I'm picking this series up after setting it aside for a while. A recap/reminder from Part 1.
What is the blockchain? At a very simplified, high level it can be thought of as a distributed database that maintains a list of records in blocks that are chained together in a specific order. Each block links to the history of the block that came before it, stamped with the time that it was created. The linking of these blocks to form this continual record is called “Blockchain”.
There are specific characteristics required to have a blockchain. It must be open and transparent. That is, all who participate on the blockchain need to be able to see the full history of the records that are stored there. For a public blockchain, it must be decentralized and distributed so that each participant in the process is able to see all of the records that are part of the blockchain. This creates trust among the participants without having to have a central intermediary as exists in many of today’s structures. It also allows for the storage of the same copy of all the records in multiple locations, so there is no single point of failure. There needs to be a consensus mechanism (or a validation process) to validate the records that are added to the chain. This allows for immutability of the transactions. Additionally, it needs to be totally secure.
In Part 2, we’ll examine the current landscape at a deeper level, to provide a better context for understanding Blockchain.
In today’s environment, when people or organizations want to move money or other assets from one point to another, they must use a “Trusted” intermediary as the central point for coordinating the transaction. This trusted organization maintains the records for these transactions in a central location and receives the input from the two or more parties involved in the transaction. The records must be updated when each transaction is completed. This all takes place using a central clearing house with a central ledger. The end to end transaction can take multiple days to process. Additionally, there is a significant fee for processing the transaction. An illustration of this process regarding the purchase of goods or services using credit cards is shown below.
This transfer of funds for the Customer, the Merchant and the associated Agencies requires trusted 3rd party coordination and processes to handle the details of the transactions. Complexity in the flow requires additional middlemen. This also requires the use of special equipment as part of the processing (such as, POS terminals, connection to Transaction networks, etc.), as well as systems for fraud detection, administration, billing, and reporting. Each step adds costs to the transaction process.
The Merchant faces additional issues, such as transaction fees of 1 to 3% and a slow settlement process. So, to the merchant, small transactions are very expensive.
Regulatory and compliance requirements must be met as part of the processing. When transactions cross borders, there are additional layers of complexity.
The entire process is cumbersome, error prone, slow and expensive.
Performing the same type of transaction on the blockchain is very different. If person A wants to move money to person B on the blockchain, then both need to have an identity on the blockchain in order to enter into the transaction. Their identities are protected with cryptographic public and private keys. The illustration below shows that on the blockchain A has an identity that can validate that there is $1500 in A’s account. Now A wants to move $500 to B. There is a ledger record created showing the reduction of the $500 from A’s account and the increase of $500 in B’s account. This is verified and validated through a proof of work consensus mechanism and the block containing the transaction is added to the blockchain. The illustration below depicts this process.
The blockchain technology allows anyone to move assets (contracts, or other item of value that has been digitized) from one individual or organization to another individual or organization following specific guidelines. Blockchain underlies the technology currently used by Bitcoin and other Cryptocurrencies as well as for a host of other purposes.
As we saw in the merchant illustration above, this transfer is already possible electronically using banks, brokerage houses and other financial institutions. What does Blockchain do differently than those organizations?
Blockchain provides a distributed mechanism to do the transfer of the assets. The diagram below depicts the centralized process that is used today vs the distributed process that is used by the blockchain.
Today, as was illustrated previously, if someone wants to purchase something from a merchant, they must use a 3rd trusted party to do that. For the work involved in doing the transaction, the institution involved takes a fee. Additionally, the transaction takes some time to complete the work. As shown in the above diagram, the records ownership in a centralized system must be maintained by a central clearing house to certify and clear all of the transactions being processed.
In a distributed ledger system, like the blockchain, the transaction is recorded on a shared ledger following specific protocols. This process is based on a chain of entries that are recorded, as each transaction takes place, is verified, and then added to the open ledger. As each entry is added to the open ledger, a communication is sent to the other nodes on the network to update their ledger based on the new transaction. The fee to do this work is minimal and the transaction is completed in a relatively short period of time.
The blockchain as used to process payments in the cryptocurrency network provides significant benefits, but it still has many drawbacks, especially regarding the length of time for completing the consensus process prior to updating the blockchain. Additionally, the management of private keys is cumbersome and presents some vulnerabilities when using mobile devices.
So, we can streamline the payment process using the blockchain. This will help increase efficiencies, reduces expenses and reduces a number of the vulnerabilities present in our current payment systems.
The next post will address permissioned vs permissionless blockchains.