The Demise of the Public Chains for Securities

The Australian Stock Exchange (ASX) made a big splash recently announcing the cancellation of their blockchain project after spending—and writing off—$165 million. While this sounds disastrous for blockchain technology, it is actually a cautionary tale since the blockchain project of ASX is based on Ethereum.

We have been saying this for over three years: public blockchains for securities and derivatives is a bad idea. In fact, Vitalik Buterin, one of the principal developers of Ethereum, himself noted back on May 19, 2016 that “…the weaker argument, that for high-value assets the economic security margin of public blockchains is too low, is entirely correct and depending on the use case is a completely valid reason for financial institutions to explore private and consortium chains.”  He was alluding to various versions of the settlement finality problem that he describes in that blog. From the subsequent failures of the ICO and the STO initiatives, it appears that very few of those developers read Vitalik’s article or understood it.

In ASX’s case, it appears that their blockchain is based on VMWare’s DLT, which is itself built on Ethereum and apparently addresses the limitations of Ethereum. The VMWare blockchain team had to go through (and probably continue to go through) considerable engineering to extend Ethereum’s functionality to make it useful for enterprise chains. Enhancements include a privacy SDK, governance, and scalability. The amount of work necessary to make Ethereum play nicely with securities is a bit like trying to convert a Ferrari into a cruise ship. It can be done, but why not start with a decent boat instead?

There are two main reasons why public blockchains are not best suited for financial securities. The first reason stems from a massive confusion about the nature of non-payment financial instruments, such as securities, derivatives, and asset-backed digital securities (such as NFTs). These financial instruments (the securities) are not bearer instruments. Transactions involving them are subject to corporate law and securities law. While some of these laws may seem onerous, they are there for good reasons that evolved with several hundred years of experience. Mainly, these laws ensure that transactions are subject to the judicial doctrine of contract law. Entities (companies or individuals) who act as intermediaries in these transactions provide valuable services, chiefly that of assuming counterparty risk. For this reason, the participants in transactions involving non-bearer instruments are either the principals or intermediaries who have fiduciary responsibilities. To put it simply, an ostrich farmer in Kenya has no business validating a securities transaction between a seller in Kansas City, KS, and a buyer in Los Angeles, CA.

This is, or should be, a powerful deterrent for using unverified participants (as in a public blockchain) to validate securities-based transactions.

The second reason why public blockchains are unsuited for such financial transactions is due to technical limitations of public blockchains. Scalability, recourse, recovery, privacy, and safety become paramount. Can a public blockchain provide all that? Yes, but at what cost, when there are permissioned blockchains available for such a use case?

To put it another way, the first reason says,”Don’t let a drunk drive a Ferrari.” The second reason says, “Don’t try to modify a Ferrari into a cruise ship when there is a cruise ship readily available to use.”

At KoreChain, we come from a multi-decade background in the financial industry, as executives, entrepreneurs, and traders ourselves. We are painfully aware of the issues in the existing legacy technologies. We also realize that regulation can be onerous even when well-intentioned. Our concern was not to waste time re-engineering Ethereum or any other public chain for that matter, but instead to focus on solving the business problem. Addressing the friction in the private capital markets was more important than going on a technology goose chase and attempting to shoe-horn a public blockchain for a very different purpose.

For this reason, we built the KoreChain on a solid base of an enterprise-ready, industrial-strength permissioned blockchain. We focused on the business architecture and design of the blockchain application.

None of this is a polemic against Ethereum itself, which is an ambitious technology that brought awareness to the power of smart contracts. It’s just not the right tool for this particular job.

What is Blockchain?

The simplest and most simplistic definition of a blockchain is that it is a chain of blocks. That’s somewhat like calling a naval destroyer a big boat. This simple definition belies the tremendous power of blockchain to transform whole industries. What gives the blockchain the power? Why do we need it? What caused it to engage the public imagination? Why is it so polarizing? Let’s explore this idea a bit.

From a technical perspective, a blockchain is a list of blocks linked to each other, where each block contains a number of transactions. This is where the story gets interesting. The transaction data is immutably locked using cryptographic methods. It is virtually impossible to modify the data without incurring tremendous expense or collusion between the participants.

There is more to it than that – the blockchain is not just an immutable database. It is also a processing powerhouse. Smart contracts drive the verification of participants and the validation of transactions through a consensus mechanism before cryptographically locking the transaction data into immutable records. Moreover, smart contracts can perform many types of processing tasks just like any computer code, but with the difference that the parties to the transaction and other responsible parties must agree and approve the processing steps. This agreement and approval, formally called consensus, is a powerful concept. We will see why shortly.

There are two types of blockchains, broadly speaking: public and permissioned. In a public blockchain, anyone can participate. The classic examples are Bitcoin and Ethereum. In a permissioned blockchain, those who want to participate must obtain permission. Permissioned blockchains are more appropriate for business use or for those applications where the participants are subject to regulatory oversight. Examples of permissioned chains include Hyperledger Fabric, Corda, and Quorum.

All blockchains have three important components: cryptography, distributed systems, and consensus. Cryptographic methods are vital for storing data securely. Distributed systems technology is essential for processing data and transactions across a widely distributed and loosely coupled group of participants. Finally, consensus ensures that only data and processing that is accepted by the majority of the stakeholders is immutably recorded on the chain.

Bitcoin is the first and most widely recognized application of blockchain technology, but is only an application built on blockchain; Bitcoin is not synonymous with blockchain. There are many other applications built on both public and permissioned blockchains.

To understand the business appeal of blockhcain, consider the simple paper-based ledger. Many decades ago, I had the good fortune of training under an auditor. My task was to examine double-entry accounting ledgers and certify their accuracy. On every page of a ledger there were a bunch of transactions (debits and credits). The column totals were recorded at the bottom, signed by the accounting assistant, and countersigned by the accounting supervisor. These debit and credit totals were carried forward to the top of the next page. New accounting entries were added to the next page. When that page was full, the debit and credit totals (which included the totals from the previous page) were recorded at the bottom of that page. And so on.

If the company that we were auditing wanted to fudge the numbers on one of the accounting entries, it would be practically impossible to do it in an undetectable way (all entries were made in ink). Suppose a crooked accountant managed to do it, they would then have to re-compute the debit and credit totals at the bottom of that page, change the brought-forward totals at the top of the next page, recompute and change the totals at the bottom of the next page, and so on. Tearing out an entire page of entries would also be easily detectable in a paper-based ledger since the method of binding the pages would make it very difficult to tear out the pages in an detectable way. Besides, the page numbers wouldn’t match.

In short, the paper-based ledger was practically fool-proof. Crooked companies found it easier to just maintain two ledgers, one for the auditors and one for the “real” transactions.

When computers and databases became widespread, the paper-based accounting system gave way to an electronic ledger. While system safeguards are built into electronic ledgers, it was much easier to make alterations in the database through “backdoor traps” and by people who had direct access to the systems.

Blockchain technology changed all that. It combined the efficiency of modern computer technology with the fool-proof nature of paper-based ledgers, but in a much more sophisticated way. The whole blockchain (viewing it as a database) is the ledger itself. Blocks that make up the blockchain are like the pages of a paper-based ledger. The blocks are linked together through cryptographic links, similar to the page numbers of a paper-based ledger. Each block records a number of transactions (similar to the rows of accounting entries in a paper-based ledger). Transactions inside each block are cryptographically bound together using sophisticated mechanisms such as Merkle trees.

The analogy to a paper-based ledger makes it easy to understand why blockchains are much more secure than just regular databases. The story gets better: paper-based ledgers, while reasonably secure from tampering, suffer from two disadvantages: they can be destroyed in a fire or stolen, and they represent the “truth” only from the viewpoint of the company that owns the ledger. The counterparties to each transaction (for every debit there is a counterparty creditor, and vice versa) may not agree with the recorded numbers. This raises the thorny problem of reconciliation. Companies spend enormous amounts of time and money performing reconciliation and settlements.

To overcome these two disadvantages, imagine if the ledger has multiple copies stored with distributed parties. Moreover, every block (“page”) of transactions are replicated in real-time. This makes it a real-time distributed ledger. Finally, assume that entries in the ledger can be made only when both (or all, or a majority of) parties agree that the numbers are correct. This is an agreement by consensus, which avoids post-facto reconciliation.

This is why a blockchain is also called a distributed ledger. The benefits are enormous: instant reconciliation, settlement, immutability, multiple copies, and agreement by consensus.

This is only scratching the surface of the benefits of a blockchain. There’s more, with smart contracts that perform distributed processing, removing some of the inefficiencies of intermediary processing. Blockchain technology is really a combination of distributed data and distributed processing. These fundamental capabilities enable many fascinating applications that are not possible through traditional and legacy technologies. More on that later!