CEO Message: Blockchains – A Major Disruption or a New Dawn for Accountants?

Prof Janek Ratnatunga, CEO, ICMA Australia

As strategists who steer their company’s future endeavours, CFOs and Management Accountants need to advice their organisations to harness the power of “blockchain” technology – and that their companies cannot afford to ignore it.

There is a paradigm shift happening that is going to change businesses in ways that will make them unrecognisable to the standard models of today. Fortune magazine (1) states that already, incumbent businesses in countless industries, from finance to energy to health care to food, are seeing the potential of a new disruptive technology that has the potential to trim costs, share and secure information more efficiently, and unleash new products at an unprecedented speed. And these businesses are doing so knowing that one day their very survival may be at stake.

Having witnessed what the advent of digital, cloud, and mobile did to laggard companies, no one wants to be left behind. Remember that when Arpanet, the forerunner of today’s Internet was introduced in 1969, very few could see its potential. Today, we are seeing the birth of a technology that could, in time, be as important as the Internet.

Blockchains

The technology that is called a ‘blockchain’, is still poorly understood. A blockchain is a sophisticated form of a general ledger (GL). All accountants know that a ledger is a financial database powered by the double-entry system that tracks credits and debits; which in turn are classified as assets, liabilities, income and expenditure.

A ‘Blockchain’ is a ‘Triple-Entry’ accounting system; where the third entry is a verifiable cryptographic receipt of any transaction. However, unlike a standard GL of today that is kept under the control of one organisation; a blockchain (in its purest form) is a common record that is accessible to everyone and controlled by no one.

One of a blockchain’s distinguishing features is that it locks-in (or “chains”) cryptographically verified transactions into sequences of lists (or “blocks”). The system uses complex mathematical functions to arrive at a definitive record of who owns what, when, where and how. Properly applied, a blockchain can help assure data integrity, maintain auditable records, and even, in its latest iterations, render financial contracts into programmable software. It is a general ledger on steroids. 

Double-entry bookkeeping powered the corporate capitalism of the 18th Century; where investors and entrepreneurs could come together in the form of a ‘Corporation’; i.e. recognized in law to act as a single entity. This enabled such entities to take risks of undertaking ventures and projects in search of commercial success; but with limited liability protection if the results turned out to be bad. Even today, such legal entities fiercely guard their information from rivals and competitors; divulging only what is required by law and their social responsibilities. In contrast, blockchains can get even rivals to cooperate by creating a common record that is accessible to everyone and controlled by no one; and as such may be the next-big thing of 21st Century commerce.

Think of it like this. Today, if you are the proud owner of your home, all that you will know from studying the ‘Deed” of the property (held in electronic or paper form by a Land Registry) is the boundaries of the land and the names of the former owners and the period that they held the property. With a blockchain, you will be able to access everything about the house, from prices paid, repairs done, insurances claimed, extensions and renovations made, material used, etc.  Then for example, if one wants to know if the same aluminium cladding that caught fire in the Grenfell Tower disaster in London has also been used on your property, with a blockchain this information would be instantly accessible to you and other interested parties such as Governments, Building Regularity Authorities and even those interested in purchasing your property.

Cryptocurrencies

One of the early (first) uses of blockchain technology was ‘Bitcoin’, a cryptocurrency. Bitcoin, which debuted in 2009, uses a consensus mechanism, which allows people to agree on a canonical form of transactions. In mathematics and computer science, the distinction between a “canonical” and “normal” form is that a canonical form specifies a unique representation for every object, while a normal form simply specifies its form, without the requirement of uniqueness.  Therefore, through a combination of cryptography and economic incentives, this uniqueness prevents double-spending and fraud – all without needing a third party or middleman, like a bank. Even if participants don’t trust one another, they can rely on the shared ledger they create. You don’t need honour among thieves – you just need a blockchain.

Where do bitcoins come from? In the old days paper money was issued based on a gold standard in which the standard economic unit of account was based on a fixed quantity of gold. In the USA, the mined gold was deposited at Fort Knox, and the quantity of US dollars issued was based on these gold reserves. But the USA moved away from the gold standard in 1970; followed by all other countries. Therefore today, in the case of paper money, a government simply decides when to print and distribute money without basing it on any standard, be it gold or any other precious metal.

Bitcoin is more like the days of old, with gold. As Bitcoin does not have a central government to issue them, it has to be mined, just like gold. Bitcoin miners use special software to solve math problems and are issued a certain number of bitcoins in exchange for their effort. This provides a smart way to issue the currency and also creates an incentive for more people to mine. However, just like the gold mining in the old days; Bitcoin mining is not easy. Gold mining required a lot of pick-axes, muscle-power and sweat. Bitcoin mining requires a lot of computing power, time, energy and cost. Further, there has been a limit placed on how much Bitcoins can be mined (just like technically Gold has a finite limit); and therefore. the more miners that join, the harder it gets to actually mine Bitcoins. Once a Bitcoin is mined, it can be either stored personally on your home computer (just like gold kept at home), or in a cryptocurrency exchange (protected much like Fort Knox is with its gold depositories).

If Bitcoin proved what was possible with Blockchain technologies, Ethereum, a rival system, took its ingenuity to a logical extreme by creating blockchains that aim to be anything to anyone. Ethereum can create representations of any asset (not just economic incentives for solving math problems as in the case of Bitcoin), which has made it the primary fuel of a digital-token boom.

Digital tokens (cryptocurrencies) are a new asset class, powered by Blockchain technologies. This year alone, hundreds of projects have collectively raised more than a billion dollars through “initial coin offerings” (ICOs) of cryptocurrency representations of various assets or services completed.  Even established venture capital firms are pouring millions of dollars into cryptocurrency hedge funds.

Looking beyond this ICO frenzy, one can see a paradigm shift with incumbent businesses in countless industries, from finance to energy to health care to food, seeing the potential of this budding technology to trim costs, share and secure information more efficiently, and unleash new products at an unprecedented speed. They are doing so knowing that one day their survival may be at stake. Having witnessed what the advent of digital, cloud, and mobile did to laggard companies, no one wants to be left behind.

However, cryptocurrencies (such as Bitcoin and Ethereum) are extremely volatile, with the total market value of all virtual currencies having reached $135 billion (up from just under $20 billion at the beginning of the year); until the Chinese Government closed the cryptocurrency exchanges in that country, and collapsed the market to 40% of its value (as I write on Sept 20 2017). More about that later.

Private Blockchains

By showcasing blockchain’s fundamental flexibility, Ethereum’s rise has also accelerated a deluge of research and development in corporations for private blockchains. The description of a Land Registry Blockchain given earlier is an example of a possible private blockchain. Many companies are adapting and advancing the core Blockchain technology to suit their needs. While some are exploring digital currency and the open-source, free-for-all ecosystem of public blockchains (of which Bitcoin and Ethereum are prime examples), far more are concentrating on how the technology underpinning those systems can add value to their businesses – by helping them with everything from linking medical records to tracking the cost of a product or service at a granular level. Many organisations are thus developing “permissioned” or “private” blockchains, designed for a more centralized architecture, where only authorised operators can join; and this should be of great interest to CFOs and management accountants.

Interestingly, there are those who argue that this new ‘ledger technology’ is not really a blockchain if the items it tracks are not financial; and suggest that any non-financial ledger should be called ‘distributed ledger technology’ rather than ‘blockchain technology’. However, this argument over terminology is not hampering the rapid development of the next-generation data structures with cryptographic signatures and joint-stakeholder elements. One could say that such ledgers, financial or not, all fall under the “blockchain” umbrella, just like all photocopies were once called Xerox copies. The point is, whatever you want to call it, more and more businesses are looking at ways to exploit the technology.

Many industry insiders believe that public and private blockchains will eventually intersect – just as internal networks came to coexist with and feed the public Internet decades ago. If the Internet is a supranetwork, then a blockchain, in its purest form, is a way to turn these networks into decentralized marketplaces. Ronald Coase, a 20th-century economist, won a Nobel Prize for formulating an explanation for why corporations existed. Their raison d’être, he said, was to maximize efficiencies in business and market negotiations: i.e. deal making is more productive when done collectively. Blockchains could take that principle and multiply it exponentially.

Supply Chain Logistics: A Case Study

An interesting case of Blockchain technology was illustrated in the Fortune magazine (1). One where Walmart’s vice president of food safety, brought a bag of mangoes from a Walmart store back to his office, placed the container on a conference table, and gave his team a mission, “Find out where those mangoes came from?”

It took six days, 18 hours, and 26 minutes to get an answer. Such a time lag could be extremely costly in the event of an outbreak of foodborne illness – one in which a suspected pathogen is tied to mangoes somewhere. With a week-long delay, Walmart might have had to pull every package of every mango product off its shelves, as a precaution. Farmers, distributors, and Walmart itself would have to bear the losses. This is a clear case of how a blockchain can save money, and thus should be of interest to CFOs and management accountants.

A private blockchain could track and catalogue a product’s status across the entire corporate supply chain. Walmart tested one, partnering with IBM for a trial run on Hyperledger Fabric, a blockchain built under the purview of the Linux Foundation’s Hyperledger group, where companies collaborate on blockchain R&D.

In the Walmart test, food shipments were tracked and digitally recorded via a blockchain. From the start of their journey at the farm, pallets of mangoes were tagged with numeric identifiers. Every time they crossed another checkpoint – from farm to broker to distributor to store – their status was signed and logged.

All that a Walmart manager needs to do now, is to enter a six-digit “lot” number on a web portal. In an instant, the mangoes’ identifying details appear on-screen: Mango spears, 10 ounces, “Tommy” variety (a cultivar optimized for transport). The fruit was harvested April 24 from orchards in Oaxaca, in southern Mexico. A day later, the fruit underwent hot-water treatment to exterminate the eggs of potentially invasive insects. On April 27, an importer received the shipment; after a few more days, it passed through Customs and Border Protection, entering a U.S. processing plant where they were sliced on May 1. From there, the mangoes moved to a cold storage facility in Los Angeles (you can pull up a safety inspection certificate with a click of a mouse). Finally, the lot arrived at a Walmart store.

The time it took to compile and present all this information was about two seconds. In the event of an E. coli or salmonella outbreak, the difference between two seconds and six-plus days can be decisive, even lifesaving. But in the context of a supply chain, a blockchain is far more than an emergency measure: The granular, secure records in the system could help prevent fraud, and provide an easy-to-use interface for executives to keep tabs on the flow of goods, as well as for regulators to check when necessary. For cost accountants such information is invaluable for product costing; as costs can be attached to cost objects in a granular manner (more on this later).

CFOs and management accountants should be made aware that many companies are now exploring blockchains’ potential for their logistics. Maersk, the Danish shipping giant, has started testing a blockchain to track its shipments and coordinate with customs officials. The potential doesn’t stop with tangible goods. Many companies and governments think blockchains could help them assemble tamper-resistant systems for storing virtually any kind of data. BAE Systems, the British defence contractor, is exploring sharing cybersecurity threat data on a blockchain. Accenture has teamed up with Microsoft and a United Nations group to build a blockchain for digital identity, especially useful for refugees who lack official documents.

Finance

Even with all these potential applications, there is arguably no industry where the promise of blockchain technology – or its peril – is more apparent than in finance; and CFOs should be well aware of this. Finance is the most obvious extension of blockchain technologies, given the monetary roots of Bitcoin. Trade finance, security clearance and settlements, cross-border payments, and insurance are all areas that could be overhauled and made more seamless. Microsoft is collaborating with Bank of America on a blockchain to digitize and automate the money flow around trades. Northern Trust, the asset management firm, is using Hyper­ledger Fabric for private-equity deal record keeping. Ripple has built a system to rival the SWIFT interbank money-transferring service using Blockchain technologies. In a very competitive sector where customers demand faster transactions and lower costs, the rewards of building the best blockchain product or service could be vast, and the penalties for missing out, proportionately devastating.

Blockchain Dangers: Hacking

Early exchanges set up for trading cryptocurrency often got hacked. Many early investors lost money in Mt. Gox, an exchange that collapsed in 2014 after hackers pillaged nearly $500 million in Bitcoin. In 2016, hackers took $72 million from the Hong Kong based cryptoexchange Bitfinex in one quick hit.

In contrast, San Francisco’s Coinbase, the world’s largest exchange for trading cryptocurrency, is one of very few such companies whose own coffers have never been hacked, a distinction that carries extra weight in the realm of blockchain, where several costly breaches (as those mentioned above) have made global headlines. As hackers have never breached Coinbase’s own virtual fortress, its impenetrability has earned it a reputation as the safest place to buy and sell Bitcoin.

But Coinbase’s individual customers do get burglarized – with surprising and unsettling frequency. How?

One of Bitcoin’s reasons for existence is that it’s censorship-resistant. That means no one, not even a government or central bank, can stop a digital currency transaction from happening. This very strength that sets cryptocurrency apart from traditional money (i.e. that transactions are instant and irreversible) is also its fatal flaw. The fraud protections traditional bank depositors rely on, such as charge-backs and the reversibility of a fraudulent transaction done by the targeted bank, are mostly unavailable in cryptocurrency transactions.

Brick and mortar bank robbers have two problems: stealing the money and hiding the evidence. A cryptocurrency solves the second one for the robber because everyone on the ledger is anonymous. Therefore, one of the major features of a cryptocurrency ledger (i.e. irreversible transactions) is one of its drawbacks – and a porthole through which an individual in a heavily fortified cryptocurrency exchange like Coinbase can still be robbed. Fortune magazine (2) spoke with more than a dozen victims, including technology CEOs and well-known blockchain proponents, whose Coinbase accounts have been targeted and hacked in almost exactly the same fashion. This is how it is done, in six easy steps:

  1. The Stakeout: A scammer scouts a target by searching for people who work in the blockchain industry—or by combing social media for mentions of Bitcoin and Coinbase. The attacker finds the target’s email address and phone number through online postings or previous data leaks.
  2. The Switch; The scammer contacts the victim’s mobile provider and “ports” the phone number to a device under the scammer’s control. It is surprising how easy for a scammer to take charge of your phone number.
  3. The Disguise: Because Gmail ­accounts often link phone numbers as a backup access method, the scammer can now log in and reset the target’s email password, then do the same at Coinbase.
  4. The Break-in: Coinbase requires two-factor authentication (“2FA”) in addition to a password. That 2FA now gets texted to the thief, who logs in.
  5. The Getaway: The scammer moves the money into digital “wallets” under his control. Law enforcement can easily track the movements of the stolen currency recorded on the blockchain, but they can’t block transactions, and figuring out who controls the wallets is difficult.
  6. The Laundering: To try to cover his trail, the scammer can move the currency to foreign “cryptoexchanges,” or convert it to other kinds of digital currency that are harder to track. Eventually, he can convert it to cash or other assets.

Coinbase still bears the cost of banking-system protocols, when traditional financial institutions take back fraudulent payments induced by hackers. Individual customer hacks, along with unauthorized credit card purchases of cryptocurrency, cost Coinbase a significant 10% of all revenue it collects, a fraud-loss rate 20 times as high as PayPal’s. To combat that, Coinbase has been using analytics to predict which customers have the highest risk of fraud and charge-backs, and pre-emptively limiting their purchasing power or locking their accounts. But that method comes with a downside of its own in the form of frustrated customers – and a backlog of help-desk requests that has stretched into the tens of thousands.

Also, clearly, not only users of cryptocurrency, but also all those who have transactions on internet (and who does not?) should take the following steps for better security: (a) put a “do not port” order on your phone number; (b) do not use text-message 2FA; instead, use an app like Google Authenticator; and (c) use a unique password, one you do not use for other accounts or social media.

Government Controls

A litmus test to the censorship-resistant claim of cryptocurrencies is the action taken by Chinese authorities who ordered in September 2017 for all Beijing based cryptocurrency exchanges to cease trading and immediately notify users of their closure. This signalled a widening crackdown by authorities on the industry to contain financial risks. According to Chinese authorities, as cryptocurrencies such as Bitcoin are “stateless” digital tokens, they thus posed risks as they could be used for illegal actions, such as money laundering. Thus, the Chinese government’s view was that rules are needed to support the development of “legal” digital currencies.

With the advent of ‘Cloud Computing’ it will be interesting to see if the Beijing based cryptocurrency exchanges will simply move to a less hostile jurisdiction and set up their ledgers on-line – away from the controls of the Chinese authorities.

Granular Costing

Today’s cost accounting and cost management systems have various systems of attaching direct costs and allocating indirect costs to cost objects such as products, services, customers, segments and white-collar departments. It is in the cost allocating aspect that most problems arise. Traditional cost allocation systems allocate indirect costs using volume based cost drivers such a ‘direct labour hours’ or ‘direct material costs”. In contrast, ABC cost allocation systems use both volume and non-volume cost drivers based on activities undertaken. With Blockchain Technologies, all this cost allocation methods – traditional or Activity based – maybe a thing of the past.

Take for example the case of Airbus, the French aircraft maker, that is looking to use blockchains to monitor the many complex parts (and their related costs) that come together to make a jet plane. Daimler, the German automaker, is investigating similar possibilities for its vehicles. This has given rise to a new term in cost accounting, “granular costing”, i.e. where the cost of any large cost object (e.g. a motor car) can be built up as the sum of its individual components and activities that went into producing it. Not only can material costs (which are easy to track) but also the cost of human input and overheads be tracked at a granular level using blockchains.

All of this can be a new dawn for CFOs, business analysts and management accountants who embrace the technology; but also, a major disruption for those who cannot grasp its potential.

Professor Janek Ratnatunga, CMA, CGBA

CEO, ICMA Australia

 

 

  1. Robert Hackett (2017), “Blockchain Mania”, Fortune, Sept 1, 2017, p. 26-33
  2. Jen Wieczner (2017), “Hacking Coinbase: The Great Bitcoin Bank Robbery”, Fortune, Sept 1, 2017, p. 34-41

The opinions in this article reflect those of the author and not necessarily that of the organisation or its executive.