www.ifc.org/ThoughtLeadership Note 40 | July 2017 Blockchain in Development – Part I: A New Mechanism of ‘Trust’? Blockchain is an exciting new technology that may prove to be a radical innovation—similar to technologies such as the steam engine and the Internet that triggered previous industrial revolutions—with the power to disrupt existing economic and business models. It has the potential to deliver productivity gains to multiple industries, from the financial sector to energy markets, supply chains, intellectual property management, “virtual firms”, the public sector, and beyond. Its ability to provide disintermediation, improve transparency, and increase auditability can significantly reduce transaction costs, introduce efficiency into existing value chains, challenge revenue models, and open new markets. And blockchain may prove particularly valuable in emerging market economies. Yet the technology is in its early stages of development and serious challenges and risks, both technical and regulatory, will need to be addressed before it achieves widespread adoption. Questions remain about blockchain’s scalability, interoperability, security, transition costs, data privacy, and governance. And business leaders and policy makers will need to think long and hard about when and under what conditions a blockchain initiative may be warranted. Overview of distributed ledger technology Blockchain has generated an enormous amount of interest over Evolution of ledgers: from centralized to distributed the last three years, with evangelists for the technology calling it a pillar of the Fourth Industrial Revolution and sceptics Blockchain introduces a database that functions like a dismissing it as an overhyped combination of existing distributed network, hence the term ‘distributed ledger’—with technologies.1 the promise of near friction-free cooperation between members of complex networks that transfer value to each other without So, what is blockchain? central authorities or middlemen. Confusion persists among the public, businesses, and Blockchain is often referred to as a ‘radical innovation’2 or policymakers as to blockchain’s structure, utility, and general-purpose technology (GPT) not unlike the steam engine applicability—and even its name. The term blockchain is often or the electric motor.3 In other words, a technology that can used interchangeably with the term distributed ledger create “subsequent innovation and productivity gains across technology, and the technology is still associated with its first multiple industries,” similar to the Internet before it.4 incarnation, bitcoin Blockchain’s primary value is its ability to deploy Though it has existed since 2009, blockchain has attracted a cryptographic mechanisms to reach consensus across parties in new level of interest over the last two years amid growing the ledger. This eliminates the need for a central authority or awareness that it could be exploited beyond digital currencies intermediary, thereby creating a distributed trust system of and used for other types of inter-organizational cooperation and value transfer.5 No single entity can amend past data entries or value transfer. approve new additions to the ledger (Figure 1).6 Eliminating Thanks to its enabling potential for digital proof of identity and the need for a central trusted party can increase speed, lower costless verification, blockchain could have a wide range of transaction costs, and enhance security in the network. applications, in the financial sector and beyond. These include peer-to-peer technology, energy markets, supply chain Blockchain first appeared in the form of bitcoin, a peer-to-peer certification and intellectual property management. electronic cash system launched by Satoshi Nakamoto in 2009 Figure 1: Evolution of Ledgers Source: Paul Baran, On distributed communications networks, 1964, and Marina Niforos, 2017. “based on cryptographic proof instead of trust, allowing any carry out the direct transaction of value between untrusted two willing parties to transact directly with each other without agents.”10 Ethereum’s market capitalization exceeded $26 any need for a trusted third party.”7 Cryptographic proof refers billion in July 2017, which is especially noteworthy since it to the cryptographic process of reaching consensus through stood at under $1 billion just six months earlier.11 proof of work eliminating the need for a trusted intermediary. Bitcoin originally had a strong anti-establishment undercurrent, How does blockchain work? backed by a community of techno-libertarians or crypto- Blockchain is essentially a meta-technology that consists of anarchists seeking to establish a currency outside of game theory, cryptography, and mainstream software government control and censorship. engineering.12 Blockchain protocols verify numbers or Bitcoin’s commitment to anonymity in transactions programs, time stamp them, and enter them as a block into a unfortunately also opened the platform to illicit activities such continuous chain linked to all previous blocks linked to the as drug trafficking and tarnished its reputation with original transaction.13 Assets may be created directly on the governments and the public alike. Despite this, the development network. For example, cryptocurrencies and rights to real world of bitcoin continued. Its market capitalization is approximately assets can have a digital representation as a token14 (referred to $42 billion and it is used by millions of people for payments, as “tokenized assets”).15 including a growing remittances market.8 A distributed ledger technology, or DLT, network can be either Designed to be much more than a payment system, Ethereum open (permission-less) or private (permissioned). Assets on a was launched in 2014 as an open-source, public, blockchain- DLT network, whether the network is public or private, are based distributed computing platform that provides a ‘crypto- cryptographically secured using a public-private key economically-secured’ platform for the development of any combination. A public key is the “address” where the digital kind of decentralized application.9 Given the extended asset is located on the network. A private key is the code that capabilities it provides to the original bitcoin-oriented gives the holder access to the asset at the address represented technology, it is often called Blockchain 2.0. by the corresponding public key. Once a transaction is initiated, it is broadcast on the network to all ‘nodes’, or participating Ethereum uses ‘ether,’ a cryptocurrency token to compensate computers,16 and the nodes acknowledge acceptance of the participant nodes for computations performed. Ethereum block by using its hash17 as an input when working on creating introduced the possibility of smart contracts, or “deterministic the next block.18 exchange mechanisms controlled by digital means that can This publication may be reused for noncommercial purposes if the source is cited as IFC, a member of the World Bank Group. Figure 2: Blockchain Value Chain such that different entities and individuals may have varying levels of authority to conduct transactions and view data (as such, they are closer to relational databases currently in use in large corporations). There are ‘trusted’ nodes or system administrators that control access and rights onto the network. They can still have an important effect in reducing transaction costs within the ecosystem of participating entities. Source: The Blockchain Lab; theblockchainlab.com Established companies, particularly those in the financial industry, are gradually adopting private distributed ledgers for internal use, as well as for conducting transactions with trusted A cryptographic hash function represents the process by which partners, attempting to experiment with the new technology miners (nodes participating in the computational review process while maintaining data confidentiality. This also allows them to performed on each "block" of data) verify and timestamp comply with regulations, something not possible under the transactions. Time stamped records are displayed in a conditions of complete anonymity of open networks. sequential manner (‘blocks in a chain’) to all parties on the network who have the appropriate access levels (Figure 2).19 Box 1: Key advantages for Distributed Ledger Technology The time required to verify and record a transaction on the distributed ledger technology network varies depending on the Distributed and sustainable. The ledger is shared, updated with process employed (for example, ‘proof of work’20 for bitcoin or every transaction and selectively replicated among participants in near real-time. Privacy is maintained via cryptographic techniques ‘proof of stake’21 for Ethereum). and/or data partitioning techniques to give participants selective visibility into the ledger; both transactions and the identity of Open versus private distributed ledger technology networks transacting parties can be masked. Because it is not owned or controlled by any single organization, the blockchain platform’s Open (permission-less) networks are accessible to anyone continued existence isn’t dependent on any individual entity. wishing to join, without restriction on membership. Data stored on these networks is visible to all participants in encrypted Secure and indelible. Cryptography authenticates and verifies format. Digital currency bitcoin is an example. Open distributed transactions and allows participants to see only the parts of the ledger that are relevant to them. Once conditions are agreed to, ledger technology networks do not have a central authority. participants can’t tamper with a record of the transaction. Errors Instead, they rely on network participants to verify transactions can only be reversed with new transactions and record data on the network, based on a certain protocol. Transparent and auditable. Participants in a transaction have The ‘miners’ participating in the verification process are access to the same records, allowing them to validate transactions incentivized to perform computationally complex tasks in and verify identities or ownership without the need for third-party exchange for bitcoin rewards (‘tokens’). This consensus-based intermediaries. Transactions are time-stamped and can be verified process (‘proof of work’ in bitcoin) to ensure encryption of the in near real-time. data requires intense computational power, which some qualify Orchestrated and flexible. Business rules and smart contracts as wasteful and restraining to the scalability of the system. that execute based on one or more conditions can be built into the However, it is this feature that guarantees the chain’s robust platform, helping blockchain business networks to evolve as they mature and support end-to-end business processes and a wide security, making bitcoin more resilient to attacks. On a public range of activities. blockchain, sensitive data needs to be encrypted to ensure privacy, but encrypted data cannot be used by smart contracts, Consensus-based and transactional. All relevant network so there is less flexibility on bitcoin for complex or highly participants must agree that a transaction is valid. This is achieved by using consensus algorithms. Blockchains establish the regulated ‘transactions’ (see Challenges below). conditions under which a transaction or asset exchange can occur. By contrast, private or permissioned networks cannot access Source: IBM Institute for Business Value data without prior permission. Permission levels may be tiered, This publication may be reused for noncommercial purposes if the source is cited as IFC, a member of the World Bank Group. Noteworthy industry initiatives to pilot private distributed Enabling a ‘distributed trust’ system through Distributed ledger technology in financial services include Digital Asset Ledgers—Economic and business model implications Holdings, Chain, R3’s Corda (which describes itself as a The innovation of blockchain is capable of transforming the distributed ledger technology but not a blockchain), and infrastructure of our economic systems, not only financial Ripple/Interledger. Linux Foundation’s HyperLedger Project services, where most of the attention is currently concentrated, and Ethereum Enterprise Alliance, while focusing primarily on but entire global value chains and revenue models. It offers a the financial sector, have a vision to test applications beyond chance to reimagine industries, rebuild financial processes, and financial services, with HyperLedger already involved in proofs build markets once considered improbable or unprofitable. of concept in supply chain provenance initiatives. The blockchain provides an infrastructure where trust in transactions is not brokered by intermediaries—as has been the Figure 3. How does blockchain work? case until now—but is embodied algorithmically in the transaction itself. The algorithmic consensus process is the trust agent. Its effectiveness can be further enhanced if combined with the use of smart contracts and digital compliance (Box 1) This process of disintermediation and decentralization, coupled with increased transparency and auditability, provides for improved efficiency, speed, and cost reduction (such as in Know- Source: Financial Times Your-Customer verification). Its immutability provides for a verifiable audit trail of any physical or digital asset.24 While private networks are practical and encourage other companies to adopt the technology, they may hinder security, Financial Services: Blockchain was first used in the financial since private blockchains are paradoxically more vulnerable to services industry, where it has been enabling digital payment external attacks. And questions about the interoperability of systems and remittances as well as testing more complex these coexisting private blockchains may arise in the future. financial instruments and transactions such as insurance, deposits, lending, capital raising, and investment A heated debate, akin to that of the 1990s Internet versus management.25 intranet concepts, surrounds the question of open or private networks relating to improved security, creating new markets, Global payments, trade finance, and automated compliance are and promoting inclusiveness.22 However, public or private some of the most active experimentation domains for blockchains are not mutually exclusive. There may also be blockchain today. There have been more than 2,500 blockchain “partially decentralized” blockchains. In these, the right to read related patent filings and over $1.4 billion in investments in just the blockchain may be public, or restricted to the participants, three years.26 At least 24 countries are investing in the or have hybrid routes that allow members of the public to make technology, 50 corporations have joined consortia around it, a limited number of queries. Additionally, data from a private and 90 banks are in discussions about it worldwide. Deloitte blockchain can be periodically fingerprinted (hashed) and sent reports that 80 percent of banks will be initiating projects on to a public one, which can provide additional auditability. 23 blockchain by next year.27 The blockchain ecosystem is currently in full experimentation Beyond financial services — A potential business and public mode, bringing new innovations and hybrid solutions. governance paradigm shift: In principle, any type of asset can Consortia are emerging globally to discuss and provide be tokenized, tracked, and traded through a blockchain. solutions, address governance and industry standard issues, and Blockchain can serve as a registry, inventory system, and provide regulatory insights. These include The Ethereum transaction platform for recording, tracking, monitoring, and Enterprise Alliance and China Ledger, which are attracting transferring rights to different asset classes, including participation from dozens of major industry players, innovators, intellectual property, votes, digital identity, health data, and real regulators, and governments. estate. Information about the origin of goods, identity This publication may be reused for noncommercial purposes if the source is cited as IFC, a member of the World Bank Group. credentials, and digital rights can be securely stored and traced blurring the lines between private and public, individual and with a distributed ledger. collective.30 Although its innovation is in early stages, blockchain use Conclusion already includes medical record companies such as MedRec In the real world, the choices for business leaders regarding and Pokitdok; digital rights and micropayments innovators such blockchain will not be clear cut. While the potential of as the Brave browser, Ascribe, and Open Music Initiative; blockchain is immense, so is the uncertainty surrounding it. The identity companies such as Uport, BitNation, and BanQu; technology is not a complete solution to be applied supply chain innovators such as Everledger, Hyperledger, and ubiquitously, but instead is one piece of a well-articulated Provenance; and peer-to-peer renewable energy disruptors such digital transformation strategy that probably includes artificial as LO3 Energy and the Sun Exchange.28 intelligence and big data management, among other emerging technologies. Companies need to proceed deliberately but “We should think about blockchain as another class of thing cautiously, in the context of a thorough cost-benefit analysis. like the Internet – a comprehensive information technology There is no magic formula that fits all firms or situations. with tiered technical levels and multiple classes of applications for any form of asset registry, inventory, and Before embarking on a blockchain initiative, organizations exchange, including every area of finance, economics, and need to determine whether blockchain is anchored in their money; hard assets including physical property; and strategy and how it will address existing business problems. intangible assets such as votes, ideas, reputation, intention, They will also need to decide if blockchain can reduce costs and health data, information, etc.” — Melanie Swan, Founder, promote market expansion, and determine whether and when to Institute for Blockchain Studies reengineer their business model to stay ahead of the competition. “A distributed ledger is essentially an asset database that can be shared across a network of multiple sites, Decision makers must also measure the potential technical, geographies or institutions. All participants within the financial, and reputational risks associated with blockchain network can have their own identical copy of the ledger. implementation, and find ways to hedge against them, for Any changes to the ledger are reflected in all copies in example by limiting the perimeter of the project or starting with minutes or seconds.” — Mark Walport, UK Government middle- or back-office improvements that have no direct Chief Science Advisor customer exposure. Businesses also need to determine the direct and organizational costs of testing and adopting blockchain “It has math. It has its computer science. It has its technology, as it may stress already limited resources. cryptography. It has its economics. It has its political and social philosophy.” - Vitalik Buterin, Founder of Ethereum About the Author Marina Niforos is the founder and Principal of Logos Global Advisors, a strategic advisory firm to high-growth startups and Additionally, distributed ledger technology can replace large multinationals, helping them form partnerships and partially or entirely the government’s role as the direct authority leverage opportunities for growth. She is also Visiting Faculty in identity authentication, issuing certificates, land titles, of Leadership at HEC Hautes Études Commerciales de Paris. storing health records, disseminating social security benefits, (marina.niforos@logosglobaladvisors.com) and managing votes and civic participation. Acknowledgments Estonia is a good example of how blockchain can be used in The author would like to thank the following colleagues for this way, with the country’s blockchain-enabled platform, their review and suggestions: Vijaya Ramachandran, Senior known as X-Road, used to provide integrated services to Fellow, Center for Global Development; Michael Pisa, Policy citizens across multiple programs. Similarly, the Dubai Fellow, Center for Global Development; Susan Starnes, government recently announced a comprehensive blockchain Strategy Officer, Sector Economics and Development Impact, strategy to help its agencies run more efficiently, with the aim Economics and Private Sector Development, IFC, William of saving up to 5.5 billion dirhams per year. 29 Haworth, Consultant, Financial Institutions Group, IFC; and Since it operates without the need for a central authority, Thomas Rehermann, Senior Economist, Thought Leadership, distributed ledger technology challenges the assumptions of Economics and Private Sector Development, IFC. governance systems that underpin today’s business models and Additional EM Compass Notes about Blockchain economic and political systems, threatening entire professions This note is the first in a series of five complementary EM and even governments. Blockchain has both the economic and Compass Notes by this author: The notes focus on: (1) a general organizational potential to reduce costs across global value overview of blockchain technology (this note), (2) an outlook chains and ‘redefine an organization’s traditional boundaries,’ for blockchain’s implications for emerging markets (Note 41); This publication may be reused for noncommercial purposes if the source is cited as IFC, a member of the World Bank Group. (3) a general overview of the impact of blockchain on financial Please also refer to EM Compass Note 38, “Can Blockchain services (forthcoming), (4) an emerging market regional Technology Address De-Risking in Emerging Markets?” by analysis of blockchain developments in financial services Vijaya Ramachandran and Thomas Rehermann, for how (forthcoming) and, (5) implications of the technology beyond blockchain can be used to mitigate de-risking by financial financial technology (forthcoming). institutions, which affects recipients of remittances, businesses that need correspondent banking relationships, and charities working in conflict countries. 1 The Fourth Industrial Revolution is the digital transformation 15 “Distributed ledger technology: Implications of blockchain for the economies are undergoing, characterized by a fusion of technologies securities industry.” January 2017. Finra. 16 Ibid. that blur the lines between physical, digital, and biological spheres. 2 Beck, Roman and Christopher Müller-Bloch. 2015. “Blockchain as 17 A hash function is a mathematical process that takes input data of Radical Innovation: A Framework for Engaging with Distributed any size, performs an operation on it, and returns output data of a fixed Ledgers as incumbent organization.” Proceedings of the 50th Hawaii size. In the bitcoin protocol, hash functions are part of the block International Conference on System Sciences, 5390-5399. hashing algorithm which is used to write new transactions into the 3 Bresnahan, Timothy and Manuel Trajtenberg. 1995. “General blockchain through the mining process. purpose technologies ‘Engines of growth’?” Journal of Econometrics, 18 A consensus-based verification process requires that a majority of 65(1), 83-108. network participants confirm the integrity of the data in a transaction 4 Catalini, Christian and Joshua S. Gans. 2016. “Some Simple before that transaction is verified and recorded on the blockchain. Economics of the Blockchain.” MIT Sloan Research Paper No. 5191- 19 “Blockchain - Out of the blocks: From hype to prototype.” 2016. 16. Efma.com. https://www.efma.com/study/detail/25582. 5 Casey, Michael. 2016. “The Blockchain: Decentralized trust to 20 A proof-of-work-based verification process typically requires unlock a decentralized future.” oreilly.com, September 8. participants on the network to conduct some work and establish an 6 World Bank Group. 2017. “Distributed Ledger Technology (DLT) economic interest (for example, obtain a bitcoin) in the process of and Blockchain.” April. FinTech Note 1 (draft). validating the integrity of the data in the transaction. 7 Nakamoto, Satoshi. 2008. “Bitcoin: A Peer -to-Peer Electronic Cash 21 Investopedia, Proof of Stake (POS), definition. System, www.bitcoing.org. www.investopedia.com/terms/p/proof-stake-pos.asp. 8 Bitcoin 22 “Fast Forward: Rethinking enterprises, ecosystems and economies Market Capitalization. July 7 2017. CoinDesk, coindesk.com/price/. with blockchains. 2016. IBM Institute for Business Value, Executive 9 The CoinTelegraph, “A Brief History of Ethereum From Vitalik Report Blockchain. Buterin’s Idea to Release.” 23 Gupta, Vinay. 2017. “Building the Hyperconnected F uture on https://cointelegraph.com/ethereum-for-beginners/a-brief-history-of- Blockchains.” Report for the World Government Summit. 24 World Bank Group. 2017. “Distributed Ledger Technology (DLT) ethereum-from-vitalik-buterins-idea-to-release 10 Szabo, Nick. 1997. “The idea of smart contracts.” Nick Szabo’s and Blockchain.” April. FinTech Note 1 (draft). 25 Swan, M., Blockchain: Blueprint for a new economy, 2015. Papers and Concise Tutorials. 11 Cryptocurrency Capitalizations, Coinmarketcap.com. 26 “Over the horizon: Blockchain and the future of financial 12 Mougayar, William. 2016. The Business Blockchain: Promise, infrastructure.” 2016. Deloitte. 27 Practice, and Application of the Next Internet Technology. Wiley. “Blockchain - Out of the blocks: From hype to prototype.” 2016. 13 Davidson, Sinclair, Primavera De Filippi, Jason Potts. 2016. 28 Catalini, Christian. 2017. “How Blockchain Applications Will Move “Disrupting Governance: The New Institutional Economics of Beyond Finance.” March 2. Harvard Business Review. Distributed Ledger Technology.” SSRN. 29 “Dubai Blockchain Strategy.” 2016. Smart Dubai. 14 Cameron-Huff, Addison. 2017. “How Tokenization is Putting Real - 30 “Fast forward: Rethinking enterprises, ecosystems and economies World Assets on Blockchains.” March 30. nasdaq.com. with blockchains.” 2016. IBM Institute for Business Value. This publication may be reused for noncommercial purposes if the source is cited as IFC, a member of the World Bank Group.