When Will Blockchain Really Matter?

by Pillsbury Winthrop Shaw Pittman LLP
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Pillsbury Winthrop Shaw Pittman LLP

Takeaways

  • Blockchain could fundamentally transform transactions, much like the internet changed communication.
  • Controversy surrounding Bitcoin still clouds interest in blockchain technology.
  • Yet, a technology that could reshape the economy should not be ignored.

Early indicators in 2017 suggest that blockchain technology is further along than anticipated and the potential implications of its development should not be ignored. However, caution should be exercised due to imprecise terminology, the immaturity of the technology and institutional barriers. Nevertheless, collaborations with established technology providers will accelerate blockchain’s impact globally.

Earlier this year at the FinTech Ideas Festival, IBM’s CEO, Ginni Rometty, said that blockchain technology is more important than artificial intelligence and “is so profound that it will do for trusted transactions what the internet did for information.” In the January-February 2017 issue of the Harvard Business Review, Marco Iansiti and Karim R. Lakhani observed in their article, “The Truth About Blockchain” that “Blockchain could slash the cost of transactions and reshape the economy ... But given the time horizons, barriers to adoption, and sheer complexity ..., executives should think carefully about the risks involved in experimenting with blockchain.”

A technology that could transform transactions and that could reshape the economy should not be ignored. It is attractive because it creates trust through better security, transparency and identity management, and efficiency through the elimination of intermediaries and the use of automation such as smart contracts. However, any organization considering the testing and development of blockchain applications should proceed with caution. The term “blockchain” is not consistently used or defined, it is not a mature technology and there are significant institutional barriers to its adoption. That said, interesting blockchain pilot projects are occurring in a number of sectors and there have been important recent announcements, including collaborations with established technology providers that are making significant commitments to this emerging technology.

Blockchain Explained

Blockchain is the architecture beneath Bitcoin, a controversial virtual currency that was introduced in 2009 by its mysterious inventor, Satoshi Nakamoto. In early March 2017, a unit of Bitcoin exceeded the value of an ounce of gold for the first time due to high demand in China but that value has since dropped. It is likely that the value of Bitcoin will remain volatile because of concerns about its anonymous and unregulated nature.

However, the application of this architecture is not limited to virtual currencies. Any type of information or asset such as deeds, stocks, diamonds, machine parts, prescription drugs, flowers and votes can be digitized, recorded and exchanged. Blockchain technology permits peer-to-peer information and asset exchanges that do not involve an intermediary, such as the government entities, banks, escrow agents and credit card companies that instill confidence in these exchanges today.

Access to blockchains is controlled by secure digital signature protocols. Public blockchains such as Bitcoin are widely distributed on many servers globally, openly replicated and visible to anyone within the network. Attempts to change the data become part of the record itself, making unauthorized alterations extremely difficult. Each transaction is time-stamped and linked to form the chain, after using agreed-upon software rules to validate it (the consensus mechanism), in chronological order. The entire blockchain is continuously updated so that every computer has the identical record. Blockchains may be public and accessible by any party, public and accessible only by a defined community or private and accessible only by a defined community. The future of blockchain could involve many types of public, private and hybrid versions.

Blockchain Features

Security and Trust

Centralized databases with password-based access systems are vulnerable to hacking, identify theft and cyber crime. Blockchain is a more transparent solution that discourages tampering as each block is visible to all users. To create transactions, a “public key” and a “private key” are required to validate the new transaction based on mathematical algorithms and record a digital signature or “hash.” As a transaction cannot thereafter be edited or removed, the combination of blockchain technology and digital signatures creates better security and greater trust.

Identity Management

Blockchain could also address the challenge of identity management. Rather than relying on others for authentication, an individual could store a birth certificate, character references, education qualifications, bank records or tax filings on a blockchain database to establish that he or she is a reputable person for multiple purposes. An entity could store a good standing certificate, certified descriptions of its experience and expertise and evidence of its financial strength to establish that it is a reputable business partner or vendor. Any party’s digital identity could confirm membership in a community or a country, title to assets, entitlement to benefits or services and most fundamentally, that the party actually exists. Creating an identity on blockchain could give individuals and entities greater control over who has access to their confidential information. In addition, a digital ID could be developed and assigned to every individual or entity involved in an online transaction.

No Intermediaries

Removing intermediaries will reduce cost, speed business processes and stop those parties from seeking control over information and records to monitor or censor activities (in the case of certain public authorities) or to monetize it (in the case of certain institutions and technology providers). In a peer-to-peer blockchain transaction, trust would not be based on the reputation of intermediaries like banks, title companies, brokers, legal professionals and escrow agents. Rather, trust will be based solely on the reputation and digital ID of each party. Notably, some private and hybrid blockchains will not totally remove intermediaries.

Smart Contracts

Blockchains can enable computable and self-executing “smart contracts” that use software agents to execute an action automatically when specific conditions are met such as when a shipment arrives. This type of smart contract is not possible when the parties to an agreement maintain separate databases. But smart contracts can operate effectively when the parties use the same database governed by agreed-upon rules. Such contracts are very helpful when parties engage in transactions frequently, especially with duplicative or ministerial tasks such as payments on specified dates and automated stock market or financial instrument activities and significantly reduce transaction time and costs. For example, the DAO (a distributed autonomous organization) was an ambitious smart contract application for a highly efficient venture capital fundraising. The DAO used smart contracts to reduce the functions of the CEO and the board of directors to coded rules. It was launched in May 2016 with a record-breaking $150 million in crowdfunding but within three weeks a flaw in the code of the smart contract itself caused it to be hacked and shut down. Despite that failure, there will be further attempts to create decentralized business models as areas of vulnerability are addressed.

Recent Blockchain Announcements

Fund Management, Shipping and Financial Transactions

The Hyperledger project is an open source blockchain platform started in December 2015 by the Linux Foundation to support distributed ledgers designed for global business transactions and supply chains. It aims to develop protocols, standards, access controls, consensus mechanisms and smart contracts (but not a virtual currency). Prominent early members included ABN Amro, Accenture, BNY Mellon, Cisco, Hitachi, IBM, Intel, JP Morgan, State Street, SWIFT and Wells Fargo. On February 22, Northern Trust, in collaboration with IBM, launched a cloud-based application on top of Hyperledger, including smart contract functionality, for the private equity investment fund market. Each investor and each fund manager is typically represented by different professionals in a highly manual, paper-based process. This new application allows each fund to transfer investor interests and be managed more efficiently without as much involvement by outside attorneys and accountants. Regulators will also have real time access to the application and it is designed to support compliance with existing laws.

It was also announced in February that Maersk, the world’s largest shipping company, had completed the first test of a blockchain application on the Hyperledger platform for freight tracking. In this pilot, Maersk, Dutch customs and U.S. Homeland Security are able to access, track and manage the shipping supply chain remotely with a significant reduction in paperwork. Digital signatures are used to make it extremely difficult for anyone to inaccurately label goods. The application could be in operation as early as this year and in the future it may be used to optimize freight flows by identifying empty containers and finding uses for the extra capacity.

Ethereum is an open source blockchain platform started in July 2015 to support distributed ledgers and it also features smart contract functionality. It is used to create a virtual currency called ether. On February 27, a number of companies, including Microsoft, JP Morgan, Accenture, Credit Suisse, ING, Intel, UBS and BNY Mellon announced the formation of the Enterprise Ethereum Alliance to create a standard version of the platform for use by global businesses to track information and undertake financial transactions. Private blockchain applications will be developed on top of the public platform. The alliance will also experiment with new governance models suited to regulated entities that are subject to strict privacy requirements.

Government Services and Real Estate Transactions

In February, the Kingdom of Bahrain announced that it was discussing blockchain technology with Singapore’s central bank, with the goal of nationwide blockchain adoption. Dubai is claiming the title as the “global capital” of blockchain and intends to be the first government to run on blockchain by moving all public documents to a blockchain platform by 2020. The technology could be used for multiple purposes, such as online voting, welfare payments, border security and other government services. Estonia has established an e-residency blockchain program and a healthcare blockchain initiative. On January 23, Nasdaq reported that it had successfully completed a test using blockchain technology to run proxy voting on the Estonian stock exchange. Delaware announced blockchain initiatives last year that are transferring public records to a distributed database and permitting companies incorporated in that state to use the technology to record and transfer shares of stock. The amendments required to Delaware corporate law to permit the use of the technology were introduced for consideration on March 13 and smart UCC filings on a blockchain ledger could be permitted later this year. Australia is leading an international blockchain standards effort and its public postal service has been testing potential applications for voting and digital identity.

The Republic of Georgia committed earlier this year to expand its pilot project registering land titles, mortgages and leases on a blockchain platform to also include the tracking of real property transactions. The goal is to have the database fully operational by the end of this year. Cook County, Illinois is also testing blockchain for tracking and transferring real property titles and other public records in an effort to help combat fraud related to vacant properties in Chicago. ABN Amro announced in December that it is working with IBM to develop a blockchain system to allow buyers, sellers, brokers, appraisers and regulators to record commercial real estate transactions and to apply for bank financing. Also in December, the City of Rotterdam, working with Deloitte and the Cambridge Innovation Center, announced that it will record real estate lease agreements on a blockchain application to reduce transaction times and to collect data to assist future investment decisions.

Challenges for Blockchain

The term blockchain is not consistently defined. It is often used as short-hand to describe a loose collection of public, private and hybrid technologies and processes. Sometimes, it is difficult to determine whether a particular reference is to blockchain as:

  • a foundational architecture;
  • a digital ledger or database;
  • an innovative security protocol;
  • a middleware application for specific businesses;
  • an identity management tool;
  • a smart contract application; or
  • some combination of all of the above.

Private blockchains may lack core features, such as fully-decentralized databases (because they may be hosted by a limited subset of users) or transparency and immutability (because certain financial institutions need to hide confidential data and to fix errors in the digital record). Without consistent definitions, there is too much room for confusion. For instance, a consortium formed by some well-known banks and corporations announced earlier this year that it was abandoning blockchain technology, but would continue to be a blockchain-inspired distributed database startup developing private, centralized blockchains.

Blockchain technology is relatively immature. For most applications, it remains in the experimental and proof-of-concept phases. Apart from virtual currencies, there are a limited number of proven applications today. It is a complex technology to test, implement and integrate especially when integrating with legacy technology infrastructure. Consistent standards, best practices and protocols for deployment and operation have not been developed or widely agreed upon.

There are also institutional barriers to the acceptance of blockchain including legal, regulatory and accounting issues. Blockchain-enabled smart contracts are controversial and raise additional questions, such as whether they are enforceable or suited to anything other than ministerial tasks. If there is a flaw in the coding, the result might be more troubling than it would be with traditional contracts because interpretation will be based entirely on the literal meaning and not on the more flexible intent of the parties.

When Will Blockchain Affect Government and Business?

The level of commitment to testing and development today reveals how seriously blockchain is being viewed by governments, financial institutions, technology providers and other industry participants. Just as the internet significantly lowered the cost of connections and shared information, blockchain technology could significantly lower the cost of database management, public services, supply chains and business transactions.

Much like the internet, it could take many years for blockchain to be widely adopted. However, today’s dynamic internet landscape could allow new blockchain applications to emerge much more rapidly. Existing cloud-based services from both startups and established companies, such as IBM and Microsoft, will make experimentation and collaboration between organizations easier and less costly. Moreover, as blockchain pilots may involve other emerging technologies, they could attract an earlier and more significant commitment of resources. For instance, there are discussions about using artificial intelligence and blockchain together to more efficiently analyze and store big data. This could then be used as an enhanced platform to manage the enormous amount of data associated with billions of connected devices on the Internet of Things. A number of very interesting blockchain applications under development are projected to be in full operation later this year.

Controversy surrounding Bitcoin still clouds interest in blockchain technology. Further confusion is created by the assumption that all blockchain platforms are open and public, with similar features to the Bitcoin blockchain. Private and hybrid blockchain applications customized for different businesses are quite distinct and mitigate certain risks and challenges. The investments by, and cloud based application development offerings of, large technology providers will accelerate the adoption of blockchain technology. The potential applications, especially if developed with other emerging technologies, could be profound.

Any pilot or other development effort should proceed carefully with the following guidance in mind in order to manage the risks of experimentation: use precise terminology, prepare clear business requirements and design specifications including privacy requirements, undertake implementation efforts with collaborative partners and experienced developers, and use rigorous acceptance testing protocols. Any confidentiality, strategic alliance, application development, licensing or other agreement entered into should be balanced and comprehensive. If an organization is not ready to consider a pilot, it should still stay abreast of announcements and devote the appropriate resources to monitoring this important evolving technology.

 

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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