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BLOCKCHAINS AND SMART CONTRACTS There are several kinds of blockchains, and to provide more general insights in this project we take a broad view. For example, the Bitcoin system is a ‘public blockchain’, which allows unfettered public participation in both its operation and use. Other well-known systems, such as the Ethereum [16] blockchain, are similar in this regard. It is possible to use a separate instantiation of the Bitcoin or Ethereum computer programs to operate a blockchain within a private context, for example on a virtual private network. These would then be one kind of ‘private blockchain’. Private networks and private computer systems allow strong access controls. This provides greater administrative control for private blockchains. However, the software for public blockchains is not always the best technical solution to use in a private setting. Many industry consortia, such as Hyperledger, R3CEV, and Ripple, are actively developing specialised private blockchain solutions. These typically support a smaller number of processing nodes than public blockchain solutions, but can provide improved security and performance. When a group of companies or organisations jointly create a private blockchain, this is sometimes called a ‘consortium blockchain’. Some authors distinguish between blockchain technology and ‘distributed ledger technology’ (DLT). A distributed ledger is in some ways a more abstract notion, capturing a purpose for use: the distributed replication of auditable logs of transactions, shared between parties of interest. While public or private blockchain technologies can be used to implement a distributed ledger, there are alternative technological approaches which could be used instead. For example, the Corda system [4] implements distributed ledgers between parties, but unlike most blockchain systems does not have a global ledger that is independently checkable by all processing nodes. Nonetheless in this report, unless otherwise specified, we use the term ‘blockchain’ to include public blockchains, private blockchains, and other kinds of DLT. 1 What we call a digital currency is also variously known as cryptocurrency, cryptocoin, cybercurrency, and virtual currency. A digital currency is a digitally communicable form of money which may be of a state-issued fiat currency, or a new unit created by non-state actors. Bitcoin is one example of the latter. Many blockchains implement or rely on a digital currency, but in principle digital currencies can operate without a blockchain, and some private blockchains operate without a digital currency. 3 Representation of transactions: A distributed ledger may record financial transactions, such as in Bitcoin. However, a distributed ledger may be thought of as a shared database, and might allow any other kind of data to be recorded. In particular, the data recorded for a transaction may be the text of a computer program, and the integrity check for that transaction may involve executing that program. This allows participants to create ‘smart contracts’, to be discussed below. A blockchain transaction is not appropriate for all data – because it is replicated globally, transactions should not contain very large data, nor plaintext data which must be kept confidential. So, there is a choice about what data should be stored ‘on chain’ inside transactions, or ‘off chain’, in external systems. However, even if static data is stored off-chain, the blockchain can nonetheless record a cryptographic hash of that data to allow its integrity to be checked. The successful operation of a blockchain system relies on several key elements, including: • appropriate integrity criteria to be checked for each transaction (and block); • the correctness of the system’s software and technical protocols; • strong cryptographic mechanisms to identify2 parties and check their authority to add new transactions; and • a suite of incentive mechanisms to motivate processing nodes to participate in the community and to behave honestly, in its interests. Blockchain systems can be different in various ways, including: Admittance of processing nodes: In a public blockchain system, such as Bitcoin, anyone may become a processing node (sometimes called a ‘miner’). In a permissioned (private) blockchain system, the admittance of processing nodes is controlled by its governing bodies. Consensus mechanism: Most public blockchains use Nakamoto consensus, where processing nodes by convention treat the longest history of blocks as the authoritative history. The rate at which blocks can be created is limited, often by using a proof of work mechanism, whereby a processing node can only add a new block by demonstrating that a difficult task has been completed. Proof of work is widely used, but the auxiliary effort required to complete the difficult task can be economically inefficient. In a proof of stake system, the processing node that can add a new block in the next round is determined by the size of its stakeholding in the global blockchain and/or in that round. Proof of stake can be more efficient, but is more recent and has not yet been widely adopted. Other consensus mechanisms have been proposed. On private blockchains, conventional replication algorithms such as practical Byzantine fault tolerance can be used instead of Nakamoto consensus. This can provide stronger guarantees about the completion of transactions, and may be more performant, but only support a smaller number of processing nodes which must be more trusted. The rate at which blocks can be created is limited, often by using a proof of work mechanism, whereby a processing node can only add a new block by demonstrating that a difficult task has been completed. 2 ‘Identity’ here refers to an identifier for the authorisation of transacting participant in the blockchain system, but does not also include the authentication of that participant’s real-world identities by governments or other authorities. This is discussed further below. 4 Risks and opportunities for systems using blockchain and smart contracts 1.2 Smart contracts The transactions stored on a blockchain can be more than simple records of the exchange of assets – some blockchain systems also allow computer programs to execute and be stored as part of transactions on the ledger. These are often called ‘smart contracts’, although the programs are typically not very ‘smart’, and are sometimes not used to execute or monitor legal contracts.3 The legal status of smart contracts as legal contracts is currently debated. A legal contract is an agreement between parties, and a computer program is either the text of source code or an executing physical machine. So smart contracts, as computer programs, may be the wrong category of thing to be a legal contract. Nonetheless a smart contract may provide evidence for there being a legal contract, and may be able to facilitate the execution of a legal contract. Importantly as a mechanism for the execution of provisions of a legal contract, smart contracts can carry and conditionallytransfer digital currency and other digital assets or tokens between parties. This can be done in a predictable and transparent way on the neutral ground provided by the mechanised infrastructure of a blockchain. The Bitcoin blockchain allows very simple forms of smart contracts, but other blockchains such as Ethereum allow computer programs to be written in a ‘Turing complete’ language that is in principle as expressive as every other general purpose programming language. As a result, blockchains can be more than a simple distributed database – they can be general computational platforms. (Albeit currently with severe practical limitations on computational complexity.) This capability significantly expands the power of blockchain systems, and increases their range of use and potential for innovation. Some blockchains eschew the use of Turing-complete smart contract languages, in order to facilitate the automated verification of the correctness of smart contracts. 1.3 Uses in industry and society Bitcoin has been operational since 2009, and its digital currency has a total market value of about USD$22B as of the end-of April 2017. The next-largest blockchain, Ethereum, has a value of about USD$6.3B, and there are many other small public blockchains with their own digital currencies. Private blockchains are increasingly deployed inside large enterprises and across industry consortia. The adoption of blockchain technologies is still in its infancy. Globally, many financial services companies, governments, enterprises and startups are exploring the applicability of blockchain technologies in their domains. New businesses and business models are expected to arise, but as yet there are very few examples of significant use in production of blockchain systems within industries or government. Blockchains, particularly public blockchains, offer opportunities for disruptive innovation. As discussed earlier, blockchains may disintermediate trusted third-party organisations, thus disrupting conventional business arrangements across society. In economies where trusted third-parties are not always trustworthy, a significant benefit of blockchain systems may be in the strong support they can provide for immutability and non-repudiation. In developed societies, trusted third-party organisations are usually trustworthy, so the benefits of using blockchain technologies would likely arise from enabling faster business model innovation, reducing the cost of establishing business relationships, and perhaps reducing the cost or risk of transactions. The adoption of blockchain technologies is still in its infancy. 3 The concept of ‘smart contract’ is more general [13] than its use in blockchain, and there are many applications for executable transactions on blockchain other than as contracts. So, the term ‘smart contract’ is far from ideal, but is nonetheless used in this report because its usage is so widespread. Alternative proposed terminology has included ‘chain code’, and ‘automated contract tools’. 5 FINANCIAL SERVICE