What Is Blockchain? A Beginner’s Guide

The year 2017, for everything else it may or may not be, is already heralded as “The Year of Blockchain.” But what exactly is “blockchain” – and why is it slated to be the debutante of the ball across multiple industries?

Essentially blockchain is a way of connecting distributed databases to each other. In other words, it connects databases on machines that are not otherwise connected to each other in one firm or location. Further, it is also a way for these databases to “talk” to each other – to issue and receive commands and data in both encrypted and hashed form to accomplish functions or tasks. Blockchain is, in effect, a new kind of database, which writes “ledger entries” in different locations, but which can then be accessed by the network of computers to confirm that transactions did occur and reconcile these transactions.

It creates what is widely known as a “trustless” network – in other words, it removes the need for trusted third parties like banks or financial institutions to “enter” or reconcile entries, however this is a bit of a misnomer. The role that was formerly played by trusted third parties is now being played by the blockchain network itself. The “trust” that is implied is that the network is stable and the code – or protocols – of the network can in fact function as they are intended to. While blockchain may remove the need for trusted third party institutions, some of the newer blockchains (including Ripple) are based on the idea of “trusted” or “authorized” parties transferring data to one another. This allows a preselected group of “trusted parties” – in this case banks – to lower transactions costs, reduce the chance of fraud and remain competitive while creating in effect a private network.

The most revolutionary aspect of blockchain is that it moves the role of verification (of a task, payment or other action) from a single entity (such as a government or corporation) to multiple computers along its network. While a government or corporate entity (or even single person with enough wealth and power) could conceivably buy the majority of Bitcoins on the Bitcoin network and then hire programmers to change the rules of the network according to its own mandate, this is currently seen as a remote possibility.

The medium of exchange in the world of blockchain is cryptocurrency – tokens that have some value determined either by (a) direct market forces as in the case of Bitcoin or Ether, or (b) by the cost of the computing power required to produce them – in which case they is known as either a “tokens” or “altcoins”.

The workhorse of blockchain is the “smart contract” – which is just another way of saying that after a token has been “paid” for a particular purpose, then a certain action or transaction is triggered. For example, if Jane wants to send Bob five Bitcoins, she can utilize the Bitcoin network to do so (as long as she and Bob both have “wallets” connected to the network) and further, a record of that transaction will be recorded in all the computers in the network. If Jane is expecting to receive, in exchange for those five Bitcoins, ten shares of Bob’s company stock, he will be required to send her the digital token assuring her that the shares have been transferred to her before he can accept the five Bitcoins.

According to Nick Szabo, a cryptographer and “father” of smart contracts, an idea which he explored in a paper published in 1998, smart contracts are “a set of promises agreed to in a meeting of the minds [which] is the traditional way to formalize a relationship.”

Said another way, smart contracts work within the protocols (or algorithms) created to link the chain of databases together, to execute how such computers communicate with each other.

There are many different use cases for this kind of technology – although it has made its first impact in the world of finance. According to the Chamber of Digital Commerce, which has just published a report “Smart Contracts: 12 Use Cases for Business and Beyond” the industries (beyond finance) which are likely to see rapid deployment of the technology in the near future range from a further development of the concept in the financial industry to insurance and the healthcare industry.

What deployment of blockchain technology really means in the immediate future, is that the world will become more interconnected, that manual processes in many industries will be automated, and that the “costs” associated with these transactions will fall dramatically.

That said, it is far too early to predict what the adoption of blockchain will accomplish – just as it was essentially impossible to see where and how the Internet would change the nature of communication and community.

Suffice it to say, however, that by 2020, the world will already be a very different place because of blockchain’s deployment. By 2025, according to top consultants like Deloitte [pdf], the banking industry (at a minimum) will be profoundly disrupted.

Marguerite Arnold is an entrepreneur, author and third semester EMBA candidate at the Frankfurt School of Finance and Management.

The Far Reaching Impact of Blockchain

Blockchain, the underlying technology used by Bitcoin, has implications that reach far beyond the financial services community and banks. This is where new development and implementation may have focussed so far. However, as the technology and its implications become better understood, it will rapidly expand to new industries and verticals.

Blockchain systems operate as a kind of distributed database that store immutable (that is, non-changeable and verifiable) transactional records stored as “blocks” of information. Each block contains a timestamp and is linked or referenceable to a previous block and hence forms part of a larger “block chain”. Blockchains can either be public, private, or a combination of the two, with information accessible to users via “keys”.

Blockchain also works very much like a large distributed, non-centralized network. Each “node” of the network is a processor (or computer server in other words) that stores each block of information processed by that node. Once processed or verified, a transaction record can then be shared with other nodes in the network. This could be anyone in the case of a public blockchain, or only authorized users in the case of a private blockchain.

Blockchain technology has been applied in the finance industry in the payments space. Ripple, for example, allows banks to transact between themselves and with individuals globally by creating a payment platform that allows banks to settle payments in different currencies in real time. Individual payments and currency settlement calculations are made by a decentralized network of processors located at the banks and clients all over the world using Ripple’s payment protocol.

However the technology has many other uses – starting with the ability to better monetize alternative energy to the digitisation of insurance contracts. The insurance industry, in particular, is starting to get serious about investigating, if not yet implementing, blockchain solutions in order to streamline paperwork, manage supply chain issues if not insurance contracts overall, accelerate the processing of insurance claims, and improve the auditability of transaction records.

In fact, the real juice behind blockchain is not bits and bytes, but in fact how events are triggered by electronic code that translates contractual relationships into action – or so-called “smart contracts” that are executed within blockchain networks.

Smart contracts – or the computer protocols that facilitate, verify and enforce agreements – are actually the heart of this revolution. They represent a unique blending of technology and law, usually with regard to payments – but not limited to them. Smart contracts are actually coded binary language triggers along the network that cause certain things to happen when specific conditions are met. For example, Customer A authorizes payment to buy a convertible bond. When market conditions warrant, the bond “smart contract” will then automatically pay Customer A the required coupon payment, convert the bond into a certain pre-determined number of shares, or take some other required action.

Despite the hype, however, there are still vast unknowns – namely the ability of coders to accurately translate legal requirements into transactions that can be understood and retranslated by people – starting with regulators. In terms of payment or other easily defined contractual obligations (such as trade confirmations), the concepts are relatively straightforward. However, as anyone who has looked at even the simplest contract knows, there are many parts of a contract that are not easy to translate into code from natural language – much less decipher downstream. This includes everything from indemnities, warranties, covenants, confidentiality, digital signatures and enforceability if not other pieces in between.

What happens, for example, when the convertible bond bought by Customer A does not react to the right market conditions? Or what happens if the electronic triggers in the smart contract for this convertible bond are activated by the wrong set of market conditions? How will lawyers without coding experience be able to catch such errors? And how will coders without a legal background know what to look for to find them?

While understanding whether payment has been made (for example) is relatively easy to understand by all parties, understanding whether a service has been correctly provided, particularly when translated into and out of digital code, represents a quagmire that is already coming – and with no easy answers.

The legal enforceability of at least part of what smart contracts represent is not far away. Payment and exchange of services or data is the easy part. Redefinition of contractual relationships, however, is where the entire conversation starts to get murky. That is nowhere more obvious when applied to a specific part of “contract” law – namely civil rights.

For those who do not believe that civil rights are in fact a contractual relationship relating to basic property rights (including payment), values, and perhaps even the meaning of citizenship itself, then look no further than perhaps one of the most overlooked parts of civil rights and contract law in the United States.

The Civil Rights Act of 1991, also known as 42 U.S. Code §1981, is a United States labour law and the most recent codification of civil rights in America. In effect, it equates the contractual value of minorities and people with disabilities with that of white men.

In other words, civil rights are the mandatory equalizing of the contractual value of individuals enforced by the state. But that state is only one country.

What happens if there is a contract, for example, between an English multinational and an American citizen for work being performed in Hong Kong?

Do American civil rights laws apply?

Which set of laws should govern a smart contract?

If smart contracts expressly choose New York law, for example, this could mean that the best of American labor and civil rights laws are automatically exported to other countries. But it could also mean that contractual inadequacies, due to a failure to expressly choose a governing law, lead to unexpected results and ultimately undermine basic notions of equality and civil rights.

Further, what is the appropriate forum for resolving disputes under a smart contract?

In a world where contracts that affect payments as well as the terms of employment are becoming increasingly undecipherable, will smart contracts, which can also be used to govern labour agreements, be literally rewritten to eviscerate the concept of equal pay, access to healthcare, and perhaps even the right to negotiate a contract in the first place? And if smart contracts hide or distort important contract terms, how will consumers actually be able to tell if they have gotten what they paid for?

These are some of the big issues which face the entire discussion around blockchain. They are not widely part of the vernacular so far. However, just as bitcoins are electronic “digital currency”, block chain, the master regulator of such systems, could easily become a place where the contractual elements of pay, consumer and civil rights are either enshrined, or eviscerated.

Marguerite Arnold is an entrepreneur, author and third semester EMBA candidate at the Frankfurt School of Finance and Management.