Blockchain Technology: Answering the Whos, Whats, and Whys

by J. Stephen McNally, CPA, CMA | Apr 23, 2019

Block_250x383Blockchains. We hear about them more and more, but what exactly are they? Who uses them, and why? Are they safe? And what about the many related terms, such as “open” vs. “closed,” “permissioned” vs. “permissionless,” “distributed ledger technology,” “cryptography,” “consensus mechanism,” and “Merkle trees”?

Perhaps your curiosity about blockchain has led to participating in webinars or conducting your own research to gain a deeper understanding of the technology. Yet, despite your curiosity and best efforts, you may still be wondering what exactly blockchains are, how they work, and if you should even care.

While this article may not be a comprehensive overview of blockchain, I have endeavored to provide insight and structure – a roadmap, if you will – to facilitate your understanding going forward. This article is intended to provide some clarity regarding the nature and purpose of this new technology, including additional insight regarding related terms, potential uses, benefits, challenges, and other considerations.

 

Background

Blockchain technology made its public debut in October 2008 with the release of the white paper Bitcoin: A Peer-to-Peer Electronic Cash System by Satoshi Nakamoto (true identity unknown). In the white paper, the author (or authors) noted that double spending is an inherent risk with commerce on the internet, resulting in the need for trusted third parties (typically financial institutions) to process electronic payments. Nakamoto proposed an electronic payment system “based on cryptographic proof instead of trust, allowing any two willing parties to transact directly with each other without the need for a trusted third party.”1

Nakamoto introduced the digital currency Bitcoin in January 2009, with the first transactions taking place within a month. Nakamoto’s conceptual blockchain design, which serves as the public ledger for all Bitcoin transactions, quickly progressed from theory to reality. According to the Harvard Business Review, “the market cap of Bitcoin now hovers between $10 billion-$20 billion, and is used by millions of people for payments, including a large and growing remittances market.”2

Since the introduction of Bitcoin, many have realized that blockchain, the underlying technology enabling Bitcoin and other cryptocurrency operations, can benefit other activities as well. Within the global finance function, for example, the technology can support the management of stockholder records, accounts receivable, accounts payable, reconciliations, intercompany transactions, and other activities. As of 2017, about 15 percent of banks were using blockchain, and nearly every major financial institution is engaged in blockchain research.3 Beyond finance, blockchain can support supply chain management, warranty service, regulatory compliance, and more.

 

Blockchain Defined

In simple terms, a blockchain is a digital register of transactions that have been independently confirmed by a peer-to-peer network of connected computers, or nodes. It serves as a shared ledger, capturing a permanent record of all transactions between two or more parties. The blockchain is the authoritative record, providing a history of what transactions were made, when, and the nature of each.

Blockchains are not static; rather they can be securely updated to reflect new transactions. New transactions, once validated, are stored in blocks. The blocks of data are encrypted, timestamped, and then, once verified, locked into the chain, making the records permanent and unalterable.

The data in a blockchain, which can be copied and shared widely, is only recorded once. As such, a blockchain provides “one source of truth” for all participants. Robert L. McDonald, a finance professor at the Kellogg School of Management at Northwestern University, noted that “much of the plumbing in (a) financial system is devoted to having a common, authoritative, up-to-date database of who owns what and who has what obligations to whom. That’s what blockchain can provide.”4 Using blockchain technology enables participants to keep all accounting systems in sync.

Another key feature of blockchain is the elimination of intermediaries. To illustrate, if I go to a Philadelphia Eagles game and want to buy a soft pretzel and a beer, the vendor gives me my food and I hand the vendor cash. At that point, our transaction is complete. If, on the other hand, I go online to buy a jersey, the vendor and I need a trusted party in the middle. Specifically, I need assurance the vendor has goods to sell and the vendor needs assurance that I have money to pay. A blockchain is like the first scenario. Participants, using a consensus mechanism, independently verify and agree to the addition of new records to the blockchain. As such, they don’t need a trusted third party, such as a bank or credit card company, to verify transactions on their behalf.

 

Types of Blockchains

There are several types of blockchains, segmented by their permission model.5 Overall, a chain is either “open” or “closed.” Open blockchains, which are open to the public and therefore available for anyone to read, are either “permissioned” or “permissionless.” While anyone can read a public, permissioned blockchain, only authorized participants can write and commit to it. This compares to the public, permissionless blockchains, best known for Bitcoin and Ethereum, which allow anyone to read, write, and commit.

There are also two types of closed blockchains, “consortium” and “private permissioned.” With a consortium blockchain, reading, writing, and committing are restricted to an authorized group of participants. An example would be multiple banks operating a shared ledger. A private, permissioned blockchain, on the other hand, is fully private or restricted to a limited group of authorized nodes. With such blockchains, also known as enterprise blockchains, the network operator is the only one who can write or commit to it.

 

Distributed Database Framework

Many use the terms “blockchain” and “distributed ledger technology” (DLT) interchangeably. In reality, one is a subset of the other. Specifically, blockchains are a subset of distributed ledgers, and distributed ledgers are a subset of distributed databases.

A distributed database stores data across multiple nodes/computers, whether located in one physical location or across multiple physical sites. Such a database can reside on the internet, on organized network servers, on decentralized independent computers, or on corporate intranets or extranets. There is no master database unilaterally deciding when data should be updated. Rather, replication (a process to identify changes then update all databases so they look the same) is used to ensure data remains consistent and up to date across the network. Distributed databases generally require a trusted environment in which to operate so that the various nodes can cooperate and freely share data.

Distributed ledgers, while a subset of distributed databases, do not assume they are operating within a trusted environment. DLT is based on the adversarial threat model that assumes the presence of bad actors, such as dishonest or malicious nodes, in the network. To address this threat, each site must be able to independently verify new transactions and recreate the entire updated history of transactions.

A blockchain, as previously noted, “is a type of database that is replicated over a peer-to-peer (P2P) network” which is “designed to achieve consistent and reliable agreement over a record of events (e.g., ‘who owns what’) between independent parties who may have different motivations and objectives.”6 Blockchains, like distributed ledgers, are based on the adversarial threat model, so they require independent verification of new transactions before adding them to the chain.

 

Key Components

According to the 2017 Global Blockchain Benchmarking Study,7 blockchains consist of five key components: cryptography, a P2P network, a consensus mechanism, a ledger, and validity rules.

Cryptography is “a method of protecting information and communications through the use of codes so that only those for whom the information is intended can read and process it.”8 To support confidentiality, data integrity, and authentication, blockchains leverage a variety of cryptographic techniques, including one-way hash functions, Merkle trees, and public key infrastructure. A cryptographic hash is a fingerprint of the data in a given block, and a Merkle tree is the data structure allowing a chain to scale while maintaining data integrity. Public key infrastructure enables digital signatures, encryption, and other such technologies across large user populations.

P2P networks represent computer systems (“peers”) connected via the internet, which can share files directly without going through a central server. Thus, on a P2P network, each computer is both a file server and a client.

Consensus mechanisms ensure transactions are genuine and that consensus exists regarding the ordering of validated events in the ledger. The consensus mechanism ensures each participant has the same view of the shared database as all other participants.

The ledger is the bundled list of transactions in cryptographically linked “blocks.”

Validity rules for a given blockchain are the network’s common set of rules for validating transactions and updating the ledger. They represent the rules of engagement.

 

Potential Uses

Although the original blockchains were used for trading and managing Bitcoin and other cryptocurrencies, the underlying technology can play a role in trade and commerce. In addition to various financial processes, business blockchains can support asset traceability, supply chain management, regulatory compliance, identity management, reconciliations, and other such activities.

Global finance teams are being challenged to streamline their processes and reduce cost. According to Deloitte,9 blockchain technology can support finance teams in managing nearly any activity entailing transaction processing, including the following examples:

  • Revenue cycle
  • Self-validating accounts payable and accounts receivable subledgers
  • Trade finance
  • Working capital and cash flow
  • Capital planning and performance
  • Intercompany accounting and consolidation
  • Tax compliance
  • Warranty accruals
  • Fraud and risk detection
  • Reconciliation and audit activities

The finance team is not the sole beneficiary of business blockchains. In real estate, for example, a blockchain of property records could provide an immutable record of ownership, potentially rendering title searches and title insurance obsolete. For manufacturers, blockchains could improve the tracking of goods and services, enhance interactions with vendors and suppliers, and generally improve supply chain management.

On Wall Street, blockchain technology could speed up the settlement of stock trades and reduce related transaction, settlement, and reconciliation costs. In addition, it could enhance the integrity of shareholder listings, support proxy voting, and more effectively control the issuance of stock.

Business blockchains could also support custodians, exchanges, banks, insurance companies, health care providers, and freight providers. Even governmental agencies could leverage blockchains to register birth certificates, ensure voter integrity, and manage tax collection, just to name a few.


Benefits

Although blockchain technology is new and largely untested, the potential benefits are many. Here are just a few:

  • The blockchain, by recording data only once and ensuring all systems are in sync, represents one source of truth.
  • Using a consensus mechanism enables stakeholders to consistently and reliably agree on the record of events in a blockchain, whether or not their objectives are aligned. This results in a reduced need for trust among participants and elimination of trusted intermediaries.
  • Blockchains provide greater transparency, global auditability, and permanence of the data and records included in the chain. Once recorded, digital assets cannot be counterfeited or forged. Participants will see if records are created “out of thin air.” Thus, there is reduced possibility of errors and fraud.
  • As a shared digital ledger, a blockchain offers participants increased transparency of digital tokens, records, and other information stored on the chain, as well as enhanced traceability regarding this data.
  • Participants have simultaneous access to the data captured on the blockchain. Thus, similar to Google Docs, blockchains can enable collaboration.
  • Blockchain technology offers the potential for streamlined business processes, internally and across third-party entities. Streamlining and automating your business processes, reimagining them end-to-end, should drive increased speed and efficiency as well as reduced cost. Of course, if you don’t rethink your existing processes and business model and simply force-fit blockchain technology into them, the likelihood of achieving significant benefit goes way down.

 

Barriers

While the technology underlying today’s blockchains seems to offer numerous advantages, including the opportunity to significantly streamline one’s business processes and enjoy cost reductions, widespread adoption is not yet a reality.

Many believe business blockchains will be commonly used within a few years: the benefits are too important to ignore. In the meantime, a number of challenges and barriers are getting in the way. Here are several examples:

  • Business blockchains are based on new and immature technology, industry standards are lacking, the technology is highly complex, and network/application deployments have been limited. It will take time for confidence in the technology to grow.
  • Transitioning from legacy infrastructure and upgrading to the new technology will be costly, requiring significant investment.
  • Organizational challenges, from teaching people new technologies and processes, to overcoming the typical resistance to such change, to finding external talent with blockchain expertise to help lead the way, will need to be addressed.
  • The legal and regulatory framework around blockchain technology is evolving. Significant regulatory uncertainty, and therefore legal risk, remains.
  • On public blockchains, and even with closed chains, trust issues as well as concerns over privacy and confidentiality must be addressed.
  • The disintermediation of certain parties, such as banks and notaries, may cause them to resist.
    Most importantly, is there a business case to move forward with blockchain in your organization? What opportunities have been identified, and what is your expected return on investment, if any?

 

Call to Action

Now that you better understand the nature of blockchain, two key questions remain. First, should you care? Second, if so, what should you do next?

Although the concept of business blockchains is relatively new and untested, the potential benefits are significant. To that end, yes, you should care, whether or not you take any immediate action.

Assuming you want to be proactive, though, I recommend the following:

  • Leverage your inquisitive nature. Continue to read articles, participate in webinars, and otherwise keep “in the know” about blockchain.
  • Monitor leaders in your industry to determine how they are leveraging blockchain technology.
  • Join a peer group focused on business blockchains, preferably a group including organizations who are already piloting the technology.
  • Identify opportunities where implementing a blockchain will offer obvious benefits and build your business case accordingly.

As a finance executive, you have choices. You can have a laid-back “wait-and-see” attitude. Or, though you believe business blockchains will add value to your company, you may want to let another function take the lead. In this case, wear your business partner hat and take a seat at the table to ensure regulatory, security, control, and other issues are fully vetted. You may want to fully embrace the technology, take the lead, and be the catalyst for business transformation. In this case, consider starting slow: identify a business blockchain pilot project and assess the business case for your organization.

I hope this overview has been helpful to your understanding of blockchain. However, to quote Deloitte’s Crunch Time IV: Blockchain for Finance, “Making it real is the best way to make it understandable.”  

1 Satoshi Nakamoto, Bitcoin: A Peer-to-Peer Electronic Cash System (October 2008), p. 1.
2 Vinay Gupta, “A Brief History of Blockchain,” Harvard Business Review (Feb. 28, 2017).
3 Ibid.
4 Drew Calvert, “How Blockchain Could Radically Alter Global Finance,” Kellogg Insight (Jan. 3, 2018).
5 Dr. Garrick Hileman and Michel Rauchs, Global Blockchain Benchmarking Study, Cambridge Centre for Alternative Finance, University of Cambridge Judge Business School (2017), p. 20.
6 Ibid., p. 13.
7 Ibid., p. 14.
8 https://searchsecurity.techtarget.com/definition/cryptography
9 Crunch Time IV: Blockchain for Finance, Deloitte (2018), p. 13.

 


J. Stephen McNally, CPA, CMA, is chief financial officer for PTI/Phoenix Family of Companies, global board director for the Institute of Management Accountants, and a member of the Pennsylvania CPA Journal Editorial Board. He can be reached at j_stephen_mcnally@att.net.

 

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