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4 things finance gets wrong about blockchain

Sep 06, 2018

With its impenetrable wall of jargon and the sheer wealth of misinformation out there, it's easy to get confused about blockchain and the potential impact it is going to have on the finance world. Sarat Pediredla, hedgehog lab CEO, unpicks and demystifies the most-hyped technology around at the moment.  

On 22 May 2010 a programmer from Florida became the first person to carry out what is widely regarded as the first completed transaction using Bitcoin.

Laszlo Hanyecz paid 10,000 BTC for two Papa John’s pizzas in what is the first recorded consumer purchase involving the then nascent cryptocurrency.

In doing so he immortalised himself in Bitcoin folklore and helped to inadvertently christen an important date on the bitcoin and blockchain calendar: Bitcoin Pizza Day. More mindboggingly, the Floridian techie’s transaction would now be worth over tens of millions of dollars in current Bitcoin prices.

Although a bit of a fudge (the transaction actually involved Hanyecz exchanging the Bitcoin to a fellow member of a Bitcoin message board who, in exchange, ordered the pizzas using his credit card), the date is so important as it marks the beginning of Bitcoin as genuine medium of value exchange and commerce.

Eight years on and we haven’t quite reached the point where you can buy your groceries (or a pizza for that matter) with Bitcoin as quickly and as easily as with a credit card, but the date in late May still represents a landmark step in the story of cryptocurrencies.

Arguments against the efficacy of cryptocurrencies as a store of value are predicated on the fact that the likes of Bitcoin cannot be readily exchanged for goods and services, which is why Bitcoin Pizza Day has been seized upon by aficionados.

As the highest profile implementation of blockchain, Bitcoin has been inextricably linked to discussions of the technology. Which explains why much of the early interest in Blockchain was centred around how it could disrupt the prevailing financial system.

Brown and DarlingFormer UK PM Gordon Brown and Former Chancellor Alistair Darling. Photo by Downing Street on Flickr

In fact, the first-ever mined block in the Bitcoin network included an overt reference to the financial crash of 2008 by including the following text embedded within it: “The Times 03/Jan/2009 Chancellor on brink of second bailout for banks.”

While cryptic, the text clearly places Bitcoin in tension, if not in opposition to the financial status quo. It’s unsurprising, then, that financial firms have had a keen interest in Bitcoin and blockchain from early on.

However, this focus on Bitcoin is at the core of why so many financiers, banks and other financial businesses get blockchain so wrong. Here are some of the most common misconceptions that finance firms often fall for.  

 

Blockchain is Bitcoin and vice versa.

 

The first and most damaging. Banks and financiers have all too often been swept along by the hype about Bitcoin as a potential replacement for traditional money. It has led to blockchain’s most vociferous criticism and it’s more voluminous praise.

Those looking to tear down the current financial order have seized on the technology while those that are part of the status quo have inevitably viewed it with suspicion. The truth, as always, lies somewhere in the middle. As for the question of whether Bitcoin is going to eradicate traditional money, that would require a blog post all of its own.

Our concern here is the misconception that still prevails amongst many: that blockchain is Bitcoin. Blockchain is the technology that underlies the Bitcoin network and maintains the cryptocurrency’s transaction ledger. Bitcoin is an application of blockchain but, in reality, there are an infinite number of other applications for which the technology could be put to use.

While the terms are not interchangeable, Bitcoin provides an excellent use case for the potential of blockchain technology, especially for currency. Digital currencies like Bitcoin have huge potential to slash transaction costs, expedite transfers and combat fraud in comparison to traditional financial structures.

Someone removing dollars from a walletThe old Yankee dollar which Bitcoin hopes to replace. Photo by Allef Vinicius on Unsplash

Unlike real money, digital currencies don’t physically exist which is a problem when it comes to stopping people from spending the same value more than once. You can’t use the same five pound note twice for the simple fact that once you have completed your initial transaction, the fiver is no longer in your possession.

With intangible currency, it’s far easier for a hacker or nefarious individual to trick a vendor or individual into accepting two or more transactions due to the relative simplicity of copying digital information. The so-called ‘double spend problem’. Blockchain tech helps to mitigate against this through its open ledger which creates a continually updated, mostly immutable record of all transactions on the network, making it impossible to spend the same value twice.

In all likelihood, if digital currency ever achieves mainstream acceptance, either through an upstart cryptocurrency or nation state’s monetary policy, blockchain technology will likely underpin it.

This does not mean that blockchain and Bitcoin are interchangeable. They’re not, and the success of blockchain as a technology is not dependent upon Bitcoin’s success (or lack of).


Blockchain protects against human error.

 

Blockchain networks are immutable (to a degree) but that’s no guarantee that they’re infallible. There is a widespread assumption that the information contained within a blockchain is tantamount to the voice of God, but this is inaccurate.

The old adage of junk in and junk out is just as much a truism with blockchain as it is with any other technology.

Network participants validate the data in a network, but if that data is flawed in the first place the network will merely be validating incorrect information. Thus hampering the data integrity of the whole ledger.

For example, consider a network that logs financial derivative trades around the globe. The fat fingers of a futures trader accidentally swapping a 5 for a 6 as part of futures contract, a minor error that both parties only spot a few months down the line. The problem is that by this point the error has been enshrined in the ledger and is, in effect, irreversible.

New York Stock Exchange and flagA blockchain-backed financial system will still be as susceptible to human error. Photo by Brian Glanz on Flickr

Just because information has been validated by the nodes in a blockchain does not mean that data is accurate. And such is the design of blockchain technology that pushing through amendments to incorrect data is possible, but exceedingly difficult, as we’ll discover later.

The key takeaway here is that blockchain-enshrined data should not be confused with truth. When they take-off, blockchains will be just as susceptible to human error as any other store or medium of data.


The immutability myth.

 

Just as blockchain networks aren’t infallible it’s also technically inaccurate to say that they cannot be tampered with. In fact, it is disingenuous to claim that blockchain networks are immutable.

While extremely difficult, it’s still possible to modify the chain of transactions in a blockchain provided specific conditions are met. With Bitcoin, if 51% of the network agree to a change, whether through collusion or force, they can interfere and introduce changes. This is potentially problematic with Bitcoin in particular when you consider that around 70 per cent of Bitcoin miners are based in China, opening up the possibility of nation state interference.

Bitcoin on a motherboardThe low cost of energy has seen China corner the market for Bitcoin mining. Photo by Marco Vech on Flickr

In reality, modifying transaction data on an open blockchain would require a herculean, concerted effort; certainly more effort than easily editable records that are prone to rogue agents. But the point still stands: blockchains are not immutable.

Private blockchains, the closed networks that are of more interest to governments and companies than the open variety, are even further from being tamper proof. In these networks, permissioned individuals are given access to the network by the network owners who act as validators.

These validators have the authority to implement changes and amend inaccurate information if they so desire. Naturally, this has practical uses, such as modifying incorrect data and remedying human error, but the danger lies in assuming that all blockchain-based ledgers provide unassailable truth.


Smart contracts are legal documents.

 

It’s easy to see the word ‘contract’ and immediately trip up on the idea that smart contracts are somehow legally binding documents. They’re not. In fact, their capabilities expand far beyond being mere legal documents.

In blockchain parlance, a smart contract isn’t what we normally mean when we say ‘contract’. It’s not a document outlining the legally enforceable characteristics of a relationship, say, for example, the terms of employment or an agreement to buy a house.

Rather, a smart contract is a program that enforces a relationship automatically through code. This might sound complex, but it’s really very simple. Think of it as a regular “if this, then that” computer program, whereby a specific value is outputted once pre-arranged conditions have been met.

For instance, blockchain firm Etherisc has developed a smart contract system for natural disaster insurance in Puerto Rico. The system works by feeding in weather data which automatically triggers an insurance payout if preset conditions are met. As a result, policyholders receive payouts rapidly while the claims process is eradicated entirely.

Voter submitting a vote at a ballot boxBallot boxes could soon be a thing of the past thanks to blockchain. Photo by Arnaud Jaegers on Unsplash

The Ethereum network, another well-known decentralised network, is built around the concept of programmable smart contracts, providing the flexibility to support an infinite number of use cases and contexts. Their genius lies in the fact that they require no interference from a third party and their distribution across the nodes in a network mean they cannot be interfered with.

Alongside insurance, they have an innumerable amount of potential uses in a wide array of scenarios. They could provide added transparency to a digital voting system or greater expediency in supply chain logistics. Property transactions could be made far more efficient by self-completing smart contracts while transparency issues with government procurement contracts could be eradicated entirety. The possibilities are seemingly endless.

Smart contracts are not legally binding agreements then, but they are extremely efficient, transparent agreements that have the potential to unlock significant efficiency savings for banks and financial firms.


Demystifying the blockchain.

 

Blockchain literacy amongst the wider population often falls down at the first hurdle due to the sheer welter of jargon and technical terms. In such an atmosphere, it’s unsurprising that myths and misunderstandings are traded so widely.

Another factor at play is that we are still at the very early stages of adoption across all sectors, including finance and banking, which means there is something of an imagination void when it comes to potential implementations of the technology.

Into this void rushes over-exaggerations such as blockchain’s supposed immutability or inaccuracies which claim that the technology protects against human error. Add into the mix misunderstandings about blockchain’s relationship with Bitcoin or the nature of smart contracts and it’s no wonder that many business leaders remain confused about the potential of the technology.

Despite these misconceptions, blockchain warrants its reputation as one of the most exciting advances finance organisations should be staying abreast of. The technology's evident versatility provides justification enough, and that's before validating intangibles such as its ability to build trust and encourage transparency.

As uptake takes off in the next few years the gap between perception and reality will inevitably shrink as real-world use cases in areas such as foreign currency transactions, clearing and settlements, and lending provide more tangible examples of blockchain’s potential.

Demystifying some of the more opaque aspects of blockchain will be a crucial step in financial organisations unlocking the full potential of the technology, something which wider adoption will only help to accelerate.


 

Can you think of any other common pitfalls that trip people up when they're talking about blockchain? Share it with us over on Twitter, @saratpediredla and @hedgehoglab.

 


Want to learn more about how blockchain is currently being utilised in supply chain management? Have a listen to Ben Lind and Hamish Kerry over on the Hogcast.

Aerial shot of shipping containers

Listen to find out about blockchain's impact on supply chains

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