgers. 2. THE FUTURE POTENTIAL The varying improvements on the original blockchain architecture have expanded the concept of digital currencies and introduced the idea of smart contracts. Blockchains have evolved, and the processes that allow applications other than payments to be executed peer to peer have improved considerably. BITCOIN ETHEREUM (SOLIDITY) Turing-complete Framework IF A B A B ELSE C The most recent large-scale endeavor in that direction is the Ethereum platform. The difference with the Bitcoin blockchain is that it includes a Turing-complete programming framework that enables users to create contracts that are more complex than the simple transactions allowed by Bitcoin. Ethereum is essentially a public blockchain-based distributed computing platform that includes a programming language (Solidity), a runtime environment (Ethereum Virtual Machine), a cryptocurrency (Ether), and APIs, among other features. The general idea is that smart contracts effectively represent contractual agreements between two or more parties. For example, they can release funds, communicate information, record and embed data, or even make purchases; all this in a pre-programmed, self-executing, autonomous manner. Digital identities can be created for physical property and intangible assets, whose ownership and functioning can be controlled through smart contracts on the blockchain. 4

5 Moving even beyond smart contracts is the idea of software-based DAOs. They can also be created for societies and corporations. At the core, they are AI-based autonomous agents. They can be a party to a smart contract, and are best defined as a set or class of long-lasting smart contracts. DAOs can be used to implement more complex governance structures, such as owning, exchanging, and trading resources, interacting with other parties (human and machine), and executing pre-defined tasks. DAO Decentralized Autonomous Organizations Corporate Governance Smart Contracts Smart Diagnostics & Machine Maintenance e-government and e-citizen Services Ethereum blockchain Smart contracts and DAOs can be used for numerous applications: digital identities, voting, governance, smart property, asset tracking, engineering-related transactions, smart diagnostics and machine maintenance, supply chain tracking, M2M transactions, tracking supplier identity and reputation, registry of assets and inventory, etc. Through these evolving technologies, blockchain will affect and perhaps radically transform all kinds of interactions, including business, legal, social, and political. 5

6 3. USE CASES FOR VERTICAL MARKETS Although major blockchain activity exists in the financial technology market, there is little commercial activity in other verticals. The reason for this is the embryonic state of the new concept, as well as lack of understanding in these end markets, which are currently in a state of digital transformation. Nevertheless, blockchain can transform, improve, and even disrupt several vertical markets, and there is some activity across the world today, hinting at the bright future of blockchain in end markets. Some potential use cases are outlined below. Automotive The automotive environment is experiencing first signs of digital transformation, including always-connected electric, self-driving vehicles, and driverless trucks. Blockchain can create a global economy that is free of middlemen in this sector and manage payments, electric charging, and part trading. In fact, there is an existing blockchain use case for automotive: the innogy Innovation Hub, a subsidiary of Germany electric and gas utility RWE, has launched electric vehicle charging stations across Germany that are connected to the Ethereum public blockchain. This is coupled with a smartphone app to create an automated and immutable charging experience. Healthcare Patient data and healthcare records are a critical domain, in which a false decision or an IT system malfunction can cost lives. Almost every health institution does not share patient data with other institutions, even in the same district, because there is no standard for communicating or sharing these data. A private blockchain between hospitals can be used to share patient data, also providing an immutable trace of the related records and transactions. The MIT Media Lab, in association with a physician named John Halamka, has created MedRec, a patient record blockchain application that has met success in early trials and pilots, with more health institutions taking part. Logistics Logistics and the supply chain management market is constantly seeking ways to improve collection, logging, and quality of information on transportation, especially for perishable goods. Blockchain can be especially useful in cold chain, where it can provide a trusted trace of environmental parameters during the transportation of perishable goods. Walmart, for example, has partnered with IBM and Tsinghua University in China to analyze how food is tracked, transported, and sold to consumers in China using blockchain technology. Digital tracking and an immutable, common log of the transportation of goods can create a more effective supply chain that can also reduce operational costs. Transportation Blockchain can be used in the transportation industry to rationalize and simplify contractual agreements between different partners. Moreover, pricing for transport can be monitored in real time and negotiations can take place between partners in a simpler manner, without a centralized entity. In the airline industry, Lufthansa has launched Blockchain for Aviation (BC4A), which can be used by the airline and its partners to ensure an immutable history of every component. This allows partners to provide verifiable documentation for the parts they have installed. Several industries have clearly just scratched the surface of blockchain potential. However, there are several barriers to overcome before most of these reach a critical mass and education needs to take place in several of these industries, as most of the initiatives described above are only in a testing phase. 6

7 4. BARRIERS TO OVERCOME FIRST While blockchain undoubtedly holds great transformative potential, it needs to overcome a number of obstacles. As a nascent technology, it is not immune to vulnerabilities and unknowns may bar the way to growth and maturity. Firstly, private centralized permissioned ledgers may jeopardize the concept of immutability. Blockchains are already potentially susceptible to colluding attacks whereby one or more nodes exceeding 51% of mining power could cheat the network into accepting unlawful transactions or other nefarious action. For example, the colluding forces could engage in a hard fork of the network and move together to an amended blockchain. The challenge is that such an attack would require a large number of colluding parties, and in the case of Bitcoin, this would be almost impossible to achieve. However, for some of the newer endeavors, with a smaller number of participants, such an effort may be successful. Certainly, private and permissioned blockchains, and new applications on public blockchains, are vulnerable to this type of manipulation. A successful hack of a DAO (called The DAO) on the Ethereum blockchain in June 2016 forced stakeholders and core developers to overturn parts of the blockchain and backtrack to a previous state. This bitterly divided the Ethereum community and revealed that the blockchain is not truly immutable. Without going into detail about the hack, it revealed essentially that code is unable to discern intent and will function regardless, allowing both good faith and malice to guide it. Smart contracts are, therefore, not likely to take the form of complex legal contracts anytime soon until issues surrounding liabilities and dispute resolution can be more effectively addressed. However, the problem of legal applicability could eventually be resolved. Recognition and support by government and law enforcement on blockchain could provide a clearer legal status. As for The DAO hack, the issue was resolved without recourse to the judicial system, which leaves many legal questions unanswered. Further, the U.S. Securities and Exchange Commission (SEC) recently weighed in on The DAO hack, stating that the tokens traded in the Initial Coin Offering were effectively securities. While the SEC did not leverage any penalties, the published decision aims to direct future ICOs in the space and possible compliance requirements with U.S. securities laws. Beyond the core issue of immutability, blockchain technology still has to overcome other barriers, notably with regard to regulatory compliance, scaling, processing and redundancy costs, and, finally, privacy and security. Currently, cryptocurrencies, DAOs, and smart contracts exist in an extra-judicial bubble governed solely by code without input or oversight by a central authority, such as a financial authority, trade commission, law enforcement entity, or other government authority. There are open-ended questions on dispute resolution, liability, and redress. Within highly regulated sectors, blockchain might not be a suitable solution if it is not in compliance, and existing regulation is often designed with a central authority to govern and identifiable parties that can be made liable in case of breach or error. It will take time to adapt existing regulation to blockchain technologies for use cases in more complex settings as they relate to the IoT, the legal profession, or even in financial services beyond digital payments. Scaling is another critical obstacle to overcome. The distributed feature requires all nodes to record all transactions within a common shared ledger. The Bitcoin ledger is currently over 100 GB in size, served by 6,900 full nodes. ABI Research forecasts 27 billion connected IoT devices by the end of Scaling blockchain technology to that kind of size is going to be difficult and costly. Even within the Bitcoin blockchain, there is a move toward using centralized intermediaries to clear payments. In fact, Bitcoin recently underwent a hard fork, with a new cryptocurrency emerging, Bitcoin Cash, after years-long debate. The reason behind it was to scale Bitcoin to more users, 7

8 with Bitcoin Cash blocks effectively increased to 8MB (as opposed to the 1MB of Bitcoin). Add to that the operational costs (in terms of processing power and energy consumption) to mining and verifying transactions on the blockchain, and it becomes clear that scale and decentralization are at odds with each other and a trade-off will need to be found, notably in light of IoT blockchain applications. Finally, but not least, there are issues revolving around privacy and security. While the Bitcoin blockchain does not record account balances (only transactions), it is possible to extract information about users based on the transactions (through public keys). This may be a barrier for those applications that require a higher level of privacy protection and confidentiality. As for security, The DAO hack shows that the blockchain is vulnerable. There have been other DAO hacks since, most recently in July 2017, when USD$7 million was drained from CoinDash s ICO. Whether through bugs in code, or by finding a loophole in smart contracts, there will always be interest by malicious parties to exploit it, and this interest will grow alongside blockchain s popularity. Blockchain security relies on verification of transactions and proof of work. Should the incentive for mining the blockchain be centralized within the entity funding the miners (as will likely be the case in permissioned and private blockchains), then the risk of a single point of failure is high. Security needs to be stronger for a more open and decentralized blockchain system. 5. CONCLUSIONS Some of these issues will eventually be resolved through standards development. There are currently competing concepts: public and private; permissioned versus permission-less. Various endeavors are employing different algorithms and methodologies to address issues in energy consumption and security, i.e., proof of work (Bitcoin), proof of stake (Peercoin), delegated proof of stake (BitShares), practical byzantine fault tolerance (Hyperledger), etc. Ethereum is planning to switch from proof of work to proof of stake before the end of 2017, citing energy consumption concerns primarily. In time, successful adoption and widespread usage will inform standards work in the future, and determine which technology will ultimately provide the most cost-effective, secure, and efficient solution. Ultimately, blockchain technologies have a long way to go before commercial applications beyond cryptocurrencies can be successfully implemented. However, much like any new market and technology before it, blockchain must undergo its fair share of trials and errors. The success of Bitcoin is pioneering the potential of blockchain, and there is great promise that it can profoundly alter and transform established industries beyond fintech as well if the current issues can be resolved. 8

9 Published September 7, ABI Research 249 South Street Oyster Bay, New York USA Tel: ABI Research. Used by permission. ABI Research is an independent producer of market analysis and insight and this ABI Research product is the result of objective research by ABI Research staff at the time of data collection. The opinions of ABI Research or its analysts on any subject are continually revised based on the most current data available. The information contained herein has been obtained from sources believed to be reliable. ABI Research disclaims all warranties, express or implied, with respect to this research, including any warranties of merchantability or fitness for a particular purpose.