Robert Kugel's Analyst Perspectives

The blockchain distributed database was invented to create the peer-to-peer digital cash called bitcoin in 2008. Although the future potential of bitcoin and other cryptocurrencies has been debated, the distributed ledger structure using a blockchain database that supports bitcoin is likely to be adopted for a range of commercial and governmental purposes. Distributed ledgers are a secure and transparent way to digitally track the ownership of assets while enabling faster transaction speeds and reducing potential for fraud. How quickly companies, governments and individuals start using distributed ledgers and for what specific purposes remain to be seen, but their use will be independent of cryptocurrencies’ fortunes. Expansion in the use of distributed ledgers will depend heavily on the success of the initial applications and whether there are major hiccups in their use.

To the extent that people have even heard of distributed ledgers, most associate the technology with bitcoin or some sort of payment system. However, it can do more than that. The technology can complement and enhance a variety of enterprise applications, facilitate commercial transactions of all types and provide governments with the ability to streamline interactions with the public.

Here’s a summary of the technologies involved: A distributed ledger is a shared database of assets and their owners located on multiple nodes (sites) on a network. All nodes have an identical copy of the ledger, and any changes to the ledger are incorporated rapidly (at a maximum within minutes; ideally within seconds) in all copies. Distributed ledgers’ distinct value is their ability to securely identify ownership of any form of asset – physical, financial, legal or virtual – and faithfully record all transactions involving these assets. The security of the validity and dependability of the distributed ledger depend on several factors: its blockchain construction, decentralized ownership of identical copies of a ledger, the use of public key encryption of the entries in the database and the use of digital signatures for access control. An important advantage of it lies in moving much of the complexity of managing security onto the structure of the system itself, making such systems easier and less expensive to manage and use than conventional on-premises and cloud-based applications.

Blockchain algorithms enable transactions to be aggregated in blocks that are added sequentially to a chain of existing blocks using a cryptographic signature. A transaction may be, for example, the sale and purchase of an asset or the addition of a health record or a patent filing.

When someone wants to add to the database, each owner of the distributed ledger runs a set of algorithms to evaluate and then verify the proposed transaction. If a consensus (usually a majority of participants) agrees that the transaction looks valid – that is, the identifying information matches the blockchain’s history – then the new transaction will be approved and a new block added to the chain in that ledger. If the participants deciding on the validity of the transactions are preselected, the ledger is said to be “permissioned.” If the process is open to everyone (like bitcoin), the ledger is “unpermissioned.” The advantage of an unpermissioned ledger is that it evades control by authorities. This may be to achieve ethical objectives (for instance, overcoming censorship or theft by autocratic or kleptocratic governments) or for nefarious purposes (money laundering or trade in contraband). Permissioned ledgers can have an advantage if managed by actors (such as self-regulated commercial body or governments) that have the trust of the participants. Permissioned blockchains provide highly verifiable data sets because the consensus process creates a digital signature visible to all parties.

The cryptographic signature using public key encryption can provide individual privacy while validating the identity of the individual making the change. Already in wide use public key encryption enables anyone to encrypt a message using the public key of the receiver, but such a message can be decrypted only with the receiver's private key. Public key encryption is often compared to a locked mail box with a mail slot. The mail slot is accessible to the public, and its location – the street address – is the public key. Anyone can drop a message through the slot, but only the individual who has the private key can open the mailbox and read the message.

The blockchain structure provides a permanent audit trail since no records can be deleted without collusion on a massive scale. Distributed mirrored databases substantially reduce the ability of anyone to tamper with data since each instance would have to be altered in an identical fashion almost simultaneously. A cryptographic hash function provides a fast and highly efficient means of detecting if a blockchain has been tampered with and for assuring the integrity of transmitted data. That said, distributed ledgers are not invulnerable to attack. Anyone who can find a way to modify one copy legitimately might be able to modify all copies of the ledger. This will happen if systems can be compromised through, for example, phishing or pretexting.

How a given distributed ledger is controlled can vary. Although the ledgers are distributed, there can be varying degrees of centralized control to suit the specific purpose of the ledger. Unpermissioned ledgers (such as bitcoin) are not owned by any individual or entity and anyone can contribute data to the ledger. At the other end of the spectrum, permissioned ledgers may have one or many owners and only they can determine who can add records and verify the contents of the ledger. In practice, the latter can only be considered a distributed ledger (in the definition I’m using) if the number of owners and their independence are sufficient to ensure that the possibility of successful collusion to alter the database is sufficiently low to achieve public confidence. I’ll leave it to others to decide for themselves if a distributed ledger organized and controlled solely by a single organization such as the financial network SWIFT should be regarded as a “true” distributed ledger. By my definition it is. It’s likely that some existing single-entity controlled networks (such as those that manage supply chains) will adopt the distributed ledger structure for all or part of their operations to provide new services or to modify their existing architecture to reduce costs, enhance performance or gain flexibility.

There is no shortage of potential uses of distributed ledgers. There are so many that they – and the underlying blockchain methodology – can appear to be another example of a new technology in search of a mission. Distributed ledgers are not an application but a facility that can support application functions. They can, for example, record the basics of a transaction (such as the details of the item that has been exchanged and the corresponding payment) or serve to signal events (such as accepting a shipment).

Distributed ledgers could serve as a secure platform for all forms of contracts; potentially they could make it easier to enforce contracts of all types in parts of the world where the rule of law is weak because the platform could ban all participants that renege. Distributed ledgers also could be used in settling securities trades of all types – this is more of an evolutionary improvement over today’s systems. In concept, a distributed ledger could cut reconciliation costs by more fully automating the trade settlement process and substantially improving the quality of data, as well as enabling financial institutions to make more efficient use of collateral and regulatory capital by limiting the volume of trades in limbo because they failed to settle.

In commerce, distributed ledgers have the potential to substantially enhance visibility in multitier supply chains and multistep distribution, increase traceability of materials and combat drug counterfeiting. They can provide accurate and immediate customer records or immediately reflect changes to the properties in product life-cycle management and product information management. Networks for connecting members of a value chain have been difficult to establish because typically they have been set up by one of the major players. Competitors of that major player cannot (will not) participate in that network, blunting its effectiveness and leading to network fragmentation. Distributed ledgers might be less prone to this defect because they provide a secure, auditable mechanism for data capture and exchange that can complement but not replace the functionality of a value-added network. Companies therefore would be able to operate on different value-added networks that all use the same transaction data.

In the public sector there are many ways in which governments can use distributed ledgers including property record-keeping, healthcare data, a digital notary system, recording government contracts and handling tax and other payments.

Despite these potential uses it’s not clear how quickly distributed ledgers will gain traction and profitability in the commercial realm. In developed economies, there already are many trusted networks and methods for transacting business governed by commercial codes. Ultimately they may adopt a distributed ledger structure because it’s superior to the technology they are currently using in terms of speed and robustness. Some observers estimate that banks collectively could save billions of dollars in IT infrastructure costs by employing them for payments across borders, securities trading and regulatory compliance. Beyond savings, the desire to improve service or the threat of competition from an upstart will drive the process. There are many opportunities to create permissionless networks in less developed economies, but it may be difficult to make them more than marginally profitable initially until some combination is achieved of their networks becoming large enough and their costs getting small enough.

Much work still needs to be done to make distributed ledgers a reality. One serious issue for distributed ledgers is the large amounts of computing (and electrical) power required to make them work. Another issue to be addressed is auditing. Accountants will need to be able to audit records on permissioned ledgers. Then, too, there is the matter of governance structures. This is less of an issue in largely free-market jurisdictions with solid rules of law. Rules established by the owners and participants of a ledger that safeguard their private interests must be supported by legislation and regulation consistent with existing commercial codes. In turn legislation and regulation must balance public and private interests without being so rigid as to stifle innovation and growth.

For the time being, it’s not clear that distributed ledgers will displace trusted networks such as those offered by ERP vendors because it won’t have the functionality and process control that are part of those products. Those running trusted networks probably will not be in a hurry to open up their management to others since all have some value associated with being in charge. And the security issues that SWIFT has encountered (hackers managed to steal $US 81 million from Bangladesh’s central bank) would not have been prevented through the use of blockchain. It’s likely that there are scores of opportunities to create blockchain networks that are economically workable, but it’s not clear how soon these will become economically significant.

I’ll leave it to others to comment on the future of cryptocurrencies. I’m fairly certain that their impact on the adoption of blockchain technology is neutral. All the attention that bitcoin and others have showered on blockchain is fully offset by entities that hold a negative view on cryptocurrencies because of their association with illegal commerce and theft. Nevertheless it is likely to have an impact someday, and software executives and information technology service providers would be well-advised to familiarize themselves with the technology and its potential.

Regards,

Robert Kugel

Senior Vice President Research

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