What is a Blockchain?

Photo by nerovivo (Flickr/Creative Commons)

Editor’s Note: The authors of this post are attorneys at Holland & Knight and are writing a series of articles on blockchain technology and its potential application to the legal industry. Below, the first article sets out basic concepts and terminology.

By Joe Dewey, Partner, and Shawn Amuial, Associate, Holland & Knight

Once an obscure technology associated solely with Bitcoin, the blockchain is now all the rage — appearing in numerous periodicals as a revolutionary technology that has the potential to disrupt countless industries, including the very underpinnings of the financial services industries.

Make no mistake, the blockchain is not a fad and it will live up to its disruptive potential. Through the next several articles, we will touch on specific applications of the blockchain to the legal industry.

But before delving deeper, it is key that you understand both the terminology and mechanics of the blockchain. It is important to note that there is not one blockchain, but rather tens of thousands or more of blockchains — some public and others private. In fact, with intermediate coding skills, you could create your own blockchain in less than an hour.

Bitcoin and similar blockchains are very transparent — every transfer of Bitcoin ever made is available for the world to view in Bitcoin’s blockchain.

Contrary to what most people might think, you don’t need a computer science degree from Stanford to understand how the blockchain works. The blockchain is often described as a decentralized peer-to-peer network that maintains a public (or in some cases, private) ledger of transactions.

But what does that really mean? For starters, think of the “ledger” component of the blockchain as nothing more than a database or an excel spreadsheet. Databases can store all sorts of information, such as names, ages, account numbers, baseball statistics and so on. Blockchains that primarily facilitate the transfer of cryptocurrencies, such as Bitcoin, maintain a database that records how every virtual coin is spent. For example, each time someone transfers a Bitcoin to someone else that transaction is recorded in Bitcoin’s database/blockchain.

Because of this, Bitcoin and similar blockchains are very transparent — every transfer of Bitcoin ever made is available for the world to view in Bitcoin’s blockchain.

So how does the decentralized peer-to-peer system work? Before answering that question, let’s take a step back and recognize that the ledgers (or databases) described above, have existed for decades in many conventional settings. For example, your bank maintains a database whose entries keep track of how much money is in each account at the bank.

But here is where the blockchain diverges from this decades old system: With the blockchain, transactions are not entered into the database manually by a bank employee or any other intermediary. Instead, a user simply executes a command to send its Bitcoin to another person without the need for any third-party intermediary, such as a bank. The decentralized peer-to-peer system makes this possible. Rather than a third-party intermediary verifying the veracity of the transaction (such as a payment processor), the transaction is verified by “nodes.”

A node is nothing more than a computer connected to a common network listening for new transactions. These nodes each contain a complete (or in some cases, an abbreviated) history of every transaction completed on a particular blockchain beginning with the first block, which is called the “genesis block.”

Each new block basically contains a set of the most recent (valid) transactions — specifically, each block contains a set of all the transactions that occurred during the (approximately) prior ten minutes.

Once a command is initiated to execute a transaction, a node (usually several nodes) will first verify that the proposed transaction is indeed valid. This is done by tracing through the history of a particular blockchain, all the way down to the genesis block, and confirming that the transacting parties can indeed transact as proposed. Once verified, a transaction is “cleared” to join a block.

This is part of the reason why the blockchain is essentially tamper proof: The blockchain is decentralized. Rather than being controlled by one party, the blockchain is stored on several (perhaps thousand of) nodes, which must confirm that a particular transaction is possible. This ensures that people can’t spend the same Bitcoin twice, which is called a “double spend.” Furthermore, another important characteristic of each block is that it contains a reference to the prior block — creating the “chain” in blockchain. This link is critically important because it all but ensures that a third-party cannot tamper with how past transactions are saved on the blockchain.

So each new block basically contains a set of the most recent (valid) transactions — specifically, each block contains a set of all the transactions that occurred during the (approximately) prior ten minutes.

But, how is this block actually added onto a blockchain? Many are familiar with the stories of the modern-day gold rush set off by the prospects of striking it rich by mining Bitcoin, but what are Bitcoin and other miners of cryptocurrency really doing? Well, the simple answer is that miners utilize computing power to “hash,” i.e., solve a complicated encryption algorithm attached to a given block in order to add that block onto the blockchain. The miner offers its hashing power in exchange for the prospect of earning new Bitcoin or other cryptocurrencies. Ultimately, a miner solves the puzzle and a new block is mined, added onto the blockchain, communicated throughout the network of nodes, and the successful miner is rewarded with newly issued Bitcoin.

Let’s wrap up with an example: I send one Bitcoin (BTC) to my friend Alex at 4 p.m. on a Tuesday. That transaction (e.g., 1 BTC with a unique identifier of say “XYZ”) will immediately be broadcast to the network of Bitcoin nodes, which will verify this transaction’s validity. If valid, within a relatively short period of time, that transaction will end up part of a block. A miner will then mine that block and it will be added to the top of the blockchain stack.

By 4:15 p.m., that transfer of 1 BTC has been registered on the blockchain. Within a short period of time thereafter, that new block will populate through all of the nodes connected to the Bitcoin protocol. If I thereafter try to spend that same Bitcoin, the transaction will be rejected by the network because that Bitcoin (XYZ) will be reflected as spent — the connected nodes will not verify the proposed transaction and therefore it will not be added to the next block. We have taken some liberties in oversimplifying certain aspects of the process — but deeper dives are the basis of entire books.

Human mobility network derived from bank note fluxes via Christian Thiemann et al
Photo by Duncan Hull (Flickr/Creative Commons)

In future articles, we will build on this foundation of basic concepts by fleshing out additional aspects of the blockchain. Hopefully, after reading this article you are ahead of the game by understanding that the blockchain is really nothing more than a database where entries are secure and trustworthy because of a distributed number of “nodes” that maintain the same database, which ensure the integrity of the new blocks being added on the top of the blockchain.

With this, it should be easier to understand how the blockchain radically differs from our current financial and monetary systems, all of which rely on third party intermediaries — such as the Federal Reserve and Visa — to process transactions and secure the integrity of transactions.  If you still find the basics confusing, don’t worry, it will become clearer once we put the blockchain into greater context in our upcoming articles.

In our next article, we will delve into how smart contracts utilize the blockchain. This area has the most potential to disrupt the legal industry, as well as several others, such as FinTech.

In the context of smart contracts, our next article will discuss specific ways in which certain blockchain platforms are moving away from blockchains made solely for virtual currencies and toward a more robust platform that will enable complex contractual relationships to exist on the blockchain. Future articles will discuss more complicated applications that will utilize the blockchain, such as transacting land sales using the blockchain rather than our traditional common law recording act based system. We will then look at what innovations are necessary to bridge the gap between traditional contract drafting and the implementation of smart contracts on the blockchain.

Finally, we will discuss what all this means for the legal industry — what should managing partners be doing to maintain a competitive advantage as the profession transitions to these new innovations? The answer to this question may surprise many in law firm management.