Blockchain Technology: How it works, main advantages and challenges

The market entry of blockchain technologies is touted as one of the most disruptive forces for the financial services industry and beyond, according to analysts, set to radically transform the way transactions and communication flows are organised. Despite the hype, the technology remains shrouded with ambiguities – Alessio Villanacci, a Senior Consultant at Sia Partners, provides a synopsis of Blockchain and its basic mechanics, as well as some of the advantages and challenges that come with the innovative technology.

Blockchain technology was introduced in 2008 along with the digital currency, the Bitcoin. Given this close relationship the two are often confused and it is important to draw a clear distinction among them. In essence, Bitcoin is the digital currency while Blockchain is the technology that enables moving digital currency or assets (think of it as the VISA circuit). 

Understanding the term Blockchain

Each ‘block’ in the Blockchain is made up of computer code containing data and can be programmed to represent anything from money (as in the case of the Bitcoin) to a birth certificate. Every single ‘block’ is connected to other blocks securely through encryption, hence the ‘chain’. This ‘chain’ can be compared to the likes of a traditional database as it contains an aggregation of data. 

The Blockchain taken as a whole can be compared to an accounting ledger which contains a record of transactions. Instead of recording transactions on paper or on a local ERP software the Blockchain relies on a ‘Distributed Ledger’. In practical terms, the Blockchain is just another name for the distributed ledger (while not completely correct* this is how the term is commonly used).

The distributed ledger

The distributed ledger is a synchronised database stored simultaneously on thousands or computers worldwide; there are thousands of identical copies of the ledger around the world at any given time. The principle of a distributed ledger is key to understanding the impact of this technology: it acts as a central repository of all transactions which represents at any point in time a single source of truth for all the members of this network.

The ledger effectively replaces a central ‘trusted’ intermediary which is represented by a bank in the transfer of money or the official land registry in the case of land ownership transfers. In other words, the Blockchain could ‘cut the middle man’ and replace several key services offered by banks and credit card circuits including money storage or transfer.

At a higher level of abstraction, the distributed ledger can be seen as a tamper proof method to share information. If widely implemented, Blockchain could transform the way society interacts not only in financial transactions, but in day-to-day life; just as the internet brought about instant digital communication, the Blockchain can bring near instant and secure digital asset transfer and movement.

Transparency, Security and Speed are key advantages

The use of distributed ledgers as a means to transfer digital assets presents various advantages vis-à-vis the current solutions:

• A transparent, single source of truth – If any member of the network tries to make a change to a block everyone else in the chain can see where the change happened and can decide whether this is an authorized change.
• Tamper proof information – In practice, say the distributed ledger is shared across 5,000 computers and a hacker wanted to change some information recorded in one of the blocks, they would have to hack all 5,000 computers simultaneously. This is an arduous task.
• Instantaneous transfer – Reconciliation and payment of transaction happens in less than 10 minutes versus an average of a few days for third-party systems.

Blockchain has limitations at the current stage of development

The lack of scale and the technical limitations at this stage of technological development lead to a number of challenges which the technology will need to overcome. These include:

• Size – each block of the chain can only contain 1MB of data
• Volume – Blockchain is restricted to handling 7 transactions per second while VISA has the peak capacity to handle 56,000 transactions per second.
• Lack of maturity – the lack of scale means high marginal cost compared to existing systems

Related: ‘The potential of blockchain as a future financial services infrastructure’ and ‘The benefits and use cases for blockchain in banking’. 

* Blockchain is a type of protocol (a common language) used for Distributed Ledger Technologies. There are other technologies that essentially do the same job but are called differently (an example is Ripple).