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How Is Blockchain Used?

Financial transactions are the most obvious application, but there are other opportunities as well.

In this second article of our blockchain series, we look at where the investment activity is and how the technology can be applied. We also name some limitations. For background, see our previous article, "Blockchain: Disruption by Decentralization?"

Among existing companies, several industries are dominating early experimentation with blockchain technology. Blockchain was invented for payments, so it’s no surprise that the financial services sector has taken an interest; Bank of America (BAC) and Mastercard (MA) have filed for dozens of patents between them. Some technology companies--namely IBM (IBM), Apple (AAPL), Intel (INTC), and Accenture (ACN)--each have accumulated patent filings in the double digits. Applications are not limited to these two sectors, however. General Electric (GE), Walmart (WMT), and others have joined the rush to create proprietary blockchain applications.

As with any emerging technology, the bulk of investment activity is occurring at early-stage companies. Excluding endeavors that have funded themselves via token offerings, companies using blockchain technology have raised billions in venture capital funding, with dozens having raised more than $10 million. Companies such as R3, Ripple, Chain, Ledger, and Digital Asset may not yet be household names, but these well-funded firms are increasingly working with companies that are. The investment activity of the largest public companies and venture capital firms is consistent with our view that there are a handful of immediate-use cases for the technology.

Most of the activity is in financial transactions, though other applications are arising. R3 has produced an open-source distributed ledger product that enables a variety of financial applications. Digital Asset’s offerings are similar, in that a permissioned blockchain is used to avoid some of the privacy and regulatory issues associated with public blockchains. Ledger provides security solutions for cryptocurrencies. Ripple is focused on cross-border payments, enabled by using its own digital asset, XRP. Blockstream is developing a variety of sidechain applications.

Steem is an interesting experiment outside the financial services sector. It produced a crypto-based social publishing platform along the lines of Reddit. Users earn financial rewards in cryptocurrency rather than "upvotes." Canaan Creative has produced specialized bitcoin mining hardware.

Venture capital firms and publicly traded companies are not the only source of funding for blockchain projects, though. The technology has made possible a completely new asset class, as ventures raise funds by selling digital assets. These initial coin offerings, or ICOs, have resulted in several billion dollars in funding for blockchain projects in the past year alone.

ICOs have produced even more speculative activity on average than the venture capital space. Larger amounts of money have been raised by ventures straying even further away from Nakamoto’s initial ambitions for payments. As a new, highly speculative asset class, ICOs have generated significant regulatory attention, with some parties engaging in outright fraud as fundraising activity skyrockets.

That said, there have been notable ICOs with viable product plans and talented teams, and sophisticated investors have backed some of them. Ethereum and Filecoin, for instance, provide distributed computing. PitchBook has developed a seven-factor framework for qualitatively assessing initial coin offerings. In addition to factors common to other early-stage ventures (market opportunity, founding team, key milestones, and legal/regulatory considerations), PitchBook suggests analysis of the incentive structure, token classification, distribution, purpose, and potential network ecosystem.

Blockchain Applications
Our analysis, along with the bulk of investment activity in the space, points to three broad primary categories of business applications for blockchain/distributed ledger technology, with significant overlap: financial transactions, data management, and marketplace activities. Financial transactions involve trust, recordkeeping, and the transfer of information and value. Data management often requires trustworthy, permanent (or at least long-lasting) storage of information. Marketplaces coordinate trust, transactions, and information transfer between unrelated parties.

Financial Transactions
In the financial services sector, payment transactions were the first application for blockchain technology. We’ve been bearish on bitcoin as a method for consumer-to-business payments, but other types of payment transactions are proving more amenable to blockchain processing. Traditional cross-border payments, for example, are often accompanied by high fees and long settlement times.

Experiments with trading applications followed initial activity in the payment space. The current financial ecosystem often involves slow transactions, costly and time-consuming recordkeeping activities by multiple parties, and limited transparency. Settlement activities often take days, with information and funds passing through multiple parties as they travel between buyers and sellers.

Blockchain-based clearing and settlement solutions are already being explored by exchanges. These solutions promise to speed up transactions and eliminate the need for costly, duplicative recordkeeping and reconciliation. For example, post-trade processes currently involve payment systems, securities settlement systems, central securities depositories, and central counterparties, often across multiple jurisdictions.

A simple example of such needless complexity is the practice of balancing a checkbook. There was a time when most bank customers would record all of their transactions and match that record to the statement sent by the bank at the end of the month. Any differences or disputes could be costly and painful to resolve, as each party has its own version of events. A similar process is undertaken by financial institutions around the world as they reconcile thousands of transactions across a wide variety of markets. Shared, verified ledgers provide an obvious solution, replacing hundreds of hub-and-spoke connections with a means for every node to interact directly with the others.

Companies that engage in similar activities on a large scale are theoretically at risk of being disrupted by decentralization solutions that allow customers to exchange value and share information without the need for a trusted intermediary. Within financial services, these include companies in the payments, custody, and trading industries.

Identity and Data Management
A blockchain is a distributed database, so it’s logical that the technology can be useful in various data management applications. The technology provides a way to secure data, permit ownership, and share that data when desired. Companies in a wide variety of industries could move data onto decentralized databases, improving access, security, and transparency in fields from healthcare to transportation. Healthcare records require high levels of security, but this is usually offset by inferior portability as fragments of data are kept at a variety of individual providers over time. As privacy concerns continue to grow and hacking becomes more damaging, consumers may wish to retake control of their own data from the corporations that have been controlling and monetizing it. Decentralized control of identity has the potential to give individuals the rights to share only the aspects of themselves they choose to release.

Supply chain management often involves information flow and recordkeeping by hundreds of parties, making blockchain a seemingly perfect vessel for the maintenance of trade records. Food safety incidents could more quickly be traced back to their origins, for example, and goods and funds could be more easily tracked across international borders.

Companies that gather, manage, and sell data on a large scale could be disintermediated if data collection and management functions move onto a blockchain, with individual citizens or companies controlling the ability to share their data. Financial and consumer data could represent low-hanging fruit for the disruptive technology.

Marketplaces rely on trusted middlemen to broker transactions of all kinds. Blockchains, in contrast, provide the ability to construct decentralized marketplaces. One such example, OpenBazaar, is a decentralized e-commerce market along the lines of eBay (EBAY) or Amazon (AMZN). In contrast to its centralized competitors, OpenBazaar charges no platform fees and has few to no restrictions. Most sectors have companies that engage in marketplace activity, matching buyers and sellers and brokering transactions of all kinds, such as C.H. Robinson (CHRW) in industrials and Intercontinental Exchange (ICE) in financials.

The growth of the sharing economy has created new such marketplaces. Companies such as Uber and Airbnb are increasingly serving as markets for unused resources. Over time, more and more economic activity could be organized and consummated using blockchains. Taking this to the extreme, one can easily envision a futuristic scenario in which all capital and labor transactions are decentralized using blockchain. If suppliers, customers, and employees can all arrange transactions via blockchain, the need for profitable intermediation services could decline rapidly.

Blockchain Limitations
Beyond competitive considerations, there are some broad technical reasons blockchain technology may not be extremely disruptive in the near term. Despite the hype, major issues remain. There are trade-offs among decentralization, scalability, and security.

It’s important to remember that decentralization is not always better. Without a clear chain of command, disagreements can cause major problems. Already, major blockchains have experienced disputes and forks--disagreements that result in permanent splits of a chain and the efforts surrounding it. Centralized control has its disadvantages, but the ability to quickly and efficiently resolve disputes is a major advantage over decentralization.

Scalability remains a major issue--typically, all nodes will process all transactions in parallel, which leads to enormous inefficiencies. Estimates from indicate that the bitcoin network alone is consuming close to 60 terawatt-hours of electricity per year. For comparison, the largest nuclear plant in the United States, the Palo Verde Generating Station, produces about 3,937 megawatts at net summer capacity, according to the Energy Information Administration. It would therefore take almost two of these plants operating at full capacity to power bitcoin for a year. There are some potential solutions to the technology’s problems. Reducing the need for parallel storage and processing is a key objective; ideally, enough nodes participate to produce the benefits of blockchain protocols, but not so many that time and cost begin to cause problems. Some actions can also be moved off the blockchain to better balance speed and security, but such solutions are in the early stages.

Privacy and security concerns still exist in the blockchain world. While the system itself can be quite secure, individual accounts can be far more difficult to maintain. In the case of bitcoins, for instance, a lost private key--and the funds attached to it--can never be recovered. Attacks to gain majority control are not out of the realm of possibility; as bitcoin mining activities became both more profitable and more difficult, large miners began to centralize processing activity with the decentralized network. Selfish mining can also create problems. This strategy involves a pool of miners temporarily "hiding" the longest chain from the network’s honest nodes. The rogue miners can thus establish a lead, generating more legitimate blocks and rewards while the honest nodes waste resources attempting to catch up. This also gives honest miners the incentive to turn rogue and join the selfish pool until rogue miners dominate the network.

Perhaps more important, a plethora of individual targets offsets the lack of a central target for hackers. Theft or loss of a bank card is now a relatively small, manageable problem. However, the loss of a private key can result in massive, irreversible losses. Responsibility for safety and security falls on the individual. Some participants prefer this philosophically, but in practice many will depend on third parties for storage and custody of valuable information, effectively recreating the existing financial system.

Bugs can also present massive problems because of the irreversibility of transactions. In a simple example, a code vulnerability led to a dispute and hard fork between Ethereum and Ethereum Classic. As smart contracts become more prevalent, users must ensure the software and smart contracts they are using are bug-free, replacing trust in humans with trust in code. If code is law, then ignorance of the code is no excuse.

Jim Sinegal does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.