The Basics of Blockchain for Business Lawyers

7 Min Read By: James A. Cox

IN BRIEF

  • As new technologies present new legal challenges, lawyers must understand the fundamentals of those technologies to practice law effectively.
  • So, to that end, what exactly is blockchain technology anyway?
  • What are its advantages and disadvantages?

Blockchain technology (or as some commentators prefer, “distributed ledger technology”) is a major technological innovation that promises to significantly alter the way we do business in several fields. Those changes, in turn, will bring new legal challenges that our laws, courts, regulatory agencies, and other institutions must address. As promising as blockchain technology is, however, it is no panacea. It can offer concrete benefits over prior approaches, but it also comes with real costs that can limit or preclude its use in some applications. To better assess the legal challenges facing existing and new applications of blockchain technology, it is important to understand the benefits and costs of the technology; that, in turn, requires at least some level of understanding what blockchain technology is.

The starting point for the technology was Satoshi Nakamoto’s release in 2008 of the white paper, Bitcoin: A Peer-to-Peer Electronic Cash System (Nakamoto was a pseudonym for the real and still-unknown authors), in which Nakamoto introduced blockchain technology for the first time along with a fully conceived platform for its use to implement digital cash.

By the time Nakamoto released his white paper in 2008, digital signatures were a well-understood feature of the mathematical field of public-key cryptography. Participants generate a key pair composed of a public key and a related private key. The public key is distributed to all participants while the private key remains secret. The relationship between the two keys is such that a message encrypted with one of the keys can only be decrypted using the other key.

In this system, a participant, Alice, can digitally sign a message by encrypting it with her private key, which only she possesses. Anyone can read the message by decrypting it with Alice’s freely available public key, but the fact that the message can successfully be decrypted using Alice’s public key proves that Alice—and only Alice—digitally signed the text with her private key because only Alice possesses that key.

Like some others before him, Nakamoto began by defining a digital coin as a chain of digital signatures, but digital signatures alone could not prevent network participants from spending the same coins more than once by signing multiple but inconsistent spending transactions—the “double-spending” problem. To prevent double-spending, the system must have some way to determine whether the sender, Alice, owns a spendable coin that has not previously been sent to someone else. Prior electronic payment systems typically solved the double-spending problem by relying on a trusted central party to keep track of all transactions. In contrast to such a centralized system, Nakamoto sought a peer-to-peer system that did not assign trusted status to a special central party.

Nakamoto reasoned that a peer-to-peer system could work if each node possessed the means to evaluate for itself the validity of the transaction. Thus, each node would have to maintain its own ledger of all transactions. This ledger—with identical copies distributed to all notes—is the blockchain. All new transactions would be distributed in blocks to all nodes, which would add them to their ledgers.

With each node maintaining its own ledger, there arose a need to ensure that the separate ledgers would remain consistent. Thus, Nakamoto needed a mechanism to achieve consensus among the nodes as to which transactions should be included and in what order. Nakamoto decided to use “proof of work” to achieve consensus on the Bitcoin network. Certain nodes—miners—would validate transaction blocks by performing a time-consuming calculation, adding proof of the successful completion of the calculation to each validated block. Then, in the event a node received inconsistent blocks to add to the chain, Nakamoto specified that nodes should select the valid blocks representing the largest amount of computational work. A proof-of-work mechanism requires a lot of computation, but it is essential to the functioning of the Bitcoin consensus system. Therefore, the system provides miners an incentive payment in the form of newly created bitcoins and transaction fees offered by the sender.

People soon realized that blockchain technology could be adapted to uses beyond Bitcoin. The first such use was to create new cryptocurrencies. Today, there are thousands of “altcoins” using blockchain technology. Beyond cryptocurrencies, many other human activities are amenable to representation in a ledger system like the one underlying Bitcoin. One obvious example is a blockchain used to keep track of assets such as real property, inventory items, and government records. The blockchains in these use cases might operate similarly to the Bitcoin blockchain, but instead of coins, they would employ coin-like tokens linked to the underlying physical assets.

Taking blockchain technology beyond Bitcoin, other developers have implemented systems that offer the ability to execute user-specified programming code on the blockchain itself. For example, the Ethereum platform begun in 2013 allows users to create complex computer code linked to transactions on a blockchain. As a result, some users speak not of submitting transactions on Ethereum, but of creating “smart contracts” (also called distributed applications, or dApps), which run on the blockchain. The availability of smart contracts in a blockchain system makes it possible to envision autonomous, distributed functioning of a number of complex activities that cannot happen today without manual control and intervention, or a centralized bureaucracy.

  • Autonomous trading platforms. Smart-contract code automatically matches buyers and sellers and automatically performs trading on the blockchain in securities, commodities, or other assets.
  • Supply chains. Actors at each stage of a supply chain—purchasing, manufacturing, transportation, delivery, payment—enter secure transactions into a blockchain system, and smart code automatically tracks products, initiates new orders, and allocates appropriate resources at the next stage of the chain.
  • Peer-to-peer insurance. The pooling of risks, the events documenting the losses and claims, and the submission and payment of claims are represented by autonomous transactions on the blockchain.
  • Organizational decision making and voting. Participants in an organization vote for new policies, investments, or candidates by recording secure transactions on a blockchain, and smart-contract code automatically tallies the results and effectuates the election results.

Although blockchain technology confers many potential advantages, its nature poses potential costs as well. Not all centralized ledgers are better replaced by distributed blockchain technology. Some of the potential advantages and disadvantages are described below. The successful use cases will be ones with a favorable balance of factors.

  • Many business processes involve complex interactions among multiple individual or institutional intermediaries that are intended to serve as a check on one another. In a blockchain network, careful planning can allow cryptography and consensus mechanisms to take the place of human judgments about trust, just as they do in the Bitcoin network.
  • Transparency and immutability. The basic operation of a blockchain system is the creation and addition of validated blocks to a chain of prior blocks. These blocks provide a complete record of all transactions and operations processed by the system. Cryptography insures that blockchain records, once recorded, cannot be forged or altered.
  • Blockchains distribute the responsibility for storing and processing information across multiple nodes in a networked system. In doing so, they reduce the number of possible points of failure or points of attack.
  • Automatic rule enforcement. The nature of blockchain systems disallows certain kinds of errors and malfeasance that in other systems might require specialized code or human intervention.
  • User autonomy. Blockchain systems can allow users great autonomy in the control over their own transactions. In the Bitcoin network, for example, so long as the network continues to operate, there is no way to prevent a user from transferring bitcoins or to force an unwanted transfer without the user’s private keys.
  • Performance and scalability. The features that provide blockchain technology its advantages come with performance and resource costs. Even if a blockchain system does not use the proof-of-work system of Bitcoin, blockchains frequently require significant storage, computing power, and network bandwidth. As a general matter, blockchain-based systems use more computing resources and scale less efficiently than systems based on centralized ledgers.
  • Complexity, errors, and vulnerabilities. Blockchain systems can be highly complex and difficult to develop. Moreover, the design and programming of smart-contract systems utilizing blockchain systems is a separate source of complexity, and almost certain to produce significant bugs and vulnerabilities that can lead to execution flaws or vulnerabilities.
  • The blockchain contains a full and detailed record of every transaction processed using the system, and the consensus mechanism of the system ensures the replication of that full record across multiple nodes of the system. These risks do not necessarily prevent the use of blockchain technology for sensitive information, but they can add complication to the design of the system.

To practice law effectively, lawyers today need a basic understanding of modern technologies, which should include the fundamentals of blockchain technology.

ABOUT THE AUTHOR

James A. Cox

For more than two decades, Jim Cox has successfully advised clients on their most challenging and difficult matters in litigation and arbitration, including complex technology-related disputes, international…

Login or Registration Required

You need to be logged in to complete that action.

Register/Login