Bitcoin, DLT and Bank Ledgers: A Central Banker’s View
Yao Qian is the director-general of the Institute of Digital Money of the People’s Bank of China.
This article represents his personal, academic opinions, not those of the institution.
Bookkeeping refers to the recording of economic data in account books.
A ledger, therefore, is a book with a certain format based on original vouchers and recorded in sequence for all economic transactions. The original vouchers are those obtained when business occurs or is completed to record or prove the evidence of the occurrence or completion of the economic business.
It is the original data and an important basis for accounting, reflecting the most primitive transaction information. It is also key to clarifying economic responsibility.
Ledgers are kept in various material, traditionally, in paper form. But with the development of information technology (IT), ledgers have gradually been digitalized and various types of accounting databases have emerged. Indeed, accounting computerization has become the main tool for accounting work today.
The emergence of distributed ledger technology (DLT) may be another major leap forward after the digitization of ledgers. In the proof-of-work mechanism, miners complete the bookkeeping process for transaction records through “mining” and provide a publicly visible decentralized, shared ledger for each node of the network.
Each blockchain is a ledger, and there is no essential difference in the accounting sense from the traditional ledgers. However, from a technical point of view, the DLT ledger not only inherits the traditional bookkeeping philosophy, but also has incomparable advantages thanks to certain innovative aspects.
As such, DLT can play an important role in addressing some acute problems regarding corporate ledgers, country ledgers and industry ledgers.
A shared philosophy
The traditional model for bookkeeping is based on accounts.
In accounting, an account is set up according to accounting categories. It is used to record the increase and decrease of account elements and to reflect the result of the changes. In terms of system implementation, an account is the carrying body of a series of service agreement. An account can contain a variety of products and services. The balance of the account is changed as a result of recording, aggregating, categorizing and consolidating of the original transaction data from the products and services.
Traditional e-payments are achieved through changes in the balance of accounts opened at centralized institutions, relying entirely on the behavior of the central agency. In contrast, the bitcoin system uses another new model in bookkeeping processing: the UTXO (unspent transaction output) mode.
From the perspective of economics, a UTXO is essentially a claim on future value based on public consensus.
Specifically, when a transaction is completed, each node forms a consensus on the transaction behavior and its results. The consensus confirms that the seller, after selling the goods or services, obtains the right to buy the same valued goods and services from other sellers in the future. This future value-claiming right is widely accepted with no objection and is used in the next transaction for payment and is refused by no one.
The necessary and sufficient condition for obtaining this right is that there must be a corresponding transaction that has obtained the consensus between the nodes. With related terms, the input of a transaction (input) is required for getting the output of the transaction (output).
Inputs and outputs
The blockchain system underlying bitcoin describes and completes the transfer of future value-claiming rights arising from transactions by constructing transaction inputs and transaction outputs that contain unlocking scripts and locking scripts. The input of a transaction is the hash value and the output index of the previous transaction, indicating that the transaction input corresponds to the previous transaction output.
The output of this transaction contains a locking script which will be unlocked by the unlocking script of next transaction in the future. The owner of the future value-claiming right constructs an unlocking script through the bitcoin transaction verification engine to prove his right in the transaction, and then transfers this right to the next entity by locking script, and so on. The unlocking script and the locking script are connected into a continuous value circulation chain.
The bitcoin blockchain does not require an account, but completes the “value” transfer through its UTXOs. UTXOs play the role of “currency.”
In fact, the essence of currency is a future value-claiming right that is widely recognized by society. A UTXO, then, is a kind of future value-claiming right obtained by consensus of the participants in the blockchain network, which is closer to the essence of currency.
However, it plays the role of a trading medium and performs a payment only within limited consensus.
The bitcoin system also stipulates that UTXO ‘s price unit is a “satoshi” and that a Satoshi is equal to one bitcoin in order to make UTXO perform better as a currency.
This is the essence of bitcoin. Bitcoin is a kind of value symbol or value unit that represents the future value-claiming right of a certain value on which a consensus has been reached.
UXTOs and accounts (differences)
When applied against other blockchains, we can understand more about this approach.
A UTXO is a form of value transfer completely different from an account, but the two things do not conflict with each other. In a sense, we can understand the blockchain as a transaction “journal account,” which immutably records all the transaction information by means of encoding.
In reality, the account information we are accustomed to is also the secondary processing of information on a transaction’s “journal account.” It is only that UTXO, through the design of the unlocking script and the locking script, concatenates a transfer and distribution channel for the future value-claiming right between the transactions with different timing. UTXO information and transaction information are unified.
Therefore, using the traditional account processing ideas, the value expressed by the UTXO forms can also be converted into that expressed by the account forms.
For example, the account balance in a bitcoin wallet is the result of the aggregation calculation of its UTXOs. Ethereum, on the other hand, introduces a traditional account based on the blockchain, and describes the process of trading on the account as a state transition function.
In this way, the state is composed of objects called “accounts,” and state transitions that transfer value and information between accounts. Each account is a 20-byte address, which can be trader’s address or the contract’s address. Through the state transition, the system automatically calculates the balance of each account.
Obviously, this is no different from the account processing originally undertaken by the central agency, except that the agency has been changed to the algorithm code. Thus, following the UTXO mode, in a DLT ledger, the account mode similar to the traditional ledger appeared.
Balance and flow
Balance and flow are two important concepts in accounting.
Balance refers to the amount of a variable at a certain point in time. Flow refers to the cumulative change over a period of time. The balance sheet reflects the “financial status” of a company on a specific balance sheet date, including the actual amount of the company’s assets, liabilities and the owner’s equity.
The cash flow statement reflects the “cash flow” of a certain accounting period of the company, and the income statement reflects the “business results” of a certain accounting period of the company.
Therefore, the statement of asset and liability is the balance accounting of the company’s economic information and is a “snapshot” of the company at a specific point in time. The cash flow statement and the income statement are the flow accounting of the economic information of the company and reflect the changes of the company during a specific period. The commonly seen periods include the month, quarter, half year and year.
The balance is static and reflects the status quo, and the flow is dynamic and ongoing. The two are linked to each other and can be converted into each other: (opening balance + increase in current period – reduction in current period = ending balance).
Among them, the balance at the beginning and the end of the period are balance. The increase in the current period and the reduction in the current period are flows.
The analysis of financial statements needs to not only analyze the financial status of a company at a certain point in time in terms of balance, but also compares with historical data, analyzing the changes in the financial status of the company and the reasons behind it in terms of flow, so as to provide a more thorough understanding of the financial situation of the company
Mix and match
As mentioned above, in essence, the UTXO mode immutably records all transaction information by means of encoding, and it is a mode of flow accounting.
Reduced by aggregation, UTXOs can be converted to account balances, and by splitting the account balance the UTXO result can be obtained. In computer terms, we can describe the conversion between UTXO and account as a split/map/reduce architecture. From UTXO to account, it is the process of map/reduce.
When a miner verifies and packages each transaction, it is map, which verifies and updates each UTXO, equivalent to generating a new key-value pair. The process of reduce is shifted to user’s wallets, and each UTXO is aggregated, thereby obtaining the fund balance based on the concept of the account in the user’s wallet.
From the account to UTXO is a split process, this work also occurs in user’s wallet. After receiving a currency transfer request, the wallet needs to split the transfer amount and quote multiple UTXOs as transaction input.
Compared with account mode, the advantage of the UTXO mode is that it is easy to parallelize and improve efficiency. However, the UTXO mode needs to store all flow information, and data storage burden is high. The account mode only requests the current balance information and ignores all flow information, but the premise is that the current balance information is reliable.
From a regulatory point of view, the UTXO mode stores all flow information and is more conducive to supervision and auditing. Still, it should be said that bitcoin’s UTXO model is rather extreme in that it removes the concept of an account in a sense.
However, UTXOs and accounts have their own advantages and disadvantages, and the two models can be integrated to show their respective strengths.
For example, in order to speed up synchronization, one can introduce an account in UTXO mode (ethereum is a typical example). For concurrent processing, account mode can refer to the UTXO concept to split accounts, that is, different departments create different accounts. the same user has multiple accounts, and the transactions of the respective accounts can naturally be processed in parallel.
After processing, the balances of all the accounts are added to obtain the total balance. Just as traditional bookkeeping accounts for both balance information and flow information, the integration of the UTXO model and the account model provides information demanders with more complete, three-dimensional ledger information, and is becoming the current trend in the development of DLT ledgers.
UXTOs and bookkeeping
A systematic exposition on the principle of double-entry bookkeeping was first presented in 1494 by Luca Pacioli an Italian, in his paper “Summary of arithmetic, geometry, proportions and proportionality.”
Double-entry bookkeeping is based on the equality between the asset amount and the amount of equity plus liability. It is a method of bookkeeping that, for every economic activity, records the corresponding changes in two or more linked accounts, thus systematically reflecting the result of fund movement.
A decrease in one account, there is an increase in another account, the debit and credit must equal. Taking capital as an example, the borrower is the receiver of funds, and the lender is the source of the funds.
If there is a spending of fund, the fund must come form somewhere. The “debit equals credit” means that the amount of the money spent equals the amount of the money deducted from the source. The double-entry bookkeeping method scientifically obtains important information on economic transactions and business results from relevant documents and creates a perfect bookkeeping methodology for the formation of modern enterprises and business society.
German philosopher Goethe praised it as “one of the wonderful creations of human wisdom, every shrewd businessman engaged in business activities must take advantage of it.”
Interestingly, like traditional account processing, UTXO ‘s processing also includes a bookkeeping philosophy of “A decrease in one account, there is an increase in another account, the debit and credit must equal.” The manifestation is that if UTXO has a transaction output, there should exist a transaction input, and if there is a transaction input, there should exist a transaction output.
The amount of transaction input should equal to the amount of transaction output, consistent with the connotation of, “A decrease in one account, there is an increase in another account, the debit and credit must equal.”
DLT ledger improvements
With this context, we can examine the benefits of distributed ledgers.
- Hard to forge, difficult to falsify, highly efficient, traceable and easy to audit
Traditionally, both paper ledger and electronic ledger are easy to forge and falsify. And the accounting process from the original voucher to the accounting book is error-prone.The UTXO of blockchain technology is designed through sophisticated data structures such as hash functions, time stamps and Merkle trees, supplemented by cryptography and consensus algorithms, to achieve the unforgeability and immutability of historical transaction records, and uses algorithm functions (eg. ethereum’s state transition function) to automatically calculate the account balance.The whole process is of high efficiency and with no error. The UTXO accounting model is also traceable and easy to audit.
- Ensures consistency of distributed ledgers through transaction signatures, consensus algorithms and cross-chain technologies, and automatic completion of account-document matching, ledger matching, and account-reality matchingIt should be said that any entity has its right to perform bookkeeping and has its own account. And the same entity usually holds a variety of ledgers, for example, a company has cashier ledger, cash ledger, bank deposit ledger, inventory ledger, invoice ledger, operating expenses ledger, general ledgers, administrative expense ledger, accounts receivable ledger, fixed assets ledger, 17 column breakdown ledger, intangible assets ledger, paid-in capital ledger, etc.From this perspective, ledgers are always “distributed” and there is no so-called centralized ledger. Because ledgers are easy to be forged and falsified, the question how to protect and maintain the consistency of various “distributed” accounts has become the key point of accounting and auditing.
Traditionally, a reconciliation regime is used to achieve consistency of various distributed ledgers.
The account reconciliation refers to checking and collating the relevant data recorded on the ledgers and accounts, so as to achieve the matching between account and document, between different accounts, and between account and real amount. Matching between account and document means that the account records match the related account documents. Matching between accounts means various books, including various books of an entity, various books from different entities that have matching entries. Matching between account and reality mean that the account balance of various property goods matches the actual amount.
DLT first guarantees the matching account and document through transaction signatures. The account is the document and the document is the account. The two are consistent and difficult to tamper with.
Second, DLT achieves the matching of accounts of various entities through a consensus mechanism.
The transaction information is written into the shared ledger only when consensus is reached. Information written into the account must have been agreed by the entities and the accounts are automatically matched. In addition, DLT uses cross-chain protocols to carry out cash-cash transaction and cash-voucher redemption, which automatically accomplishes the account-reality reconciliation.
DLT ledger improvements
Cross-chain technology not only guarantees the atomicity of pay in cash-cash transactions and cash-voucher redemption, it also guarantees the consistency between the accounts of different cross-chain entities.
Cross-chain technology includes three types:
- Notary schemes – This is a centralized or multi-signature-based witness model. The main feature is that it does not focus on the structure and consensus characteristics of the cross-chain, but instead introduces a trusted third party to act as a notary, acting as an intermediary for cross-chain operations.
- Sidechains and relays – The side chain is a kind of chain structure anchored to the primary chain. It is not a fork of the primary chain, but extracts specific information from the data flow of the primary chain to form a new chain structure. Relay is a channel for cross-chain information exchange and delivery. Whether it is a side chain or a relay, data is collected from the primary chain and it plays the role of a listener.
- Hash-locking technology – It sets an interoperable trigger between different chains, usually a hash value of a random number to be disclosed. The hash value is equivalent to a puzzle for currency transfer, and only those who get the secret random number can get the money. At the same time, it also constructed two “redeem contracts,” which need to be double-signed to become effective and have a time limit, in which the redeem contract for the person making the transfer hash puzzle is longer in duration than the other. One can thus protect his rights and interests.
It can be said that through specific single-chain and cross-chain bookkeeping technology, DLT ledger eliminates a lot of time-consuming, costly and error-prone reconciliation work. It automatically achieves the consistency of all kinds of “distributed” ledgers in real time.
Returning data rights to individuals
Traditionally, individual information of many participants has been “marked out” on various types of ledgers.
Especially with the development of digital economy, privacy protection of personal data is becoming more and more prominent. China’s “Cyber Security Law” and the EU’s General Data Protection Regulation (GDPR) provide legal protection for data subject(owner) to enjoy such rights as the right to know, the right to access, the right to object others’ access, the right to carry the data elsewhere, and the right to be forgotten, in order to strengthen personal privacy protection.
With the signature, encryption and other technical methods, DLT is truly able to return data rights back to individuals on a technical level.
By using cryptographic primitives and schemes such as zero-knowledge proof, homomorphic encryption, secure multi-party computation, ring signature, group signature, hierarchical certificates, and coin shuffle, the privacy protection of transaction identities and contents can also be achieved.
Improving value of financial statement information
DLT ledgers are traceable, immutable and hard to be forged, which can guarantee the authenticity and reliability of financial statement information. Moreover, DLT ledgers can further enhance the value of financial statement information in the following aspects.
This can happen in three ways:
- Improving the timeliness of financial statement information – Traditionally, account processing, recordkeeping, and reconciliation require costs. Therefore, based on the principle of cost-benefit, traditional accounting practices generally require one to create and disclose accounting statements on a monthly, quarterly, semi-annual, or annual basis.This kind of financial statement is based on a periodic assumption that has serious time delay, which affects the timeliness of the financial information. Investors, creditors, financial analysts, business managers, and other entities that need such financial information make decisions continuously. They hope that they can obtain information needed at any time for decision-making.The timeliness of financial information is crucial.From the technical feasibility point of view, based on the DLT with automated execution, real-time accounting and achievable global consistency, instantaneous balance sheet generation has become possible. This may be an important innovation in financial accounting.Of course, some necessary preconditions are required. For example, the DLT ledger should have enough ubiquity to cover all types of accounting elements globally.
- Improving the relevance of financial statement information – According to the principle of meeting demand, financial statements are designed to satisfy the information users’ decision-making needs. Therefore, financial statement information should be relevant to the decision process of the information user.Compared with historical cost information, fair value information is more relevant.However, traditionally, due to the difficulty in achieving the timeliness of the preparation and disclosure of the aforementioned financial statements, one has to rely more or less on historical cost method, which impair the relevance of the financial information to the user’s decision-making process.The use of DLT not only can achieve the reliability of financial information, but also can achieve the timeliness of the preparation of financial statements, making measurement based on fair value method more feasible, so as to better meet the needs of information users.
- Improving the completeness of financial reporting. Similarly, because bookkeeping requires cost, based on the cost-benefit principle, traditional financial statements often selectively reflect information that is presumed to be useful or important to decision makers. Information users can only access the part of information about the company’s business activities, rather than global information.DLT not only reduces accounting costs and improves efficiency, but also allows the user to penetrate to the bottom of the business operation and obtain complete information, thus improving decision-making efficiency. However, in this process, it may touch upon the information disclosure boundary between the relevant stakeholders’ right to information and the company’s need for protection of trade secrets, which needs further balancing.In addition, the acquisition of global information means the large-scale growth of information, and how to extract information value better becomes crucial. From this perspective, the integration of DLT with big data analysis, cloud computing, artificial intelligence, and other technologies will probably become the future direction of the ledger technology.
DLT for national ledgers
Although existing ledger technology can fully meet the economic needs, as the economic activities continue to evolve toward digitization and intelligence, the upgrading and transformation of traditional ledger technology will be inevitable.
As an emerging technology that is still developing, DLT is not necessarily a must-have item for future ledger technology. However, strengthening research and exploring its application in the generation of various types of ledgers are undoubtedly of practical significance.
In the modern economy, as government deepens its degree of economic participation, national balance sheet management is becoming increasingly important. The 1992 European currency crisis and the Mexican currency crisis from 1994 to 1995 indicate that serious sovereign country asset and liability maturity mismatches, currency mismatches, and fiscal deficits will trigger currency crises.
The outbreak of debt crisis in Europe and the U.S. is even more prominent.
Maintaining soundness of sovereign countries’ balance sheets is particularly important for the effective response to financial crisis and for achieving speedy economic recovery
Not only that, the compilation and management of national balance sheets has become an important part of promoting the modernization of national governance systems and governance capabilities. June 26, 2017, The 36th meeting of the Central Leadership Group for Comprehensive Deepening of Reform examined and adopted the “working scheme of national and local government balance sheet generation.”
Results so far
It can be said that the national ledger is an important support for finding out what is the bottom line, revealing risks, and helping the country’s governance. However, in the actual preparation process, it faces many challenges and difficulties. So far, only Canada has compiled the balance sheet of the local government, and other countries have not, which shows how difficult it is.
Among all the difficulties, the most fundamental issue is data collection.
National balance sheets require a large amount of basic data, high data quality and high technical requirements, and is difficult to implement.
For example, there are insufficient data and statistics; it involves a wide range of cross-agency cross-ministry, cross-industry, cross-regional transaction data, which is difficult to collect and aggregate. In this regard, DLT may have a role to play in making the preparation of the national accounts a reality.
Using blockchains to link natural resources, intangible assets, financial assets, and physical assets, and building a data sharing platform that breaks down various information barriers, unifies information entry, avoids a lot of duplicate work, and reduces the error rate of data validation. Data sharing, verification, and statistics among agencies, ministries, industries, and regions become more efficient.
Judging from the technical characteristics, each participant of the blockchain system is a remote multi-active node. It is an innate multi-active system and can achieve consistency of information across different ledgers through cross-chain technology, and it is suitable for a wide range of coverage.
DLT in financial accounts
The importance of comprehensive financial statistics is self-evident.
Accelerating the development of comprehensive financial statistics is the key information foundation to effectively monitor the effectiveness of the financial services for the real economy and to improve service efficiency. It is an urgent need to preemptively prevent and resolve systemic financial risks and safeguard financial stability. It is an important move to comprehensively deepening the reform of financial system and to establish a modern financial system.
On April 9, 2018, the State Council issued “Opinions on Fully Promoting Financial Comprehensive Statistics Work” to decisively deploy the comprehensive financial statics work, and made the request for a working mechanism of a unified standard, synchronous data capturing, centralized data validation, and aggregate data sharing.
Undoubtedly, from a technical point of view, DLT is more suitable for these four requirements and may become an infrastructure for comprehensive financial statistics.
Modernization of ledger technology is the foundation of modernization of corporate governance and even state governance. DLT has unique advantages and is expected to play an important role. Of course, it also has its shortcomings. For example, DLT is not scalable enough to meet requirements.
Data privacy and access control need to be improved. Integration of DLT into existing accounting systems still needs research. How to further applied it to generate various types of ledger requires further trial and error and exploration. Obviously, higher-level DLT ledger application is based on the maturity of lower-level application.
For example, it will be natural for DLT ledger to be applied at national and industry level when it is already widely used at enterprise level.
Therefore, attention should be paid to the scale effect and synergy effect of technology application, so as to release the positive energy of DLT ledger to the greatest extent.
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