A blockchain is a digital ledger of transactions secured by cryptographic techniques and shared by a network of computer systems, so the records can be accessed simultaneously by multiple parties. This type of distributed ledger technology (DLT) was initially created for the peer-to-peer exchange of Bitcoin, but the opportunities for innovation extend far beyond cryptocurrency.
Theoretically, blockchain technology increases trust in business relationships by providing a transparent and tamper-resistant way to process and record transactions. Because no third-party intermediary is needed to settle transactions, they can be completed instantaneously and at a lower cost. Blockchain applications can also be programmed to automate how assets and/or contract obligations are issued, traded, and transferred from one owner to the next.
According to one forecast, global spending by corporations and governments on blockchain solutions is expected to surge from about $6.6 billion in 2021 to $19 billion in 2024.1 Just about any business or organization that depends heavily on a database might see potential in this emerging technology, but the financial services industry seems poised to lead the way.
How Blockchain Works
When a new transaction is added to a distributed ledger, the related data is encoded into a numeric string called a “hash” and recorded in a “block.” The key feature is that each new block contains the hash for the current transaction, along with the hash from the prior block, forming a chain that links all the data from every previous transaction together in chronological order. After each addition, the ledger is synchronized so that all network participants have an updated replica. This structure makes it extremely difficult to hack or cheat the system, because any bad actor trying to manipulate the record would have to get past security measures and alter the data — not just once but many times.
A permissionless (public) blockchain has no central authority, which typically means that any user may join the network, often anonymously. A permissioned (private) blockchain is managed by one authority or a group, so access to the data could be restricted for security, privacy, or general business reasons. The largest public blockchains, like Bitcoin and Ethereum, have thousands of “nodes” (the computer systems belonging to the network’s stakeholders), whereas a private blockchain may have only a few. Either way, a network’s nodes are relied on to “mine” new coins and order or “validate” transactions.
Transaction requests are broadcast to the entire network, then each of the nodes works to validate the legitimacy of the transactions and group them into their own separate blocks, while racing against the others to solve a complex mathematical puzzle through trial and error. The first node to determine the answer earns the right to add its validated block to the permanent record and is rewarded with a pre-set amount of cryptocurrency. This consensus protocol — the way in which network participants reach an agreement on the state of the ledger — is called “proof-of-work.”
A Critical Shift
One common criticism of blockchain technology is the immense amount of energy it takes to mine cryptocurrency and validate transactions. As of July 2022, the electricity needed to operate the Bitcoin network for a year exceeds the electricity consumption of entire nations such as Belgium and Finland.2 That’s because the proof-of-work method described earlier provides a strong incentive for miners to run the biggest, fastest, and most powerful computer systems available. It also results in a vast amount of electronic waste, as major mining operations constantly upgrade warehouses full of specialized machines to keep up with the competition.
However, some blockchains — Ethereum included — are taking an alternative approach known as “proof-of-stake.” With this method, nodes that contribute (or stake) some of their own cryptocurrency to the network are entered proportionally in a lottery to become validators. The bigger the stake, the better the chances of being chosen to validate transactions (and earn more crypto).
Ethereum is an influential, open-source blockchain that was designed to accommodate smart contract functionality, so applications can be coded to execute or enforce the terms of an agreement automatically when certain conditions are met. In addition to its native currency, Ether (the second-largest cryptocurrency by market cap after Bitcoin), there are thousands of projects operating on top of the Ethereum network. These include businesses that create and exchange nonfungible tokens (NFTs) and decentralized finance (DeFi) applications that let users trade, borrow, and lend among each other without third-party intermediaries such as banks. Ethereum is testing a second blockchain that operates by proof-of-stake, and developers plan to merge both platforms and fully transition away from proof-of-work sometime in 2022. This change is expected to reduce Ethereum’s energy consumption by 99.95%, as it will no longer be necessary to mine new coins solely as rewards for validating transactions.3
Why It Matters
Businesses and governments worldwide are exploring and investing in blockchain technologies for both financial and nonfinancial applications as they seek to solve complex problems, improve efficiency, and reduce costs. Other than cryptocurrency and NFTs, some promising applications include real-time securities trading, public real estate registries, identity verification, fraud prevention, electronic medical records, supply-chain tracking, and online voting, to name just a few.
Industry consortia are working together on joint projects, while individual companies are trying to influence what might become common standards. But despite the heightened levels of interest and investment in blockchain, widespread adoption could be years away. Some factors slowing the pace of deployments are cybersecurity and privacy challenges, regulatory uncertainty, and a shortage of professionals with blockchain skills.4
In the longer term, however, blockchain could be a transformative or disruptive force that creates a new set of winners and losers. Speedy and successful implementation may deliver a competitive advantage to some companies, while punishing others that don’t keep up with the pace of change. And even if efforts to reduce the technology’s environmental impact are successful, there may be other societal costs, such as its potential to displace a significant number of human workers.
All investing involves risk, including the possible loss of principal, but new technology ventures are especially risky. Some blockchain projects may turn out to be viable and profitable, but many others could fail. It’s important to be skeptical when evaluating a claim made by a company about its entry into this arena. Rising interest in blockchain and crypto is also being exploited by scammers, so steer clear of unsolicited investment offers — and never wire money to pay for an offer or service.
Cryptocurrencies are not a traditional investment, are highly speculative instruments, carry a significant amount of risk, and are not suitable for all investors. Cryptocurrencies are not typically subject to the same reporting and data integrity requirements that apply to more traditional investment products, and they lack many of the regulations and consumer protections that apply to legal tender currencies and regulated securities.
1) International Data Corporation, 2021
2) Cambridge Bitcoin Electricity Consumption Index, July 2022
3) Ethereum.org, July 2022
4) U.S. Government Accountability Office, 2022