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Bitcoin and Blockchain Technology

There has been a significant amount of news recently about Bitcoin and the fortunes that have been made and lost over the past few months. Bitcoin is going to have a profound impact upon the financial services industry. There is no question about that. The question is when your Board of Directors and Executive Leadership Team is going to be coming to you with questions about the technology that you’re going to have to explain in terms that they can understand. In this blog entry, I’m not going to get into Bitcoin as a financial instrument. We’ll save that for a later post. Right now, I’d like to lay the foundation for you by sharing my interpretation of the technology behind Bitcoin and its sibling cryptocurrencies (I hate that term … ‘currency’ implies a sovereign backing that doesn’t exist).

 

Simply put, Blockchain is the decentralization of transaction recordkeeping. Basically, a ‘chain’ of transactions is created. As new items or transactions are added to the record, or digital ledger, of a block (think a coin here), the chain is extended or amended to include the new transaction at the end of the chain. Once we add encryption to this chain, the idea is that an unbroken, tamper-proof, and error-free ledger is maintained for each block. Notice that no third party is required to manage the ledger. This is typically the function filled by financial institutions in processing the movement of money. I tell my bank to transfer $1,000 from my account to another account (via check, payment card, ACH or Wire, etc.) and they keep track of the transaction until it is complete and verified. With Blockchain, this verification and transaction log virtually travels with the money as it’s moved. The bank is no longer needed as the middleman. There is no central repository for the ledgers and thus no central control over the data. Since there is no requirement for independent verification, transactions are virtually immediate with no lag in verification. Verification travels with the block, so transaction are verified 24 hours a day, 365 days a year.

 

Now, I keep referring to financial instruments such as coins when referring to the block. However, there are other financial transactions that could be modified to use Blockchain. Think for a moment about the immensely complex transaction in purchasing a home. The transactions that occur between attorneys, banks, inspectors, insurers, regulators, tax agencies, title companies, etc. The notarization of documents that have to be sent around these participants in the process. The loan officer is typically responsible for keeping up with all of this paperwork. Verifying each transaction and certifying that everything has been completed correctly and recorded. Participants must keep their own copies of the records separately. Blockchain would facilitate a trusted, error-free, and encrypted digital ledger of the entire transaction. Visible to all participants, it would facilitate every element of the transaction until it was complete. The buyer and seller would be able to determine easily if everything was complete prior to closing. Participants not fulfilling their obligations in a timely manner would be immediately apparent to everyone.

 

So now that you know it’s not simply about coins, and that there may be some value for you in learning about this technology, let’s dive in a little deeper. Let’s begin with understanding how the Blockchain created. There are two primary ways that Blockchains are validated: Proof-of-Work (PoW), and Proof-of-Stake (PoS).

 

Proof-of-Work is the model currently used for cryptocurrency miners. In this model, people with really high-powered computers compete against each other to be the fastest to apply a complex algorithm for solving the encryption protecting transactions on a Blockchain network (i.e. Bitcoin, Etherium, etc.). The first person to solve the algorithm validates the block of transactions. This is, for lack of a better term, creating the block. In the example of cryptocurrency, the miner is rewarded for his effort by being paid with a very small fraction of the digital bitcoin that was created.

 

Proof-of-Stake depends upon how many blocks you already own (your ‘stake’ in the entire Blockchain network). As a block holder, you are chosen to validate new blocks and add to the Blockchain based upon your total investment in the network. The more blocks (coins) that you own, the greater the chances that you’ll be chosen to validate additional blocks. As with PoW, a tiny transaction fee is paid by the users of the block that is being verified.

 

The term ‘cryptocurrency’ implies that all Blockchain transactions are anonymous. Well no, they’re not. In fact, most Blockchain transactions aren’t anywhere near anonymous. It is possible to analyze the chain and trace back to individual senders and receivers of funds. Some of the cryptocurrency coins have made a concentrated effort to increase security by using protocols designed to obfuscate forensic efforts at identifying the sender, receiver, and amount of the transfer. These are the coins that are being used by criminal elements for ransomware, acquisition of illicit products, and facilitating terrorism. These providers obviously give Blockchain a black eye. Efforts should be made to curtail them. However, it’s not only coins that are going to be facilitated with this technology. Therefore, the technology should not be dismissed simply because there are ugly applications as well as beneficial applications.

 

We are going to see additional applications of Blockchain in our industry in the future. The Internet of Things is going to be a significant opportunity for this technology. As will supply chain in manufacturing and industrial control system management. Practically anything that involves transactions and recordkeeping will likely have a Blockchain application.

 

Updated 2/22/2018: I’ve been receiving one question repeatedly over the past few weeks regarding this post. Who gets the $10,000 or so from mining a new Bitcoin if the miner only gets a dollar or two for his effort? The answer to that is the person receiving the coin. Let me present a simple scenario that I hope will explain this for you. I have to pay a ransomware hacker one Bitcoin to unlock my files. I go to an online provider, create a wallet and use my credit card to buy one freshly minted Bitcoin. I have now added value to that ’empty’ new coin in the amount that coins are currently exchanging. Let’s say that’s $10,000. Now I send that coin to the hacker. He now has a coin that has some value to it. He can exchange it with someone else, let’s say on eBay for a car, or he can try to sell it on the open market for cash. In either case, $10,000 in value is now transferred from him to someone else. This scenario now repeats itself over-and-over with the digital ledger keeping track of the coin’s ‘current’ value as it is repeatedly transacted. But the point is, that the freshly minted coins have zero value until I ‘purchase’ it for $10,000 and then transferred that value to the hacker who now had ‘my’ $10,000. Hope this helps. – Brian.

 

Brian Toevs, PhD. MBA

Sector Chief – Financial Services

InfraGard Indiana Members Alliance

Work: (812) 238-2165

iPhone: (540) 815-3465

brian.toevs@indianainfragard.org

Twitter: @indinfragard

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