Blockchain and Distributed Ledger Technologies

Historically, the financial system has been enabled through a network of centralized counterparties, such as banks and brokerage firms. These counterparties facilitate borrowing and deposits as well as enable trading and custody of securities. These counterparties typically have a physical domicile where they are required to comply with local or national banking laws and securities regulations. Each nation has its own currency, which brings currency conversion costs to global trading. Each currency has its own government, central bank, and monetary and fiscal policies, which sometimes leads to hyperinflation and currency debasement, with the most recent extreme cases seen in Zimbabwe and Venezuela. There also are concerns about the risks that these counterparties bring to the global financial system, which was demonstrated during the Global Financial Crisis. These centralized counterparties also earn significant fees that can be reduced through a decentralized system.

Each of these counterparties keeps a private, centralized ledger of all the assets and liabilities in each customer’s account. Should that ledger be compromised due to fire, flood, cyberattack, or insolvency of the counterparty, clients may struggle to recover or identify their personal assets.

The goal of a distributed ledger system is to have multiple copies of these asset and liability accounts available on a publicly accessible network maintained by redundant ledger keepers. In the digital-asset world, the distributed ledger systems are termed blockchains.

If the distributed ledger on each blockchain is maintained by 1,000 globally distributed counterparties, the risk of failure of a single counterparty is reduced substantially.

Each public blockchain is designed to be global, distributed, and immutable.

Once a transaction is recorded on a blockchain, it can’t be changed. Each miner or validator—local operators who maintain a copy of the distributed ledger— records transactions to the blockchain. The term cryptocurrency is derived from the idea that these networks are secured by cryptography, which encrypts data to ensure that it cannot be changed. A focus of these cryptographic mathematical puzzles are hashes. An example of a hash is the 64-character output from bitcoin’s SHA-256 hash algorithm: f7225388c1d69d57e6251c9fda50cbbf9e05131e5adb81e5aa0422402f048162.

On the bitcoin blockchain, transactions are gathered for 10 minutes and then published as a block (see figure 1). The transaction records in each block will include the sender’s bitcoin address, the receiver’s bitcoin address, and the size of the transaction. When either of these addresses transacts again in the future, the ledger keeper will look back to this transaction to view the available balance of each market participant. The key innovation is that this structure prevents the double-spending of each currency or token.

Immutability of these records is enforced when each block is identified with a hash that is a unique identifier of the information contained in that block. The hash of the previous block is included in the next block, which chains the blocks together with a common identifier. If a single character in a block is modified, the hash will completely change and the mismatch between the two blocks will be recognized by the ledger keepers. Once this error is noted, the ledger keepers will go back into their records and replace the mismatched or recently changed information with the correct, original version of the transaction log.