Blockchain is often difficult to understand and is usually thought of in relation to cryptocurrency. But this dynamic technology is being used in new and innovative ways to securely manage all kinds of data.
Blockchain technology evolved from a transaction recording mechanism that has been used for centuries – the financial ledger. Analyzing the financial ledger processes that preceded blockchain can help build an understanding of how the technology is being used today.
Historically, a bookkeeper would record the dates and amounts of financial transactions within the ledger. This eventually shifted from a pen and paper book to the digital formats we see today. Despite modernization, the concept of keeping a ledger has remained fundamentally the same: a centralized single source of truth to record financial activities. The integrity of a ledger is essential, where individual contributors who update the ledger and the centralized system need to be extremely trustworthy, reliable and accurate in their entries.
This system has its flaws, as it leaves room for human error or deceit. There are risks for information to be tampered with, transactions to be inaccurately recorded or data to be lost if something goes wrong with the single ledger system being used. Thus, blockchain was created to solve these issues.
The Inception of Blockchain and Cryptocurrency
In 1991, cryptographer Stuart Haber and scientific researcher W. Scott Stornetta invented a system that ensured that document timestamps could not be altered. They are often credited to be the co-inventors of blockchain technology, because of the way their system stored and secured data using hashes – but more on those later. A year later, mathematician Dave Bayer helped incorporate a data structure called a Merkle tree into the system’s design to improve its efficiency.
The rise of cryptocurrency began shortly after Haber and Stornetta released their original paper, “How to Time-Stamp a Digital Document” (1991). And while several versions of cryptocurrency were created throughout the 90s and 2000s, only one from that period has stood the test of time: Bitcoin. In 2008, a person or group of people using the pseudonym Satoshi Nakamoto posted the whitepaper titled “Bitcoin: A Peer-to-Peer Electronic Cash System” on a mailing list. The most cited work in Nakamoto’s whitepaper was Haber and Stornetta’s, “How to Time-Stamp a Digital Document,” as Bitcoin was the first cryptocurrency to rely on blockchain. Nakamoto is credited as the primary inventor of blockchain technology. However, the Bitcoin blockchain is used solely for digital currency transactions.
In 2011, a brilliant Canadian teenager named Vitalik Buterin discovered cryptocurrency and began writing blog posts about Bitcoin in exchange for coins. Later that year, Buterin co-founded an original cryptocurrency news publisher known as Bitcoin Magazine. Buterin did extensive research on blockchain and wanted to create a platform that exceeded the capabilities of Bitcoin. He envisioned one single blockchain that everyone could use as a foundation to build their own applications on. By late 2013, Vitalik Buterin had released a white paper for Ethereum: a decentralized, general purpose blockchain.
Ethereum officially launched in 2015, and like Bitcoin, it offers cryptocurrency that can be exchanged without centralized intermediaries like banks. However, Ethereum is a platform, and Ether is its currency. And unlike the Bitcoin blockchain, the Ethereum blockchain also has the capability to power:
- Decentralized apps (dApps): developers can code applications and then use the Ethereum network to deploy their app. This way, developers can harness blockchain advantages for their app (such as security and privacy), without having to construct their own blockchain. Common types of dApps on the Ethereum network include token exchangers, investment trackers, social medias or blogs and games.
- Smart contracts: a piece of code that mimics a real-world contract, except there are no intermediaries, (no lawyers, brokers, agents, etc.) The smart contract alone is coded to collect and store the data, then execute the corresponding action once the conditions are met. Typical uses of smart contracts regarding cryptocurrency are flash loans and crypto trading. But a more relatable example commonly used to illustrate the capabilities of smart contracts is insurance. For instance, crop insurance: perhaps a smart contract is coded to hold thousands of dollars that the insurance company has invested. If the temperature exceeds 35 degrees Celsius for five days in a row, the smart contract deposits money into the accounts of farmers who purchased crop insurance.
- Non-fungible tokens (NFTs): they were first seen back in 2014, but NFTs became incredibly popular in 2021 and have maintained a major presence in the crypto community. NFTs can be found on other blockchains but are most often held on the Ethereum blockchain.
To break down how this technology works, we can look at how blockchain solves many of the inherent problems with previous methods of ledger-based record keeping. There are four key points to understand how blockchain works:
- Decentralization: there is no single entity responsible for inputting and validating data the way a bookkeeper would. Information of any kind is stored using a ledger system that is decentralized and distributed across a network of computers. The decentralization of these systems means that there is not a singular entity acting as a middleman for transactions, or harboring all of the data. No one institution such as a bank or government has full control, responsibility or risk.
- Distribution: any computer on the network has access to the blockchain and the data contained in the ledger. A “block” stores data and is simply a collection of records for a particular period. The “chain” in blockchain metaphorically represents how blocks are chronologically organized and linked together on the network.There is not one singular location where data is stored. Everyone participating in the blockchain network has a copy of the ledger where the data is being recorded. This distributes power and decreases risk.
- A Proof-of-Work (PoW) model: the computers on the network must agree that the data being recorded is valid, or the block will not be added. Using the cryptocurrency Bitcoin as an example, the data being recorded on the block (or ledger) represents transactions between users. You’ve likely heard of mining Bitcoin – this is where blockchain technology really comes into play. When a certain number of transactions are recorded on a block, in order to be added to the network (or “mined,”) a unique cryptographic puzzle for that block must be solved. The users of Bitcoin and their computers on the network are all competing to solve the puzzle first. In the case of Bitcoin, the user whose computer solves the complex cryptographic puzzle for the block is rewarded with an amount of the digital currency. The victorious computer is required to share its solution with the other computers on the network, which then must validate that the solution is correct. This collaborative model allows the users on the network to work together to ensure legitimacy, without having to trust or even know each other. In the case of Bitcoin, transactions will not go through and will remain in a pending stage until the network validates the block on which the transaction is recorded – meaning Bitcoin transactions are not instant. If the network validates the solution, the block can be added to the blockchain – once a block is added its data cannot be backdated or tampered with. This process of validation also makes blockchain technology extremely secure. The inherent security makes this technology well-suited to other uses outside of cryptocurrency, which we will explore.
- Secure cryptography/immutability: the cryptographic math problem typically needed to be solved in blockchain is called a hash function. These functions are not reversible, meaning that it would require unfeasible computational power to calculate the input of the function if you and your computer only had the output to analyze. Already solved blocks on the blockchain are timestamped and locked using these kinds of complex math functions, making them secure and immutable –meaning the data cannot change. Since Bitcoin is public and records transactions, cryptographic digital signatures are required to ensure that no one attempts to falsify the transactions.
What Does Blockchain Hold for the Future of Credit Unions?
DeFi, or Decentralized Finance is the umbrella term for the financial transactions and inventions that are on public blockchain technology, like cryptocurrency. DeFi has sparked global interest and disruption within the finance industry, which can feel threatening to some financial institutions. But cryptocurrency in particular faces a lot of criticism. Influential investors like Warren Buffet have deemed it unproductive and limited. Energy intensive crypto mining is now recognized as being bad for the environment. And the complete lack of government involvement intrigues some but creates a barrier of distrust for others. Ethereum is set to update in the upcoming months in order to mitigate some of these issues and will be switching from a Proof-of-Work to a Proof-of-Stake model. But even then, there will still be critics.
Adapting to the circumstances by integrating the positive concepts of blockchain technology into consumer banking is the best path forward for financial institutions. Smart contracts in particular could provide advancement for the banking industry. According to a recent article, “They are tamper-resistant, self-executing, and self-verifying. They are also changing the face of the banking industry in the form of error-free processing of insurance claims, smooth peer-to-peer transactions, streamlined KYC processes, transparent auditing, and so on.”
Ultimately, while cryptocurrency has been the main use of blockchain technology, the landscape is evolving. Blockchain’s secure and immutable properties can be used for storing medical records, tracking supply chains, recording land ownership and more. And of course, the usage of smart contracts could provide the elements of security, transparency and efficiency that consumers are seeking in their day-to-day banking.