Prologue

Blockchain is one of the buzz words of 2016. By the financial industry, blockchain is seen as the future. Its impact is compared to how internet has revolutionized the computer and global communications, like nothing before. Especially, financial parties seem to be investing in blockchain and the potential advantages this technology may offer to them. Undoubtedly many know what blockchain is all about. But probably even more don’t. This article is aimed at the latter. In order to help understand what this “buzz” is all about, blockchain is demystified in four consecutive parts:

Part 1. What is blockchain? 

Part 2. Transparency, Security and Governance.

Part 3. Thoughts around the regulatory environment on blockchain.

Part 4. Impact of blockchain on the financial sector.

Part 2.

What is the security model of a blockchain?

Or rather, who gets to make entries into the ledger? When do they get to make them? And why should anybody trust that the updates that are made are accurate?

The basis of the blockchain network is individuals, connected to one another via the internet, keeping copies of the blockchain on their computers. The purpose of this network is for all participants with a copy of the blockchain to agree on the state of that blockchain at any given time. The state in which all, or the majority of the network agrees on the same versions of the blockchain is called “consensus”, It’s from consensus that a blockchain running network achieves most of its security.

Proof of work mining.

The mechanism used to maintain consensus on who owns what at any given time is called “proof of work”. The primary goal here is to not have individuals broadcasting conflicting versions of the blockchain at the same time. Through using what’s called “proof of work mining”, consensus is maintained. Updates to the ledger should only be made one at a time. Which everyone else can then take a moment to agree with, and incorporate the update into their own copy of the blockchain. This is achieved using specialized computers called miners (or nodes). These miners solve self-adjusting math problems, also called “hash functions”. The difficulty of the math problem is set to increase as the numbers of miners on the blockchain network increases. This ensures that only one miner solves the math problem at a time and that it happens consistently every few minutes, and never at the same time. Miners compete amongst themselves. The first miner to solve the math problem gets a financial reward of newly created coins on the blockchain, and is the one who gets to create the next block.

Creating the next block consists of a few actions. The miner validates the respective transaction and adds it to its own the ledger. Next, the ledger needs to be synchronized across the network. This is done by publishing – broadcasting – the solution to the earlier mentioned math problem, as validation proof, and validated transaction to the network. This enables others to update their ledger accordingly.

This means that the new money created, is both predictable and transparent (the entire history of every unit is public in the blockchain).

Accounts.

Accounts aren’t organized by name like with a bank, but are rather tracked by alpha-numeric addresses (for example: u98un20d0f9j2if9f2467f). Transfers between accounts first require these alpha-numeric addresses, as a sort of “public key”. Secondly also a “private key” (known only to the account holder) is required. To initiate the transfer, the special software – a so called wallet – is used. The account uses the private key to digitally sign the transaction, broadcast the transaction to the entire network, so that they can update their ledgers accordingly once a miner solved the hash function.

Bitcoin fraud. Can the blockchain system be beaten?

This is the (only) paragraph where it gets a bit more technical and complicated, but it helps to illustrate.

Let’s suppose that a certain transaction from A to B takes place and the transaction amount is 1 Bitcoin. Imagine that A previously received 5 Bitcoins. So A’s Bitcoin wallet will create a transaction record that i) includes information about how A got these Bitcoins, ii) specifies that A wants to transfer 1 of these Bitcoins to B, and iii) specifies that 4 Bitcoins stay with A.

Bitcoin became the first digital coin (crypto-currency) in 2009. There were more than 710 crypto-currencies available for trade in online markets as of 11 July 2016.

Next, this transaction record is going to be broadcast out to the entire Bitcoin world (including A and B). You will recall, there are these special nodes, miners, responsible for making sure that everything checks out in the transaction from a global perspective. They look at the full – public –  record of transactions, the transaction blockchain. This Blockchain contains the history of every single transaction that has ever occurred within the system, from the beginning of time – the time of the first block – which in Bitcoin is known as the “genesis block”. Everyone can verify the details of any transaction due to the fact that the information is public. And in particular, what the miners will look at is whether or not A previously received 5 Bitcoins from anybody else, and whether or not A has tried to spend those Bitcoin previously.

If for whatever reason there is more than one version of the transaction blockchain out there, according to the protocol, everyone is just supposed to work off of the chain that had the most work put into it – the so called – longest chain in the system.

Let’s imagine that A is dishonest and decides to try to defraud the system by attempting to create another transaction in which the already owned 5 Bitcoins get double-spent. It’s important to keep in mind that if A simply tried to spend these same coins again, without trying to cover his tracks, everybody out there would know that A is up to no good (because they can see so from the existing longest transaction blockchain). So what A has to do is actually – on his own – create a different transaction blockchain that contains this second fraudulent transaction. Remember that since everyone in Bitcoin ultimately works off of the longest blockchain, A has a fighting chance.

The real question is, how likely is A to pull this off? A has to start off with the transaction blockchain that existed previously (before the transaction illustrated above), and has to try to add to that transaction blockchain a different (fraudulent) transaction. Rather than the one where A paid to B, an attempt needs to be made to now create a (fraudulent) transaction where for example A pays to C. This creates more than one version of history – known as a fork in the chain – but only one branch in this fork is legitimate (obviously the one containing the transactions from A to B for 1 Bitcoin).

Remember that any transaction block that’s added to this transaction blockchain, has to contain within it, a proof-of-work puzzle – or solution -, otherwise, no one will accept the chain. So if A wants to cheat the system, A has to secretly solve a new proof-of-work puzzle. But the challenge for A is that he’s starting off with a bit of a handicap because there’s already this longer chain out there that people have started accepting. Keep in mind that because this chain is out there, other nodes may have started to build on top of this chain. So if A wants to create his own fake chain, it has to be the longest chain. This basically means that A has to compete all the proof-of-works to create a chain that is longer. A has to outrun the existing proof-of-work chain, meaning not just typically solve one proof-of-work puzzle, but many. Fundamentally, whatever computing power A has access to, it needs to be more than the rest of the network – the computing power of all the honest nodes in the system – put together. In practice it will be quite hard for A to be able to create a fraudulent transaction chain simply because it’s impossible to outrun the honest people.

Coming up in the next posts:

Part 3. Thoughts around the regulatory environment on blockchain.

Part 4. Impact of blockchain on the financial sector.

ING’s short video on blockchain:

About the author

Norbert Braspenning – Managing Director Asia-Pacific – of ING Bank N.V. (wholly owned subsidiary Bank Mendes Gans N.V.). Norbert Braspenning is responsible for establishing and building market share Asia. As a vital resource to his prospective clients, he provides a vast knowledge of accounting, system, operational, legal and tax issues related to ING’s liquidity management solutions. Braspenning is a lead liquidity management solution expert with proven abilities to succeed collaboratively within a multi-cultural, complex organizational environment. In this post Norbert Braspenning expresses his personal insights, expert views and opinions with respect to the topic(s) discussed.

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