Blockchain is in the news a lot these days. Yet the technology is in the early stages of development, and the blockchain industry is full of charlatans and unjustified hype. It might be hard for a traditional alternative investment professional to get up to speed. Fortunately the Chicago Federal Reserve put out a basic introduction, which is also being used by the CAIA Level II Curriculum. Here are a few of the highlights that all alternative investment professionals need to know.
In Part 1, we’ll cover the following topics:
- How a simple distributed ledger works.
- How transactions are added to a blockchain
- How the blockchain consensus mechanism works. The differences between permissioned and permissionless networks.
A distributed ledger is simply a special kind of database that exists across several locations or among multiple participants, i.e. it is a way of mutualizing database infrastructure. It can be public or private, permissioned or permissionless. In its simplest form, each user can read and write from the database, and each user’s copy is automatically updated to reflect an agreed upon consensus.
A distributed ledger is not necessarily completely decentralized, but it will be more distributed than a typical relational database.
According to the Fed’s explainer:
Relational databases are centralized, with a master copy controlled by a central authority. Users sharing a database must trust the central authority to keep the records accurate and maintain the technological infrastructure necessary to prevent data loss from equipment failure or cyberattacks. This central authority represents a single point of failure; if the central authority fails, the database is lost. Users who do not trust one another must maintain separate databases that they periodically reconcile.
This chart shows a basic distributed ledger setup:
How a transaction works:
When a member of a blockchain network engages in a transaction, they submit the transaction to the network… The submission of the new transaction changes the state of the ledger (which is now in conflict with the state of other copies of the ledger. Once the new transaction is discovered by the network, the consensus breaks, forcing other operators to either validate and update their records with the latest change or reject the new addition to the ledger…. A consensus mechanism then confirms the submitted transaction as valid. There are various methods of achieving consensus on a blockchain, as we discuss below. At this point, it is simply important to understand that a blockchain database must have a mechanism through which participants agree to a change in the state of the ledger. Once consensus is achieved, all ledgers are updated to reflect the new state
Adding Transactions to the Blockchain
The key elements of a blockchain include its distributed nature, its immutable character, and its agreed upon consensus mechanism.
This chart shows how a transaction is added to a blockchain:
Permissioned vs Permissionless Networks
A permissionless open network is open to anyone who wants to transact. All users can see all transaction records. New transactions are added via cryptographic methods. Permissionless networks do not require central authority. This avoids central points of failure.
However financial markets might require a permissioned network for three reasons. First there are trusted intermediaries who assist with transactions. Second, complete transparency isn’t necessarily desirable. Third, regulatory requirements might conflict with a completely permissionless network. Therefore blockchain applications in finance are more likely to use permissioned networks. “Permissioned blockchains allow certain members to control the confirmation of transactions. These permissioning members (consensus authorities) can exert control in various ways depending upon the network design. They could be responsible for explicitly approving transactions. Another option would be to designate the permissioning members as the sole members of the network able to participate in a cryptographic consensus mechanism.
There is controversy in the blockchain industry over whether permissioned or permissionless networks are better:
Some argue that a permissioned blockchain removes “a major benefit of the blockchain system: the system works between parties that do not need to trust each other. If the concept is to implement permissioned distributed ledgers between trusted [parties] … why would you use blockchain technology when more efficient alternatives are available?”5 However, permissioned blockchains retain many key features and benefits of permissionless blockchains, including the decentralized storage of the database and the (near) real-time reconciliation of all copies of the database. They also alleviate some of the problems posed by the permissionless system, including its need for substantial computing resources to confirm transactions.
How a Consensus Mechanism Works
Consensus mechanisms are necessary to add blocks to a blockchain database. The specific way a consensus mechanism works varies depending on the design of the blockchain. If it’s permissioned, then it might require approval of a central authority. If it’s permissionless, then it might require some cryptographic confirmation. For example, the bitcoin blockchain uses a proof of work consensus mechanism.
On the bitcoin blockchain, individuals known as miners compile submitted transactions into blocks. They confirm that those spending bitcoins mine each transaction received those bitcoins from some earlier transaction recorded on the blockchain and race to solve a difficult computer problem; the first miner to solve the problem confirms their block and adds it to the blockchain. The miner is awarded a certain number of bitcoins in return. Because every user on the blockchain has access to the entire ledger, users can confirm for themselves that the latest block of transactions added to the chain records valid transactions, that is, that the users spending bitcoins in the latest round of transactions received them in some earlier transaction and have not yet spent them.
In part 2 of this post will examine post trade settlement, and other key things to implementation considerations for blockchain.