The truth about blockchain

Contracts, transactions, and their records are among the defining structures of our economic, legal, and political systems. They protect assets and manage organizational boundaries. They establish and verify identities and record events. They govern the movement between nations, organizations, communities, and individuals, guiding governance and society. Yet these critical tools and the bureaucracies that have grown up to manage them have not kept up with the digital transformation of the economy. They are like a rush-hour traffic jam that even Formula 1 cars can’t handle. The way we regulate and maintain administrative control in a digital world must change.

Introduction: How blockchain works

First, five basic principles of technology are proposed.

1. Distributed Database

Every party on the blockchain has access to the entire database and its complete history. No single party controls the data or information. Each party can directly verify the records of its transaction partners without the need for a middleman.

2. Peer-to-peer transmission

Communication occurs directly between peers, rather than through a central node. Each node stores and forwards information to all other nodes.

3. Transparent anonymity

Any user with access to the system can see every transaction and its associated value. Each node or user on the blockchain has a unique address of more than 30 letters and numbers that identifies itself. Users can choose to remain anonymous or provide proof of their identity to others. Blockchain transactions occur between these addresses.

4. Irreversibility of records

Once a transaction is entered in the database and an account is updated, the records cannot be altered because they are linked to every transaction record that came before them (hence the term "chain"). Various different algorithms are employed to ensure that the records in the database are permanent, chronologically ordered, and accessible to all other nodes on the network.

5. Calculation logic

The digital nature of the ledger means that blockchain transactions can be linked to computational logic and are inherently programmable, so users can set up algorithms and rules that automatically trigger transactions between nodes.

Blockchain can solve this problem. As the core technology underlying Bitcoin and other virtual currencies, blockchain is an open distributed ledger that can effectively record transaction information between two parties in a verifiable and permanent manner, and the ledger itself can also be programmed to automatically trigger transactions.

How blockchain works

In blockchain, we can imagine a scenario where electronic contracts are embedded in digital code and stored in a transparent shared database, where they are protected from deletion, tampering and revision. In this scenario, every agreement, every process, every task and every payment will have a digital record and signature that can be identified, verified, stored and shared. Middlemen such as lawyers, brokers and bankers may no longer be needed. Individuals, organizations, machines and algorithms will freely trade and interact with each other at high speed and low cost, which represents the huge potential of blockchain.

Virtually everyone has heard that blockchain will revolutionize business and redefine companies and economies. While we sense its potential, we are still concerned about the bubble. It’s not just security issues that we’re concerned about (such as the collapse of a Bitcoin exchange in 2014, and the recent hacks of others). Our experience studying technological innovation has taught us that if the blockchain revolution is to take place, many barriers – technical, governance, organizational and even social – must change simultaneously; rushing into innovative applications without understanding what changes blockchain may bring can be a serious mistake!

We believe that true blockchain-led transformation of businesses and governments is still many years away. This is because blockchain is not a “disruptive” technology that attacks traditional business models with lower-cost solutions and quickly overtakes existing businesses. Blockchain is a foundational technology: it has the potential to create a new technological foundation for our economic and social institutions. But despite its enormous impact, it will take decades for blockchain to permeate our economic and social infrastructure. The process of adoption will be gradual and continuous, not sudden, as the tide of technological and institutional change gains momentum. This insight and its strategic implications are what we will explore in this article.

Technology application model

Before deciding on a blockchain strategy and investment, let’s reflect on what we know about the application of technology, especially the typical transformation process of other foundational technologies. One of the most worthy examples is the distributed computer network technology: TCP/IP (Transmission Control Protocol/Internet Protocol), which laid the foundation for the development of the Internet.

Introduced in 1972, TCP/IP was first adopted in a simple use case: as the basis for email among researchers on the ARPAnet (led by the U.S. Department of Defense and a predecessor to the modern commercial Internet). Before TCP/IP, telecommunications architecture was based on "circuit switching," in which a connection between two parties or machines had to be pre-established and maintained for the duration of the exchange. To ensure that any two nodes could communicate, telecommunications service providers and equipment manufacturers had invested billions of dollars in dedicated line infrastructure.

The innovation of TCP/IP lies in its header: The new protocol transmits information by digitizing it and breaking it into very small packets, each of which includes address information. Once released into the network, the packet data can take any route to the recipient. Intelligent sending and receiving nodes at the edge of the network can disassemble and reassemble the packets and interpret the encoded data. There is no need to build dedicated lines or large-scale infrastructure. TCP/IP creates an open, shared public network without any central body responsible for its maintenance and improvement.

The traditional telecommunications and computing sectors were skeptical of TCP/IP. Few imagined that data, messaging, voice, and video connections could be built on a new architecture that was so flexible that the security and scalability of the original information systems could not meet. But during the late 1980s and 1990s, more and more companies such as Sun, NeXT, Hewlett-Packard, and Silicon Graphics used the TCP/IP protocol, in part, to create localized private networks within their organizations. To do this, they developed building blocks and tools that expanded its use beyond email systems, gradually replacing more traditional local network technologies and standards. As more organizations adopted these building blocks and tools, people felt the significant increase in productivity brought by the new technology.

TCP/IP became widely used in the mid-1990s with the advent of the World Wide Web. New technology companies quickly emerged to provide the "plumbing": the hardware, software, and services needed to connect to the now public network and exchange information. Netscape released commercial browsers, web servers, and other tools and components to help people develop and adopt Internet services and applications. Sun promoted the development of the Java application programming language. As information on the network grew exponentially, companies such as Infoseek, Excite, AltaVista, and Yahoo were born to guide users into the Internet.

Once this basic infrastructure reached critical mass, a new generation of businesses took advantage of low-cost Internet connectivity to create an alternative Internet service that was more attractive to existing businesses: CNET online mobile news, Amazon offers more books than any bookstore. Priceline and Expedia made it easier to buy airline tickets and brought unprecedented transparency. The ability of these new entrants to achieve broad coverage at relatively low cost put enormous pressure on traditional businesses such as newspapers and brick-and-mortar retailers.

Based on widespread Internet connectivity, the next wave of companies created novel, transformative applications that fundamentally changed the way businesses create and capture value. They were built on new peer-to-peer architectures and generated value through distributed networks. Think of how eBay changed online retail with auctions, Napster changed the music industry, Skype changed telecommunications, and Google changed web search by leveraging user-generated links to provide more relevant results.

Many more companies are already using blockchain to track items through complex supply chains.

Ultimately, it took TCP/IP more than 30 years, through all its phases – single use, localized use, substitution, and transformation – to reshape the economy. Today, more than half of the world’s most valuable public companies are Internet-driven, platform-based business models. The foundations of our economy have changed. Physical scale and unique intellectual property no longer confer unparalleled advantages; increasingly, economic leaders are businesses that act as “cornerstones,” proactively organizing, influencing, and coordinating vast networks of communities, users, and organizations.

New architecture

Blockchain – a peer-to-peer network that sits on the internet – was proposed in October 2008 as part of a draft of Bitcoin, a virtual currency system that eschews central authorities to issue coins, transfer ownership and confirm transactions. Bitcoin is the first application of blockchain technology.

The relationship between blockchain and TCP/IP is parallel. Just as email opened up peer-to-peer information communication, Bitcoin opened up a new era of bilateral financial transactions. The development and maintenance of blockchain is open, distributed, and shared - just like the maintenance model of TCP/IP, with teams of volunteers around the world maintaining the core software system. Like email, Bitcoin was first maintained and managed by an enthusiastic but relatively small community.

TCP/IP unlocked new economic value by dramatically reducing the cost of connections. Similarly, blockchain can dramatically reduce transaction costs. It has the potential to become the system of record for all transactions in the future. If this expectation is realized, the economy will once again undergo a fundamental transformation as new business giants emerge with blockchain-based influence and control.

Let's look at how business works: Keeping ongoing records of transactions is a core function of any business. These records track past actions and performance and guide future planning. They provide a view not only of how an organization works internally, but also of its external relationships. Every organization keeps its own records, and they are private. Instead of having a general ledger that records all of its activities, many organizations keep records scattered across internal departments. The problem is that reconciling transactions across individual and private ledgers takes a lot of time and is prone to errors.

For example, a typical stock trade can be executed in microseconds, usually without human intervention. However, the transfer of ownership of a stock can take up to a week to complete. This is because the parties do not have access to each other's ledgers and cannot automatically verify that the assets are actually owned and can be transferred. The actual business process is: a series of intermediaries act as guarantors of assets, separately record transactions across organizations, and update their respective managed ledgers.

In a blockchain system, the ledger is replicated in databases on a large number of peer nodes, each hosted and maintained by the parties involved. When a change is entered in one copy, all other copies are updated simultaneously. Therefore, when a transaction occurs, a record of the value and assets exchanged is permanently entered into all ledgers. There is no need for third-party intermediaries to verify or transfer ownership. If a stock trade occurs on a blockchain-based system, it will be settled securely and verifiably within seconds. (The weaknesses exposed by the previous hacker attack on the Bitcoin network did not originate from the blockchain itself, but were related to the various participants linked to the blockchain.)

Introduction: Application process of basic technology

The adoption of foundational technologies typically occurs in four phases. Each phase is determined by the innovativeness of the application and the complexity of the coordination required to make it viable. Applications with low innovativeness and complexity gain adoption first. Applications with high innovativeness and complexity take decades to be adopted but can have a more profound impact on changing the economic system. TCP/IP technology, introduced on the ARPAnet in 1972, has reached the transformational stage, but blockchain applications (red) are in the early stages.

The blockchain framework

If Bitcoin has the same power as early email systems, will it be decades before blockchain unleashes its full potential? In our opinion, the answer is yes. We can’t predict exactly how many years this transition will take, but we can guess which types of applications will benefit first and how blockchain will eventually gain widespread acceptance.

In our analysis, history shows that two dimensions influence the development of foundational technologies and their business use cases. The first is novelty – the degree to which the application is new to the world. The more novel something is, the more effort it takes to get users to understand what problem it solves. The second dimension is complexity, which is the collaborative effort of the ecosystem participants to leverage the technology to generate business value. For example, a social network with only one member is of little use; the value of a social network is only realized when many of our own social connections are already connected to the network, and these new users create value together with everyone else. The same is true for many blockchain applications. And as these applications grow in size and impact, more significant structural changes will occur.

We have developed a framework that maps innovation to these two contextual dimensions, dividing them into quadrants. Each quadrant represents a stage in the development of the technology, helping policymakers understand the types of challenges that technological change presents, the level of collaboration and consensus required, and the corresponding legislative and regulatory efforts. The diagram also gives reasonable suggestions on what processes and infrastructure must be established to promote the adoption of innovation. Managers can use it to assess the state of blockchain development in any industry, as well as to evaluate the strategic investment strategies they may take in blockchain capabilities.

> Single use

In the first quadrant are low-innovation and low-coordination applications that create better-use, lower-cost, highly centralized solutions. Email: A cheap alternative to phone, fax, and traditional mail, it is a one-time-use application of TCP/IP (its value increases with the number of users). Bitcoin also falls into this quadrant. Even in its early days, Bitcoin was used by a few people as an alternative and convenient payment method (you can think of it as a complex email that not only transmits information, but actual value.); at the end of 2016, the value of Bitcoin transactions was expected to reach $92 billion. Compared to the $411 trillion in total global payments, this is still a rounded record, but Bitcoin is growing rapidly and becoming increasingly important in scenarios such as instant payments, foreign exchange, and asset trading where the current financial system has limitations.

>Localization

The second quadrant includes innovations that are relatively high in novelty, but only require a limited number of users to create immediate value, so it is still relatively easy to promote their adoption. If blockchain follows the path of web technologies entering business, we can expect blockchain innovation to build on one-off applications to create local private networks where multiple organizations are connected together through a distributed ledger.

Most of the initial private blockchain-based applications are occurring in the financial services sector, often among small businesses, so coordination requirements are relatively low. Nasdaq is working with Chain.com (one of many blockchain infrastructure providers) to provide technology for processing and verifying financial transactions. Bank of America, JPMorgan Chase, the New York Stock Exchange, Fidelity Investments, and Standard Chartered are testing blockchain technology to replace paper-based and manual transaction processes in areas such as trade finance, foreign exchange, cross-border settlements, and securities. The Bank of Canada is testing a digital currency called CAD-coin for interbank transfers. We expect rapid expansion of private blockchains to meet specific business needs in different industries.

>Alternative

The third quadrant contains applications that are relatively low in novelty because they are based on existing single-purpose and localized applications, but have high coordination costs because they involve broader public use. These innovations aim to replace entire ways of doing business. At the same time, they face high barriers to adoption; not only do they require more coordination, but people expect the replacement process to be complete and deep into the core of organizations and institutions. Examples of possible replacements include cryptocurrencies - entirely new monetary systems that have evolved from simple bitcoin payment technology. The key difference is that cryptocurrencies require that each party to a monetary transaction accept it, which will also challenge the authority of governments and institutions that have always handled and overseen financial transactions. Consumers will also have to change their behavior in order to understand how to use the new capabilities of cryptocurrencies.

A recent experiment at MIT highlights the challenges facing digital currency systems. In 2014, the MIT Bitcoin Club provided $100 in Bitcoin to 4,494 undergraduate students at MIT. Interestingly, 30% of students did not even register to receive it, and 20% of those who registered converted the Bitcoin to cash within a few weeks. Even the most technologically savvy people have a hard time understanding how or where to use Bitcoin.

One of the most ambitious alternative blockchain applications is Stellar, a nonprofit that aims to bring affordable financial services, including banking, micropayments, and remittances, to people who have never been exposed to blockchain. Stellar offers its own virtual currency: lumens, and also allows users to keep a range of assets on its system, including other currencies, phone minutes, and data credits. Stellar is initially focused on Africa, especially Nigeria, the largest economy there. It has already seen significant adoption among its target population and has proven its cost-effectiveness. But its future is uncertain because the challenges of ecosystem coordination are high. Although Stellar's application practice among the grassroots has proved the feasibility of Stellar, to become a banking standard, it needs to influence government policy support, convince central banks and large organizations to use it, which may take years of coordinated efforts.

Further reading

For more in-depth information on the application of blockchain technology, please pay attention to other articles on HBR.org:

“Digital Ubiquity: How Connections, Sensors, and Data Are Revolutionizing Business”
Marco Iansiti and Karim R. Lakhani

“Strategy as Ecology”
Marco Iansiti and Roy Levien

“Right Tech, Wrong Time”
Ron Adner and Rahul Kapoor

> Transformation

Enter the final quadrant: Completely novel applications that, if realized, will necessarily change the nature of economic, social, and political systems. They involve coordinating the activities of many actors and reaching institutional agreement on standards and processes. Their application will require major social, legal, and political changes.

“ Smart contracts ” are perhaps the most transformative blockchain application currently, and are ideal for scenarios such as automating payments, currency, or other asset transfers. For example, a smart contract might send payment to a supplier immediately after a shipment is delivered. A business could send a message through the blockchain indicating that a specific item has been received, or the product could have GPS capabilities that would automatically record location updates that in turn trigger payment. We’ve already seen some early experiments with self-executing contracts in venture capital, banking, and digital rights management.

The implications are fascinating. Companies are built on contracts, from corporate to buyer-supplier relationships to employee relationships. If contracts are automated, what happens to traditional corporate structures, processes, and intermediaries like lawyers and accountants? What about managers? Their roles will be radically changed. Before we get too excited, we should remember that we are still decades away from widespread adoption of smart contracts, and effective use cases cannot be formed without institutional application of blockchain, for example. There is a clear understanding of the complex efforts and investments required to design, verify, and implement smart contracts. We believe that it will take a long time for institutions to implement these arduous tasks, and the complexity of the technical challenges (especially security) is daunting.

A Guide to Blockchain Investment Methods

How should management think about blockchain in their own organization? Our framework can help companies identify the right opportunities.

For most, the easiest starting point is a one-off application, which minimizes risk because they are not new and there is little coordination with third parties. One strategy is to add Bitcoin as a payment mechanism. The infrastructure and market for Bitcoin are already well developed, and adopting the virtual currency will force a variety of functions, including IT, finance, accounting, sales, and marketing, to build blockchain capabilities. Another low-risk approach is to use the blockchain as an internal database for applications such as managing physical and digital assets, recording internal transactions, and verifying identities. This can be a particularly useful solution for companies that need to collaborate across multiple internal databases. Testing one-off applications will help organizations develop the skills they need for more advanced applications. Experimentation is becoming easier with the emergence of cloud-based blockchain services from startups and large platforms such as Amazon and Microsoft.

Localized applications are a natural next step for companies. We are seeing a lot of investment in private blockchain networks right now, and the projects involved seem to be promising to deliver real value in the short term. For example, financial services companies are finding that they can significantly reduce transaction costs between each other using private blockchain networks established with a limited number of trusted counterparties.

Organizations can also address specific issues of cross-border transactions through localized applications. For example, some companies have used blockchain to track items through complex supply chains. This is happening in the diamond industry, where gemstones are tracked from mines to consumers. This experimental technology is now available for practical use.

Developing alternative applications requires careful planning, as existing solutions may be difficult to implement. One approach may be to focus on alternatives: solutions that do not require end users to change their behavior, but can replace expensive or unattractive solutions. To gain a competitive advantage, alternatives must be able to provide functionality that is as good as traditional solutions and must be easily adopted by the ecosystem. First Data's research on blockchain-based gift cards is a good example. Retailers can significantly reduce the cost of each transaction during the sales process and improve security by using blockchain to track the movement of money within an account without relying on an external payment system. These new gift cards even allow balances and transaction capabilities to be transferred between merchants through a shared ledger.

Disruptive applications may still be far off. But it makes sense to evaluate their possibility now and invest in the development of technologies that can make them more powerful. They will be most powerful when combined with a new business model, especially one where the logic of value creation and capture is very different from existing ways. Such business models are difficult to create, but when successful, they can unlock a company's growth potential.

Consider how law firms need to change to adopt smart contracts: They will need to acquire new expertise in software and blockchain programming, may have to rethink their hourly payment model, and entertain the idea of ​​charging transactional or contractual fees as two possible approaches. Whatever steps they take, executives must ensure they understand and assess the impacts before making any business model shift.

Transformative scenarios will eventually materialize, but they will also provide tremendous value. Two possible areas where they could have a profound impact are large-scale public identity systems for passport management, and algorithm-driven decision making in preventing money laundering and complex financial transactions involving many parties. We expect these applications to be at least a decade away, if not longer, from being accepted.

Transformative applications will also give rise to new platform-level players that will orchestrate and manage new ecosystems. These will be the next generation of Googles and Facebooks. Patience is needed to find and realize such opportunities. While it may be too early to start making significant investments in them, it is still worthwhile to develop the foundation (tools and standards) needed for them.

in conclusion

In addition to providing a good template for blockchain applications, TCP/IP is a case study in a very smooth way. TCP/IP has become ubiquitous, and blockchain applications are being built on top of digital, communication, and computing infrastructure, which reduces costs and will inspire new use cases to emerge quickly.

Today, with the existing technology framework, managers can figure out where to start building blockchain-based organizational capabilities. They need to ensure that employees understand blockchain, develop applications that serve the company in the quadrants we identified, and invest in blockchain infrastructure.

But given the time span, technical barriers and sheer complexity of adopting the technology, decision makers should carefully consider the risks involved in experimenting with blockchain if it is to reach the level of widespread acceptance of TCP/IP technology. Obviously, starting small is a better idea for applying new technologies. But the level of investment should depend on the context of the company and industry. Financial services companies have taken the lead on the blockchain path, while the manufacturing industry has not yet.

Regardless of business context, blockchain has the potential to impact your business. The big question is when.

Marco Iansiti is the David Sarnoff Professor of Business Administration at Harvard Business School in Boston. Twitter: @marcoiansiti and @digHBS

Karim R. Lakhani is the Lumry Family Associate Professor of Business Administration at Harvard Business School and the principal investigator of the Harvard-NASA Match Lab at the Institute for Mathematical Social Sciences. Twitter @klakhani