By Michael Mazier
The first practical blockchain was created to disrupt and fragment political and market power by “allowing any two willing parties to transact directly with each other without a trusted third party,” according to the original bitcoin whitepaper attributed to Satoshi Nakamoto (http://satoshinakamoto.me/whitepaper/) in response to the financial crisis of 2008. The headline of the Times of London on Jan 3, 2009, “Chancellor on brink of second bailout for banks,” was written into the first transaction of the first ever block written for bitcoin, the first and still most famous use case of the underlying technology we’ve come to call blockchain.
At first, there was only one kind of blockchain, which we’ll call an open and public blockchain. Further developments have led to private blockchains.
Public Blockchains: To this day, anyone can freely download and run bitcoin’s open-source software, which finds and connects to IP addresses that point to other processes running the same bitcoin software. The result is a “peer-to-peer” network of the most unexclusive club in the world – anyone can join.
On open public blockchains such as Bitcoin, Ethereum, and Litecoin, to name a few of the larger ones, participants have two choices when joining, depending on their objectives:
a. Verifier participants, (or “miners” in Bitcoin) - run “full nodes” and use cryptography and incentives to run consensus algorithms to verify transactions, with the ultimate reward of earning value in a cryptocurrency, such as bitcoin.b
b. Transacting-only participants (“Transacting Party”) – run “light nodes” to send and receive transactions, paying transaction fees to process these transactions. Most users will use this type of node.
Many flavors of consensus algorithms exist, some require specialized hardware, while some rely on a set of trusted third parties to verify transactions. A key point is that in a public and open blockchain, anyone can join and become a transacting party or verifier.
Private Blockchains: A private blockchain, like a piece of land marked “private property,” has an owner with the property right to grant permission. Yet if the original purpose of blockchains was to allow willing parties to transact “without a trusted third party,” then at first blush a “private blockchain” is a paradox. The owner of the private blockchain is the “trusted third party” that blockchains are designed to eliminate. No one ever says “permissioned private property,”. But we’ll go along with this current redundant usage of “permissioned private blockchain.”
Other than incumbents seeking to protect their market turf, or cash in on blockchain hype, are there any reasons to ever use a private blockchain? The owner of a private blockchain may retain market power, but property rights can take on many forms. I might be OK with using a private blockchain belonging to an owner with limited market power running a business model that is monopoly-resistant. But if their market power gets strong enough to extract economic rents, then as a user I’m not happy.
Figure 1
Figure 1 shows a framework for comparing private permissioned blockchains to public open blockchains.
What happens if the owner of a private blockchain has the power to grant permission to what was originally an open Transacting Party or open Verifier?
Let’s look at these one at a time. We note that permission comes in shades of grey, not black and white. Hence, many variations exist within each of our Four Quadrants, generalized below.
- Top Right: “Market Power Decentralized” is for open pubic blockchains, like Bitcoin or Ethereum. No single entity can become a dictator or undo a transaction. Maintaining this consensus balance is not easy. One way to attack bitcoin is via a “51% attack” in which Verifiers (aka Miners in bitcoin) might collude to take over the entire network by joining together to collectively own or control 51% of the aggregate computing power on the network, potentially reversing transactions to steal cryptocurrency. As a result of such an attack, an open public blockchain would drift down to the Bottom Right quadrant in which Verifiers hold all the power. Concentrated ownership of a crypto- currency is also a potential problem. These are known problems that continue to be monitored and researched by the blockchain community.
- Top Left: Market Power to Gatekeeper(s) –A gatekeeper controls who can transact on a blockchain, while allowing open verification. Using Ethereum, anyone can become a gatekeeper by writing rules in a smart contract that define how a token is used. Perhaps that token represents a certificate of ownership for a real-world object that only certain people can own. The details of the smart contract code are critical for determining exactly what a user is getting into when they buy a token.
- Bottom Left: Market Power to Gatekeeper(s) and Verifier(s). This case can easily degrade into a very inefficient way to emulate a traditional database and can end up being worse than bad. One very good use case here is a Federated (aka Consortium) Blockchain, used in Blockstream’s Elements, which uses a consensus model designed for a group of mutually-distrusting participants. This type of private blockchain relies also on governance rules – like the house rules in a private club. The club members collectively decide on the rules. Cryptocurrency exchanges can use Federated blockchains to trade only with each other. Many use cases exist subject to careful consideration of governance rules.
- Bottom Right: Market Power to Verifier(s). This case can easily degrade into a fool's bet unless the Verifiers and whoever is in charge of granting permission to the Verifiers are trusted beyond reproach. The willing Transacting Parties must trust and accept the consensus view of the Verifiers. A blockchain and its consensus mechanism are not necessary if only a single Verifier exists. One legitimate example is a blockchain in which bonafide Notaries public or some super trusted group verify transactions.
The Case for a Private Blockchain: First point to make, if a traditional database can do the job, then there is no need for a blockchain solution.
So, when may a private permissioned blockchain make sense? We think:
- A Federated (aka Consortium) Blockchain in which mutually-distrusting participants have compelling business reasons to go beyond a traditional distributed database.
- A monopoly-resistant Notary type system in which willing Transacting Parties have absolute trust in the consensus view of the Verifiers and the Verifiers are mutually-distrusting.
Looking at your industry and the strategy that your company is pursuing, what quadrant would you envision your organization lies? Is blockchain the appropriate solution, or can it be addressed by a traditional database? If your answer is a blockchain solution, what conditions point to a blockchain solution?
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About the author(s)
Mike Mazier is a financial technology entrepreneur, adviser and consultant to Fintech and blockchain companies. He is currently working on openseatdirect.com, a blockchain solution to address the event ticketing industry. He founded and holds a patent pending on bondirectly, a peer-to-peer bond trading platform and co-founded LendingCalc, a peer-to-peer marketplace loan analytics firm and was previously was chief quantitative strategist and portfolio manager at Van Eck Global, where he managed $5 billion in exchange-traded funds, and advised on hedge fund manager selection. He has also been a bond analyst, information technology manager and analytics developer at Morgan Stanley, vice president and closed-end fund analyst at Bank of America/Merrill Lynch and product manager at Citibank. He began his career designing hardware for military communication satellites as an Electrical Engineer at General Electric. He has BS in Electrical Engineering from Syracuse University, an MS in Electrical Engineering from Villanova University, and an MBA from Columbia University Graduate School of Business.