Blockchain is the innovative database technology at the heart of almost all cryptocurrencies. By distributing identical copies of a database across an entire network, blockchain makes it very difficult to hack or cheat the system. While cryptocurrency is the most popular use for blockchain currently, the technology offers the potential to serve a very wide range of applications.
What is a blockchain?
At its core, blockchain is a distributed digital ledger that stores data of all kinds. A blockchain can record information about cryptocurrency transactions and ownership of Non Fungible Tokens (NFT).
While any conventional database can store this type of information, blockchain is unique in that it is decentralized. Rather than being maintained in one place by a centralized administrator—think of an Excel spreadsheet or a bank database—many identical copies of a blockchain database are kept on multiple computers spread across a network.
These individual computers are referred to as nodes.
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How Blockchain works
With blockchain, the digital ledger is described as a “chain” consisting of individual “blocks” of data. As fresh data is periodically added to the network, a new “block” is created and attached to the “chain”.
This means that all nodes update their version of the blockchain ledger to remain identical.
How these new blocks are created is the key to why blockchain is considered highly secure. A majority of nodes must verify and confirm the legitimacy of the new data before a new block can be added to the ledger. For a cryptocurrency, they might involve ensuring that new transactions in a block were not fraudulent, or that coins had not been used more than once.
This is different from a stand-alone database or spreadsheet, where one person can make changes without supervision.
“Once there is consensus, the block is added to the chain and the underlying transactions are recorded in the distributed ledger,” says C. Neil Gray, partner in the fintech practice areas at US-based Duane Morris LLP. “Blocks are securely linked together, forming a secure digital chain from the beginning of the ledger to the present day.”
Transactions are usually secured using cryptography, which means that the nodes must solve complex mathematical equations to process a transaction.
“As a reward for their efforts to validate changes to the shared data, nodes are typically rewarded with new amounts of the blockchain’s native currency, such as new Bitcoin on the bitcoin blockchain,” says Sarah Shtylman, fintech and blockchain advisor at Perkins Coie.
There are both public and private blockchains. In a public blockchain, anyone can participate, which means they can read, write, or revise the data on the blockchain. In particular, it is very difficult to change transactions logged in a public blockchain, as no single authority controls the nodes.
A private blockchain, meanwhile, is controlled by an organization or group. Only it can decide who is invited to the system, plus it has the authority to go back and change the blockchain. This private blockchain process is more similar to an internal data storage system except spread across multiple nodes to increase security.
How is Blockchain used?
Blockchain technology is used for many different purposes from providing financial services to managing voting systems.
Cryptocurrency
The most common use of blockchain today is as the backbone of cryptocurrencies, such as Bitcoin or Ethereum. When Australians buy, exchange or use cryptocurrency, the transactions are recorded on a blockchain. The more people use cryptocurrency, the more widespread blockchain can become.
“Because cryptocurrencies are volatile, they are not yet widely used to purchase goods and services. But that’s changing as PayPal, Square and other money services companies make digital asset services widely available to vendors and retail customers,” notes Patrick Daugherty, senior partner at international law firm Foley & Lardner and head of the firm’s blockchain task force.
Banking operations
Beyond cryptocurrency, blockchain is used to process transactions in fiat currency, such as pounds, Australian dollars and euros. This can be faster than sending money through a bank or other financial institution, as the transactions can be verified more quickly and processed outside normal business hours.
Asset transfers
Blockchain can also be used to record and transfer the ownership of various assets. This is currently popular among digital assets such as NFTs, a representation of ownership of digital art and videos.
However, blockchain can also be used to process the ownership of real assets, such as property and vehicle deeds. The two sides of a party will first use the blockchain to verify that one owns the property and the other has the money to buy. They could then complete and record the sale on the blockchain.
Using this process, they could transfer the property’s title deeds without manually submitting paperwork to update land registry records – it would be instantly updated on the blockchain.
Smart contracts
Another blockchain innovation is self-executing contracts often called “smart contracts”. These digital contracts are automatically adopted when the conditions are met. For example, a payment for an item can be released immediately when the buyer and seller have met all specified parameters for an agreement.
“We see great potential in smart contracts, using blockchain technology and coded instructions to automate legal contracts,” says Gray. “A properly coded smart legal contract on a distributed ledger can minimize, or preferably eliminate, the need for external third parties to verify its performance.”
Supply chain monitoring
Supply chains involve huge amounts of information, especially as goods move from one part of the world to another. With traditional data storage methods, it can be difficult to trace the source of problems, such as which poor quality supplier the goods came from.
Storing this information on the blockchain will make it easier to go back and monitor the supply chain, for example with IBM’s Food Trust, which uses blockchain technology to track food from harvest to consumption.
Voting
Experts are also looking at ways to use blockchain to prevent voting fraud. In theory, blockchain voting would allow people to submit votes that cannot be tampered with, as well as remove the need for people to manually collect and verify paper ballots.
Advantages of Blockchain
Higher accuracy of transactions
Because a blockchain transaction must be verified by multiple nodes, this can reduce errors. If a node has an error in the database, the others will see that it is different and catch the error.
In contrast, in a traditional database, if a person makes a mistake, it may be more likely to go through. Additionally, each asset is individually identified and tracked on the blockchain ledger, so there is no chance of double-spending it (like a person overdrawing their bank account, thus spending money twice).
No need for intermediaries
Using blockchain, two parties to a transaction can confirm and complete something without working through a third party. This saves time as well as the costs of paying for an intermediary, such as a bank.
“It has the ability to bring greater efficiency to all digital commerce, to increase financial empowerment of the unbanked or underbanked population of the world and to power a new generation of Internet applications as a result,” says Shtylman.
Extra security
Theoretically, a decentralized network, such as blockchain, makes it almost impossible for anyone to make fraudulent transactions.
To enter counterfeit transactions, they have to hack every node and change every ledger. Although this is not necessarily impossible, many cryptocurrency blockchain systems use “proof-of-stake” or “proof-of-work” transaction verification methods that make it difficult, as well as not in the best interest of participants, to add fake transactions.
More efficient transfers
Since blockchains operate 24/7, people can make more efficient financial transfers and assets, especially internationally. They don’t have to wait days for a bank or government agency to confirm everything manually.
Disadvantages of Blockchain
Limit on transactions per second
Given that blockchain relies on a larger network to approve transactions, there is a limit to how fast it can move. For example, Bitcoin can only process 4.6 transactions per second versus 1,700 per second with Visa. In addition, increasing the number of transactions can create problems with network speed. Until this improves, scalability is a challenge.
High energy costs
Having all the nodes working on verifying transactions requires significantly more power than a single database or spreadsheet. Not only does this make blockchain-based transactions more expensive, but it also creates a large carbon burden on the environment.
Because of this, some industry leaders are beginning to move away from certain blockchain technologies, such as Bitcoin. For example, Tesla CEO Elon Musk said last year that his company would stop accepting Bitcoin, in part because he was concerned about the damage to the environment.
Risk of loss of assets
Some digital assets are secured using a cryptographic key, like cryptocurrency in a blockchain wallet. You must guard this key carefully.
“If the owner of a digital asset loses the private cryptographic key that gives them access to their asset, there is currently no way to recover it — the asset is gone permanently,” says Gray. Because the system is decentralized, you cannot call a central authority, such as your bank, to request access again.
Potential for illegal activity
Blockchain’s decentralization provides more privacy and confidentiality, which unfortunately makes it attractive to criminals. It is more difficult to track illegal transactions on the blockchain than through bank transactions linked to a name.
In fact, the Australian Competition and Consumer Commission (ACCC) has issued warnings about Australians being caught up in crypto scams.
How to invest in Blockchain
You cannot actually invest in the blockchain itself, as it is only a system for storing and processing transactions. However, you can invest in assets and companies that use this technology.
“The easiest way is to buy cryptocurrencies, such as Bitcoin, Ethereum and other tokens that run on a blockchain,” says Gray.
Another option is to invest in blockchain companies that use this technology. For example, US-based Santander Bank is experimenting with blockchain-based financial products. If you were interested in gaining exposure to blockchain technology in your portfolio, you can buy the stock.
For a more diversified approach, you can buy into an exchange-traded fund that invests in blockchain assets and companies. There are thousands of exchange-traded funds (ETFs) that offer Australian investors exposure to foreign shares.
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The bottom line
Despite its promise, blockchain remains something of a niche technology. Gray sees the potential for blockchain to be used in several situations, but it depends on future government policies. “It remains to be seen when and if regulators will take action. One thing is clear – the aim will be to protect markets and investors,” he says.
Shtylman compares blockchain to the early stages of the internet. “It took about 15 years of the internet before we saw the first version of Google and over 20 years for Facebook. It is difficult to predict where blockchain technology will be in another 10 or 15 years, but just like the internet, it will significantly change the way we trade and interact with each other in the future.”
Obstacles remain, particularly with the transaction limits and energy costs, but for Australians who do their due diligence and see the potential in the technology, blockchain-based investment may be worth considering.
This article is not an endorsement of any particular cryptocurrency, broker or exchange, nor does it constitute an endorsement of cryptocurrency or blockchain more generally.
