Blockchain: Basic building blocks

Investors beware

I get to meet founders who claim that their cryptocurrency offering will reinvent the future of money as we know it. I love their enthusiasm, but I want to caution any angel investor trying to ride on the back of the public success of well-known cryptocurrencies such as Bitcoin / Litecoin / Ether.

Many angel investors have been lured by the prospect of investing in the new “digital- gold” without really understanding what they have invested in.

I want to write up on Blockchain technologies to shed some light on this topic- this is for beginners only- experts can choose to ignore this!

Block in a Blockchain

I happen to believe that Blockchain is one of the most game-changing human inventions since the Internet. At the same time, I have come to understand that it is not a panacea for all that ails the Internet as we know it. To understand the business implications of blockchain technology, we need to understand some of its fundamental concepts:

What is Blockchain?

The MIT technology review calls it- “A mathematical structure for storing data in a way that is nearly impossible to fake.” Satoshi Nakamoto, the mysterious creator(s) of Bitcoin, also created the first Blockchain, announced the Blockchain in this way, “I’ve been working on a new electronic cash system that’s fully peer to peer, with no trusted third party.”

The best way to understand a blockchain is to think of it as a database. Updates to this particular database are always added to the end of it instead of tinkering with the existing records. These records are combined in a chain format. Any new link to the chain contains references to the previous links.

Blockchain is decentralized because the database is stored over multiple nodes (computers), each of which has a copy of the entire database. Blockchain has “trust” built-in because it is immutable. Immutable means that the records on a blockchain cannot be changed. This feature makes it tamper-proof and brings in the ability to store transactions. Imagine having land records that list out all the owners starting from the first person who sold it. There would not be fewer land disputes!

How does it become tamper-proof?

First, all the nodes have a copy of the entire database. So a few rogue elements cannot tamper with previous records. It would require more than 50% of the nodes to work in concert to tamper the previous records.

Also, remember we spoke about how the records /blocks are linked together? If you change a previous block, ALL of the blocks created after that record have to be replaced. Why? Because all of those records are linked to its previous record.

To make a change, you would have to convince a majority of the owners of the nodes of the blockchain network to change the records as well.

Representation of a Blockchain

Hashing

Another reason for the tamper-proof nature of the Blockchain is the math behind it called- “hashing.” Any new record on the Blockchain is stamped with a mathematical representation of the previous record and a timestamp (to establish a chronological order). Each record is called a block (1 MB in size), and all the blocks are linked together like a chain. Hence the name blockchain.

This stamping process is done by what is known as a “hash function.” You can think of a hash function as a complicated math formula that takes some data and spits out a number, called a ‘nonce.’ If you make even a tiny change to the input data, the output number will be different. The nonce is combined with the transactional data on the block to create a ‘hash.’ The hash is a 64 character output. You can think of this as an encrypted digital fingerprint for a transaction.

Issues with the Blockchain

In the case of the bitcoin blockchain, a block is created approximately every 10 minutes. Now you can easily bat away anyone who says that she is going to create the world’s most exceptional payment system like Visa or MasterCard. You can’t have a customer wait for 10 minutes for a transaction to be validated at the cash register!

Maybe a later version of Blockchain will solve that problem. The other issue with Blockchain is the sheer amount of power required to keep it running. For this, we need to understand the incentive system for maintaining the Blockchain. It is supported by computer systems connected over the Internet by private players (node operators).

What is the incentive for the node operators to store and operate the Bitcoin Blockchain? The reason for this is “mining.” The node operators of a blockchain are rewarded with bitcoins for recording a new transaction on a blockchain. As of May 2020, it is 6.25 Bitcoins for every block. Look up the value of a Bitcoin, and you will understand why that is an incentive for the node operators (or miners).

To record a transaction, the node operators race to solve a math problem to create the next block. This math problem is built into the blockchain algorithm.

This work requires the usage of a tremendous amount of energy because multiple miners are racing to create the block, before the other operators.

Only the first miner who completes the math problem is awarded the bitcoins. Hence, bitcoin mining is not conducive to preventing climate change. Millions of homes could be powered by the energy required to run a blockchain.

I have restricted my discussion to the bitcoin blockchain. There are other cryptocurrencies, and they all have their implementations of the Blockchain.

Applications

Here is a cheat sheet for applications of the above features of the blockchain technology:

1. Confirm identity: Once you have created a customer’s /citizen’s identity on a blockchain, it is tamper-proof.
2. Confirm ownership: Create the proof of purchase, and it is tamper-proof
3. Confirm transaction: Create a transaction block, and you cannot change it
4. Decentralized business process: Trusted third-parties are no longer required to facilitate transactions such as money transfer or trade finance because trust is “coded” into the way the blockchain algorithm functions
5. Deconstructed organizations: An organization is a collection of contracts (Ronald Coase got a Nobel prize for the work on transaction costs). If the contracts can be smartly embedded onto a blockchain, you can conceive of organizations that exist by coordinating the activities of their departments on a blockchain.

Examples of activity

Examples that I have seen working in practice or have seen pitched for funding:

1. New Social media where the producers are rewarded for their content. Not like now, where FB packages your data and sells it to advertisers
2. Cross-border currency transfers at a lower price than what is done today using SWIFT. Who is currently doing it? RIPPLE network, which is an adaptation of the blockchain technology
3. Automatic Trade settlement for capital markets: BY building a trading platform on Blockchain, you don’t need to do the back-office work of reconciling each transaction. All transactions will be automatically marked with the seller/buyer, and the payment can also be automatically triggered
4. Financial inclusion: Anyone with a computer can technically be allowed to participate in the blockchain economy. Transactions can be done using the cryptocurrencies and centralized agencies such as banks; governments cannot exclude anyone
5. Smart contracts: Insurance claims can be automatically paid out by building applications that respond to a claimable event and thus reduce the claims handling costs. For example, if you have travel insurance against flight cancellation, the blockchain application could get information about the flight cancellation from travel APIs and automatically trigger a payment to the policyholder.

These are just some examples, and there are plenty more that many of the blockchain experts are working on. There is a reason why many global financial institutions are invested in creating blockchain applications.

Promising Blockchain implementations

One of the promising blockchain implementations is Ethereum (creator: Vitalik Buterin) that can be used to build web applications on top of a blockchain. These applications would then have all the positives features of a blockchain; trust, immutability, security, integrity, and so on.

Also, check out the R3 consortium working on a blockchain called Corda, with 32 banks working together to build the next generation of banking reconciliation software. That is the kind of coordinated effort that is required across industries to make blockchain adoption mainstream.

I think it is suitable for both investors and would-be founders to fully understand Blockchain technology as they work to build innovative applications based on this remarkable invention. The simple heuristic that I follow is, “Say no to startups offering “get-rich-quick” initial coin offerings and selectively say yes to Blockchain applications that utilize its fundamental principles to transform business as we know it.”

I hope I have shed some light on this seemingly arcane subject.

References to delve deeper:

1 What is Blockchain? MIT tech review (April 2018).

2 Blockchain explained: by Carson, Higginson, and London, Mckinsey.com,(Sept 2018)

3 Here’s why Blockchain will change the world, Don Tapscott & A. Tapscott, Fortune.com, (May 2016):

4 The Truth About Blockchain: Lakhani & Lansiti: HBR.org (Jan 2017)