What is blockchain – and why should you care?

Blockchain emerged in public discourse with the introduction of bitcoin, which is why the two terms are often used synonymously. However, there are clear distinctions between the two: blockchain is the underlying technology for bitcoin, which is one of many co-called cryptocurrencies.

Virtually everyone has heard about blockchain and that it will revolutionise our world. But despite being the hot topic, it is rarely mentioned why or how these momentous changes should come about. Consequently few people fully grasp the inner workings of blockchain and find the concept somewhat elusive. In this article we therefore briefly discuss the underlying technology (block, hash, and so on), possible applications (cryptocurrencies, smart contracts) and where blockchain is being used and how this might affect certain industries or FDI in general.

So what is a blockchain?

As the name suggests, a chain of ‘blocks’ which, in nerd-speak ‘are kept in sync in a peer-to-peer system of distributed databases’. But what does this mean in layman’s language?

A block essentially is nothing more than a computer file for storing data. The best way to think about blocks and blockchain is by thinking about the pages of a book. Many pages make up a book, much like many blocks form a blockchain. The data stored in each block is equivalent to the text of a story you are reading on each of the pages of the book. The page numbers and chapter headings are not part of the story, but information which helps you navigate within the book. In much the same way blocks have a similar type of information that helps to maintain order. And it is especially this ‘support- information’ that makes blockchain so special.

One of these special features is that the information in the block (i.e. the story on the page) is used to calculate the encryption for the entire block. This encryption or fingerprint is called a hash.

Hashes are algorithms which turn the content of the block into a number of a fixed length: a kind of password for the block that is dynamically determined by its very own data. If we take for example the text: “What on Earth is a hash” we get the hash-value “f1c4b4e268a007e37c515541bfdccd20558f e5cbbb91f6befa3a89b0727587ef” And you get this number, every time you calculate it. Again and again (I’ve tried it several times).

Each block on the chain contains the hash of the previous block as part of its content. Changing the content of one block also changes the hash-value (i.e. password) of the block, as it is constantly recalculated. So, trying to change anything within the block not only changes the hash of that specific block, but also the hash-value of the linked block, which in turn changes the next block’s hash and thus creates a chain reaction of changes.

The other key feature of a blockchain is the fact that it is a distributed database. Rather than having one central server (which can be hacked), data is held on hundreds of computers and laptops around the world: the so-called ‘peer-to-peer distributed database’. This means a hacker would not only have to attack one central server and change a whole string of blocks, but do so simultaneously with hundreds, maybe thousands of computers. The analogy is, an email sent out to hundreds of your friends. If later on you decide to change the story you told in the email, you would have to convince those hundred friends of yours to change or delete that email.

Hence, no single person or institution owns or controls data. It is available to everyone; this is the democratisation of data which was hitherto managed and controlled by a small oligopoly of players (banks, trading platforms, and so on.)

Public versus private

It is of course not quite as simple as this; and even as neat a technology as blockchain has drawbacks, which we will discuss later on.

If blockchain is the ability to speak, then bitcoin, Ethereum, Corda et al are akin to being its languages. Languages that can be divided into ‘public’ or ‘private’ languages. Or to use IT-lingo, ‘permissionless’ (i.e. public languages, with free access, where everyone can write on the blockchain;  ‘permissioned’ is where the access is restricted to a small group of known users, hence private blockchains).

It is self-explanatory that with private blockchains (industry or company blockchains with known and trace-able users) security requirements are considerably lower than in public blockchains. Conversely blockchains used as currency have by definition to be public, so that everyone can write as well as read data from it. This has significant repercussions in terms of the construction of these blockchain types.

Cryptocurrencies

Bitcoin, Ethereum, Ripple, Litecoin, Monero and approximately 700 other cryptocurrencies are what currently we see as the most advanced blockchain application: electronic cash.

While the explosive growth of cryptocurrencies speaks to the popularity of the concept, it also poses a very real problem. Too many currencies make interoperability and trading with each other difficult, just as the lira, franc, pound, peseta and mark made it more difficult to trade than the euro. Traditionally we conceive cash as coins made from metal discs or bills of printed paper. Physically handing over these tokens of value to another person constitutes the transfer of value. If this is not possible (due to distance) we use trusted middlemen (i.e. banks) to handle this transaction for us. It should maybe not come as much of a surprise that bitcoin –  i.e. an alternative form of money - was invented in 2008, when trust in banks, the by-then nefarious middlemen of the financial industry, was at its lowest.

In terms of the practical operations one performs to transfer money via blockchain, there is not much difference to the processes we use today; We keep our money in bank accounts, which we identify via account numbers. Bitcoins have an ‘address’. If you want to send a bitcoin payment to another person, you have to know his/her personal address, to know where to send it to.

Bitcoin ownership is therefore primarily a question of which addresses these bitcoins are attached to. So it is primarily the link between a bitcoin and an address controlled by oneself (the so-called public key). Transactions of bitcoins are the shifting of these token via password (or private key) to unlock the fund from one’s own address and attach it to someone else’s. So wallets are not storing bitcoins but rather the private keys which allow you to transfer them.

Smart contracts

Smart contracts are essentially software programs that translate real world contracts or expressions of will into code. These often highly complex “if – then” relations are embedded into the blockchain and self-execute if certain conditions are met. A bit like a macro in a spreadsheet which self-triggers when certain conditions are met. The applications for such smart contracts are endless; for example a shipment arrives at the factory gate (verified by a GPS signal), the smart contract triggers the paperwork being prepared and payment being released; if certain stock values are met, buying or selling processes are triggered; if temperature sensors report that sub-zero temperatures happened on a vineyard (and thus the harvest presumably being destroyed) the settlement process of an insurance contract is activated. Liking payment processes triggered through smart contracts with cryptocurrencies obviously further enhances their efficiency.

Blockchain: what is it is good for?

The far more interesting question is, what is blockchain actually good for? Which industries will blockchain impact and how is this likely to happen? 

The industry which has put serious intellectual effort into this technology and developed the most advanced applications is finance, presumably on account of bitcoin/blockchains being specifically developed as an alternative process to their very services. So rather than small groups of technophile aficionados as in other areas, in the financial industry we see the big players moving into the technology. The most widely cited example of this is R3 (i.e. 45 of the biggest banks, such as Barclays, JPMorgan, Credit Suisse, Deutsche Bank, setting up a joint initiative to establish common standards and find common solutions).

In terms of applications, we have already discussed the process of transferring cryptocurrency values, which is much the same as wiring money from one bank account to another. But given the perception of the banking industry as inflexible, at times arrogant, charging hefty fees while at the same time reducing branches and thereby underserving large areas, the possibility of an omnipresent online service is a highly attractive one, in that there is a real danger that blockchain is doing to banks what Amazon did to High Street bookstores.

Increasingly we also see blockchain-based solutions in more advanced areas of the financial industry, such as securities trading (equity Bits, Spritzle, Secure Assets, Coins-e), foreign exchange (Bit Pensa, Ripple, Stellar, Kraken) or OTC trading derivatives via smart contacts blockchain is offering solutions.  The most widely reported examples in this context are the bond issuance of Daimler, in cooperation with LBBW via the IBM Blockchain and the Xetra/Eurex trade settlement pilot of Deutsche Börse and Deutsche Bank.

Besides the financial sector there are also countless other interesting applications (from land registry, health and education, and so on). Among the more advanced and interesting examples are the sharing economy and energy.

With the claim to take out the middleman, blockchain looks like being able to make current central platform operators – such as Uber or Airbnb – superfluous and directly link people looking for a room with those seeking to rent it out. With the peer-to-peer logic of blockchain the sharing economy really has a chance to take off big time.

What is true for Uber is of course also true for the likes of Amazon marketplace and eBay. The power of Amazon as intermediary would evaporate if publishing houses and readers find each other directly.

The shift from the near-monopoly power of the big energy conglomerates to a ‘democratisation’ of energy production is further facilitated by the convergence of smart homes, micro-grids and renewable energy producers as well as smart sensors with a technology to carry and reliably log all of this data. This confluence of conditions is set to change dramatically over the next few years.

Blockchain-based smart contracts could not only direct the flow of energy (i.e. prosumers that are producing more energy than their need redirecting the energy into public networks or storage) as well as everyone-to-everyone (peer-to-peer) trading with automated billing models.

Big pilot projects in this field include the RWE subsidiary Innogy setting up a peer-to-peer charging network for electric vehicles via the e-mobility start-up Share & Charge or the co-operation of ENI, BP and Wien Energy to test wholesale energy trading via a platform solution.

Downsides and problems

The current blockchain hype promises a near-utopian world of security and efficiency. An utopian promise especially for Europeans, given that in March 2018 the General Data Protection Regulation (GDPR) will come into force, which guarantees every European the right to be forgotten. But how does that square with a technology whose key feature is immutability and inalterability, the very essence of blockchain being that data out there cannot be changed or deleted? So will we have to make do without blockchain or without the not yet granted right to be forgotten?

The other problem is a more mundane, but equally vexing one. Regulatory frameworks in most countries have not caught up with developments. When Daimler issued the blockchain bonds, they had to do this in parallel – via the hyperledger and paper process – to conform to the existing regulatory rules.

The permanent encryption and recalculation of the entire bitcoin blockchain in decentrally replicated databases, each of which with a complete copy of the entire file, ensures the immutability of data but also causes its biggest problem. The longer the blockchain, the bigger the computational effort to handle this data monstrosity. Something which starts to limit the applicability of the technology (even at the very early stage we are at). While it is estimated that Visa can process up to 60,000 transactions per second, bitcoin manages between three and four. Some state a theoretical maximum of seven transactions per second, but at any rate an order of magnitude less than existing technologies.

Attempts to address this problem resulted in options such as ‘Bitcoin Cash’ (SegWit) or Ethereums’ off-Blockchain Raiden platform. Moving transactions ‘off-chain’, towards Hyperledger solutions, allows for faster transaction times, means however that we are – strictly speaking – not dealing with a blockchain anymore. Essentially we are facing a trade-off between security and capacity.

Closely connected to the above is the question of bandwidth. A system that thrives of the constant exchange and recalculation of the whole dataset throughout the entire distributed network, takes up a significant amount of bandwidth. With the bitcoin blockchain file grown to approximately 100 gigabytes (and continuing to grow exponentially), scalability will become an issue on this side as well.

The hype around the un-attackability of blockchains it not quite correct. While Ethereum’s blockchain itself operated flawlessly, hackers managed to steal 50 million Ether from an investment fund via an integrated smart contract that was somehow corrupted. While the blocks are safe, the interfaces in between applications and the technology still open entry gates for hackers. 

A more mundane but probably more far-reaching question is that of interoperability. In Europe we have dozens of languages, which occasionally results in not understanding each other particularly well. The lack of standardisation in blockchain leads to a very similar problem.

The flipside of this is R3: big banks moving in, to defend their market by building a proprietary blockchain that specifically favours their needs. Essentially this is the trade-off of the democratisation of data and the non-central control aspect which is essentially terribly inefficient and causes the problem of different ‘languages’ (i.e. different cryptocurrencies), versus an efficient and interoperable system with some sort of centralised structure.

What does it mean for FDI?

Time for those famous, words: it is too soon to tell. Blockchain, just as with the wider field of digitalisation, is undoubtedly changing the game. Where that will lead us to, and what the repercussions will be, is still hard to predict.

What we can say for certain right now though is that blockchain and bitcoin are massively overhyped, at the moment. But in the long run, blockchain might indeed change the world. The internet once looked like only a connecting tool for a few computers but ended up as a complete paradigm shift of how we do business.

Blockchain has the capacity to do the same. Primarily in fundamentally changing the role of banks due to a shift in how we transfer value; blockchain makes micropayment feasible, allowing us to charge the owners of drones for recharging their batteries on our rooftop solar cells; payment processes with values of less than a cent might be changing the way how we conceive services.

As for the claim that blockchain will lead to middlemen being cut out, this is a question we are less sure about. Uber and Airbnb revolutionised the market with their platform technology and are thus – next to banks – the quintessential middleman. Would it not be the case that blockchain only facilitates that very process more efficiently, but in the end also needs the establishment of a layer in between the peer-to-peer process. So aren’t we only replacing one actor (i.e. banks) with another one (blockchain-based settlement firms)? And with the banking industry moving in to capture the technology, one might wonder if indeed much is going to change. R3’s proprietary Blockchain Corda, Western Union piloting remittances via blockchain, and the above mentioned examples of Deutsche Bank, LBBW and Alfa Bank, might mean middlemen using different technology; but it appears likely that we will continue to see the same set of middlemen.

As for reduction in transaction fees, again, this remains to be seen. Is it really that inconceivable that miners won’t suddenly start charging extra fees for transactions when the supply of blocks in certain blockchain is dwindling?

On the upside, blockchain can certainly revolutionise legal processes via smart contracts.

What we are looking at is possibly a new era in computing. A revolution on par with the shift from mainframe computers in climate-controlled basements to laptops in the hands of spotty teenagers, lounging in coffeeshops. Just as the internet disrupted many industries, so might blockchain. Even more so – given that we are now transferring not only information, but also value. And given that we are solving one of the biggest problems we face right now: data security.

But this will not happen overnight. After all the internet was “invented” around 1990.

While advanced manufacturing and robotisation might shift production locations and hence FDI flows, blockchain probably will not. At least not in the foreseeable future. 

Martin G Kaspar is head of business development at a German mittelstand company within the automotive industry and a PhD candidate at Durham University. E-mail: martin.georg.kaspar@gmail.com