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Blockchain : A look into the Future - & Basic Risks
Issue Number 449

Blockchain : A look into the Future - & Basic Risks

Technological innovations such as robotics, artificial intelligence, cloud technology and the mobile economy have established themselves very quickly over the last few years through developments like social media and digital identities, and have now become a key element of the commercial and social economy (e.g. sharing economy, crowd funding). It is therefore important for companies to understand the impact of these technological advances on their business models so that they can adapt themselves to new circumstances.

The ability to change is now a necessary if not vital skill that companies must possess if they are to defend or expand existing competitive advantages and market shares. These adjustments result in a transformation strategy that makes the difference between success and failure.

The World Economic Forum defines Blockchain technology as follows:

Blockchain or distributed ledger technology (DLT) is a technological protocol that enables data to be exchanged directly between different contracting parties within a network without the need for intermediaries. The network participants interact with encrypted identities (anonymously); each transaction is then added to an immutable transaction chain and distributed to all network nodes.

As a result, Blockchain is expected to offer enormous potential for bringing about radical change in a wide range of industries, business models and operating processes such as payment settlement, accounting or the use of customer and loyalty cards. this new technology will in all probability only catch on gradually and depending on how it develops over the coming months and years. It is therefore less a question of whether Blockchain will establish itself and more a question of when and in what areas.

Total venture capital investment in Blockchain activities reached a new high of USD 1 billion in the end of 2016. The main reason for this rapid growth is the effort being made by the financial industry to capitalize on this highly promising technology. New consortia are being established almost daily and investing further hundreds of millions of US dollars in Blockchain technology.

At this rate, Blockchain could soon overtake all other technological developments (such as cloud computing, data analysis and the Internet of Things) in terms of venture capital activity and increase the gap to other prominent topics such as artificial intelligence and robotics.

This is in part attributable to the challenges facing Blockchain in terms of scalability. The traceability offered by Blockchain can only be achieved by storing the full details of each stage of a transaction, which in turn influences the size of each block and the time required to validate a transaction. The number of storage nodes also grows, and synchronization becomes more difficult as the number of nodes increases. This ultimately increases the waiting time until a transaction is confirmed in a Blockchain network. Power and server costs also rise sharply as a result and negatively affect DLT’s eco-logical footprint.

Blockchain networks can currently record and validate up to seven transactions per second . Fast-paced industries such as financial services need to process thousands of transactions per second and require correspondingly scalable networks and infrastructures. Blockchain networks such as bitcoin and Ethereum are developing concepts for multiplying transaction volumes in order to fulfil these requirements. For example, Bitcoin is to switch to a payment approach (the Bitcoin Lightning Network) that is able to process around 45,000 transactions per second.

This is achieved by breaking down the settlement process into several steps. The Lightning Network makes it possible to execute the transactions themselves outside the Blockchain, with only validation taking place within the Blockchain. This is implemented by opening up payment channels between two or more parties to a transaction contract outside the Blockchain. As soon as the transaction is closed out it is transferred to the Blockchain for validation and recording, in line with the current principle. The transaction between the contracting parties is broken down and encrypted during negotiations.

Another solution for scaling the Blockchain could be a decentralized database that has the characteristics of a Blockchain and can be used for both public and private Blockchains . Such databases will not replace Blockchain platforms but are intended to be used alongside them. One advantage of this is its linear scalability; performance and capacity improve as more nodes are added to the platform.

As soon as there are a given number of copies of a data record, these are replicated in the network. In addition, all transactions are first laid out in a row and then validated, allowing invalid transactions to be removed and added back into the block after correction.

One of the most important developments in the Blockchain ecosystem in recent months is the examination of the idea of private Blockchains. In areas such as the financial industry, a private approval-based Blockchain currently appears to be the only realistically feasible option. The network for such Blockchains can only be joined by invitation, meaning that participants must be known and vetted in advance.

The private Blockchain concept will drive acceptance and implementation of this new technology. This is particularly true for industries in which strict compliance, regulated activities, data protection and specialist knowledge are prerequisites for settling contracts and doing business. The Hyper ledger project is a key example of this trend. The project is a global open source collaborative initiative to advance cross-industry DLT and is hosted by the Linux Foundation. The collaboration includes leaders in financial services, the Internet of Things, supply chains, manufacturing and technology. A key aspect of the project is the protection of privacy through identity and membership services that offer a private Blockchain.

Two groups of innovators have formed on the technology supply side: infrastructure providers (platforms and frameworks) on the one hand and software providers on the other. These two groups are currently driving innovation and permitting demand-driven business innovations. Another unique feature of the Blockchain ecosystem is the formation of consortia from the software supply side and the demand organizations with the aim of speeding up the generation of business innovations.

The vast majority of these applications are currently being pursued in the financial industry, but Blockchain is also picking up speed in other industries as well. Examples of this include the supply chain, container shipping and healthcare sectors, and also public services. This trend will spread to other industries as Blockchain technology becomes increasingly mature.

Blockchain is a highly dynamic technology. In addition to an increase in activities in all sectors, Experts expects to see further innovations and surprises that will confirm Blockchain’s potential.

The risks of blockchain

Risk practitioners across sectors are very excited about blockchain’s promise to help organizations minimize—and in some cases eliminate—the risks posed by current systems. Blockchain is being viewed as the foundational technology for the future re of risk management. However, as the technology continues to mature and many theoretical use cases begin to get ready for commercialization, it behooves the industry to start focusing on a less discussed question: “Do blockchain-based business models expose the firm and market to new types of risk? If so, what should firms do to mitigate these risks?” It’s critical for firms to understand that while blockchain promises to drive efficiency in business processes and mitigate certain existing risks, it poses new risks to the firm and market. Additionally, it’s important to understand the evolution of regulatory guidance and its implications.

These blockchain risks can be broadly classified under three categories:

Standard risks: Blockchain technologies expose institutions to risks that are similar to those associated with current business processes but introduce nuances for which entities need to account.

Value transfer risks: Blockchain enables peer-to-peer transfer of value without the need for a central intermediary. The value transferred could be assets, identity, or information. This new business model exposes the interacting parties to new risks that were previously managed by central intermediaries.

Smart contract risks: Smart contracts can potentially encode complex business, financial, and legal arrangements on the blockchain, and could result in the risk associated with the one-to-one mapping of these arrangements from the physical to the digital framework.

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