This second article in the series by Dr Jag Kundi, a Hong Kong–based scholar-practitioner active in the FinTech space, explains what blockchain is, how it works and its important relationship to governance.
Governance is a system of rules, policies and processes to direct and control an organisation. It aims to balance the interests of the various stakeholders of a company. A primary objective is to centralise information and oversight in the board of directors. How to reconcile this with blockchain? Blockchain is a distributed and decentralised ledger technology that permanently records every transaction made on its network. Combined with smart contracts, blockchain has the potential to revolutionise governance by making the transaction of money, property and shares transparent and conflict free, especially amongst private companies.
What is blockchain?
Blockchain is bringing on a fundamental shift in the way we carry out business transactions, banking, education, governance and pretty much everything else. Blockchain has been publicised to be the next generation of the internet (the internet for the exchange of value, rather than the internet for the exchange of information), as it is no less transformative in its potential to liberate the commercial and business world than the advent of the internet that proliferated global exchange of information.
Blockchain combines the power of peer-to-peer technology with strong encryption to facilitate a secure, decentralised (distributed) ledger that overcomes the problems of single point of vulnerability, distribution of data and its control, bandwidth limitations and the problem of double spend. Blockchain has the potential to move any kind of data swiftly and securely, and at the same time, make a record of that change available instantly and permanently to anyone. The first cryptocurrency, called Bitcoin, is powered by blockchain.
In the simplest of terms, we can think of a blockchain as a shared and synchronised digital database that is maintained by a consensus protocol, an algorithm, and stored on multiple nodes – the computers that store the local version of the distributed ledger (see Figure 1: How does blockchain work?). The purpose of the consensus protocol is to ensure that all participants in a blockchain agree what constitutes a ‘block’ – a grouping of multiple transactions added to an existing chain of blocks. These blocks are chained to the existing ledger through a hashing process (cryptography). A hash is a function that converts an input of letters and numbers into an encrypted output of a fixed length. Think of it as a unique ID, a ‘digital-fingerprint’ that represents information as a string of characters and numbers. Consensus occurs when more than 50% of nodes conclude that a message is authenticated and verified so can be added as a block to the blockchain. The most popular consensus protocol on blockchain is Proof of Work (PoW), as used by Bitcoin. However, due to the extreme amounts of energy and computational power needed, it is not so practical as a business blockchain. An alternative would be Proof of Stake (PoS).
Blockchain was actually a spillover effect from the development and implementation of Bitcoin. Satoshi Nakamoto, a pseudonym, who authored the first Bitcoin white paper in 2009, developed the technical infrastructure needed for Bitcoin. Blockchain was part of this technical infrastructure, but has since become more relevant in its own right.
Blockchains also come in many ‘flavours’. Rather than think of them of as a single type of technology, it is maybe easier to consider them as a class of technologies (see Figure 2: Types of blockchain). They can be public or private, permissioned or unpermissioned and centralised or decentralised in their technological set-up and governance structure.
Traditional ledger systems
The underlying technology for a blockchain is not new; it is in fact hundreds of years old – think of ledgers. Ledgers are the building blocks of double-entry accounting and are based on the notion that each party in a business transaction will either receive or give something. In accounting terms, a ledger is a system to record what is received (a debit) and what is given (a credit). Accounting practitioners will recognise this representation via ‘T-accounts’ – where debit entries are depicted to the left of the ‘T’ and credits are shown to the right of the ‘T’.
Interestingly, the word ‘debit’ comes from the Italian word debito which comes from the Latin word, debita and debeo, which mean ‘owed to the proprietor’ or an asset of the proprietor. Whereas the word ‘credit’ comes from the Italian word credito which comes from the Latin word credo which means ‘trust or belief’ in the proprietor or owed by the proprietor.
Versions of a double-entry system were practised in Florence in the late 13th century by merchants and bankers. Luca Pacioli’s reputation as the ‘father of modern accounting’ is on the basis that he codified this system and published it. In effect he was the first person who produced the GAAP for bookkeeping!
This concept of ledgers and double entry, as refined and published by Luca Pacioli, initially worked well for tangible assets and physical goods as indicators of economic value – who owes/owns what. This system served its users well as long as the underlying assets were tangible, that is observable and measurable – it was perfect for score-keeping in transactions involving physical assets whether land, buildings or inventory. Max Weber considered that the invention of double-entry bookkeeping was fundamental to the development of capitalism.
However, in the 21st century value is being defined, created and shared across digital platforms and much of this value is intangible in nature – such as big data. As economies shift more and more into intangibles as drivers of economic value, then the double-entry bookkeeping system of recording, classifying and summarising needs an upgrade. Witness companies like Apple that create significant value out of intangible assets through combining design and software – both intangibles. These are then shaped to give the consumer the ultimate user experience – again an intangible. This may help to explain why Apple has a market value approaching US$1 trillion, and why Alphabet (the parent company of Google) and Amazon are close to these breathtaking valuations.
The new ledgers of blockchain
Blockchain takes the concept of a ledger one step further by introducing the idea of a decentralised (distributed) ledger as opposed to a centralised ledger (see Figure 3: What is a distributed ledger?). More importantly, blockchain allows the creation and authentication of digital assets (digital tokens) that can be exchanged for value. These digital assets would not be recognised in the traditional accounting ledger systems as they are intangible.
The process of tokenisation refers to issuing a blockchain token that digitally represents a real tradeable asset (see Figure 4: Tokenisation simplified). Such tokens can be stored and managed on a blockchain network. Tokenisation can have tremendous impacts on trading and investment, by offering greater transparency, liquidity, data integrity and exchange potential.
As the digital tokens are verifiable and belong to a party at a point in time (that is, ownership can be assured), the blockchain can avoid the problem of double-spending. Imagine a digital asset like a picture or video; this can be shared multiple times via email over the internet at no additional cost – it is subject to endless digital reproduction. A physical picture or video recorded on some media such as a Blu-ray disc can only be accessed by one person at a time via that media. However, posting the picture on an online site or streaming the video (Netflix) allows the simultaneous viewing (or consumption) by millions. The existing internet has effectively created ‘digital abundance’ for us all. We have access to a vast amount of information at almost zero cost. Whilst beneficial for users, there is a cost for the producers of this information, whether they are individuals or businesses.
What blockchain has done is introduce scarcity to the digital world. As Simon Dingle says, blockchain has created ‘digital scarcity’. Because digital assets cannot be copied or double-spent, they are unlike any previous digital asset and that scarcity adds value. That value can be recorded, maintained and authenticated via the blockchain. Hence, the reference earlier to blockchain as the internet for the exchange of value.
Using blockchain, the issuance of digital assets can be limited and timed. Each digital asset can also be linked immutably to its owner/creator, who has full control over the digital asset until it is sold or transferred to another owner. This algorithmic verifiable ownership makes it easier to proliferate digital scarcity. As a result, content creators can now charge for their digital content as their digital assets can be monetised. Consequently, it is expected that a whole new blockchain economy will emerge from this with less dependence on advertisers and commission or fee-seeking intermediaries. This will create another set of governance related issues. These blockchains will become of increasing value – Metcalfe’s Law states that a network’s value increases exponentially with each additional participant.
With the emergence of a new blockchain economy, agreed-upon transactions would be enforced autonomously following rules defined by smart contracts. A smart contract is a computer protocol intended to digitally facilitate, verify or enforce the negotiation or performance of a contract. Smart contracts allow the performance of credible transactions without third parties being involved. Taking a logical step further, this could manifest itself in a new form of organisational design – decentralised autonomous organisations (DAO), which effectively would be organisations with governance rules that conform to the business logic specified in blockchain.
For now, the legal aspects around blockchain are still not clearly identified or defined. This technology is evolving very rapidly (witness the extraordinary high level of investment being channeled into blockchain companies, which should hit US$2.9 billion in 2019 and is forecast to be US$12.4 billion by 2022 according to International Data Corp), yet the regulatory framework is far behind. Regulators have to contend with the challenges set out below.
Existing IT governance issues
Security and safety regulations around wider blockchain adoption need to be improved and updated. You may well ask how it would be possible to govern a decentralised, publicly available and permissionless ledger? The security of blockchains have several layers that may include:
- the basic requirements for the transaction information
- trusted portals for presenting transactions to the network
- the number of participants (nodes) in the network
- the difficulty of the algorithmic puzzle required to ‘mine’ a block of transactions that are encrypted correctly
- required consistency with the previously validated historical record as part of the transaction information and encryption process, and
- the quorum/number of other ledger participants that is needed to confirm the blocks’ encryption solution before its acceptance onto the permanent record across all ledgers in the network.
In addition, the wider use of smart contracts, DAOs, digital signatures, privacy concerns and asset ownership all add to the complexity mix for regulators.
Property rights and tax regulations
The development of clear, legally enforceable property rights (in particular, via the rules and laws surrounding software creation, maintenance and updating, and IP ownership), as well as appropriate tax regulations, will be key issues. The issue of tax is a particularly vexing one for governments. Blockchain businesses are quite unique in their ability to create valuable, tradeable cryptoassets (via the tokenisation process) to self-fund their initial development, despite not having established businesses. Such cryptoassets give rise to a number of tax consequences depending on their character and age. As the most valuable part of many of these businesses, the use and/or trading of these assets may constitute the single biggest source of revenue for blockchain companies. For the accountants, cryptoassets present challenges around the areas of accounting for intangible assets and revenue recognition. As such they would be of significant interest to tax authorities and regulators.
Market depth issues
At the moment this is a very specialised niche market. Increasing market depth would require incentivising the market to attract more market participants and to increase frequency of transactions. In the state of Delaware, where a majority of Fortune 500 companies are incorporated, tests are being undertaken to develop a distributed code-based ledger that would allow companies to register shares, undertake proxy votes and do all of their public filings on blockchain. Called the Delaware Blockchain Initiative, launched by the then-Governor Jack Markell, the state had plans to make Delaware the first state to embrace this technology as a way of upending the way businesses govern and finance themselves. The state saw this as a natural first mover advantage that would unleash this disruptive technology into the business community.
The implications for governance
Solutions to the regulatory challenges set out above are not insurmountable, but challenging. The emerging blockchain-driven economy necessitates a reassessment of established notions of governance. How exactly governance will respond to these changes is still unclear. However, the value and usefulness of the blockchain economy will be dependent on the introduction and implementation of an effective governance infrastructure, which will ultimately depend on a deep-dive understanding of the phenomena.
Different countries have taken different approaches here, which further complicates the issue, rather than aiming for a unified standard approach (See Figure 5: Blockchain regulatory regimes around the world). Although there is a certain amount of hype associated with blockchains, they are rapidly transforming the way the world economy works. For the first time in history, blockchains will make it possible for people all over the world to transact securely on a peer-to-peer basis without trusted intermediaries. The creation of a new blockchain economy based on dis-intermediated individualised markets with new business models will pose challenges for law makers, policy makers and regulators. This will require coordinated and concerted efforts at the global level by regulators. An ad hoc country by country approach to regulations will simply mean that businesses will country-shop for the friendliest regulations and avoid heavily regulated countries.
The challenge will be for individual regulators to ensure that their regulations encourage innovation in this space rather than overly regulated environments that stifle creativity
Blockchain promises so much but will it ultimately deliver?
Dr Jag Kundi
Dr Jag Kundi is a Hong Kong-based scholar-practitioner active in the FinTech space. He can be contacted by email: email@example.com, or via LinkedIn: www.linkedin.com/in/jagkundi.
This article is part of a series of articles in which Dr Kundi explores the interaction of emerging technologies of the digital era with governance and ethics. Future articles in this series will explore the impacts of articifical intelligence and machine learning.