Distributed ledgers, blockchain technology and implications for insolvencies

Distributed ledgers, blockchain technology and implications for insolvencies

Cryptoasset Series - Part 2

Traditional ledgers and distributed ledgers

Ledgers have been used for centuries as a mechanism for recording data (typically financial transactions) in a single, central place. This concept has been very powerful as the master record of these transactions particularly across multiple parties, where a single version of the truth is needed. For the single version of the truth to be maintained across parties, the model has had to have either two or more separate ledgers with independent versions of the truth or to have a single centralised ledger used by everyone. The challenge with separate ledgers is that there is no single version of the truth and the ledgers have to be reconciled frequently to ensure they remain synchronised. The challenge with a centralised ledger is that all parties need to rely on a single party to administer the central ledger and trust that they will faithfully maintain the single version of the truth for everyone (e.g. central clearing house).

A distributed ledger (Figure 1) allows the data to be shared without the need for a central authority and solves the problem of separate or centralised ledgers. It is a database that is de-centralised across multiple parties and locations where all the parties work together to store, validate and distribute the data. Each of these parties is called a node.

Figure 1. Centralised compared with a distributed ledger

Introduction to blockchain and distributed ledger technology

A blockchain is a type of database which is simply a collection of organised data. As implied by the name, a blockchain is a chain of blocks with each block containing data. Blockchains are described as immutable which means that once data is written to the blockchain it can never be erased or modified. This is because blockchains add data sequentially where new blocks of data are added to the end of the chain. Immutability doesn’t mean however that the data is impossible to change. As with any ledger you can make amendments by adding a new block to reflect how the data has changed.

Distributed Ledger Technology (DLT) is the underlying technical solution behind any blockchain, so think of a blockchain as a type of DLT. Unlike a traditional database, a DLT solution is spread across several computer nodes where each node replicates and saves an identical copy of the ledger. Each node of the network updates itself independently. The key differentiating aspect of DLT is that the ledger is not maintained by any central authority; updates to the ledger are independently constructed and recorded by each node. The nodes then “vote” on these updates to ensure that the majority of nodes agree with the conclusion reached. This voting mechanism on a single copy of the ledger is called consensus and is conducted automatically by a consensus algorithm. Once consensus has been reached the distributed ledger is updated (by adding the last block to the end of the chain) and the latest version of the ledger is saved on each node separately.

How does DLT use cryptography and why is it secure?

Firstly, DLT uses the power of modern cryptography to create hash values. This means that it takes any input data of any length and returns a short, fixed length value that uniquely represents the input data. Any changes to the input data will cause the hash value to change so it is a useful mechanism for verifying data (see consensus mechanism page 8). Hashing is asymmetric which means that the same hash value can always be encoded from the same input data, but it is impossible to derive the input data from the hash value.

Secondly, DLT uses public key cryptography to encrypt the hash value using a private key to sign the data with a digital signature. This helps prove that the publisher of the data is valid and authentic. These two processes are performed by a node on the ledger and is then sent to every other node. On receipt of the message, each node uses the sending node’s public key to decrypt the data and read the hash. If the decrypted hash has the same value as the hash of the receiving node (it generated its own instance of the hash previously) then we know that the data from the sending node is reliable. Hashing is important in this step as if, when compared the hashes are different, it proves that one of the hashes has been modified and cannot be trusted.

Figure 2. Cryptography used in Distributed Ledger Technology

Consensus mechanism

The process of each node creating its own instance of the hash value and then comparing this to the incoming (encrypted) hash value from another node is termed the consensus mechanism. Given that DLTs have no single co-ordinating party, the framework uses the consensus of the nodes confirming the hash values to validate that the data is correct, after which each node can save the data. In the use case of a financial transaction, the transaction as defined by a new block is committed to the end of the blockchain once each node has validated that the hash value is the same. Once this point is reached, that block of the blockchain cannot be removed or modified.

Different implementations of DLT (e.g. public, private, enterprise) will use different consensus protocols but the basics described above is the common framework. The most notable DLT implementation is Bitcoin which is a fully public blockchain. Bitcoin uses a deliberately cumbersome consensus protocol linked to the hash of each transaction. With Bitcoin, blocks can only be added to the chain, or mined after a computationally intensive puzzle has been solved. Whoever solves the puzzle first is permitted to add the block to the chain and is rewarded with 1 bitcoin. Given the value of a single bitcoin, nodes now employ enormous amounts of computing power in an attempt to win the race to solve the puzzle first. This protocol is one of main criticisms of Bitcoin in that it’s very expensive (in terms of computing power and energy) to operate.

Business applications for DLT

Whilst DLT and its variations is the underlying technology behind a whole range of crypto assets, it can be used across a much broader set of industries and use cases. The DLT concept is most ripe for using when there are multiple, independent parties who are unwilling to trust one another (or a single co-ordinating party) and yet have a common interest in the same information during its lifecycle. Below are some notable examples of its use which drive major operating and financial efficiencies:

TradeLens is a DLT enabled ecosystem which brings together all the interested parties in the global container supply chain (traders, freight forwarders, inland transportation, ports and terminals, ocean carriers, customs and government agencies) into a single, secure data-sharing and collaboration platform. By sharing real-time, actionable supply chain information across all parties digitally, Tradelens expects to reduce the operational inefficiencies and costs across the shipping process by 15%, increasing the annual value of containerised freight from $12 trillion to $13.8 trillion.

Home Depot uses a DLT solution to gain real-time, shared, and trusted information of goods throughout the shipping and receiving process, reducing the number of vendor disputes and accelerating dispute resolution, driving efficiencies in the supply chain.

Traders, particularly SMEs, who traditionally did not have access to bank guarantees, invoice financing and credit insurance, use we.trade (a DLT trade finance solution) to enhance their cashflow and digitise their existing paper-based processes. Companies use we.trade’s digital platform to address challenges such as the late payment of invoices, cyber fraud and where pre-payments are requested by sellers to drive step-changes in terms of time savings and capital efficiencies. Ultimately we.trade has rapidly accelerated the process of validating the relevant documentation across the supply chain, driving efficiencies for all parties.

DLT limitations

Whilst the DLT concepts have existed for very nearly a decade the technology is still in its infancy and inevitably there are some limitations. As stated earlier, there are different ways in which the consensus mechanism can be implemented but whatever is used the message throughput is relatively slow when compared to traditional technology. Engineers are working to solve this issue so for now DLT is not being used in exchanges, for example where low message latency is important.

Media is awash with stories of fraud where blockchain solutions have been hacked and crypto assets have been stolen from rightful owners. Whilst no current cryptographic solution is totally unbreakable, the DLT implementation makes it incredibly difficult (and financially unviable) to hack.

The stories of crypto assets being successfully stolen are typically where the encryption keys have been stolen (i.e. the keys were compromised rather than the encryption algorithm was broken) or the traditional technology surrounding the DLT solution has been compromised (i.e. the hot or warm wallet containing the crypto assets has been hacked).

DLT implications for crypto asset insolvencies

DLT is an emerging technology with many future business applications. Within the crypto asset world the technology itself may not present any additional or fewer challenges than traditional technology when managing an insolvency. The immutability of the transactions in the ecosystem will show the ownership of each asset better than traditional technology; the challenges will be related to the business model in how the technology has been used. Unlike typical insolvencies in financial services firms using traditional technology, determining true ownership of crypto assets will be more complicated if the records of ownership are stored in offline wallets (e.g. cold storage). Without this information it would be impossible to create the link between a real owner of an asset and the transactions stored on the blockchain, given that in many instances the transactions on the blockchain are anonymous.

One new challenge however relates to the distributed nature of technology. With traditional technology the data needed in an insolvency is usually stored within a defined set of systems which are housed in a physical data centre or a defined set of virtual servers (in a public cloud environment). Either way, it is relatively straight-forward to demarcate the systems to be investigated.

In a blockchain solution, the nodes of the network could be distributed all over the world. Obtaining access to the contents of a single node (or at least a few to allow consensus of ownership) could prove very challenging, especially when the ownership of these nodes is not clear or the owners are unwilling to co-operate.

The degree of the challenge may well be influenced around how the DLT is used in the business operating model. Some crypto exchanges for example use a private DLT where the nodes of the ecosystem are owned by subsidiaries of a single parent entity where each entity is fully incorporated in its local jurisdiction.

Definition of decentralised finance (DeFi)

Decentralised finance (DeFi) is an ecosystem where financial services are available on a public decentralised blockchain network, open to all. Unlike traditional finance structures, the services are available to anyone (corporates large and small and individuals) to use directly rather than accessing them via a third party such as a bank. In addition, it supports the supply and consumption of these services directly, using software (smart contracts) thereby reducing or removing the need for intermediaries in the value chain.

 


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