What is Blockchain?

The word “blockchain” never appears in the paper that popularized the concept. Satoshi Nakamoto, the pseudonymous publisher of the 2008 white paper “Bitcoin: A Peer-to-Peer Electronic Cash System,” sought a way to overcome an “inherent weakness of the trust based model” in today’s payment systems.¹ Essentially, he, she or they seemed to think the current financial system worked pretty well, but could benefit from a means to make payments peer-to-peer without needing a trusted intermediary like a financial institution. This new system, Nakamoto thought, could reduce fraud and transaction costs.

What later became known as blockchain was the answer to the fundamental problem the author(s) needed to solve in order to achieve their stated goals. To change the trust model from one reliant on a central authority, the system had to prevent double-spending of electronic “cash.” To do that, Nakamoto suggested a combination of known elements, including:

• accounting ledgers
• distributed computing
• a decentralized consensus protocol
• cryptography (digital signatures, asymmetric key pairs, hash algorithms)
• an incentive or reward structure

Bitcoin was the first application to run on a public, decentralized platform with all of these features. Though none of the elements were new in and of themselves, the combination represented an innovation potentially applicable in a number of business use cases.

Some have suggested blockchain will enable the “internet of value,” where transfers of assets, resources, intellectual property, and data can be exchanged between parties without needing an existing relationship or the establishment of trust either directly or through a third party. Supporters claim the math supplies valuable features like non-repudiation to prevent fraud, resilience through decentralized systems, and efficiency through the elimination of intermediaries between transacting parties.

The Sum of Its Parts

Nodes

The public nature of the Bitcoin blockchain makes it attractive for its users in many ways. Because it is public, everyone who participates in the network has a copy of the ledger. To participate, a user typically establishes one or more “nodes” on the network. A user may decide to become part of the verification network or may decide to be a more passive participant. In a public blockchain, everyone has the ability to view all of the transactions committed to the ledger.

Block

A block is a data structure containing information on a group of occurred transactions. Blocks are added to the end of the chain and, once added, the chain cannot be altered. Every node has a copy of the blockchain.

Digital Wallet

In addition to establishing a node, a participant needs a means to transact on the network. They do this through establishing a “digital wallet,” a piece of software capable of managing the inputs and outputs of transactions and generating asymmetric key pairs, one private and one public.

Public and Private Keys

The public key is seen by all and is used by participants to direct and receive funds, similar to your home address or email address. The private key is used to “sign” or authenticate transactions. Think of a private key as something like a personal identification number. It is supposed to be a secret that only you know, and it is used to validate that the owner of the secret is also the owner of the value being exchanged across the blockchain network. The public and private keys are computationally related to each other, but can’t be derived from each other, so knowing one does not mean you can figure out the other. When a transaction is initiated, a participant enters the public address of the wallet he or she is sending funds to and signs the transaction with their private key. But before this transaction can be considered complete, it must be checked for correctness in formatting, bundled into a block, and added to the chain. Now, every node in the network can check that the block is valid. As mentioned, some participants just transact. Others earn incentives by doing the work of bundling the transactions into blocks.

Miners

Participants who wish to earn the incentives built into the platform “compete” for the right to add the next block in the chain. These participants are known as “miners.”

Miners, like most participants in the network, are known only by the public key address used by all participants to send and receive transactions. In addition to transaction fees, miners earn rewards in the form of Bitcoins when they solve a computationally-intensive puzzle and win the right to add the next block in the chain.

Proof of Work

The puzzle requires a miner’s computer to crunch numbers until it finds a combination that produces a number that meets the criteria designated by the protocol. This math problem is difficult to solve, but a correct solution is easy for others in the network to verify quickly. Known as “proof of work,” this protocol produces a consensus among participants that the blocks in the chain are valid, showing that the “state of truth” for the blockchain is accepted by all participants.

The process of investing computing power to earn rewards maintains the network because it does the work of adding transactions to the chain, but it also incentivizes the continued participation, maintenance and existence of the network over time.

When a Strength Becomes a Weakness

Bitcoin’s blockchain and its governing protocol deliver much of what Nakamoto and others envisioned: a secure way to create a peer-to-peer value transfer system without a central authority. Central banks are among the many that have recognized the potential of the intersection of distributed database technology, cryptography, incentive structures, and ledger-based accounting—the blockchain.

But the same qualities that make the Bitcoin blockchain useful for its participants (it’s public, maintained through a decentralized participant-driven network, and pseudonymous) make it an unacceptable tool for most financial services business applications. There are no controls or barriers to directly joining a network beyond a computer and technical know-how. This is a problem when a business such as a financial institution is required to comply with Know Your Customer or anti-money laundering rules. If anyone can join the network without any processes to confirm identity, a business can’t know who’s on the other end of a transaction without an intermediary of some kind.

Both Bitcoin and Ethereum are meant to support public participation. The barriers to entry are low. You need only a computer capable of downloading the software and the skills to utilize it.²

A Focus on Smart Contracts

Innovators, inspired by the idea of blockchain, envisioned a more generalized platform capable of supporting numerous different applications. Among the first to consider how businesses might effectively utilize a blockchain platform was a 19-year-old Russian-Canadian. In 2013, Vitalik Buterin wrote a paper titled, “A Next Generation Smart Contract and Decentralized Application Platform.”³ The idea behind the Ethereum platform was born.

The ability of the Ethereum platform to support “smart contracts,” what Buterin describes as, “systems which automatically move digital assets according to arbitrary pre-specified rules,” offers a particularly compelling opportunity. With a smart contract, actions can be pre-programmed to execute based on different events. While “if/then” logic isn’t new, there’s potential in the ability to use sophisticated, self-executing if/then logic and complete transfers of value secured with cryptography in such a way that authenticity of the data, non-repudiation of the transaction, and a single shared data source among transacting parties can be achieved without necessarily trusting each (or any) party.

Blockchain Evolution Moving Forward

Just as blockchain platforms evolved to provide more robust (i.e., Turing complete) programming languages, more limited access to data on the blockchain and new consensus methods (e.g., proof-of-stake) will continue to evolve to meet the growing needs of the business and government entities looking to exploit them. Keeping up with the evolution will be worth the challenge.

The views expressed in this report are those of the authors and do not necessarily represent positions of the Federal Reserve Bank of Boston or the Federal Reserve System.