June 27, 2017

Taming the Blockchain Badlands

Holland & Knight
David P. Sofge

In the wild and lawless lands of the blockchain, settlers are coming. A sign is the R3 Consortium's recent announcement that it raised more than $100 million in funding from a group of banks and technology companies, sending a powerful signal of support for its effort to fence off and cultivate sections of the new environment created by blockchain technology.1

Early pioneers beginning with "Satoshi Nakamoto"2 in 2008 were drawn by a vision – the prospect of a distributed ledger software running simultaneously on thousands of computers around the world, with information formed into mathematical "blocks" that, when linked into a chain, would be computationally unbreakable and therefore free from tampering or fraud. This "blockchain" would be transparent to all nodes on the network, verifiable immediately at all times and incorruptible. Payments could be immediate and essentially cost-free (no banks or financial intermediaries necessary), so Bitcoin, Ethereum and other 'cryptocurrencies' representing economic value could replace monetary systems controlled by governments and central banks. Tokens representing ownership of land, vehicles, commodities, copyrights and any other asset could be held and transferred without official registries or ledgers. With the "disintermediation" of central authority – governmental and corporate – conditions would exist for the creation of new forms of business and society.

In practice, the new world created by blockchain was not without hazard. Along with the visionaries and social reformers also arrived a cast of rogues, bandits and desperadoes familiar to fans of American horse opera. Mt. Gox, the largest "Bitcoin bank," went bust and collapsed in bankruptcy and scandal. Pirate Bay and Silk Road operated "dark net" online bazaars for illegal and illicit commerce, and their founders were pursued and locked up by real-world authorities. The Decentralized Autonomous Organization (DAO), a European experiment in establishing a venture capital fund running entirely on blockchain software without human governance, made a highly successful offering, quickly raising the equivalent of $160 million in Ethereum (a cryptocurrency rival to Bitcoin). Within days, the fund was attacked by hackers who identified a vulnerability in the DAO software and drained off about $60 million, leading to suspension of the project.3

The Wagons Roll

Undaunted by blockchain's rough and rowdy past, global banks and tech firms have started moving into the territory. R3's new funding will reportedly be used to place into operation a new system for trade finance in conjunction with Japan's Mizuho. Other groups are also pushing in (with overlapping membership, as banks and tech firms hedge their bets). These include the Enterprise Ethereum Alliance (EEA), the largest consortium by headcount, with backing from Microsoft; Ripple, which among other things is advising the Depository Trust & Clearing Corporation (DTCC) on settlement of derivatives transactions; the Hyperledger Project, which has powerful support from IBM; and Digital Asset Holdings (DAH), formed by Wall Street veterans and deeply involved with the world's largest banks. All are committing resources to discover ways that blockchain systems can be used to cut costs, increase speed and offer transparency.

Don't Fence Me In

The new arrivals in blockchain territory bring with them new regulatory issues (since many are regulated institutions), related requirements for human oversight to fix errors or block fraud, and fences – especially fences.

Hearkening back to old days on the frontier, a powerful lure then was the prospect of an open range, with no boundaries or barriers. Cryptocurrencies and related projects can generally be accessed freely by anyone choosing to download the software. Access is anonymous and requires no consent from any authority as a condition of participation (hence the appeal to libertarians and those mistrustful of governments and central banks). In network jargon, the systems are "permissionless."

The new corporate-backed projects are by contrast heavily "permissioned." They are accessible only by the consent of the system authorities for closed private networks, which means that in the case of R3, for instance, all of the members with access will be major financial institutions. In broader private networks such as those working in trade finance, participants are admitted based on their specific function in a transaction.4 Anyone breaking the rules or causing a ruckus is quickly run out of town. Creators of the new permissioned systems say this provides the one element that is essential for any commercial intermediary: trust.

Those who hope to preserve the wide open spaces of the original vision feel they are being hemmed in. They say that the new commercial initiatives will lead to re-imposition of centralized authority in the hands of a few large firms, and that when the new arrivals say "alliance," we should hear "cartel."  On this view, what could have been a societal revolution may turn out to be "just a boring upgrade" to existing systems.5

Eventually the American frontier was staked out, fenced in and made safe for settlers, but its myths and values survived to become pervasive memes in global culture. Domestication for commercial development may well turn out to be the fate of large portions of the blockchain, but it will be of more value if the new protocols and systems – even as they are progressively integrated into mainstream financial architecture – retain something of the vision and social purpose that motivated the early pioneers.6

Holland & Knight is currently engaged in a variety of research and development projects with clients and others relating to the improvement of business processes, legal informatics, machine learning and distributed ledger technology.


1 Free-and-easy use of the terms "blockchain" and "distributed ledger" as synonyms has riled up many who believe that R3's Corda distributed ledger system has gone far beyond the bounds of the original blockchain concept, putting them in a mind to dispense a bit of frontier justice. Risking public obloquy or worse, this article will use the terms interchangeably.

2 A pseudonym. His or her true identity has never been ascertained.

3 The purloined funds were largely recovered or frozen in place. Organizers of the project overcame the objections of blockchain purists and re-established human control over the network, intervening in ways not contemplated by the original software – i.e., a "hard fork."

4 A freight forwarder, for instance, will have access for the specific actions it is to perform in connection with a specific shipment.

5 In what may be seen as a gesture of goodwill to dissidents, portions of the new systems have been made "open source" to allow some free range for independent development.      

6 In the meantime, the frontier Wild West show has moved on to Initial Coin Offerings (ICOs).

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