[IMGCAP(1)]You may have heard people talking about blockchain technology, but how does it work and what does it mean for tax compliance?
Today, we are witnessing a potentially profound change in the underlying technology for conducting business transactions. It’s called blockchain, and it could dramatically shift the way we define, track, share, own and manage transactions.
Blockchain technology was developed to implement Bitcoin, but it's entirely separable from Bitcoin. What makes blockchain useful to Bitcoin makes it ideal for all kinds of other business transactions.
The Shared Ledger
We're all used to managing private ledgers. For example, if you run the finances of a company, you have a general ledger (usually software) that records your company’s transactions, leading to income statements and a balance sheet giving current totals for each account. Your general ledger is usually managed privately and only by authorized employees or agents.
The GL works great for internal transactions. But transactions that represent relationships with outside entities require expensive overhead to manage. Let's say we're Company A, and our books have an accounts receivable total that says Company B owes us $100,000. That's only really valid if Company B has a corresponding balance in their accounts payable owing Company A $100,000. Today, we validate and coordinate by having staff sending and entering invoices with elaborate approval processes (often, with auditors and accountants reviewing things to ensure we get it right). If things really get bad, we kick it up to the attorneys. That's a lot of effort (and cost).
In contrast, the blockchain comprises both the transaction itself and a shared ledger for that transaction. Using blockchain, we all share the same data. There is one ledger for this transaction that is shared between the two companies; we can conclusively say B owes A $100,000, because both A and B are looking at exactly the same data.
How Blockchain Addresses Ownership Tracking
Tracking ownership of things today is generally an expensive and antiquated process. What blockchain does really well is track ownership, of anything. Since blockchain is a shared public ledger of all transactions in the system, all users can calculate the current state (balance sheet) of the system at any time. It does this by solving all of these problems:
• Synchronization: Each party has its own full copy of all of the data (of all the entries in the ledger).
• Indelibility: Once a transaction is recorded, it is effectively impossible to undo or erase that transaction.
• Deterministic: Blockchain can tell absolutely if a transaction happened or if it didn’t.
• Single use: If the system records product as owned by A, and A wants to sell it, it ensures A can only transfer ownership of the product exactly once. Similarly if A owns $10, then A can only transfer out $10.
• Nonrepudiation: All transactions are digitally signed. So if there is a record of A selling the product, we can cryptographically prove that someone with A's credentials approved that sale. There is still vulnerability if electronic credentials are stolen, but it’s a much smaller problem than the paper signature system we use today.
• Speed: Blockchain transactions can be confirmed in about 10 minutes. Compare that to daylong processes today around settling stocks, property or even ACH transfers.
So let’s consider some real-world potential applications of blockchain:
• Real estate: Real estate ownership in the U.S. is tracked publicly by local governments (towns or counties), which use systems that haven't changed in hundreds of years. Say you want to transfer property. You write a paper contract, sign it, notarize it and then file it with the county clerk. If you want to know who owns a piece of property, you ask the clerk for photocopies of everything that has ever been recorded about a parcel and you do a ton of reading. Beating (or cheating) this system is fairly easy: anyone with some gumption and a $15 stamp can file falsified papers to legally transfer any real property to their name. That’s why there is a $20 billion title insurance industry: to prevent fraud and to manage the uncertainty inherent in this ancient process.
Blockchain potentially obviates the need for expensive title insurance, because it is synchronized (each party has copies of the ownership contract); its non-repudiation ensures that the contract has integrity (it’s been digitally signed and authenticated); and it’s both deterministic and indelible (blockchain includes proof that it actually happened).
• Financial securities: Although far more automated, PwC predicts that $2.3 billion will be spent in 2016 on security in financial services, while clearing and settling financial transactions still generally takes a number of days.
Blockchain could greatly reduce the likelihood of fraud through non-repudiation, and speed, since transactions can be cleared in minutes (rather than days)
• Art and collectibles: There is no clear system for proving the provenance of expensive collectibles. In fact, there is an entire industry built around selling fake copies of art, because there are no reliable ways to prove ownership of collectibles.
Blockchain eliminates the murkiness of provenance and authenticity, since the chain of ownership is documented as part of its determinism, indelibility and single-use properties.
• Concert and sports tickets: Is the guy on the street selling half-price tickets giving you real tickets or fakes? Did he sell them just once, or did he make many fraudulent copies? Ticketmaster provides a solution to this problem with their resale market, but they take 10 to 20 percent of the sales price for that service.
Blockchain offers an automated, low cost method of authenticating transactions—again via determinism, indelibility and single use. Using Blockchain, what you got is what you thought you got.
• Funds transfer: The AR and AP examples above, or managing bank balances, are just exercises in proving the ownership and transfer of money. Consider how much time auditors spend sending request letters to verify AR balances with counterparties. Blockchain eliminates this need, since transactions are synchronized and nonrepudiated.
Blockchain accomplishes all of the above with an open, legitimate means for achieving consensus. The shared ledger is entirely open. But if anyone can write on your ledger, how do you know it's any good?
That's where consensus comes in—a means for proving exactly what belongs on that ledger. There are two approaches:
Open and decentralized: In this model, no one is in charge. The details are complex, but the fundamental innovation of blockchain is to create a way that uncoordinated parties can agree on what transactions are valid in the shared ledger. Blockchain technology makes it hard computationally to add transactions to the ledger; as long as “good guys” have more resources than “bad guys,” the ledger will reflect what good guys have accepted as valid transactions. Another way to put it: if transactions are invalid (due to “bad guys”), then the shared ledger is no longer legitimate. It may be hard to accept this can work, but this is exactly how $5 trillion in current bitcoin value is managed today, and it does work.
Private: In this model, a private entity (such as your bank or broker) is running the blockchain. The private entity decides which transactions are valid.
There's an ongoing argument about whether a "private blockchain" is really a blockchain at all; without the distributed consensus mechanism, Blockchain is really no different than any shared database that’s been available for years. I believe we'll eventually see both models thrive. A decentralized blockchain is revolutionary and unleashes many new applications, but there are also times when people like a throat to choke. If you lose your Bitcoin credentials, there is absolutely no one to turn to, who can help you.
Once blockchains are used to manage ownership of property, then the Smart Contract becomes an exciting possibility.
Let's say A wants to sell 100 acres of waterfront property to B for $100 million. Today, we would negotiate a lengthy contract in words. Part of that contract would include escrow instructions and would require a human being at an escrow firm to implement those instructions.
Smart Contracts allow us to include the programming code to implement the deal into the contract itself. In this case, the code would make entries in the blockchain that records ownership of property to transfer the waterfront parcel from A to B, and make entries in the blockchain that records ownership of money to transfer $100 million from B to A. Then once the contract is signed, we just run the program contained in the contract.
Reading and writing computer programs as part of a contract may seem difficult for nonprogrammers. But Wall Street whizzes who trade complicated financial instruments (such as credit default swaps) are already working on exactly such systems. And, over time the programs inside contracts could be simplified and made more accessible to the general public.
Once property is tracked in open computer-readable systems, why would we describe that transaction in English, instead of in a program that would actually make the changes?
The Next Steps
Most blockchain implementations (other than Bitcoin) are just pilots at this stage. But there are a lot of pilots and a trainload full of venture investment money pouring into this space. Google conducted the first Dutch auction IPO. It's not hard to conceive of the next like-minded attractive company telling the financial industry it doesn't need their help in its IPO—it would prefer to track ownership of its shares via a blockchain method instead.
Blockchain and the Accounting Profession
Blockchain is a rapidly evolving paradigm shift that has the potential to change the way in which your clients transact and manage their business, and directly impact deficiencies related to security, transparency and business efficiency. In your advisory capacity, clients will soon be looking to you for information and guidance related to the applicability of blockchain to their business.
The blockchain is coming. It’s up to each of us to understand and embrace it.
Peter Horadan is chief technology officer of the tax technology company Avalara.
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