What is a distributed ledger? Answering this question is key to understanding the technologies that provide the foundation for digital currencies. The blockchain, which is crucial for many cryptocurrencies, is a kind of distributed ledger.
In a way, a distributed ledger is just what it sounds like: a method for keeping track of transactions spread across multiple nodes (devices). The U.K. Government Office For Science has provided a more specific definition, stating that a distributed ledger "is essentially an asset database that can be shared across a network of multiple sites, geographies or institutions."
Distributed Ledger Basics
Ledgers have been around for some time and were historically formed using materials like clay, papyrus and wood.
However, technological advances helped enable the creation of distributed ledgers. In a distributed ledger, every single device in a network is involved with both creating and maintaining digital records.
Basically, every node (or device) draws its own conclusions about every single transaction that took place on the network. Then, it "votes" on what happened. When a certain majority of devices on a network determine that they agree, the distributed ledger updates and all nodes store their own individual copy of this ledger.
Kinds Of Distributed Ledgers
The most basic kind of distributed ledger is the blockchain.
Just like it sounds, a blockchain is a series of blocks that are attached in a chain. The first blockchain was rolled out for Bitcoin, and it was designed to keep track of every Bitcoin transaction.
The Bitcoin network takes several transactions and combines them into a block. Every block in the chain references previous blocks. In other words, every time a block is created, it uses the information for transactions that took place earlier.
As a result, altering the blockchain would require a nefarious party to change every block in the chain. This, in turn, would require an enormous amount of processing power and would be prohibitively difficult.
Another kind of distributed ledger is IOTA's Tangle. A blockless distributed ledger, the Tangle was designed to circumvent the problems inherent to the blockchain. The blockchain creates two groups: the users who execute transactions and the miners who verify them.
At more than one point, these two groups have come into conflict. While users benefit from lower fees, miners benefit from higher fees. To eliminate this problem, the Tangle combines miners and users into one group.
In order to issue a transaction, a node must verify two other transactions. As a transaction receives more approvals, there is greater assurance that the system accepts it as being valid.
In early 2018, a new distributed ledger called the Hedera Hashgraph platform was launched by Swirlds. Leveraging an algorithm that is designed to reach consensus quickly, this new distributed ledger can process hundreds of thousands of transactions per second.
"Hashgraph is an alternative to blockchain — a first generation tech with severe constraints in terms of speed, fairness, cost, and security," Mance Harmon, co-founder and CEO of Swirlds, said. "A fundamental bottleneck has been the performance — how many applications are there that can run on a database that can just do 5 transactions per seconds."
He stated that as a result, "We can process hundreds of thousands of transactions per second on Hedera Hashgraph, compared to proof of work blockchains like Bitcoin or Ethereum's blockchain that can do 5-7 transactions per second."
Permissioned vs. Permissionless Distributed Ledgers
Another important distinction is the difference between permissioned and permissionless distributed ledgers. The ledgers used by major digital currencies, for example Bitcoin and Ether, are permissionless, meaning that anyone can use them without receiving authorisation from a central party.
Permissionless ledgers, alternatively, are more likely to be used like organisations such as companies. Unlike their permissionless counterparts, permissioned ledgers require interested parties to receive the approval of a central party in order to be part of the network or make transactions. Further, they cannot see the network's transaction history without obtaining this permission.
By leveraging permissioned distributed ledgers, these companies can maintain control over their operations.
Why Distributed Ledgers Matter
Distributed ledgers are relevant to technologists, investors and other interested individuals because they eliminate the need for a trusted intermediary or third party. Many distributed ledgers, including those used by major digital currencies like Bitcoin and Ether, are immutable, meaning that their transactions cannot be erased.
The fact that many of these ledgers are not only immutable, but also decentralised, helps them ensure integrity by making it very difficult to defraud the system. If distributed ledgers were mutable, users could make transactions and then erase them. Alternatively, if these ledgers were centralised, someone with the right access could potentially erase transactions or enter transactions that never happened.
Distributed ledgers are decentralised methods for keeping track of transactions, and they can be very helpful in ensuring integrity. There are different kinds of distributed ledgers, including the blockchain, IOTA's Tangle and the Hedera Hashgraph.
These distributed ledgers form the foundation for digital currencies, as virtually all of these digital assets use the ledgers to keep track of their transactions. The distributed ledgers that are crucial to digital currencies are permissionless, meaning that anyone can use them. However, some organisations have permissioned ledgers, which allow them to maintain control over use of their network and therefore their operations.
Senior Market Specialist
Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…