Finance & Accounting

Ethereum – Or the Power of Smart Contracts

How Bitcoin and Co are changing the world of banking (part 3/7)

Axel Wieandt - May 4, 2021

Even though Bitcoin is the better-known blockchain application, experts consider Ethereum to be the more significant. This is because it offers possibilities which go beyond those of a cryptocurrency: Smart Contracts. Entire business processes and even complete organizations can be mapped via this open and decentralized blockchain platform. The fact that this also entails risks is something that became apparent in the early days of Ethereum.

Ether, the native token of Ethereum, is the second largest cryptocurrency by market cap, but has received much less public attention than Bitcoin. Most insiders, however, argue that Ethereum is the more important decentralized platform. Ethereum is a general purpose programmable blockchain, i.e., a virtual machine, that supports decentralized applications known as “dapps”. Running dapps requires “gas” that can only be purchased using ether, Ethereum’s native token. The recent jump in the price of ether has increased the cost of running dapps, forcing sponsors to explore private, permissioned side-chain solutions for interim processing and recording.

A dapp consists of a web-front-end interface, decentralized storage and messaging protocols, and smart contracts. Smart contracts are software algorithms designed to automate the execution of the contract obligations of the participants in any transaction based on the blockchain. In other words, if and when certain events or conditions are recorded on the blockchain, the execution of certain pre-agreed actions is triggered. This allows for example for an entire “order-to-delivery-and-payment-cycle” to be decentralized and fully automated. The combination of several smart contracts could even replicate an entire organization.

Unlike Bitcoin, Ethereum is inflationary. Up to 18 million ether can be generated per year, without any aggregate cap, with blocks being “mined” every 10 to 20 seconds and rewarded with 2 ether per block. The Ethereum network has recently been undergoing a multi-stage transition from a Bitcoin-like proof-of-work system, which relies on a competitive race to solve a mathematical problem, to a proof-of-stake system where all ether token holders can participate in the blockchain validation process, subject to minimum amount of 32 ether being “staked”, i.e., deposited. The transfer to proof-of-stake will significantly increase the scalability of the Ethereum blockchain and reduce its carbon footprint, both of which should strengthen its position as the public, permissionless enterprise blockchain platform of choice. However, relying on software code and automated contract execution is not without pitfalls, as the following DAO (decentralized autonomous organization) case illustrates.

Important lessons learned from the beginnings of Ethereum

The Jentzsch brothers, two early Ethereum programmers, launched the first DAO in the summer of 2016. The DAO contained only 663 lines of codes from a total of 860 commits by 18 contributors. It was designed to work as a decentralized, investor-directed venture capital fund. Within a few days after its launch, it had gathered 150 million US Dollars worth of ether from its new members, for which they received 1.15 billion DAO tokens. The DAO tokens represented the right to make and vote on investment proposals and collect distributions. Shortly after the launch, the DAO became the victim of an anonymous attack that used a bug in the built-in split function for DAO leavers to divert 50 million US Dollars worth of ether from the DAO. When the hack was discovered, the price of ether collapsed. Although the young Ethereum community had previously upheld the gospel of “the code is the law”, the Jentzsch brothers, with the active involvement of Vitalik Buterin and the Ethereum foundation, decided to implement a so-called “hard-fork”, essentially rewriting the code of the Ethereum blockchain and thereby invalidating the ether stolen from the DAO.

Participants in public permissionless enterprise blockchain platforms can learn important lessons from the DAO case:

  • First, software at the application layer is hardly ever bug free. Simplicity and rigorous code testing and auditing are key and smart contract security has increased over time, making Ethereum one of the most rigorously tested enterprise blockchains.
  • Second, a failure in the application layer creates reputational issues for the base layer and other applications on the same base layer.
  • Third, at the time, the DAO collected 15 percent of all available ether, making it “too-big-to-fail” for the Ethereum blockchain.
  • Fourth, the hard-fork solution revealed the potential benefit of centralized control in a seemingly decentralized network, particularly for new launches.
  • Finally, in terms of regulation and oversight, the hack raises the question of whether one can really “code away the law”.
Business blockchain platform with potential

Despite these early mishaps, Ethereum has established itself as the dominant public, permissionless enterprise blockchain solution. The network currently consists of over 8,500 nodes, with one third based in the United States and 20 percent in Germany, followed by China, Singapore and France. More importantly, on average almost 2,300 developers actively contribute to Ethereum today, an increase of over 200 percent from three years ago. Over 3,000 dapps have been deployed on Ethereum in the last few years and many large companies have begun to test enterprise use ranging from supply chain and retail (Amazon), consumer goods and beverages (Anheuser-Busch Inbev), banking and finance (JP Morgan, Fidelity, ING), energy (BP), healthcare and insurance (Metlife), and software (Microsoft), which is evidence that Ethereum is the leading cross-industry enterprise blockchain solution. It could become the back-bone of a decentralized internet and as such a new source of risk.

Last but not least, Ethereum is also the base layer of choice for most decentralized finance (DeFi) applications, an umbrella term for a variety of decentralized financial applications geared towards disrupting financial intermediaries.

Bitcoin and Ethereum represent important technological advances

Like Bitcoin, Ethereum with its built-in application programming platform represents important technological advances that could help to provide less expensive and more secure services and products in a transparent way, as well as the redefinition of the boundaries between organizations, industries, and markets.

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By the first week of each month, a new article is published in the series of "How Bitcoin and Co are changing the traditional banking world". More articles published so far:

Tips for practitioners
  • Recognize Ethereum as an innovative public, permissionless enterprise blockchain of choice that supports decentralized applications which enable full automation of cross-company and industry business processes.
  • Begin to experiment with the deployment of smart contracts and dapps on Ethereum, participating in consortia in your industry and your supply chain to drive the automated delivery of products and services.
  • Keep an eye on how the Ethereum ecosystem as a whole is developing and how smoothly the transition to Proof-of-Stake is advancing.
Literature reference
Further reading
Author

Professor Dr. Axel Wieandt

Axel Wieandt - former DAX 30 bank CEO/CFO, Global Head of Corporate Development, FIG banker and McKinsey consultant - is a senior financial services professional with a focus on banking, fintech and finance. Axel is currently advising US and European private equity/venture capital funds and real estate companies on their investments and value creation plans. He is also serving on the ad-/supervisory boards of German fintech and real estate investment companies. Axel is an early fintech investor himself and has teaching assignments with top-ranked international business schools, e.g. WHU – Otto Beisheim School of Management. Over the years he has published over 70 research papers, op-eds, and interviews; he is a frequent conference speaker/panelist. Axel is the author of "Unfinished Business: Putting European Banks (and Europe) Back on Track" (2017).

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