Blockchain Technology

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Summary

The rise of Blockchain technology (‘blockchain’) is a paradigm-shifting event similar to the rise of the Internet. This paper provides a summary of the advantages and opportunities of blockchain technology. We argue that blockchain technology will one day facilitate the majority of the world’s exchanges of information (‘transactions’). Blockchain should not be considered synonymous with Bitcoin. Bitcoin represents but one blockchain-based solution for one of many information-exchange problems. While Bitcoin is the first Blockchain-based coin achieving widespread media attention, the impact of the blockchain extends beyond Bitcoin.

Reliance on central entities: exchanging information before the blockchain

First, let’s look at the pre-blockchain world using the most-talked example of exchanging information – money. To help, we’ll introduce Zander, an American millennial with an insatiable desire to buy things online and Tara, a small online-business owner located in Australia. The two are about to exchange information to complete a transaction. Specifically, Zander wants to give 100 US dollars to Tara in exchange for one of Tara’s handmade products. Zander and Tara can use any currency that both agree has value. They might agree the product is worth 100 US dollars, or 120 Canadian dollars, or 80 Great British pounds.

Zander might give 100 US dollars to a central entity such as Paypal via the Internet to execute the exchange. Paypal would then review and authenticate the information exchange. Paypal’s code will confirm that both Zander and Tara are on the Paypal network. Is Zander really Zander based on his log-in credentials, location and past behaviors? In some cases, Paypal may have a human employee review the transaction. If everything looks good, Paypal works with other central entities such as Chase Bank and Commonwealth Bank of Australia to complete the transaction. These other central entities perform similar verifications. Ultimately, after several days, the 100 dollars passes from Zander’s account to Tara’s account.

Importantly, each central entity takes a cut for helping along the transaction. Paypal might take 1 dollar. Chase Bank might take another 2 dollars and Commonwealth Bank of Australia might take 2 more. Because Zander and Tara live in different countries, the number of central entities and overall fee amount increases due to regulations and negotiated across-country partnerships.

The blockchain: a distributed network

Blockchain technology allows Zander and Tara to exchange information with no central entities. Instead, blockchain technology automatically creates and maintains a distributed network. In the purest example, a blockchain network is made up of many individual computers taking the place of these large, central entities. In the blockchain world, the operators of these computers are called miners. These computers or nodes make up the supply-side of the network. A successful blockchain network will have a large number of computers helping to transfer information. If only a few computers are on the blockchain network, individuals like Zander will need to wait longer for information to pass to Tara: the computers will be busy transferring other information. More computers mean information can move more quickly.

To help computers within a blockchain network communicate with one another, Blockchain technology necessarily creates a currency or ‘coin’ (also known as ‘cryptocoin’, ‘cryptocurrency’, ‘digital coin’, and ‘digital tokens’). Each blockchain produces a unique blockchain coin based on the type of information passed in the network. The BitCoin blockchain produces Bitcoin. The Ethereum blockchain produces Ether. The Litecoin blockchain produces Litecoin. Litecoin and Ethereum are examples of the many hundreds of ‘altcoins’ that have been created as alternatives to Bitcoin.

In today’s blockchain environment, Zander and Tara implicitly agree on an exchange rate between US dollars and their chosen blockchain coin. They will likely use the market to help them determine this rate. Today, they would likely use the blockchain market leader: Bitcoin. If the market says that 100 USD equals 1 Bitcoin (the actual exchange rate is much, much lower) then Zander tells the Bitcoin blockchain network that he wants to send 1 coin to Tara. One of the many computers or nodes in the Bitcoin network accepts this request. In actuality, the nodes compete for the chance to be a ‘block’ in the chain of blocks that together create a successful transaction. The ‘winning’ node is the first block in the chain. This node then passes the information to another node, which becomes the second block in the chain. At each step, many nodes compete for the chance to pass the information to the next node. The winning nodes or ‘blocks’ keep passing the information until it reaches Tara. This transaction blockchain stretches from Zander to Tara with no breaks. In this way, many distributed entities pass information with no central entity involvement. Cutting out central entities means fewer fees and faster flow of information because all nodes in the network are using the same common currency.

In practice, if Zander and Tara use Bitcoin today, they likely still need to rely on central entities. Zander first needs to exchange his US dollars for Bitcoin. He will pay a fee to an ‘exchange’ company such as CoinBase to transfer his currency. After this point, though, Zander can send his Bitcoin to Tara. Tara will then need to use an exchange if she wishes to convert her Bitcoin into another, more usable currency.  In the future, if a blockchain currency becomes a default currency (similar to the US dollar today), then Zander and Tara would not need to agree on an exchange rate, and not need to convert dollars to cryptocoin. In this hypothetical world, Zander will buy his groceries with the digital currency, pay his rent with this currency, and send this digital coin to Tara, who will be able to directly buy her own goods and services using the same coin. If everyone agrees to use the same cryptocurrency, there is no longer a need to swap US dollars into cryptocoins.

The blockchain: an incentive-based distributed network

Why, though, do many thousands of computers volunteer to join the blockchain network and fight to spread information? The answer is that the blockchain automatically ‘pays’ these helpful computers. Each winning block receives digital coin from the blockchain network, not from individuals like Zander or Tara. In the Litecoin network, for example, each computer receives a small amount of Litecoin from the blockchain each time it is selected as a block to pass information. If few computers (‘supply’) are on the network, then each computer needs to go a relatively long way to pass information from Zander to Tara, and the blockchain network will pay a relatively high amount to each computer. Because the network is issuing higher payments, new computers are more likely to join the network. By producing digital coins for suppliers and charging no fees to demanders (Tara and Zander), blockchain networks provide a novel incentive structure. By directly releasing coins to miners in the network, the blockchain incurs the cost of information transfer, instead of passing it on to individuals using the network. As a result, Zander, Tara and others like them are incentivized to join the network.

Because the blockchain is decentralized, miners cannot control or influence the price of coin. If some miners decide to stop mining blockchain coin, causing the price to rise, other miners will start mining due to higher prices, and restore market equilibrium. Contrast this with the pre-blockchain world, in which central entities raise transaction prices due to higher barriers of entry for new suppliers.

In the past, other distributed networks failed to achieve widespread adoption, in part because they could not incent suppliers to join the network. One example is Bittorrent, a Peer-to-Peer network allowing users to share files. While users were eager to download these files, few volunteered to host them, because there was no incentive to do so.

The blockchain: a cryptography-based distributed network

The blockchain utilizes cryptography to secure transactions. Unlike traditional transactions, a blockchain transaction cannot be influenced, hacked or reversed, because cryptography technology takes the place of central entities. At a high-level, each computer in the network is actually solving part of a pre-defined math problem (a ‘cryptographic puzzle’). The first computer to solve the puzzle ‘wins’ the right to transfer the information to the next computer. The computers in the blockchain network then compete to solve the next puzzle. The cryptographic foundation of the blockchain world provides a mathematical guarantee that information will pass from Zander to Tara.

In the pre-block chain world, Zander’s transaction with Tara might involve Paypal, Chase Bank and possibly other centralized entities such as Amazon Web Services (AWS), Visa, and Oracle. Each central entity represents a potential point of failure. These entities each maintain independent code that reviews the incoming information and passes it on to the next central entity or end user. If any of these entities is hacked, has a software bug, or just decides to change how they do business, then both the transaction and record of past transactions are at risk.

In contrast, in the blockchain world, all code is maintained directly within the framework of the blockchain. Miners solve problems pre-defined by the blockchain’s code, but miners can’t change the rules. No code is maintained by the computers facilitating the transfer of information. Furthermore, once a new blockchain coin launches, no one – not the founding developers, a group of activists, or hackers – can change this version of the blockchain code.

Instead, if an entity wants to change the code of a blockchain, they need to create a whole new version. If the founding developers offer a new, updated version of a blockchain coin like Ethereum, then technically a new coin is created. If individuals buying and selling Ethereum (the ‘market’) agree the new coin is a much better version, then the new version of Ethereum might take the market place of the old one.

If a group of activists launches a change to a blockchain coin, but the market sees value in both the new and old versions of the digital coin, then the market and trading infrastructure might choose to support both versions. This is called a ‘hard fork’. Recently, a group of activists, for example, modified Bitcoin’s code to improve (in their mind) the Bitcoin currency. The market continued to see value in the old Bitcoin version (which remained named ‘Bitcoin’) but also valued the new version (named ‘Bitcoin Cash’). Note that these forked currencies are often priced differently by the market. As of January 2018, Bitcoin is priced approximately 5x higher than Bitcoin Cash.

If a hacker modifies Ethereum’s publicly available code, and thus creates a new version, the market will see that the code is malicious, and will effectively value that version of the digital currency at nothing. No infrastructure will update to support this version of the digital coin.

The linearity of blockchain transactions (Zander passes information to the first computer, this computer passes it to the next computer, and so on, until the information reaches Tara) also creates a tamper-proof record of all previous blockchain transactions: the blockchain thus creates a ledger of transactions. Anyone can review a public blockchain to understand how information flowed in the past. If another person looks at the ledger at another time or place, they will see an identical history of transactions. No central entity has the ability to modify the record because the ledger is maintained within the blockchain code.

In comparison, transactions with currencies such as the US dollar are incredibly difficult to track over time. Blockchain-based currencies thus provide the opportunity for better accountability. If a democracy leveraged a blockchain-based currency, for example, constituents could pay taxes in this cryptocurrency, then track exactly how the government spent each coin. More realistically, donors to a charity could see how charities spend their donations. One could watch a donation pass from the charity to a local house building company, and finally to individual workers. Regulatory entities would have an easier time enforcing compliance with cryptocurrencies due to the objective distributed ledger.

Using blockchain technology as currency

Because blockchains necessarily create coins that all transaction participants (Zander and Tara in our example) agree have value, blockchain technology lends itself to act as currency. We find it likely that blockchain currencies gain adoption by first facilitating private transactions, international transactions, and micro-transactions, and then eventually scale to become the default currency for all transactions.

Privacy-seeking and law-avoiding entities were likely two of the first groups to leverage cryptocurrencies like Bitcoin as currency. Digital currency is appealing to these segments because it relies on distributed networks and avoids tracking, censorship, and other forms of meddling.  In comparison, the alternatives of sending cash in the mail or using by-the-book financial institutions are less appealing. Bitcoin, for example, initially gained popularity on black market websites such as Silk Road. After Bitcoin’s early success, founders have launched dozens of new cryptocurrencies with even more emphasis on privacy and anonymity. We expect strong growth in the use of blockchain-based currency in these segments.

Blockchain technology is useful to geographically-separated entities like Zander and Tara. Because they live in different countries, Zander and Tara’s non-blockchain-based transactions require high dependence on multiple central entities, long processing times, and high fees. High costs of international transactions are particularly painful to entities in developing countries with unstable currencies who want to transfer wealth into international currencies.

Blockchain technology is also useful to individuals performing micro-transactions. If an individual wants to send $1.00 to another individual, fees in the pre-blockchain world can easily amount to 30-40% ($.30 – $.40) of the total transaction. As a result, companies have been forced to roll transactions into monthly invoices, and these high fees also deter founders from starting businesses relying on small monetary amounts in the first place. Suppose an entrepreneur wants to start a business where individuals in France can send $1 payments directly to farmers in Kenya to help them build farming infrastructure. After the entrepreneur and his potential donors realize almost half of these payments go to central entities, the entrepreneur is likely to give up, the donors likely to walk away. On the flip side, if an entrepreneur in a developing country wants to shift his wealth (e.g., $2-$5 a day) from local unstable currencies to more stable international ones, he will be hit with the double-trouble of high fees for international transactions and high fees for small transaction sizes. Blockchain-based currencies offer a solution to these problems.

Tackling these customer segments will help cryptocurrencies interact with more users, work out customer problems and launch helpful new cryptocurrency versions. This groundwork will help the blockchain take over more and more of the world’s transactions. The world’s payment infrastructure was built before the Internet and is ripe for disruption. In the short-term, partial blockchain solutions will become common. Already, financial institutions are creating their own private blockchain networks and producing digital coin. Participating institutions act as nodes in the blockchain, and have visibility into all transaction on the shared digital ledger. Today, these financial institutions leverage global exchange rates to pass money from mainstream currencies (e.g., Mexican Pesos) into the private digital coin, and then into another mainstream currency (e.g., Australian Dollar). In this way, financial institutions can continue to maintain their roles as central entities while improving security, speeding up processing times, and lowering fees for their customers.

Using blockchain technology as a store of value

Blockchain technology also has potential to provide a new independent store of value. Today, the classic independent store of value, gold, is partly valuable because humans have decided to value it independently of nation states (e.g., Canada) or nation alliances (e.g., the European Union) unlike other mainstream currencies (e.g., the United States dollar is closely tied to the success of the United States of America). Gold is generally inversely correlated with the US dollar: in other words, gold acts as a hedge against the current global financial system. Because gold is difficult to store – heavy, relatively insecure – digital blockchain-currencies represent an attractive alternative. If digital currencies become more stable over time (currently, they are extremely volatile), they may one day augment or supplement assets such as gold.

The bigger store of value opportunity, however, is helping entities buy into the global financial system in the first place. In developing countries, for example, many entities are eager to shift local, unstable currencies to stable currencies such as the US dollar to better protect their wealth. Like the US dollar today, the blockchain-backed currencies that facilitate world transactions tomorrow will also naturally act as a store of value. Entities will invest in these currencies as they do the US dollar today. As a result, the same blockchain-based currencies that gain mainstream adoption for payments are also likely to gain mainstream adoption as stores of value.

If digital currencies replace traditional currencies like the US dollar and the Euro, then these digital currencies will represent the dominant financial system. In this world, these currencies would no longer act as a useful hedge for the current status quo: they would be the status quo! And we would expect investors to look to gold, similar assets, and perhaps non-dominant digital currencies to hedge against these now mainstream digital currencies.

Using blockchain technology to facilitate simple information exchanges

Ultimately, the value of Blockchain derives from its potential to secure and automate the transfer of information – an endeavor with nearly infinite opportunity. While blockchain-based currency represents a big opportunity to simplify the transfer of information, any current process or system that transfers information digitally (i.e., anything on the Internet) could potentially be revolutionized by blockchain tech. In the blockchain world, the programmable rules that determine how a blockchain passes information are called smart contracts. Today, the largest and most popular decentralized blockchain platform that supports smart contracts is Ethereum. The advent of Ethereum should not be understated: it expanded the commercial scope of the blockchain from currency to all digital information.

You can think of smart contracts as programmable if-then statements. If Fact A happens, then automatically take Action B. Let’s look back at our initial information exchange between Zander and Tara. Zander wanted to pay Tara for a product. Let’s assume Zander wanted to buy a concert ticket. In the pre-blockchain world, Zander sends Tara $100 dollars and then prays that Tara sends him the ticket. If the stakes were higher (e.g., a $10,000 transaction) then Zander and Tara might use a third-party escrow service. Under this arrangement, Zander would send the third-party $10,000. Once the funds were received, the escrow service would instruct Tara to send the ticket to Zander. Once Zander received the ticket, the escrow would release the $10,000 to Tara, less a fee for providing the service.

In the blockchain world, Zander and Tara might use ConcertCoin, a (fictional) blockchain-based coin to help buyers and sellers exchange tickets. While digital coins such as Bitcoin can be used to store value and help users exchange money, many altcoins are built for more specific transactions. These altcoins use blockchain technology and smart contracts to address areas such as advertising, content creation, gambling, and real estate transactions. In Zander and Tara’s case, the two might agree the ticket is worth 20 ConcertCoin. Through ConcertCoin’s specialized contract framework for ticket transactions, Tara and Zander might agree to a smart contract that states: If Tara has the ticket, then transfer 20 ConcertCoin from Zander to Tara. If Tara receives the 20 ConcertCoin, then transfer ownership of the ticket to Zander.

Smart contracts are really just automated contracts. For a smart contract to work, three things need to happen. First, all stakeholders need to agree the digital coin has value. In this case, both Zander and Tara need to agree that 20 ConcertCoin (or some other amount) is an appropriate price for the concert ticket. Second, all stakeholders need to agree on each definition in the smart contract. In this case, Zander and Tara need to agree on what it means for Tara to “have the ticket”, and “transfer ownership” to Zander. Third, the digital coin needs to be integrated with programmatic sources of truth for each definition. In this case, ConcertCoin would programmatically check Tara’s account for a valid ticket and respond ‘Yes’ or ‘No.’ If ‘Yes’, ConcertCoin would automatically transfer funds from Zander to Tara, change the name on the ticket from Tara to Zander, and move the ticket to Zander’s account.

Using blockchain technology to facilitate complex information exchanges

One example of a complex information market for blockchain technology is storing digital information. Today, a large portion of the internet is hosted by Amazon Web Services (AWS) and similar products provided by other central entities. These entities build and maintain worldwide data stores and servers to support cloud infrastructure. In the blockchain world, however, companies could pay with an information-storage blockchain coin (we’ll call this fictional coin ‘FileStorageCoin’) in exchange for secure storage on a highly-distributed network, for a fraction of the price charged by central entities such as AWS.

In typical supply-and-demand fashion, demand for FileStorageCoin drives up the FileStorageCoin price. In response, miners respond by offering more storage on the network. Each time a computer is selected to store information (a block in the chain) the blockchain releases some FileStorageCoin to that computer. The network becomes more valuable with each additional computer storing information. Just as AirBnB and Lyft allow capital owners to get more out of their physical assets, the blockchain can help digital capital owners get more out of their digital storage. With adoption, FileStorageCoin could serve as a larger and more efficient information storage network than could be provided by any one company.

While blockchain can help users get more value out of storage, connectivity, bandwidth, visits to websites, and content creation, the technology is not limited to digital information; the technology can also make physical-world assets more liquid (easier to sell and buy) by making them more reducible. In other words, the blockchain better facilitates ownership of assets across multiple people.

Consider a dozen people who pool their resources to buy ten houses as investment properties. The group plans to sell the houses ten-to-fifteen years down the road for a tidy profit. In the pre-blockchain world, an owner (call him Jim) who needs to take his money out with a return on investment before the houses are sold (say, only three years after purchase of the houses) will have trouble finding buyers, determining the right price of his share of the houses, and executing the transaction. If Jim initially invested $10,000, he might want to sell his share for $15,000 because he feels the prices of the houses have increased over three years. Because the asset is complex, and with risk, potential buyers would likely want to know Jim personally. In this case, the most likely buyers are the other eleven members of the fund. Ten might not be interested. One might offer him $11,000. The fund hasn’t sold any of the houses yet, the fellow investor might reason, so the fund hasn’t realized any actual gains yet. Because Jim needs the money, he would be forced to take the $11,000.

In the blockchain world, the dozen people could agree to create what’s called an Initial Coin Offering (ICO) and issue blockchain coins in exchange for ownership in the fund. In this case, the dozen people issue 100 RealEstateCoin to each investor. If an investor wants to leave the fund early, blockchain technology expands the number of potential buyers to anyone on the Internet. While mega-companies (e.g., Amazon, AirBnB) have successfully built their own digital marketplaces in the past, blockchain provides the available-to-all, trust-building, low-cost financial infrastructure via smart contracts, secure transactions, and an authoritative ledger to a wide set of entities. As a result, Jim has thousands of potential customers demanding his 100 RealEstateCoin. He sells each coin for the equivalent of $17,500 apiece. Blockchain allows any individual or company to create a digital market for their current assets.

The above example showcases how blockchain technology can change the ownership model of an investment fund. Unlike crowd-funding sites like Kickstarter, where early backers receive nothing but a product or service, ICOs let entities actually own part of meaningful ideas. If a company does well, the unique blockchain coin for that company will increase in value, as more individuals exhibit demand for that coin. If a company does poorly, the blockchain coin will fall in value.

These blockchain coin incentives are powerful. Today, for example, some small number of individuals choose to crowd-fund movie ideas even though they know that they won’t receive anything but gratitude. In the blockchain world, these individuals would actually own part of the movie. As a result, the number of potential investors and amount of money supporting these types of projects will increase; more people will support things they love when they also have the chance to profit from them. Blockchain will unlock new funding for creative, non-profit, and for-profit projects and companies. Blockchain can create a decentralized, secure, incentive-based online marketplace for anything.

Predicting the future of blockchain technology

Blockchain technology creates information networks. The fundamental rule of networks is that when a new person joins any network, the network becomes exponentially more valuable. As a corollary, each time another person joins a widely-used network, it becomes exponentially harder for competing networks to offer similar value to people. You use Facebook because all of your friends are on the platform. You are less likely to use a new social network because few of your friends would be on it. As a result, networks tend to produce winner-takes-all markets. Facebook, WeChat and a few other businesses, for example, dominate the social networking space.

We expect a similar winner-take-all outcome for blockchain technology. So far, founders have created many hundreds of digital coins. They will create thousands more over the next few years. We expect a handful of these digital coins to successfully walk out onto the global stage, while the vast majority of these coins will ultimately become valueless. In the future, two cryptocoins, for example, might act as major global currencies, a third might act as a global store of value to hedge these digital currencies, and a half dozen other cryptocoins might together constitute a global platform for smart contracts.

First, we expect investors to pour funds into the blockchain technology market as a whole. Investors do not know which coins will end up like Amazon.com and which ones will end up like Pets.com – so they will invest across the board. Ultimately, though, blockchain coins will be valued – like all networks – based on users. While Bitcoin has a headstart and the largest number of users, a lot more users need to join and use the network to meaningfully simplify the flow of information across the board. Still, Bitcoin’s users incent more entities to join the network, suppliers to mine more Bitcoin, and founders to build more infrastructure for the coin – which in turn attracts even more users to join the Bitcoin network. As a result of these network effects, we expect Bitcoin to be around for a while. On the other hand, at least one of the digital coins that will change the world has probably not been created yet.

Conclusion

Blockchain’s promise of a more secure, decentralized, incentive-aligned world is inspiring. The higher the number of central entities (e.g., middlemen), the bigger the opportunity for simplification through blockchain. To accomplish this vision, stakeholders will need to agree to use and value the same digital coin. They will need to agree on the same standard definitions in a smart contract and agree upon programmatic data sources of truth for these definitions. Finally, these stakeholders need to actually use these digital coins to exchange information. This process will take time, but ultimately we expect blockchain technology to transform the flow of information and business.

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