Blockchain Technology: Why Law & Finance Won’t Look the Same in 5 Years (Part 2)

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blockchain

In my first blog post on blockchain technology and its potential impact, I described how virtual ledger technology works and why its development is progressing at a much faster rate over a number of platforms and communities.

Regardless of the protocol, however, all blockchains share at least two fundamental characteristics. First, they are decentralized in design. Rather than rely on a central ledger that is maintained by a trusted party (e.g., your bank, the U.S. Federal Reserve, the Social Security Administration), a copy of the ledger exists on every participant’s computer (referred to as a node) and each copy of the ledger is updated simultaneously as and when information changes.

This decentralized architecture is often referred to as being a peer-to-peer network since individual nodes all have peer nodes with whom each communicates, but not all nodes share the same peers. An important benefit of this architecture is that there is no single point of failure. The disconnection of any one node has no material impact on the network as a whole because the remaining nodes will continue to operate uninterrupted.

In addition to a decentralized architecture, all blockchains have a means for achieving what is referred to as “consensus”. Consensus answers the question that you may already be asking yourself: Without a sort of central “clearing house”, how does every participant know that its ledger looks the same as everyone else’s ledger and that this shared ledger is accurate. At the heart of each protocol is a solution to this problem, which is referred to as its consensus algorithm or mechanism.


Without a sort of central “clearing house”, how does every participant know that its ledger looks the same as everyone else’s ledger and that this shared ledger is accurate. At the heart of each protocol is a solution to this problem, which is referred to as its consensus algorithm…


For example, both of the better-known cryptocurrencies that use blockchain technology — Bitcoin and Ethereum — use a technique known as “proof of work” to ensure that malicious nodes are unable to tamper with the ledger. Proof-of-work is based on the simple economic principle of scare resources. More specifically, the nodes that are responsible for ordering transactions into sequential blocks (known as “miners”) are all engaged in a game of sorts. The protocol is programmed such that only one miner can win the game and have its block added to the chain — and in exchange, be rewarded with a fixed amount of Bitcoin or Ether, as the case may be.

The “game” each miner is trying to solve requires a large expenditure of electricity and computing power. So much so, that the cost to tamper with the ledger would in theory far exceed the gain achieved by such a malicious act. Proof-of-work is not an optimal solution, however, because it does require such a massive amount of electricity and computing power to maintain the integrity of the ledger.

There are several other alternative consensus algorithms that are also available. Proof-of-stake (which Ethereum ultimately intends to implement in place of its current proof-of-work model) requires that the validating nodes have an economic stake in the underlying ledger (through ownership of its underlying cryptocurrency).

The amount of each validator’s stake is proportionate to its influence on the ordering of transactions and creation of new blocks. Again, the idea is rooted in basic economics inasmuch as validators have the incentive to be honest or otherwise lose the value of their stake in the protocol. Within permissioned ledgers, the most common consensus algorithms being developed are based on Byzantine fault tolerance (BFT) algorithms, which are essentially mathematical models which determine what percentage of consensus among the total number of validating nodes must be achieved in order to ensure the integrity of the ledger. Permissioned protocols under active development include those used by Hyperledger Fabric, Chain’s Core and several other protocols and are all capable of relying on BFT-like algorithms.

In my final post in this series, I will discuss sample use cases and share my opinion on how blockchain technology will impact transactional lawyers in the years to come.