An Overview of Blockchain’s Characteristics

Opportunities, Constraints, Regulations, Solutions, Trade-offs

Sven Böttger
Sep 2, 2018 · 14 min read

Blockchain is regarded as revolutionary but is controversially debated at the same time. Discussions about the technology neglect its holistic affordance that is still criticised as conceptually ambiguous. Due to the increasing adoption of blockchain, a clear understanding of blockchain’s characteristics is needed and advantageous in order to exploit the innovation potential and create viable business models around this technology.

Thirteen individuals who either have professional experience in the blockchain ecosystem and/or published research in this space were invited to participate in semi-structured interviews. In addition, twenty-four documents were analysed to triangulate the primary data and provide better in-depth insights. Direct quotes in this article derive from these data sources and are kept confidentially.

Neutral Parameters

Blockchain is a technology that concatenates records into blocks and publishes them across a distributed ledger. Each blockchain has an individual consensus algorithm which determines how new blocks are created and verified by the network. This facilitates a trustless peer-to-peer network and an immutable storage. These indispensable key features are neutral and only represent the parameters in which a range of different applications are possible. The parameters can be adjusted according to the context and intended purpose of blockchain in the business.

Opportunities

Many opportunities in the ecosystem of permissionless blockchains are only enabled through different technological phenomena. The first enabler for blockchain’s major benefits is open-source development which facilitates the rapid development in the field of blockchain. The second technological phenomena is the token economy. The token economy is created through the digitalisation and represents an essential opportunity for many unexplored business cases. Tokens are divided into three different categories (1) the security token, (2) utility token and (3) equity token. In order to enable the token economy, so called smart contracts are implemented, representing the third fundamental enabler for opportunities.

Combining the technological key features (distributed ledger, consensus algorithm, immutable storage) with the technological phenomena (open-source, token economy, smart contracts) a series of benefits emerge, described as follows.

As a main opportunity, these technological features and phenomena allow the cutting of intermediaries. Therefore, blockchain technology facilitates a decentralisation that connects users peer-to-peer. Due to the replacement of trusted intermediaries, the technology affords this trust.

Another opportunity, especially supported through the token economy is related to the funding of blockchain-based businesses. By means of the tokens it is possible to receive funding for blockchain businesses by individuals from all over the world, called an initial coin offering (ICO). This funding mechanism is similar to an initial public offering and crowdfunding and is (financially) strongly supported by the blockchain community.

Other benefits include but are not limited to: ease of payment across national borders; data security and immutability; solve income inequality; political neutrality; and authenticity.

Furthermore the opportunities can be understood as an industry potential. Following industries or application cases can potentially gain maximum benefits from the technology: decentralised financial exchanges; prediction markets; asset management; logistics industry; real estate industry; self-sovereign identities.

Implemented successfully, blockchain provides many opportunities as described above. However, the opportunities do not apply for all business cases because blockchain is often misapplied or the context requires better solutions to constraints. For instance, competing with businesses such as Uber and AirBnb requires blockchain technology being capable of handling tens of millions of active daily users. Such an application is at present not feasible due to constraints that are described in the next section.

Constraints

Generally speaking, current blockchains promise a lot but most of the time, it does not work as well as expected. As mentioned above, the indispensable key features of blockchain are distributed ledger, consensus algorithms, and immutable storage, representing the parameters in which a range of different applications are possible. In this section, poorly conceived applications are implied, in order to underline the constraints that arise through the infancy of permissionless blockchains.

1) Scalability

When it comes to the technology’s limitations there is apart from many, one that is standing out: scalability.

“If you are making lots and lots of reads and writes to the blockchain, a lot of notifications and uploading data very, very quickly you are going to run into problems very, very soon.”

Whereas many nodes increase the network’s security they also aggravate inter-node latency. As the blocks have to be propagated throughout the whole network, high interaction rates create bottlenecks that lead to large fees and limited computational capacity that prevent widespread blockchain adoption as well as value capture with blockchain businesses.

2) Storage

Furthermore the concatenation and distribution of blocks lead to storage constraints — particularly under high interaction circumstances. Therefore, most applications that are built on a permissionless blockchain will require a storage solution.

3) Governance

The next striking constraint that can be identified is the lack of governance and standards.

“A public, decentralized blockchain has no central authority or organization making decisions. […] Blockchain governance is an incredibly tricky problem and finding a balance between centralized and distributed control will be key to keeping development on the right path.”

At the end of the day, even a decentralised network needs some direction and management in order to grow and develop. If blockchain aims to achieve widespread adoption by established companies, some implementation of governance is essential.

“If you don’t have a good form of governance, if you don’t have good people behind it, everything sort of breaks down very, very quickly.”

4) Programmability and Interoperability

The next concern is linked to blockchain’s programmability which appears to be challenging at this early stage of the technology.

“Developing a functional protocol or decentralized application on the blockchain is a daunting task even for today’s most seasoned developers.”

In addition, blockchain’s interoperability represents another challenge, as the possibilities to connect blockchains with other blockchains or with related software are nearly non-existent. These barriers in programmability and interoperability point out a very fundamental core issue — security. As mentioned in the section of opportunities, the main benefit of blockchain is trust. Since the technology affords this element of trust for almost all other promises, it underlies one elementary condition:

“Trust requires not only the blockchain to be secure but also all the steps in-between until the layers of applications — everything needs to be reliable secure.”

The promise of trust also means that complete security and faultless soft- and hardware are required. Complicated programmability and interoperability set this promise into danger.

5) Human Capital

Human capital represents another factor that currently constraints blockchain-based business models. Due to the recency of blockchain technology, blockchain developers are scarce which is aggravated through the complicated programmability of blockchain software. However, a blockchain requires human capital for all kinds of responsibilities. From back end development to front end; and not only coders but also designers, business developers, and much more. This requires the development of a large and strong community which is a further challenging process.

6) Privacy and Encryption

Another constraint is linked to privacy and eventually also to encryption.

“The transactions are recorded and stored in a public ledger, but they are linked to an account address comprised solely of numbers and letters. With no real-world identity attached to this address, the transaction’s originator seems impossible to track. However, this appearance of total security is misleading. It’s true that a person can preserve his or her privacy as long as the pseudonym is not linked to the individual, but as soon as somebody makes the connection, the secret is revealed.”

The constraint is a big problem regarding data protection laws such as the European GDPR. Not only that blockchain’s data encryption lacks in privacy protection, the data is also stored on an immutable distributed ledger across an indefinite number of nodes — forever. Stronger methods of encryption could potentially solve the issue but even the most complex encryption technologies could be broken in the future through the use of quantum computing.

7) Misapplication

The reasoning behind some constraints, such as the scalability, can be considered as a misapplication of the technology. But even irrespective to the aforementioned constraints, misapplication of blockchain in businesses is a big issue, underlining that many people do not really look at what blockchain is actually providing.

“The whole notion of decentralization is great but if your use case doesn’t require decentralization, you’re over complicating your system for no benefit. […] Great, your data is stored on a blockchain and is replicated across thousands of machines. But what benefit does that actually give your users, what benefit does it give you?”

Regulations

Although the handling of regulations in the context of blockchain is complicated and might be perceived as constraining at this stage, the regulations also bear promising potential. Many people think blockchain is a means to get rid of the heavy apparatus of government regulation, but in fact it doesn’t magically take away human conflict. Regulations are important for blockchain-based businesses as they have nearly in all cases points of contact to regulatory issues when they enter the market. In those cases, blockchain-related questions need to be answered such as:

  • Where in the world is the business offering the service?
  • Which legal form does the company have?
  • How is the company’s token designed?
  • Is the company a registered business at the regulatory authority?
  • How does the business comply to anti-money laundering laws?
  • How is personal data protected?

The understanding of how the regulations apply to blockchain is still very vague and especially for companies that offer their service worldwide, this is an extraordinarily difficult situation, because they have to be compliant in every market in which they offer their service or digital unit. It does not matter if the regulatory level is extremely low where the company is located. In addition, by virtue of the technology’s infancy, it is unknown how these regulations look like.

“These companies, but also we as a major multinational law firm, are unable to actually cover all the jurisdictions of nearly 200 countries, and to develop a token that is assured to be allowed.”

Running a business in the field of permissionless blockchains will most likely lead to a lot of work around compliance which can be very challenging to handle for a small start-up, reported an interviewee that already made this experience. Furthermore, the potential consequences were highlighted; the company’s management becomes subject of criminal proceedings if they are active on markets where they mistreat legal foundations. This applies to all financial regulations but also to personal data laws:

“The GDPR covers everyone who is in Europe. So, if your blockchain includes anyone in Europe, it generally applies and could therefore, be by the European Union either banned, sued, or worse.”

It is very challenging for businesses to be compliant in the field of blockchain and to deal with the regulations but if the management does not pursue to violate any laws, the business has only two choices: (1) avoid the legal restrictions through offering different services or looking for a loophole, or (2) enforcing and maintaining compliance in every country their service is offered. Both approaches require high (financial) resources and might decrease the funding potential as it might be not feasible to offer the ICO tokens to the whole world. However, even if regulations might be perceived as constraints, these rules are necessary to enable a functioning market. Even if regulations are constraining the blockchain economy to some extent,the implementation of regulations should be considered as supportive for blockchain’s development. Data protection laws are important and once financial regulations are clear and set in the field of blockchain, major financial firms will start to invest in the technology’s ecosystem. Once there is a commercial solution for investing in blockchain it is expected to see an immense financial upsurge. Therefore, the regulations inherit a huge potential and at the end of the day, are very important to build the required trust.

Solutions And Trade-offs

There are a variety of potential solutions to the aforementioned constraints. An adjustment of the neutral parameters allows to withdraw the majority of constraints. However, many of these solutions are only presumptions that have not been field tested yet and involve different trade-offs; typically, between security and control.

Overview Different Types of Consensus Algorithms

1) Scalability

The first potential solution to overcome scalability limitations is the modification of the blockchain’s consensus algorithm. The different modes of consensus algorithms are uncountable but the two major ones that stand out are proof-of-work and proof-of stake. Proof-of-work has been field-tested trough bitcoin during the past decade and is integral part of the most disseminated blockchain world-wide. However, the consensus algorithm has its drawbacks. The process of validating and creating blocks consumes high resources of energy. Moreover, in case of bitcoin, so called mining-pools were developed, controlling the network though superior hardware. This development is criticised, as it creates an element of centralisation and therefore, worsens the blockchain’s security regarding immutable storage through decentralisation. Furthermore, the consensus algorithm itself remains rather cumbersome and not scalable unless other features of the blockchain are adjusted. The second most common mode of consensus is proof-of-stake. According to the interviews the consensus algorithm could replace proof-of-work entirely and carries the highest potential in order to cope with the constraints. However, the consensus algorithm has not been field-tested yet for a longer period of time and neither with high number of users. It remains unproven if novel consensus algorithms can meet the current expectations.

The second potential solution to overcome scalability limitations is the implementation of off-chain channels. One particular method that can be underlined in this context is the Lightning Network. It is Bitcoins approach to build a decentralised second layer network that uses state channels via smart contracts to enable instant and scalable payments across a network of participants. This does not require every interaction with the software to be recorded on the main blockchain and therefore, increases scalability — even with proof-of-work consensus algorithm. However, on the downside, trust is reduced in off-chain solutions as not every interaction is recorded on the distributed ledger.

The third potential solution is an approach that initially derived from centralised database optimisation: sharding. Hereby, scalability is provided by dividing the network into subgroups that follow a hierarchical structure in which the leaders agree on a consensus with each other. The approach is promising but the blockchain community is generally against hierarchies and any form of centralisation.

The last solution for increasing the scalability is a rather simple one: adjusting the block size of the blockchain can re-expand the bottleneck and leads to a maximised information throughput. Whereas Bitcoin has a fixed block size, other blockchains use a dynamic model which allows unlimited block sizes. The trade-off for this solution is that decentralised network structures become more centralised as not every full node across the globe has a sufficient bandwidth to download, process, and mine the entire blockchain. Therefore, certain groups are excluded which is against the ideology of blockchain’s fundamentals. Furthermore, for already established blockchains, a belated adjustment of the block size is no longer possible without restrictions. Bitcoin would have to conduct a hard fork as the block size is defined in the network’s protocol.

Finally, the pressing question is how promising are the scalability solutions?

“The truth of the matter is that unfortunately, none of the solutions provide the silver bullet answer to scalability. In reality, each one of these solutions will help improve scalability incrementally. Combined together, there’s a promising outlook for the future of blockchain scalability.”

2) Storage

One approach to cope with the storage constraints is called segregated witness. A process in which insignificant information of the blocks is removed in order to free up space on the chain, which increases the capacity to add more data.

3) Governance

It appears that some mode of centralised authority is required at the current stage in order to provide the network with guidance — even though the decentralisation is the pillar of blockchain’s trust mode. All major blockchains have a foundation or thought leaders that govern the blockchain in the background. Examples include the Bitcoin Foundation or thought leaders like Vitalik Buterin. Nevertheless, these examples will not be the final solution for governance; concluding that the required rules and structures are yet to be discovered.

4) Programmability and Interoperability

In regard to interoperability there are some businesses working on potential solutions, such as the Quant network which aims to connect the world’s blockchain networks. Any potential solutions to the programming constraints could not be identified leaving the question about complete security unresolved.

5) Human Capital

In order to deal with human capital constraints in the context of blockchain it is inevitable to build, maintain, and grow a large and strong community. Therefore, it is crucial to interact with the community through online channels, meet ups, etc.

“If you draw from the community, you should also give something back to the community. And if you’re offering some sort of value to the community, then the right people come back to you in order to work on your projects. That is how you find the groups with whom you can build blockchain projects together.”

Apart from that, three main factors could be identified that influence a programmer’s employer choice: salary, vision, and team.

6) Privacy and Encryption

In order to cope with blockchain’s data misuse two potential solutions were identified in order to secure privacy. Firstly, the so called ring signature. An encryption method that is implemented by Monero and allows the network to approve transactions without exposing who was part of it. Another solution to the constraint of privacy are zero-knowledge-proofs or also called fraud proofs, which are mathematically or programmatically included in certain protocols. These methods allow to approve transactions without revealing anything except if the quality is true or false. However, the trade-off for increasing the privacy also reduces the feasibility of tracing criminal activities. Decrypting the private data for legal reasons would require some implementation of centralised authority, which leads back to limited governance capabilities. No data source provided any solution for the potential constraint that quantum computing could break encryption.

7) Misapplication

Last but not least, businesses should not integrate blockchain in their business model if an implementation does not lead to more value for the business and the customer. As shown above, blockchains opportunities should provide a scope of what applications make sense in this context — mainly considering the marginalisation of middlemen. However, it is useless to apply traditional business models on the blockchain and expect equivalent value capture. Especially, in regard to the constraints in scalability, many businesses might rethink their application of blockchain:

“In a sense, current conceptions of blockchain are trying to do the impossible. They want the security of a decentralized system with the control of a centralized one. The desire is the best of both worlds, but what they end up getting is the worst of both worlds. You get the costs and difficulty of a decentralized system with the failure modes of a centralized one.”

Conclusion

The presented findings only provide a snapshot of a very young and rapidly developing technology. The ecosystem has not gathered a dominant design yet, which leaves room for the development of clearer characteristics and further research. The ecosystem of permissionless blockchains is working actively on overcoming the constraints and the presented solutions appear promising. However, it remains to be seen if such novel approaches can keep their promise and if the associated trade-offs are worth it.

Overview Constraints, Potential Solutions, and Trade-offs

Let me know what you think about blockchain’s characteristics and don’t hesitate to correct any mistakes I’ve made, or start a (healthy) discussion in the comments.

Also, don’t miss my other articles about the design of blockchain-based business models and value capture with blockchain-based business models.

Happy blockchaining!

Sven Böttger

Written by

Blockchain Researcher at the University of Edinburgh Business School

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