Bitcoin at all-time high - A 101 on the topics Blockchain, Cryptocurrencies & Smart Contract

During 2008, when the trust towards the financial system was at its lowest because of the financial crisis, Satoshi Nakamoto developed the idea of chaining transaction blocks in a distributed way, through a blockchain that was implemented to create the first cryptocurrency: Bitcoin.

Figure 1: Bitcoin price - source: Coindesk 

There was a storm around blockchain technology in past years and someone declared the end to currency as we know it now while others even claimed that this technology has eliminated the need for banks. With Blockchain we mean a DLT, distributed ledger technology, information technology that had allowed to implement or try to apply new concepts as building a non-mutable ledger for government records, developing other digital currencies, and permitting cross border transactions thanks to the distributed ledger. 

Figure 2: What is a blockchain? – Source: BlockART Institute 

Under an operative point of view, with Blockchain, when an individual requests a transaction, it is broadcasted to a network that has to validate it using predefined logics and rules and creates a group of verified transactions to create a block that is then added to the current chain of block making it unique and uned-itable. This technology has been applied to build digital currencies basically because it is secure, not duplicable and globally distributed without the need for intervention from government entities. 

Indeed, the main characteristic of a Blockchain is that it works as a distributed ledger because the transaction is shared among all the nodes and all the enti-ties can modify the single copy of the transaction. After a transaction is recorded by an entity, then the same true copy is visible to all the entities for viewing and editing. Moreover, all the participants in Blockchain must agree on a mechanism or a rule to update and approve editing on the information through a consensus mechanism. So distributed ledger eliminates the need of having a third party or a clearinghouse to set rules and workflows for consensus and authorization of the transaction in question. 

Figure 3: How a blockchain works – Source: BlockART Institute 

Every record has a timestamp and a unique cryptographic signature enabling audit trails and registrations through the entire transaction history. To sum up, when a transaction is recorded in a public or private network of a Blockchain, all the history related to the transaction is permanently recorded in a sequential chain of blocks. The latter is protected through cryptography and linked through a unique hash code generated by a mathematical function. All blocks are thus linked in a chain from the first transaction to the current state and each entity would be accessing the single true copy of the transaction all the time until it is posted and they can only view/edit the blocks in the chain when they are authorized to do it. 

In the Blockchain, cryptographic hashes are needed to ensure that any changes to a transaction result into a different hash with respect to the original one. The most used algorithms for cryptography in the blockchain world are SHA256 and RIPEMD. 

As previously mentioned, the consensus is another fundamental concept in Blockchain since entities need to agree on the validity of transactions so that once a transaction is recorded in a chain it cannot be edited. Some of the most used algorithms used to reach the consensus are the practical byzantine fault- tolerant algorithm (PBFT), the proof of work algorithm (PoW) and the Proof of Stake algorithm (PoS). Thanks to this mechanism, it is ensured that the distributed ledger has the same copies as any modifications to the same will have to occur across all the nodes at the same time. 

All the transactions in a chain are digitally stored so that the identity of the transaction is available in digital format and is called digital signature that ensures prevention of fraudulent entities altering the information before it is submitted to the chain. So digital signature is one of the mechanisms transaction owners could employ to address privacy requirements associated with a transaction. Blockchain could also be based on smart contracts in which there would be conditions applied to transactions and as soon as the conditions are satisfied the next set of transactions would be automatically initiated. 

So, thanks to all these characteristics of the Blockchain, its notoriousness within the financial system is significantly increased especially with the birth of Bitcoin, the first-ever cryptocurrency introduced that has also permitted the development of the concept of mining block: a mechanism that rewards entities for solving computationally expensive mathematical puzzles to add a new block. Bitcoin transactions are relayed to the network of servers, gathered together and added in a block by the first miner able to crack the current puzzle. If a standard computer tried to mine the block by itself it would take more than 500 years to complete it, so that by spreading processing power required to solve the puzzle across lots of dedicated machines the mining time is greatly reduced, this is a costly process. Bitcoin has fostered the development of crypto-world and after it a lot of new cryptocurrencies have been created. Special mention could be made for Ethereum, the second biggest and most diffused cryptocurrency after Bitcoin, that in turn enhances itself the development of digital currencies. Ethereum must be mentioned because it took the application of the underlying blockchain technology to another level introducing a platform including a Turing complete programming language that could theoretically solve any mathematical problem allowing users to create customized currencies and digital financial instruments. 

Figure 4. Ethereum price - Source: Coindesk 

A crucial role here is assigned to smart contracts that allow users to control digital assets through lines of code, enabling them to create entirely customisable systems. The most famous example is the DAO, a crowdfunded Decentralized Autonomous Organization that distributes Ether as a form of venture capital to several ventures depending on how its investors vote it. Indeed, in this case voting rights are permitted through a digital share token allowing shareholders to have their say on proposals submitted. 

Figure 5: Smart Contracts – source: BlockART Institute 

Coming back to Ethereum, its blockchain enables more open, inclusive and secure business networks, allowing for shared operating models, more efficient processes, increasing cost reduction and new products/services in banking and financial world. Ethereum platform allows digital securities to be issued within shorter periods at a lower unit cost with a greater level of customization enabling the tailoring of digital financial instruments, adapting them to investor demands. Thus the market for investors has the potential to expand itself, decreasing costs for issuers and reducing counterparty risk. 

Security, transparency, trust, programmability, privacy, high performance and scalability are the main benefits resulting from the application by enterprises over the last five years of Ethereum blockchain. Regarding the forecast by the sector’s experts, blockchain deployments will enable banks to realize savings on cross border settlement transactions up to 27 Billion dollars by the end of 2030 reducing costs by more than 11%. In particular, Ethereum has already demonstrated the disruptive effect over 10x cost advantages against incumbent technologies. A lot of financial institution acknowledges that distributed ledger technology will help to save billions of dollars over the next decade so that they have started to invest in this technology. 

Figure 6: What Blockchain is built for - source: BlockART Institute  

Besides cryptocurrencies, Blockchain technology has left the floor for the development of digital financial instruments convenient to issue for different reasons; in particular, they are secure, scalable, rapidly transferable, they allow for fractionalized ownership of real-world assets, tokenized micro-economies and more. First of all, digital securities are characterized by authenticity and scarcity since digitization ensures data integrity and enables asset provenance and transaction history in a single shared source of truth. The programmable capabilities are another point in favour of digital financial instruments since through the code is possible to address governance, compliance, data privacy and identity thanks to KYC and AML attributes. Moreover, the processes in this kind of securities are streamlined increasing overall operational efficiency, thus enabling real-time settlement, audit and reporting, reducing processing times, potential errors and number of steps and intermediaries required to achieve the same levels of confidence in traditional processes. In this way, operational efficiency especially impacts infrastructure, operation and transaction costs. Digital securities also allow greater customization allowing issuers to create bespoke digital financial instruments directly matched to investor demand and they can be issued within a shorter time window. All these benefits and characteristics result in more accountable transparent governance systems, more efficient business models, better incentive alignment between stakeholders, improved liquidity, lower cost of capital and risks, and easier access to a broader investor and capital base.