Distributed ledgers and blockchain: how digital assets are recorded

What is a distributed ledger?

A distributed ledger technology (DLT) network lets many participants keep the same record of who owns what, with no single keeper. A distributed ledger is the shared database at its heart: entries are recorded, stored and spread across the network so that every participant holds a matching, verified copy of all current and past transactions.

Three elements make up a DLT network: the digital ledger itself, a consensus mechanism and the network of participants (called nodes). Consensus has two steps. The network first validates a transaction, then agrees to update the ledger. Once agreed, a record is practically immutable (unchangeable), yet participants can see it in near real time.

Cryptography is the algorithmic scrambling of data so that it is useless to anyone not authorized to read it. DLT uses it to prove who the participants are and to protect the data, which gives the network its security and integrity.

Smart contracts are programs stored on the ledger that carry out themselves when pre-agreed conditions are met. Examples are paying a contingent claim on a derivative automatically, or moving collateral the instant a party defaults.

Potential benefits are greater accuracy, transparency and security of records, faster transfer of ownership and peer-to-peer dealing. Drawbacks: the technology is not fully secure, privacy and data protection can be breached, and the computing behind it can consume enormous amounts of energy.

How does a blockchain add a transaction?

A blockchain is a distributed ledger in which entries are recorded in sequence inside blocks, and the blocks are linked (“chained”) together and secured with cryptography. Each block holds a group of transactions plus a hash , a secure fingerprint-like link to the block before it. Because every block carries the previous block’s hash, altering an old block breaks the links after it.

1. A transaction takes place between a buyer and a seller.
2. A block with the transaction details is created and broadcast to the network’s nodes.
3. The nodes validate the transaction and its parties.
4. The verified transaction is combined with others into a new block of a predetermined size.
5. The new block is linked to the previous blocks by a cryptographic process.
6. The transaction is complete and the ledger is updated.

How do networks agree: proof of work or proof of stake?

Memorize

Blockchains let parties who do not trust each other work from the same record. The rules that decide which block may join the chain are the consensus protocol. Two matter for the exam.

Consensus protocolsthe rules for adding a block; both reward the validator with new digital assets

• Proof of work (PoW) Memorize the most widely used protocol
  • Validators are miners solve costly puzzles with computing power and energy
  • Attack threshold control most of the network's computing power (51%)
• Proof of stake (PoS) Memorize lower energy use
  • Validators pledge (stake) assets they propose blocks; other validators attest
  • Attack threshold control most of the staked assets

Under proof of work , the right to add the next block is decided by a computationally costly lottery. The miners on the network use powerful computers and a great deal of energy to solve a cryptographic puzzle, and the winner locks the block into the chain and earns new cryptocurrency. The cost makes it very hard and expensive to rewrite history. Participants treat the longest valid chain as the true record, so an attacker would have to out-compute the rest of the network, which in theory takes most of its computing power. That is the 51% attack threshold, and it marks the limit of the protocol’s security. Proof of work has been the most widely used protocol.

Under proof of stake , selected participants called validators pledge (stake) capital to vouch for a block. A validator proposes a block, a majority of the other validators who have also staked assets must attest that it is valid, and validators are rewarded for both proposing and attesting. Security rests on honest validators controlling most of the staked assets. It uses far less energy than mining.

Under both protocols, validation is rewarded with new digital assets, whether a cryptocurrency or a token.

Exam tip Puzzles and computing power point to proof of work; pledged assets point to proof of stake. Watch the wording: the rewarded validation is loosely called “mining” under both, so a question can say a miner earns new coins whatever the protocol.

Who may join: permissionless or permissioned?

Memorize

Distributed ledger networkswho may take part decides speed, cost and governance

• Permissionless (open) Memorize anyone can join and perform every function; Bitcoin is the best-known example
  • Decentralized governance by the members; no trust needed between parties
  • Slower and costlier many members must reach consensus
• Permissioned (restricted) Memorize membership is limited, with varied rights
  • Partly decentralized governed by a central organization
  • Faster and cheaper few members validate each transaction

A permissionless network is open to any user, every user can see every transaction, and any participant can perform every network function. No central authority confirms transactions; the consensus mechanism does. There is no single point of failure because every node stores a copy. Trust between the transacting parties is not required. Bitcoin, created in 2009, is the best-known example, and most cryptocurrencies use permissionless networks.

A permissioned network limits membership, often giving members different rights (a regulator might be allowed to view but not to validate, for instance). Because few members validate each transaction, it is faster and cheaper, but it is only partly decentralized and a central organization decides the governance.

	Permissionless	Permissioned
Access	Anyone	Restricted members, varied rights
Speed	Slower	Faster
Cost	Costlier	Cheaper
Decentralization	Full	Partial
Governance	By members	By a central organization

What kinds of digital assets live on a ledger?

Digital assets are assets that exist only as electronic records, with rights to use, buy or sell them. They can stand for securities, currencies, property or commodities. Cryptocurrencies have their own blockchains; tokens are built on an existing blockchain. When a question asks you to classify, a CBDC goes with the cryptocurrencies (even though a central bank issues it), and initial coin offering (ICO) tokens, NFTs and utility tokens go with the tokens.

Digital assetsexist only as electronic records with rights to use, buy or sell

• Cryptocurrencies Memorize digital currencies with their own blockchains
  • Bitcoin the first and largest
  • Altcoins every other privately issued cryptocurrency
    • Smart coinsprogrammable, such as Ether
    • Stablecoinsaim to hold a steady value
    • Meme coinspopularity, not utility
  • Central bank digital currencies (CBDCs) Use it a central bank's tokenized fiat currency; not privately issued
• Tokens Memorize built on an existing blockchain
  • Non-fungible token (NFT) Memorize unique, certifies a specific item
  • Security token Memorize digitized ownership of a security; may pay dividends
  • Utility token Memorize pays for services and fees on a network
  • Governance token Memorize votes on how a network is run
  • ICO tokens Use it sold in an unregulated offering to raise money

Cryptocurrencies are privately issued units for transferring or storing value, with near-real-time transactions and no intermediary. Central banks are studying their own versions: a central bank digital currency (CBDC) is typically a tokenized version of the central bank’s fiat currency, in effect a digital bank note or coin.

Tokenization is representing ownership rights to a physical asset (property, luxury goods, commodities) on a ledger. A single digital record of ownership, history and authenticity simplifies verification and transfer.

• A non-fungible token (NFT) links a digital item to a certificate of authenticity. Unlike a cryptocurrency unit, each NFT and the item it certifies are unique. The most common use is digital art.
• A security token digitizes ownership rights in a security. Holding it on a ledger can speed up post-trade processing, settlement and custody, and a single ledger removes the need to reconcile records. It may pay dividends.
• A utility token pays for services and fees inside a network. It compensates activity on the network and does not pay dividends.
• A governance token is a vote on how a network is run, important on permissionless networks where no central body decides. Owners can vote on a fix after a technical problem or on major changes.

An initial coin offering (ICO) is an unregulated sale of newly created tokens for money or another cryptocurrency, typically tokens that can be used for products or services the issuer is developing. Compared with an initial public offering (IPO) it can be cheaper and faster, but most ICOs carry no voting rights, regulation is only under consideration in several jurisdictions, and there have been many cases of investor loss through fraud.

Go deeper Why the longest chain is treated as the truth

Several miners may find a valid block at about the same time, so the network can briefly hold competing versions of the latest block. Nodes accept whichever chain has the most accumulated work behind it, and honest miners keep building on it, so the competing branch dies out. A cheat who wanted an altered history to win would need to add blocks faster than all the honest miners combined, which is the 51% attack. Even a briefly successful attacker can only change as much history as the period of control allows.

Go deeper Clearing and settlement as a DLT use case

Today, after a trade, buyer, seller, broker, custodian and clearing agent each keep their own records and reconcile them over a day or more. If ownership is a security token on a shared ledger, there is one golden record that everyone sees, so reconciliation falls away and settlement can approach real time. That is why the industry’s interest in DLT centers on post-trade processing and compliance, with smart contracts automating the steps and identity verification built into the network.