“Digital assets” traditionally included music, videos, photos and any other data that has value. The evolution of blockchain technology ushered in a new era and expanded the definition of digital assets with cryptocurrencies and other types of assets that are stored on blockchains.
How a blockchain works
How it works: A blockchain is a transactional system that can track and transfer assets, record payments and memorialize interactions. It can provide record keeping that is more secure, trusted and transparent than traditional database or application architectures can provide. How does it do this? Each blockchain is a distributed database that serves as a digital ledger of transactions between accounts (electronic address). Each transaction records the accounts involved and the amount. The database is distributed, in that duplicate copies are stored on computers that form a network. These copies are called “nodes” and are equally authoritative about the transactions — each node can independently validate a group of new transactions in a “block.” When a significant number of nodes validate the transactions in a block, the nodes confirm and finalize the block. If one node submits an unauthorized or invalid block, the other nodes in the network will reject it. Once transactions on the ledger (blocks on the chain) are confirmed and finalized, they can never be edited — only added to, with new transactions.
Why it matters: Blockchain technology delivers better trust and resilience than most traditional database systems. A blockchain network is trustworthy because a block of transactions must be validated, and then cannot be undone or reversed. A blockchain network is resistant to disruption because its nodes operate independently and are equally authoritative — if one node goes offline, the blockchain still functions.
The trust and resilience of blockchain technology mean that we can use it to store currency, tokens, contracts and more:
- Cryptocurrency and tokens
Most cryptocurrencies have a set number of coins. Each coin is of an equal value, and is stored on a blockchain where every exchange is recorded and holders can verify their balances. A token typically isn’t currency itself — it’s more like a gift card or a claim check. A token can be created in a system running on top of a blockchain, rather than directly on a blockchain.
- Non-fungible tokens (NFTs)
An NFT is usually a one-of-a-kind asset stored on a blockchain. We can “tokenize” (create a token that signifies) anything people value, effectively like a digital trading card. It has value as long as long as someone wants it.
- Smart contracts
A smart contract is a program that includes automatic actions — like automatically transferring money at regular intervals or when a particular event occurs. It’s effectively like a traditional contract, except that it doesn’t require human intervention to carry out its terms and payments, and it cannot be tampered with on a blockchain.
So, how can you turn blockchain technology’s capabilities into business benefits? Here are just a few of the areas where blockchain has proven that it can provide benefits:
Systems can use blockchain technology to process payments securely without third parties. This can lower the cost and risk of payment processing, especially for cross-border payments to new business partners. These payments can even be triggered programmatically, as part of agreed-upon terms in a structured contract.
Contracts and leases
Many enterprises are accountable for a complex network of contracts and leases, often created by various teams, in different locations, with divergent terms and conditions. The Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) now have standards that require companies to record almost all of their leases on the balance sheet.
Grant Thornton Advisory Manager Sean Roberts said “There’s really a shift in the way that some technologists are thinking about this, in regards to how we can use smart contracts and how we can use the technology of blockchain, which especially is helpful for things like immutability — the ability to lock something in and say that ‘this cannot be changed from here on out.’” But, blockchain’s locks must be built into a larger system. Grant Thornton Innovation Director Malcolm Silberman said, “If you design this appropriately, you shouldn’t even know that you’re on a blockchain… really, from an architectural point of view, we’re looking to design user experiences where users don’t know about the complexity of the blockchain.”
A shared blockchain can be used to help detect cases of fraud, even when entities are not at liberty to share all of the identifying details.
For instance, banks typically offer “accounts receivable financing” — a business loan where the collateral is the sum of money that customers owe to the business. Businesses can only borrow against this collateral once, but banks have no way of checking for duplicate applications at other banks because they cannot share the details of loan applications. So, instead, the banks can use a shared blockchain network where they convert loan application details into a “hash” — a long and unique string of characters that cannot be decoded. Then, the banks simply need to check whether the hash already exists in the blockchain. If so, then the business has already received this loan and it is fraudulent for the business to apply again. Because of blockchain technology’s trust and resilience, others cannot hack this network and the network will continue to work even if several of its individual nodes go offline.
Products often come to market through a complex network of negotiated collaborations that span suppliers, manufacturers, distributors, retailers — and countries. That means multiple parties need to track regulations and contractual obligations around the world. This challenge can quickly consume administrative time and erode profits for everyone in the production chain. Plus, it introduces risks that can simply put some collaborations out of reach.
But blockchain can reduce this administrative burden and open the door to new partners by tracking each product with a permanent record. Silberman said, “If you abstract a mental model of what we’re trying to do in all these solutions, it’s first and foremost: We are bringing parties together.”
For instance, large-scale shipments on container ships often have hundreds of pages of manifests that ship captains need to track. These shipments can also be subject to delay if harbormasters or others require bribes to keep things on schedule. The captains, clients, financiers, harbors, governments, insurance companies and others involved in these complex networks can make it hard to verify complaints or track evidence of wrongdoing. So, a system with a blockchain network at its core can provide one trusted and resilient place that tracks a ship’s contents, schedule, budget and other important details, confirming when there are changes and even tracking why.
Settlement of securities
The Securities and Exchange Commission (SEC) has approved stock exchanges that use blockchain technology to settle security trades. This could make the back-office work for trades less error-prone and time-intensive, ultimately saving cost while still ensuring that trades are secure.
Other potential uses cases and benefits
The trust and resilience of blockchain technology can help us solve traditional problems in non-traditional ways. However, there are still some risks.
Data processing demands
Many blockchains use a Proof of Work (PoW) process to validate each transaction. In PoW, a significant number of the blockchain network’s nodes (computers) must independently evaluate and validate a group of new transactions in each new “block” before the block can be finalized. Estimates indicate that validating one cryptocurrency transaction can consume more than 1,700 kilowatt hours of energy, or about the same amount consumed by the average U.S. home over two months. This raises ecological concerns for high-volume blockchain use cases.
The validation process can also take from about 10 minutes up to 6 hours, depending on the blockchain network. This raises timing concerns, and is one reason that blockchain networks cannot be the primary method for processing transactions where users expect an immediate settlement.
Both of these issues also raise a question about scalability. The processing requirements for blockchain technology mean that it might not scale for solutions that suddenly need to process a larger volume of transactions, especially within time limits.
Some blockchain networks use Proof of Stake validation, or other more efficient methods, but the energy and time required to validate blockchain transactions should always be a consideration as you evaluate a blockchain technology solution.
One of the risks is data privacy. To ensure the data privacy that regulations and users require, blockchain solutions sometimes need to take non-traditional approaches:
Not all blockchain solutions involve cryptocurrencies. However, when they do, cryptocurrencies can introduce some unique risks:
The values for non-stablecoin cryptocurrencies shift more than most traditional government-issued (“fiat”) currencies like the US dollar.
Some of the less-common cryptocurrencies have limited markets for trading them. Those markets can charge high fees or pose other challenges for exchanging these less-common currencies.
As with any system that handles financial information, systems that handle cryptocurrencies are at risk of being targeted by hackers, malware, ransomware and fraudsters.
Cryptocurrency holdings can be difficult to insure. If uninsured holdings are lost from a hack or a lost password, they might be unrecoverable.
- Substantiation and tracing
Since cryptocurrency transactions only record account information for participants, they can be pseudo-anonymous. That can make it difficult to establish and substantiate the true source of a cryptocurrency donation. If a cryptocurrency donation is found to originate from criminal activity, the recipient might need to return the donation.
Digital assets often fall within an existing classifications and guidance, for security, accounting, tax and other purposes. However, there is some specific cryptocurrency guidance in the following:
Our video outlines three data privacy challenges that are unique to blockchain (ownership, deletion and smart contracts), along with guidelines for approaching them.
Accounting for cryptocurrencies
The American Institute of Certified Public Accountants (AICPA) has published guidance on accounting for blockchain. Make sure that you understand the relevant guidance that is specific to what your organization decides to do with the assets.
Taxes on cryptocurrency holdings
The IRS Notice 2014-21 explains how to treat digital assets for federal Income Tax purposes. It indicates that, for federal tax purposes, virtual currency is treated as property. The general tax principles that apply to property transactions also apply to transactions using virtual currency. The character of the gain or loss generally depends on whether the virtual currency is a capital asset in the hands of the taxpayer. The IRS published an FAQ on Virtual Currency that addresses many other tax-related considerations.
If you decide to transact in cryptocurrencies directly, consider which currencies you will accept. You also need to determine whether your organization will hold cryptocurrencies or immediately convert them and other digital assets to a fiat (national) currency. Many service providers can help your organization process cryptocurrency transactions. Some are cryptocurrency payment processors and clearing businesses that directly convert cryptocurrencies into fiat currencies. Service providers can come with costs, but they can minimize some of the administrative burden and risks involved in handling cryptocurrencies.
Alternately, your organization can set up its own digital wallet, with a unique “private key” for access. The wallet lets your organization receive, hold and send cryptocurrencies through its account. Having your own wallet could be more secure, but it also gives your organization an administrative burden without the support and other benefits of a service provider.
Should you use a blockchain?
Blockchain technology is powerful, but it is more complex than other database technologies. So, you should use it when other database technologies simply cannot offer the trust and resilience that you require. In other words, the litmus test for whether you should use blockchain is this question:
Can this be done with a database technology other than blockchain?
If you do use blockchain technology, you’ll want to ask more questions to determine the blockchain design. Depending on your use case and governance, you can establish a blockchain that is public (fully decentralized, with nodes from anywhere), permissioned (partially decentralized) or private (centralized, with nodes from a restricted network).
Once you understand the benefits, risks and guidelines for digital assets on blockchain technology, you can outline a strategy for how cryptocurrencies, NFTs, smart contracts or other digital assets can help you achieve your business goals.
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