Blockchain and Distributed Ledger Technologies - Valkyrie

Blockchain and Distributed Ledger Technologies

Key Takeaways

  • When investors open a bank account or a brokerage account, their assets are tracked on a centralized ledger controlled and secured by a single bank or brokerage firm. The goal of blockchains is to distribute those ledgers around the world, making the information public and secured by thousands of computers worldwide.
  • A blockchain is simply a number of blocks chained together to enforce security and immutability. Each block contains transaction information such as the number of tokens bought and sold along with the addresses of the buying and selling counterparties.
  • The blocks are chained together using hashes, which are an encrypted summary of the transactions in each block. By including the hash of the previous block in the subsequent block, any changes to transaction histories becomes evident and miners and validators can restore the transaction history to the previously verified information.

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.

Figure 1: Illustration of a blockchain

Source: Paiementor (2020)

Proof of Work versus Proof of Stake

The bitcoin network is secured through a proof-of-work process, where miners compete to solve cryptographic puzzles. This community of hundreds of thousands of bitcoin miners running redundant ledgers makes the blockchain extremely secure, but it consumes vast amounts of energy. Bitcoin miners may use as much as 0.5 percent of the world’s electricity and emit more than 0.1 percent of greenhouse gas emissions. This energy usage may be larger than that of entire countries, such as the United Arab Emirates, the Netherlands, or Argentina. Recently, attention has been focused on this energy usage, with a drive by some market participants to increase the use of renewable energy and reduce the use of electricity generated by fossil fuels. Bitcoin miners frequently are located in geographic areas with very low electricity prices, and they often seek out innovative solutions such as moving mining machines to areas with abundant hydroelectric power during wet seasons and moving to another location when that cheap power is not available. The growth of bitcoin mining in Texas has been spurred by electricity generated with flare gas, which would otherwise emit methane into the atmosphere. Of course, bitcoin enthusiasts like to point out that the environmental impact of bitcoin mining is less than that of gold mining or investment bankers traveling the world in jet airplanes. China at one time was home to more than 65 percent of the global population of bitcoin miners, but negative publicity about the environmental impacts has led regional Chinese governments to evict miners[1].

Proof of stake is the alternative way to secure a blockchain; it calls for the owners of large holdings in a specific digital asset to secure the network by depositing assets into coins and locking the value into an operating network. Proof-of-stake projects include Cardano, Polkadot, Binance, Stellar, and Cosmos. Although the ethereum blockchain is currently managed through proof-of-work, an environmentally friendlier proof-of-stake process may arrive with ethereum 2.0.

[1] “China is Kicking Out More than Half of the World’s Bitcoin Miners,” MacKenzie Sigalos, CNBC.Com, June 15, 2021.