What you need to know about blockchain

Market commentary, Technology & Telecommunications | Comments (13)

What you need to know about blockchain

Back in 2008, Satoshi Nakamoto conceptualized the first blockchain. The following year, he used it as a core component of the digital currency, bitcoin. Since then, blockchain has become something of a buzz word. So what is it, and why does it matter?

What blockchain does is create a unique identity for digital assets. When I have a physical pen – it is easy to trace who is holding that particular pen. It is obvious if I am holding the pen, or I pass it to you. This is a bit trickier when I have a digital pen. If I forward you a pen – how can you tell I haven’t also forwarded it to my friend Alex?

Blockchain gives pens (or blocks) a history of ownership (a chain) so you can tell where each pen is (there are a finite number of pens). Each pen can only be in one place at a time and has had its own path there – if I gave you my pen, I no longer have one to forward to Alex. Everyone can see where the digital pens are on a public ledger – just like everyone can normally see where all the physical ones are.

Where this gets interesting is not when we own unique digital pens, but when we start applying this to the financial system – what if we use it for a currency (like bitcoin) or to record who owns a share?

There are some pretty big statements being made about how disruptive blockchain could be. Could it reshape the role of banks? Exchanges? Settlement systems? Certainly there are inefficiencies in the financial system that blockchain offers a solution to. A blockchain world means that, rather than each of these players having their own spreadsheets of who owns what stocks, there is one universal one that can be updated.

But does it matter?

Certainly – but probably not for a while. It has real implications particularly for exchanges and share registries (think ASX, CPU). Blockchain means settlement could potentially be reduced to minutes or seconds rather than days, or that you and I can trade shares directly – rather than going through a bank, an exchange and a register.

For now, we still need an exchange to see the market, a register to create and settle shares and a broker to execute a trade. But whether this exact structure will remain unchanged is uncertain. By way of example, whilst paper stock certificates still exist, they are now significantly costlier (up to $500 a pop) and were certainly disrupted by digital forms.

* Adding to the enigma of blockchain is the identity of Satoshi Nakamoto. He has still not been positively identified, and there is speculation Nakamoto could be a pseudonym for a team of people.

This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.

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13 Comments

  3. Andrew Bunting
    :

    Effectively concise. What are the implications for, say MasterCard or Visa, does this technology mean they’re headed the way of chequebooks?

    • Lisa Fedorenko
      :

      Thanks Andrew, it’s a very good question. Certainly both MasterCard and Visa are already investing in Blockchain technologies, but how the end game looks is hard to predict at this juncture. What we can say is any disruption there is likely a few years away yet. It is possible to make a case that some less efficient systems are at more immediate risk.

  4. Paul Nguyen
    :

    I feel the need to share a more detailed explanation of the blockchain every time I see it in investing circles, because there is a huge disconnect between what it is and what investors think it can be used for.

    1. How it Works:
    Shared databases have existed for a long time. The technological breakthrough of the blockchain is that it solves the double-spending problem: preventing users from duplicating their digital assets. It achieves this using a voting system called proof-of-work: users called ‘miners’ dedicate their computing power to solving massive cryptographic puzzles. The data is organised into blocks, each one with its own puzzle that links it to the previous block. By doing so as a group, they prove they are the majority and vote on the proper state of the ledger.

    For bad actor(s) to rewrite the ledger, they must re-solve all of the blocks using their own computing power. Since their computing power is dwarfed by the majority their version of the chain cannot keep up with the majority. It achieves a consensus by attrition.

    The ledger itself is a record of every bitcoin transaction ever recorded. It has a list of public addresses owned by various unknown users with corresponding bitcoins on them. A sender uses their private key (secret password to their public address) to write a digital cheque to the receiver. The cheque is broadcasted to the miners who add it into the next block. A block may contain thousands of such transactions.

    What the miners are actually doing is verifying transactions and keeping the ledger secure. As a reward they receive newly generated bitcoins. Their role is similar to that of a bank, except anyone can be a miner and it is a network rather than a central authority.

    2. Why It’s Different to Regular Databases
    Before the blockchain, we used trusted middlemen such as PayPal and traditional banks to maintain our ledgers of money and verify transactions between individuals online. Now we can use the blockchain instead, and effectively trade “money” peer-to-peer. Unlike our current financial infrastructure, the Blockchain:
    – Is Open and Permissionless: anyone can use it
    – Is Decentralised: with no Central Authority or single point of failure
    – Is Private and Censorship Resistant

    Now, the blockchain can be used for things other than bitcoin. Remember those digital cheques? Well you can actually write data on the back of them before you send them out. This means the cheque can be used to represent something other than just some bitcoin: such as a stock certificate, a deed to a house, or just a record of some data that you thought was worth sharing on the ledger. Some people have actually had their marriage vows recorded on the blockchain.

    The closest analogy I can think of for this technology is the Internet itself. While the Internet allowed us to send data peer-to-peer, the blockchain allows us to send digital assets peer-to-peer. Some experts have called this ‘The Internet of Money’.

    3. The Disconnect Between Hype and Reality
    The blockchain hype comes primarily from this notion of ‘private’ blockchains and blockchains where the currency is issued by a central bank. However, in such arrangements there is no double spending problem, as the controller of the database can identify all users, block malicious ones, and verify all transactions itself.

    For example, to issue its own digital currency the Federal Reserve can maintain an ordinary database where it controls who owns what amount of ‘FedCoin’, identifies all users, and verifies transactions itself. It can be completely transparent and compliant. But what it has created is not a blockchain and has nothing to do with it. It is a glorified national PayPal.

    A blockchain is only needed when the participants are unknown to each other and communicating over an insecure network. This means that the vast majority of blockchain research groups are wasting their time reinventing the wheel.

    • Lisa Fedorenko
      :

      Thank you for your detailed contribution Paul. Certainly lots of detail and some good sources there on the more technical aspects.
      Although in it’s pure-est notion blockchain is about an open and permissionless ledger, as you highlight – there is certainly an ongoing debate about the place for variations. Much like we have the open internet, but there is also a place for many private intranets.

  5. andrew
    :

    One thing to note here is that the reason why ‘blockchain’ is so transformative is that it is open source, trustless and public for all to see. It is able to do this because it is secured by the incentive to mine bitcoin as a reward. No trust in a third party is required.

    While the ‘blockchain’ technology will be of use for the financial industry it will more be a shared database with much improved speeds and accounting than a blockchain.

    • Lisa Fedorenko
      :

      Agreed on the features of blockchain – just be careful distinguishing the concept of blockchain and the particular example of it’s implementation, being bitcoin. I also agree that when used for another situation, it will likely be implemented slightly differently – similar to how a booking system for a restaurant or a doctor will have differences too.

  7. Kelvin Ng
    :

    Thank you!
    That’s the clearest and most concise explanation of blockchain I’ve ever read.
    Kelvin

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