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Blockchain

Blockchain enables the ownership of virtual property to be determined beyond doubt, as well as allowing ownership rights to be freely traded. The technology eliminates the need for a central ledger. The Center for Innovative Finance (CIF) at the University of Basel is investigating how these technologies are affecting business and society. The research unit is supported by Credit Suisse Asset Management, which has endowed a professorship in Distributed Ledger Technology (Blockchain)/Fintech.

Security, efficiency, and reliability – these have always been the criteria on which payment and transactions systems are judged. To become established, a new system has to offer an improvement in at least one of these dimensions. Cash was better than bartering because those involved in trading no longer needed both parties to have exactly what the other required. Credit or debit cards are often more efficient than cash as payments are processed electronically, removing any geographical restrictions on handing over payment. Not only that, if a credit/debit card is mislaid balances are not automatically lost, which is a major advantage over cash. The same is true of bank transfers, which have now become the norm – especially for large amounts.

But however efficient these electronic payment systems are, they all share one key drawback. Every transaction has to be processed centrally to prevent double spends – situations in which a person tries to spend the same electronic money more than once. This issue does not arise with physical means of payment such as cash, as every coin and note only exists once and the unit of value is transferred to its new owner along with the physical currency. In contrast, electronic data can be copied countless times. To take one example, imagine a money file that you could send as an email attachment. Like Word or music files, any number of copies of the money file could be created and sent to different people. It would be possible to replicate money at will, therefore making it worthless. But if there is a central database, electronic account balances belonging to the persons involved in transactions can be amended unequivocally, preventing people from spending more than they actually own or their limits permit.

At this point I should stress that centralized databases are highly efficient. As things stand there is no truly decentralized system that can deliver comparable speed or efficiency. However, the very efficiency of these centralized systems depends on a huge level of trust. If someone has exclusive control of the database and the power to make decisions affecting its current status, they have to be trustworthy. Otherwise, major problems may arise. If someone controls the database, this person could – in theory – seize credit balances, censor transactions, or completely exclude specific persons. Happily, in Switzerland scenarios like this are not an issue and seem far-fetched. But we should be aware that such incidents are not without historical precedent in some places. Furthermore, attacks can also be perpetrated by third parties, and centralized databases create a vulnerable point in an overall system, otherwise known as a single point of failure. If an attacker succeeds in disabling a central node in the system, this can have far-reaching consequences.

This is precisely where blockchain comes in. The technology enables management of a database to be shared. In public networks, any participant can hold a copy of this ledger and independently verify the accuracy of all the entries in it. A sophisticated system of incentives means it is in the interest of all participants to manage their own database in accordance with the shared rules. This ensures consistency across the various ledgers, creating a consensus as to which transactions are valid. If a person makes changes to their own copy of the database that breach the rules, this version can immediately be identified as invalid by the other network participants and therefore ignored. As none of the network participants have a privileged role and the data can be stored anywhere, there is none of the cluster risk inherent in centralized systems. All participants are replaceable, and network connections can adapt dynamically if individual participants leave.

Interestingly, the components of blockchain technology have existed for many years. Decentralized peer-to-peer networks are by no means a novelty. This is also true of public key cryptography and the hash functions that are used to verify transactions and reach consensus. What is new, however, is the way in which these technological components have been connected and combined into an overall system. These connections are what have enabled virtual assets to be held independently, with all the upsides and downsides this entails.

Great power comes with great responsibility

There is a fine line between the benefits and drawbacks of this new technology. If people have custody of their own units of value, they have complete autonomy over what they do with their assets. Assets can be transferred directly from A to B without any need for a chain involving multiple intermediaries – 24/7 and generally within a few minutes. This compares favorably with systems that only operate during office hours and do not deliver the funds until two days later in many cases.

Yet this autonomy also entails great responsibility. If someone’s private key is lost or falls into the hands of a third party, the crypto-assets will be irrevocably lost. As a result, many people decide to store their cryptoassets with providers of custody services, contradicting the spirit of public blockchains in general.

The fact that blockchain gives holders of cryptoassets a choice is undoubtedly positive. They are free to choose whether to make use of these custodial services or hold the cryptoassets themselves. These virtual units of value have therefore broken new ground. As a result, this technology may be useful in the specific context of the debate over the systemic importance of individual corporations.

Blockchain – the investor perspective

Blockchains can also be used for other purposes. For example, companies can issue tokens, units of cryptoassets that represent securities. Just imagine you hold your securities yourself in your personal crypto wallet. Dividends and interest payments are distributed automatically. As far as trading is concerned, you can choose from a large number of exchange platforms, some of which are themselves completely decentralized and based on autonomous smart contracts. Any voting rights are linked to the token and can be exercised – quickly and securely, of course – using an electronic signature.

Unlike cryptocurrencies, these tokens are subject to issuer risk. Nonetheless, these cryptoassets can also benefit greatly from decentralization when it comes to transfers and custody. From an economic perspective, the option of decentralized, autonomous management is very welcome and makes systems more robust.

Furthermore, tokenization covers far more than conventional securities. To take one example, imagine that a museum creates 1,000,000 tokens representing partial ownership of a painting. This would give investors the chance to acquire tiny shares in a wide variety of assets, enabling them to diversify their portfolios to a previously unimaginable degree. The museum could use the funds raised to purchase additional works of art. A similar approach is conceivable for solar power plants, a football club, or indeed more or less any asset. Even though many of these visions would require legislation to be amended, I would go as far as to say that we are no longer very far away from a future in which many new asset classes will be created and tokenized.

Nevertheless, I should sound a note of caution at this point. Blockchain is frequently portrayed as some sort of universal remedy, and the technology is being used for all manner of purposes for which it is completely unsuitable. This is very unfortunate and sometimes leads to frustration with the technology when people finally realize that they should not have used blockchain in this particular context. Yet these projects should not obscure the fact that there are certainly useful blockchain applications. The technology has huge potential as long as it is deployed correctly. To sum up, we can say that the variety of ways in which blockchain can be used is being substantially overestimated. At the same time, the effect that blockchain can have on the areas in which it can be deployed successfully is being significantly underestimated.

Scope – the magazine

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