Blockchain: Disruption by Decentralization?

Blockchain is full of promise. Investment in the space totals billions of dollars. Large corporations, venture capital funds, and initial coin offerings are funding projects. The activity is not completely misguided; blockchain has the potential to disrupt economic activities ranging from simple payments to the structure of a corporation as it currently exists. In this first of three articles, we’ll cover the basics.

Traditionally, some of the strongest competitive advantages have come from centralization. Network effects, for example, can lead to huge profits for companies that centralize and control transaction activity--for example, payment networks, marketplaces, social networks, and futures exchanges. Similarly, centralization can create competitive advantages via economies of scale, as fixed costs are spread over a large number of transactions. Blockchain technology provides a way to decentralize three important economic functions: financial transactions, identity and data management, and marketplaces. Decentralized solutions could disrupt companies that create value by centralizing such activities.

Less than a decade since the introduction of bitcoin as a means to solve a problem in the realm of digital payments, the underlying technology it introduced is making it possible to decentralize all types of activities. Cryptocurrencies began as a threat to the payment industry, but it is becoming clear that blockchain technology and cryptoeconomics could someday threaten a wide variety of business models, and conceivably the traditional means of corporate organization itself. The decentralized autonomous organization allows algorithms or owners, rather than layers of bureaucracy, to govern an organization.

As with any new technology, blockchain has created intense debate among prognosticators. Some believe there will be no valid uses at all over the long run. Others have proposed that blockchain will disrupt nearly every industry and decentralized networks will eventually surpass the capabilities of most centralized companies. In fact, Ronald Coase’s Nobel prize-winning theory of the firm is based on the idea that the high cost of using decentralized markets is the very reason companies--with centralized management and delegation of activities--exist at all.

We suspect the truth lies somewhere in between. Blockchain technology has plenty of potential, but there are still obstacles to world domination. These include difficulties inherent in the technology itself, as well as the established economic moats of the incumbents in various industries.

A Brief History Bitcoin was not the first attempt to create a viable digital currency; interest in such a system dates back more than 20 years. The "cypherpunk" movement incorporating elements of philosophy, computer science, and mathematics--along with a strong desire for privacy--spawned a number of efforts. In fact, prominent figures in this movement are occasionally rumored to be responsible for the creation of Satoshi Nakamoto and bitcoin. False starts in the digital currency field include DigiCash (1989), E-gold (1996), and B-money (1998). PayPal was initially envisioned as a "new world currency" before finding success in the more mundane world of traditional payment processing.

Introduced in a 2008 white paper by the mysterious Nakamoto, bitcoin solved the problem of trust in online financial transactions. Previously, transferring digital assets required the involvement of one or more trusted third parties. For example, a customer purchasing a soda via debit card at a convenience store depends on effective coordination among his own bank, the merchant’s bank, and a card network such as Visa or Mastercard. These trusted third parties deal with the problems of double-spending and transaction reversal. The customer’s bank keeps a record of his spending, the card network assists in communication and funds transfer, and the merchant’s bank records and stores funds as they come in. Disputes are handled according to standards set over time by the networks and the participants in them.

Bitcoin, in contrast, uses a distributed peer-to-peer network to authenticate and record all transactions in the order they occurred, eliminating the need for intermediaries. In this way, participants can verify a clear chain of ownership for digital funds without relying on a trusted third party. The peer-to-peer network maintaining the digital ledger--or blockchain—is a decentralized record of transactions.

Others were quickly captivated by the technology’s potential and introduced rivals to bitcoin and new blockchain-based functionalities. Ethereum may be the most important of these later introductions. While bitcoin’s software performs relatively simple transaction processing, Ethereum’s software essentially provides an operating system by which the network can be programmed to perform a variety of computations, making it a “world computer.” A variety of applications (decentralized applications, or dapps) can be built on top of Ethereum. For example, EtherTweet is a decentralized rival to Twitter. While Twitter has a staff of paid programmers and its own data centers and servers, EtherTweet is open-source software running on the Ethereum blockchain. Thus anything that can be programmed can potentially be decentralized. That said, the technology is still in the very early stages. Nakamoto’s paper was published as the Internet celebrated its 40th anniversary.

Technical Summary The peer-to-peer networks that process instructions and maintain records in a blockchain depend on a few cryptographic principles and the mechanism laid out in Nakamoto's white paper. One of these principles is private key cryptography, which allows two-way message transmission using public and private keys. In one example, a sender can encrypt a message with the recipient's public key, ensuring that only the intended recipient (who possesses the associated private key) can decrypt it. Conversely, a user can use his private key to encrypt a message. The recipient can use the sender's public key to decrypt it, proving that the message was legitimately sent. This method can also be used to sign documents. A sender/signer can pair the hash (a unique, irreversible string of text generated by algorithm) of a digital document or asset with his private key. When the result is decrypted by his public key, a check of the decrypted hash against the accompanying digital document or asset proves the "transaction" is legitimate (any changes would not result in a matching hash).

A blockchain consists of a chain of such signed “transactions.” Each new transaction is joined to the existing chain, signed by the sender’s private key and the recipient’s public key, and can be verified by the sender’s public key. To ensure the data is accurate, the process is made more difficult with a proof of work. All computers in the network, upon receiving a new transaction, combine it with a nonce--a random string of text--looking for a desired output. In the case of bitcoin, the desired output is a long string of zeros at the beginning of the hash, but it could be any difficult-to-find string. The successful user is awarded new coins for his efforts, and the new block becomes the de facto standard for the network moving forward.

Blockchain zealots fiercely debate the technical definition of a blockchain. For our purposes, a blockchain is essentially a distributed database, with data shared across a network of computers, and a consensus mechanism--rather than a central point of control--used to ensure the accuracy and trustworthiness of the shared data. Some insist that a correct definition must include a description of the economic incentives involved, but we assume that both types of distributed databases pose similar competitive threats. We also acknowledge that the degree of centralization varies within the blockchain economy. Bitcoin and its peers are public blockchains--anyone is able to fully participate in the network. On the other end of the spectrum, private blockchains are open only to those with explicit permission to participate. For the purposes of competitive analysis, a variety of applications across the spectrum of decentralization are worth examining.

In addition to its distributed nature, an immutable record is another key feature of the technology. A blockchain incorporates a full history of transactions (changes to the database), ensuring that all participants can verify and agree on the state of the database. A block contains a group of transactions, while a blockchain contains multiple blocks. Very simply, when any change occurs (as in the case of a single transaction), the proposed change is broadcast across the network and verified by a chosen consensus mechanism.

Consensus mechanisms are another key feature of blockchains. Initially, bitcoin and similar applications used a proof-of-work method of reaching consensus. Proof of work involves a difficult system of trial-and-error computation. Nodes attempt to cryptographically transform the new data into a desired output, which must be done using trial and error. Once a solution is found, it is broadcast to the network, which incorporates the transaction into the existing blockchain. More recently, this costly and time-consuming consensus mechanism has been supplemented by other methods. One such method, proof of stake, typically combines a node’s standing in the network (measured by ownership, age, reputation, or other means) with other methods, including random selections.

Blockchains in all their permutations have several attributes making them potentially useful for a variety of business applications. A blockchain is ideally trustworthy, transparent, and decentralized. These features provide most of the technology’s appeal, allowing businesses to solve problems related to trust, recordkeeping, and transaction costs.