Of Blockchains and Bitcoins

Of late there has been much buzz about the Blockchain and cryptocurrency technology, due to soaring cryptocurrency values, revolutionary technological developments, and increasing regulatory scrutiny and concerns amidst reported frauds and speculative losses. However, what exactly is the Bitcoin, and how can a piece of computer data be worth so much? What is the Blockchain and why has it gathered so much interest? This article explores the latest cryptocurrency and Blockchain developments, explains the technology, and highlights the regulatory concerns.

CRYPTOCURRENCY AND BLOCKCHAIN DEVELOPMENTS

Bitcoin, the cryptocurrency which until recently was synonymous with Blockchain, has just soared above US$8,000 per piece at the time of writing, from less than US$500 just two years ago. With the explosion in Bitcoin value, a host of other cryptocurrencies have emerged, jostling for investor interest and money. And investors are biting. In fact, interest mounted so rapidly that a new term, Initial Coin Offerings (ICO) has been coined (pun intended) to describe offerings of new cryptocurrencies to hopeful investors searching for the next Bitcoin.

The allure of rich rewards associated with such new technology is inevitably an irresistible driver of innovation, of which there is no shortage in the cryptocurrency space.  These range from cryptocurrencies that can be spent via debit/ credit cards, to asset-backed cryptocurrencies, cryptocurrencies with built-in smart contracts, cryptocurrencies for shipment bookings, cryptocurrencies for digital advertising, and many more.

While cryptocurrencies are taking off, the Blockchain technology, which was previously synonymous with Bitcoin, has also expanded in scope, spreading into a wide range of unrelated applications.  Examples to date include data storage, tracking of digital identities, smart contracts, digital voting, cryptographic notary services, facilitation of trade processing and settlement, insurance claims, as well as management of property rights. In Singapore, the port operator PSA International, shipping company Pacific International Lines, and technology giant IBM, are working on a blockchain-based supply chain solution to improve security, efficiency, and transparency in regional supply chain business networks. Most of these newfound Blockchain applications involve the creation, processing and storage of records, in an automated and secure manner that engenders trust with minimal human intervention, regulatory supervision or independent certification.

TECHNOLOGY OVERVIEW

As a general framework, Bitcoin is built on the Blockchain technology, which in turn is built on the Distributed Ledger Technology (DLT). Let us discuss each of these in reverse order, starting from DLT.

Distributed Ledger Technology
The DLT technological blueprint was initially developed to address security concerns. In traditional record keeping, the records (or “ledger”) are usually kept, either manually or electronically, in a single location. This presents a security risk because an unauthorised intruder can successfully falsify records by penetrating a single location. DLT addresses this risk by maintaining multiple copies of those records in a wide variety of locations, and the correct “version” of the records is determined based on a majority consensus among available copies of the records. As such, the intruder now needs to penetrate multiple locations to successfully falsify DLT records.

In the context of Bitcoin, each such computer where copies of Bitcoin records are stored is known as “node”. According to bitnodes.earn.com, there are 11,000 Bitcoin nodes globally at the time of writing, and the need to simultaneously penetrate half of these computers, presumably, should discourage less sophisticated intruders.

Blockchain technology
Blockchain builds on DLT to further improve security by amplifying the impact of unauthorised changes. To illustrate this, imagine 3 friends Dan, Eve and Abe. In successive transactions, Dan pays Eve $500, Eve pays Abe $500, and Abe pays Dan $500. They decide to record this information in a ledger that stores three records (or “blocks” of information), e.g.:
 
  1 Dan-Eve $500 (an arbitrary short-hand to signify that Dan pays Eve $500).
  2 Eve-Abe $500
  3 Abe-Dan $500
The Blockchain technology codes each record (i.e. block) into a single number, and stores this number (“Hash Code”) in the next block. A simple way to do this is to convert each alphabet to a number (a=1, b=2, etc.), then add up the numbers. Using this method, the Hash Code for block 1 is 551 (calculated as Dan(4+1+14) + Eve(5+22+5) + $500). Attaching the Hash Code to the second block, it now reads:
 
  2 Eve-Abe $500; 551
The Hash Code of block 2 is 1,091, calculated as (Eve)5+22+5 + (Abe)1+2+5 + $500 + 551, and attaching this to the next block results in:
 
  3 Abe-Dan $500; 1091
Assume that an unauthorised intruder now tries to change the first transaction to $600 (i.e. Dan-Eve $600). Blockchain will be alerted, because the Hash Code for this block (651), now does not match the code previously stored in the second block (551). The intruder must also change the Hash Code stored in the second block, but that change in turn necessitates a change to the Hash Code stored in the third block, and so on. The Hash Code stored in each block effectively “chains” each block to the previous block (hence the name “Block-Chain”).

This makes Blockchain very secure, because, to effect one change, the intruder must change all subsequent records, and do so on at least half the computers that store the Blockchain ledger (due to DLT). Due to its security, Blockchain applications extend beyond Bitcoin to all situations that require secure and trusted records with minimal external intervention, supervision or certification.

In practice, the coding formula used will be more complex than the simple additive formula above. Bitcoin, for example, uses the SHA-256 algorithm, which is a Secure Hash Algorithm (SHA) designed by the US National Security Agency. Also, Bitcoin records multiple transactions in each block.

Bitcoin
Bitcoin, which records all transactions in a Blockchain ledger, builds further on this technology. One shortfall of Blockchain is the need to store the Hash Code, which can be a very large number due to SHA-256, and this taxes digital storage requirements. Bitcoin mitigates this by appending an additional number (known as the “Nonce”) to each block, that will lower its Hash Code below a pre-set maximum (the “Target”). With a lower Hash Code, storage requirements correspondingly reduce.

In the example above, the coding formula is purely additive, and therefore a lower Nonce will lower the Hash Code. However, due to the complexity of SHA-256, the effect of the Bitcoin Nonce is much less predictable, and a higher Nonce can increase or lower the Hash Code. The solution for a SHA-256 Nonce that gives a Hash Code below the Target is only found by trial and error, a computationally-intensive process. Because of this, Bitcoin participants who invest the resources to derive the Nonce are rewarded with Bitcoins (“Reward”), a process called “Mining”.

CRYPTOCURRENCY ECONOMICS

Bitcoin demand has been growing as more participants get attracted to this payment system. This is partly due to the security and reliability of the Blockchain ledger. Bitcoin is, also, until recently, largely unregulated, and this is attractive in the context of a global monetary environment that is becoming increasingly complex and sophisticated. On the other hand, the supply of Bitcoins is falling, because the number of Bitcoins in circulation can only increase through Rewards for Mining, and Bitcoin is programmed to halve this reward every 210,000 blocks, eventually becoming negligible. Bitcoin also caps the maximum number of Bitcoins in circulation to 21 million, of which about 17 million are already in circulation. Given rising demand and limited supply, economic principles dictate that Bitcoin value will rise in the absence of contrary developments.  Finally, it is not unusual for technological innovations to spur speculative frenzies, which may have in part contributed to the meteoric rise in Bitcoin value.

REGULATORY ISSUES

As cryptocurrencies become popular, governments worldwide are becoming watchful for fraudulent activities. The United States Securities and Exchange Commission (SEC) recently charged 2 ICOs with fraud, while Chinese and South Korean regulators have clamped down on cryptocurrency exchanges, prompting some to move to Japan.

In Singapore, the Monetary Authority of Singapore (MAS) has recently clarified that while cryptocurrencies per se are not regulated in Singapore, the activities surrounding cryptocurrency usage may be regulated. For example, MAS is working on a new payment services regulatory framework that is expected to address the risks of money laundering and terrorism financing risks associated with the anonymous nature of cryptocurrency payments. Secondly, ICOs that issue cryptocurrencies structured in the form of securities must comply with existing securities laws, including registration of prospectus, requirements for intermediary or exchange operator licences, anti-money laundering rules, and others.

From a financial reporting perspective, there are also increasing calls for global standard setters to regulate financial reporting for cryptocurrencies. Some regulatory bodies and accounting firms have published views on accounting for cryptocurrencies, assessing whether they qualify as financial assets, inventories, or intangible assets, among other possibilities. It is probably only a matter of time before global standard setters take on board this project.

CONCLUSION

This is no doubt an exciting yet uncertain time for the development of Blockchain and cryptocurrency technologies. How will the introduction of new regulation interact with new technological developments to impact the underlying economics? Only time will tell.