Blockchain came to mainstream attention in 2017, despite having existed for almost a decade prior. The author explains how this new technology, perhaps best known for its role in enabling cryptocurrencies, works. In his view, blockchain has the potential to change the way the world does business, and its impact is being vastly underestimated by the accounting profession and society at large.
Cryptocurrencies have become a prevailing topic of conversation, even among the most novice investors. While Bitcoin and Ethereum are the most well-known, few people realize that there are currently more than 1,600 different cryptocurrencies. Even fewer realize that their underlying technology—blockchain—may be a far more meaningful disruptor in the financial sector than cryptocurrencies themselves.
Blockchain, a form of distributed ledger technology (DLT), is essentially a decentralized, trustless, openly auditable ledger that can be shared and viewed by all users. The genesis of the technology is still being debated, but most would say that blockchain coalesced in the midst of the 2008 global financial crisis. Many cryptography enthusiasts in the San Francisco Bay area had become tired of the centralized nature of the banking system and started discussing over online forums ways to shift trust from the centralized authorities. In November 2008, a person or persons writing as “Satoshi Nakamoto” published a now-famous white paper focusing on a peer-to-peer electronic cash payment system. The white paper offered insight into how this technology could be used to replace centralized financial institutions, and it was first known to be implemented in January 2009.
Traditional banking and business is centralized, meaning the ledger indicating who owns what or who owes whom is kept on a private database and relies on the overseeing body of the database to keep the records safe and accurate. Therefore, the system depends upon people’s trust that the bank or business is keeping proper track of the ins and outs of users’ money and information. Any failures with this single source of authority could mean trouble, especially since many people are unaware of actual banking laws and what the banks do with money once users deposit into their accounts. Prior to the 2008 crisis, few thought that banks were being reckless or questioned the risky lending choices they made with users’ money. People also didn’t think that the banks would need a $7.7 trillion taxpayer bailout—more than half the value of everything produced that year. These breaches of financial trust, as well as the notable hacks in recent years that have gained access to millions of users’ sensitive personal information, have brought much-needed scrutiny to the inner workings of the financial system.
Ledgers keep track of how humans interact with each other; without them there would be no accountability in global trade. Blockchain is an immutable distributed ledger that is shared among a set of databases or nodes. Individual ledgers keep track of informational changes that are then fully synced to all databases within the blockchain to ensure that they all have the most recent ledger. This consistent third-party validated ledger is open, searchable, and virtually fraud-proof. The entire user population is consistently validating information, ensuring that it is accurate and up to date.
Within a given blockchain there are multiple individuals (or nodes) confirming transactions and ensuring the accuracy of the distributed ledger. This is done by sharing one overall database among many nodes. Furthermore, blockchain databases do not have the limitations of more traditional databases and can keep a running log of every transaction ever made on the system.
Within a given blockchain there are multiple individuals (or nodes) confirming transactions and ensuring the accuracy of the distributed ledger.
Blockchain Simplified
A very basic example demonstrating the use of blockchain is illustrated below; the more technical aspects are broken down in greater detail in further sections. There are many nuances to each blockchain regarding recommended confirmations, protocols, and consensus mechanisms. In addition, as blockchain is best know for its use in conjunction with cryptocurrencies, this example utilizes those terms; other paradigms may be used when blockchain is applied to accounting and auditing procedures.
At the most basic level, blockchains work by incentivizing parties to agree on any given transaction’s authenticity. Transactions are organized and grouped together into “blocks” that are presented to the blockchain for authentication. The creation of these blocks is called “mining,” and miners are incentivized by a reward of native tokens (i.e., brand new coins that had not previously existed). Once a block obtains enough confirmations, the transaction is considered to be validated and have been placed on the blockchain as the next sequential block. At this juncture, it is important to note that all blockchains have varying levels of confirmation requirements; Bitcoin’s blockchain requires six confirmations, while Ethereum’s requires 30. A confirmation is essentially the node agreeing on the authenticity of all transactions within the newly created block and the underlying chain, and this process is completed every time a block is created.
Suppose Company A wants to purchase $500 worth of goods from Company B; this purchase is grouped with other transactions into one block on the blockchain. The vendor and other parties within the blockchain are then notified of a payment for $500 in exchange for the goods. This transaction is then confirmed by prerequired number of nodes within the blockchain, and the $500 is moved from the customer’s bank account to the vendor’s. If there are not enough confirmations—meaning not enough parties can agree that these transactions are accurate—the block is not validated, and the transaction is not executed.
There are two major types of consensus protocols by which miners operate: proof of work (POW) and proof of stake (POS). Both have advantages and disadvantages, but are roughly equal in reliability.
Proof of work.
POW confirms transactions by having miners compete to solve mathematical equations to create new blocks and confirm transactions. These equations are not easily solved and have varying levels of difficulty, depending on the demand and load of the blockchain (i.e., volume of transactions) and number of miners currently mining. Miners solve the equations through brute force, throwing as much computing power as possible at the problem until it is solved. The first node to solve the equation receives the reward of native currency, places the block in sequence, and confirms the transaction.
Some of the most famous cryptocurrencies use the POW mechanism, such as Bitcoin, Ethereum, and Litecoin. Bitcoin’s protocol regulates the difficulty of the equation in such a way that miners are only able to create blocks roughly every 10 minutes, which leads to an approximately one-hour wait time for transactions to go through under a normal transaction volume. Scalability issues arise when volume spikes, however, as in late 2017 and early 2018, when some transactions took days to go through. This is because blocks can only hold a finite amount of data; when demand becomes too large, transactions must wait in a queue to be placed in the next block. Fees are also added to each transaction to entice miners to add a given user’s transaction to the next block; when demand increases, so do the fees. In late 2017, fees reached into the $20 range. This can be disadvantageous when wanting to use Bitcoin for a minor purchase; this is a major issue for the adoption of Bitcoin as an everyday medium of exchange.
With the amount of computing power and time needed to process transactions using the POW protocol, Bitcoin is beginning to struggle to scale in the global economy. One other notable drawback to POW is wasted energy from nonawarded miners. It is estimated that, to process one transaction on Bitcoin’s blockchain, enough energy is consumed to power a house for one week (Christopher Malmo, “One Bitcoin Transaction Now Uses as Much Energy as Your House in a Week,” Motherboard, Nov. 1, 2017, http://bit.ly/2xtpqQt). POW does, however, provide greater decentralization and liquidity than POS because miners are constantly competing to validate blocks and are incentivized to do so.
Proof of stake.
POS, which is growing in popularity due to its scalability and environmental friendliness, overcomes the need for massive computing power and energy consumption by foregoing the process of having miners compete to solve mathematical equations. Instead, POS protocols select miners to present blocks by allowing them to “stake” a portion of their native coins to the network. It works like a lottery system whereby each coin held by an individual represents a lottery ticket. The POS protocol will randomly choose a validator from the entire pool of staking miners, with the winner being rewarded with the ability to place the next block in sequence (“minting”) and more native tokens. The greater number of coins staked, the higher the chances of minting the next block. While POS is less decentralized and may lead to the “rich getting richer,” it does allow for a more stable network, since any bad act by a miner would cause that miner to lose tokens.
Every POS blockchain has its own required minimum tokens for staking or obtaining a “masternode.” Masternodes are different from regular nodes in that they keep the full copy of the blockchain, in real time, and are always up and running. Masternodes have higher authority and are mostly obtained for governance power within the blockchain. Obtaining a masternode is much more difficult than normal staking; miners typically must stake a significantly greater portion of native coins, open a virtual private server (VPS), and have significant amounts of storage space to house the entire blockchain. Once a masternode is obtained, however, the rewards are much higher and more regular. Masternodes typically receive recurring payouts in native coins, almost like getting interest on a loan. The theory is that these masternodes bring greater stability to the network by disincentivizing individuals with significant numbers of tokens (whales) from manipulating the market by dumping massive amounts at one time.
Cryptography and the Blockchain
Cryptography is a practice that has been used throughout history. Julius Caesar used cryptography to send private correspondence by substituting a given letter with a different one (i.e., “A” represented by “D,” “B” by “E”). The cryptography used in blockchain is, naturally, much more complex.
Each transaction presented to the blockchain is first turned into a cryptographically secured hash, a fixed-length alphanumeric string that is then used by the blockchain as an identifier for transactions. These hashes are based on public and private keys, which are generated by individuals using the blockchain. A private key is like a digital signature that is unique to each individual; a public key is a derivative of an individual’s private key that is broadcasted to the public whenever transactions are to be made, but it is not accessible without the private key. Public keys, often referred to as “wallets,” can also vary in levels of anonymity. Bitcoin public keys are quasi-anonymous and act more like a pseudonym that keeps the individual’s identity private only to the extent that the individual does not reveal his true identity.
These links play an important role in the immutability of a blockchain, which prevents bad actors from changing the data on the ledger by themselves.
Once the transaction is hashed, it is grouped together with other transactions into a block and validated by the blockchain using agreed-upon consensus protocols. Each validated block also contains a link to the previous block, which includes a link to the block before that, and so on; the linked blocks form the blockchain. This linking also allows users to trace transactions back to the initial genesis block.
Once a block is created and validated by the blockchain, it can never be destroyed or altered unless 51% of the blockchain agrees and determines change is needed. Within mature ecosystems like Bitcoin’s blockchain, this type of coordination would require massive global efforts, rendering hacking an actual blockchain virtually impossible. Since, however, obtaining 51% consensus is more possible within new ecosystems, many emerging cryptocurrencies are opting to “airdrop” tokens; that is, send native tokens, typically in small amounts, to anyone who wants them and has a compatible wallet. This spreads the cryptocurrency rapidly and incentivizes a larger pool of users to promote and use the blockchain, which in turn diminishes the likelihood of any one bad actor obtaining 51%.
As noted above, each block contains a link to the previous block before it, thus creating a chain of blocks anchored by the genesis block. These links play an important role in the immutability of a blockchain, which prevents bad actors from changing the data on the ledger by themselves. This is imperative for the integrity of the blockchain and the backbone for why it is reliable and accurate. Users can have full confidence that transactions on the blockchain are as indicated with no falsification.
Blockchains refresh whenever confirmations occur, which is, on average, multiple times an hour. The entire chain is resynced to ensure accuracy and any conflicts are resolved, automatically and on a regulated basis. When a refresh happens, all extinct blocks—those that did not attain the required minimum confirmations to be validated by the blockchain—fall off the chain, and only the longest chain is left standing. Extinct blocks are also created when two miners present blocks at the same time; only the block created most quickly is placed on the blockchain. In summation, only properly validated blocks are linked to the genesis block, and the genesis block is the anchor of the main chain. When a refresh happens, the only blocks left are the ones connected on the main chain. Exhibit 1 illustrates the refresh process.
Exhibit 1
Blockchain Refresh Process
Blockchains use the longest chain rule to prevent double spending, which is one reason governments and financial institutions are currently centralized. These institutions regulate the issuance of money and enforce laws for bad actors who falsely create more money than has been authorized. Prior to the creation of blockchain, double spending was a hindrance to the proliferation of digital currencies; similar to printing counterfeit money, bad actors could copy and paste digital money like data in an Excel spreadsheet. With blockchain, however, bad actors need 51% consensus to get enough confirmations for the double spend to be validated by the blockchain. For POW, the bad actor would need 51% of the hashing power, which for Bitcoin would be impossible due to the sheer energy consumption and computing requirements. For POS, the bad actor would need 51% of all coins in existence; while this might be possible for immature blockchains, it would not be beneficial to the bad actor, who would be damaging his own stake in the long run.
Centralized, Decentralized, and Distributed Networks
Proponents of blockchain technology frequently describe it as “decentralized.” A more accurate description, however, might be “decentralizing and becoming more distributed.” What is the difference?
Centralized networks store and send data through a single database or server, which is responsible for ensuring that the information sent is properly relayed to the end user. Decentralized networks look more like clusters of centralized networks, with each centralized cluster transmitting information not only within itself but to other clusters as well; therefore, the clusters rely on each other somewhat as shared information sources. Distributed networks do not have a centralized database or server, and there is no information storage. Each node contains information and is connected to many other nodes; the data is transmitted to the end user by traveling through whichever nodes offer the quickest path.
Centralized networks have a single point of failure, so removing or disrupting the central node could cause mass failure throughout the network; this is perhaps their biggest flaw. On the other hand, because there is only one source of data, centralized networks are much easier to maintain. Centralized networks also tend to have a much faster rate of development and implementation once a process is determined. Despite the seemingly beneficial aspects of centralized networks, on a global scale these benefits can slow the development of ideas and processes, limit the scalability of the network, and compromise the stability of the network. When a single framework is followed, real diversity is stifled.
From a distance, decentralized networks resemble distributed networks, but closer inspection reveals that they are in fact a distributed group of centralized networks—the more distributed they are, the more difficult maintenance becomes, but the higher the level of scalability and stability. Failure in a single node of a distributed network will not render the network useless; instead, the data finds a different route to the end user, bypassing the failed node. Implementation of decentralized or distributed networks is much more complicated than centralized networks, with distributed networks being the most arduous, due to the enormous foundation required to support such a global infrastructure. Once established, however, distributed networks have the potential to evolve at a tremendous rate. Networks that house ledgers containing information to be used on a global scale tend more towards decentralized and distributed over centralized.
Blockchain is built on a decentralized ledger, which is one of the main reasons why it is so disruptive. As mentioned above, current economic conditions require that a central authority keep the ledgers of the world in check and balance, but blockchain relies on peer-to-peer authentication and agreement. Trust is transferred from a central authority to a majority authority, under the assumption that the majority cannot all be wrong.
Why Now?
In 1908, the first Model T was completed; by 1927, the Ford Motor Company had built more than 15 million Model Ts and disrupted the transportation industry forever. This disruption was due to the convergence of the invention of the combustion engine, a drop in the price of steel, and Henry Ford’s innovation of the assembly line. Disruptive technologies never have any single catalyst; rather, they are the result of many technologies and trends coinciding.
Bitcoin and blockchain technology have been around for nearly a decade, finally garnering mainstream media attention at the end of 2017. The growing rate of distrust in the world’s financial and governmental institutions following the 2008 crisis made people more open to trying a different system. Time was needed, however, to cultivate the foundational technology for initial distributed networks as well as secondary technologies such as smartphones and big data. Today there are areas where, even though clean running water is still a dream, the inhabitants still have smartphone connections powered by small solar panels attached to the roofs of their huts (Phoebe Parke, “More Africans Have Access to Cell Phone Service than Piped Water,” CNN.com, Jan. 19, 2016, https://cnn.it/2L5UlnS). Imagine these unbanked regions with the full power of a global economy powered by blockchain.
Exhibit 2
Centralized, Decentralized, and Distributed Networks
Blockchain Use Cases
Detailed below are some issues that new emerging blockchain technologies are trying to solve. This listing is in no way exhaustive, nor are any of the native tokens associated with the blockchains promoted or endorsed in the given examples. This listing is meant to illustrate the application of the above concepts as they pertain to the real world.
Cross-border payments.
Moving money from one country to another is currently done on archaic payment rails, supported by the Society for Worldwide Interbank Financial Telecommunications (Swift). These payment rails require users to pay extremely high fees and wait three to five (or more) days for the transfer of funds to be completed. With information moving so freely, the general population expects its money to move freely as well.
Ripple, a blockchain company in San Francisco, is utilizing DLT to create what it calls the Internet of value (IOV). With this technology, users can send any amount of money anywhere in the world at a fraction of a cent in fees. This company has partnered with over 100 banks, and the technology is currently being used by a handful of financial institutions like Santander Banco, Moneygram, and Western Union, with many more in the pilot phase. This company also offers another product that utilizes its native cryptocurrency to source liquidity from exchanges when moving money from one country to another.
Using existing technology, when a person wants to send money across borders, domestic banks must source their own liquidity at the foreign bank; that is, the bank sending money to a foreign bank must maintain dormant capital at the correspondent bank in a Nostro account. These accounts are denominated in the foreign currency as a way to hedge exchange fluctuations and facilitate the settlement of foreign exchange and trade transactions; they hold trillions of dollars that sit dormant, require banks to pay fees, and are subject to regular compliance testing. With DLT and the native cryptocurrencies, these Nostro accounts would be obsolete, and the dormant capital could be freed up for other, more productive uses.
Assume that Bob wants to send $100 to his sister Jane in Japan. Using DLT, Bob can initiate the transfer to Jane, who will receive a notification of the amount of USD being sent in real time and the equivalent amount of Yen using current exchange rates. Once the transaction is confirmed, the 100 USD is immediately converted into the native cryptocurrency at a U.S. exchange and then converted into Yen at a local Japanese exchange, then delivered to Jane.
Accounting.
As a CPA, this author has seen firsthand the issues companies run into when closing books at month- or year-end. Issues often arise with reconciling items or properly reflecting GAAP standards. This can be very time consuming and require overemployment of accounting personnel to service this need. In addition, auditing techniques still require either written confirmation of year-end accounts receivables or physical inspection of invoices or subsequent payments to ensure that balances exist. With blockchain technology, the need to examine physical documents will be replaced by downloading the transaction history from the blockchain.
As addressed above, transactions on the blockchain are immutable and can never be changed once validated. To prove that company A owes company B, an auditor can simply look on the blockchain and have full comfort in knowing that the amount owed to company B is proper and complete.
Request Network, a blockchain company in London, is implementing blockchain technology that allows users to request payment when buying items online. An entry is made to the blockchain that records what is owed by and to whom, essentially creating an accounts receivable and accounts payable entry to the distributed ledger. It is apparent this would be of great benefit to auditors and accountants alike.
Moreover, this company is also building a user interface for auditors that would allow for what it calls “smart audits.” These smart audits would eliminate the need for traditional auditing techniques and allow audits to be done more efficiently, thus reducing audit times and allowing the auditor to focus more on advising clients. The company has recently partnered with PricewaterhouseCoopers of France and plans more partnerships as the technology emerges.
Logistics.
Shipping products from one place to another is crucial for the global economy; however, the shipping of products is inefficient. The FBI estimates that approximately $27 billion was lost due to cargo theft in 2016 (“Cargo Theft, 2016,” http://bit.ly/2sll5Kq). In addition, communication between carriers, tracking across carriers, and the practice of 50% markups all need to be drastically improved.
These inefficiencies are being mitigated by Shipchain, a blockchain company that utilizes DLT to render communication and tracking transparent, allowing every step of the supply chain to be documented. The company also incentivizes carriers with its native cryptocurrency for using the most efficient routes and delivering goods on time. By putting the supply chain on the blockchain, records will never be altered, communication will be open, and tracking will be transparent.
Governmental records.
The U.S. government, the gatekeeper for voter registration, identities, and even ownership of property, is one of the world’s largest central authorities; citizens must use government resources and deal with bureaucratic red tape to initiate, maintain, and obtain specified records. Several companies, however, are now vying to put voter registration, deeds, and identities on the blockchain, which would allow users to carry all their personal records with them at any time. Users could log in with facial or thumbprint recognition on their smart-phones and have access to personal documents. This has the potential to reduce the risk of identity theft and decrease the wait time for property deeds.
Imagine a world where value flows like information over the Internet, or where neighbors trade energy generated from solar panels among themselves without a centralized authority setting the price. Blockchain is creating this world, and while the change is massively disruptive, this author believes it will ultimately be for the better. Just as the Internet changed the way the world viewed information, blockchain will change the way people view trust.
