In the spotlight: blockchain

Why blocks and chains hold the promise of new freedom

 

Adrian Keller
Partner, Blockchain Audit Leader, PwC Switzerland

Sebastian Ahrens
Director, Head Blockchain Solution Development, PwC Switzerland

Bastian Stolzenberg
Blockchain Expert Assurance, PwC Switzerland

Blockchain technology is rightly considered to be revolutionary. It makes the value chain more reliable and efficient than any conventional approach, especially in the financial world. It’s a place where transactions occur without an intermediary, in real time, and with unalterable records. A widespread application of blockchain technology is cryptocurrencies. These digital coins have many benefits, but also downsides – including a lack of oversight and vulnerable identification mechanisms. But the main thing still missing for blockchain technology to make a breakthrough is widespread trust.

A blockchain is a continuously expandable list of data records or transactions (blocks) linked together in a chain. They function according to the concept of distributed ledger technology (DLT), which in simple terms is a bookkeeping system with ledgers distributed decentrally across the network. These ledgers are run and stored by participants (nodes) in the network. Transactions are done on a direct peer-to-peer basis between buyers and sellers, which means there is no need for an intermediary such as a bank or bureau de change.

The blocks can be used to store all kinds of transactions. Once they’ve been time-stamped they can’t be altered and are thus always traceable. Transactions are chronologically linked to each other, with later transactions being built on top of earlier ones and validating these (Figure 1). This way the blockchain is able to transparently record entries that cannot be erased. Individual blocks are checked by validators (which, in the case of the virtual currency Bitcoin, are called miners). Depending on how the consensus mechanism in the blockchain functions, more than one miner may be necessary. As soon as a block is validated, it is distributed in the network.

Figure 1: The reliability of a blockchain stems from the fact that previous records can’t be altered.

A distinction is made between private and public blockchains. Private blockchains are especially popular with banks, as the closed system checks all the details of transactions and access is by invitation and controlled with a private key. Information on a private blockchain is only visible to those participating in the blockchain. Public blockchains, by contrast, are freely accessible with a public key. Here you can view data and trace transactions without having to participate in the blockchain. With private blockchains, one can only view and conduct transactions by using the private key.

The real value of virtual currencies

One of the most common applications of blockchain technology is virtual currencies, also known as cryptocurrencies. These are used to execute digital payment transactions. Owners store transaction data in encrypted form.

Virtual currencies trace their origins back to the 1990s when programmers and cryptographers tried to use encryption algorithms to protect private email traffic from unwelcome spam. The anonymous creator of the first virtual currency goes under the pseudonym of Satoshi Nakamoto, who on 1 November 2008 presented the idea of a cryptocurrency called Bitcoin in the Cryptography Mailing List. The first transaction with Bitcoin took place only two months later. In 2011, Bitcoin’s creator disappeared from the scene; his idea, however, has continued to develop rapidly.

Now there are more than 3,000 blockchain applications and virtual currencies, almost 100 of which have already notched up a daily trading volume of more than USD 1 million.[1] Bitcoin, the first cryptocurrency, is the best known. Its algorithm is designed to ensure that there will never be more than 21 million Bitcoins in total.

[1] See CoinMarketCap (coinmarketcap.com), Top 100 Cryptocurrencies by Market Capitalization.

Rich potential

Given their disruptive approach, blockchains with virtual currencies are seen as game changers, particularly in the financial industry. Here’s a summary of three of the main advantages:

a) New types of investment

Virtual money grants access to a broad range of digital and low-cost asset classes. It provides the option of tokenising assets on the blockchain. Tokenisation enables assets to be freely split up, traded and transferred between owners.

b) Smart contracts

Smart contracts are programmes on a blockchain that use recurring if-then loops to execute and secure a contract. They automate the process of contract fulfilment, but not the conclusion of a contract. Smart contracts are best suited to standardised mass business where they can replicate repetitive rules.

Let’s take the example of flight delay insurance to illustrate this. Assume that flights are delayed at the airport. On the basis of booking and check-in data, the airport knows which passengers took which delayed flights, and how serious the delays were. It could use smart contracts to automatically pay appropriate compensation or refund tickets for passengers who have taken out and paid for the corresponding insurance.

c) Transactions in real time

Thanks to blockchain and the properties of virtual currencies, money can be transferred directly to underdeveloped areas that aren’t part of the financial services system, without the need for a complicated process or intermediaries. These transactions are cheap and quick. Conversion into a local currency isn’t necessary as the recipient can use the virtual currency for further transactions.

Here’s a simplified example, first of all done the conventional way: A wants to transfer money overseas to B. To do this he needs a trustworthy intermediary, usually a bank. So A instructs his bank to make the transfer. As a rule this takes a few days. The intermediary charges A a bank or currency conversion commission for the transfer.

Now the same example with blockchain: A initiates an electronic transaction which is entered online in a block and sent to all network participants. The miners check to make sure A really has the money and the transaction is valid. The network participants let the others know whether they’re confirming the transaction. Only once network participants (in the case of Bitcoin, the majority) have approved the transaction is it added to the chain as a time-stamped block. And only then is the money transferred to B, as a rule within only a few seconds.

Risks and side-effects

As is so often the case, the greatest strengths also represent the greatest risks. It’s the same for blockchain and virtual currencies. Here are brief explanations of the main challenges:

a) Safekeeping investments

Assets in digital accounts (wallets) are created flexibly and quickly, but they’re only loosely controlled by the owner with a digital private key. If the key is lost or stolen, in many cases the assets are lost. A famous case is a man in the UK, James Howells, who bought a hard disk containing 7,500 bitcoins for a few cents and then threw it out in 2013. Now the disk would be worth more than EUR 57 million. Various institutions are currently working on ways of systematically storing keys and access to digital assets.

b) Smart contracts

Smart contracts allow you to cover many eventualities, but by no means all. Errors in processes or inadequate programming can lead to problems in processing the contract. The contracting parties can’t revoke a smart contract; it was agreed and is automatically fulfilled. Also, the transparency of distributed data in the blockchain means that the algorithms, parameters and terms of smart contracts are visible to everyone, even those not involved in the contract.

c) No central intermediary

The digital transfer of assets does away with the need for a control function performed by an intermediary. So far legislators, supervisory authorities and standard-setters have not established any generally applicable compensatory controls. This increases the risk of abuse, especially money laundering. And because everything is decentralised, there are no bank statements or technical proof of ownership.

All Eyes on Trust

The risks described can all be mitigated with appropriate governance, effective controls, clear processes and stringent guidelines. It’s worth having the infrastructure or outsourced processes set up, checked and certified by a neutral third party. At PwC we’ve developed an application for cryptocurrencies combining our long experience as auditors, our knowledge of software development and our blockchain expertise. The system is modular, is constantly being expanded to include new currencies, and can be adapted to an organisation’s individual needs. Essentially it performs two core controls:

Proof of ownership

The application enables a company to verify ownership and technical accessibility of virtual assets in the blockchain quickly and easily. It supports this proof of ownership either on a case-by-case basis or regularly as part of an annual review of the entire population or individual sample records.

Transaction reporting

Organisations can use the application to generate transaction and inventory reports for any given number of digital assets. The configurable Excel reports allow further transaction tests, analyses or reconciliations. The reports contain opening and closing inventories for the selected period, as well as all the relevant transaction details, including associated transaction fees for selected crypto-addresses.

In reliable hands

Our application allows uncensored access to all information on the blockchain. This is so valuable because it’s recorded in the blockchain in unalterable form and therefore cannot be manipulated. An application of this type goes at least some way to being a substitute for the control function performed by the financial intermediary in a conventional set-up. With this tool we’re able to help organisations deal with the challenges of blockchain technology and implement processes and controls as part of their financial and regulatory governance.

Source: "Do you need a Blockchain?", Karl Wüst, Department of Computer Science, ETH Zurich (https://eprint.iacr.org/2017/375.pdf)

Figure 2: Is blockchain relevant for you? Six questions, one answer.

Not only for financial services

Blockchain solutions and virtual currencies aren’t just for financial services. They can also be used in other industries and areas of everyday life, for example:

– In the luxury goods business, blockchain technology can be used to seamlessly track value creation from the origin to the first purchase and beyond. This involves recording data, reliably and unalterably, on the sources of raw materials, the manufacture of products, trading in these products, and the entire logistics and supply chain. A data history of this sort goes way beyond any real-time certificate or expert opinion.

– In the Internet of Things, physical and virtual objects work hand in hand with the user by way of new technologies and modes of communication. If blockchain technology is combined with artificial intelligence, your smart fridge can automatically order and pay for milk and other foodstuffs according to your wishes and habits.

Something for you?

For many people, blockchains and virtual currencies are an (analogue) closed book. If that applies to you, we suggest checking to see whether blockchain technology could be used to improve and boost the efficiency of processes in your business. All you have to do is answer a few questions to find out whether blockchain is something for you, and if so, what approach you should be going for (Figure 2).

Contact us

Adrian Keller

Partner and Leader Audit for Blockchain, PwC Switzerland

Tel: +41 58 792 23 09

Sebastian Ahrens

Head Blockchain Solution Development, PwC Switzerland

Tel: +41 58 792 1628

Bastian Stolzenberg

Blockchain Expert Assurance, PwC Switzerland

Tel: +41 58 792 6877