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Cyber Brief: Reviewing The Credit Aspects Of Blockchain

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Cyber Brief: Reviewing The Credit Aspects Of Blockchain

Blockchain technology is being used by entities rated by S&P Global Ratings to address credit risks and operational challenges. Not only is blockchain the backbone of cryptocurrency, which has its own credit risks and benefits, but issuers are introducing additional uses as well, often citing cyber security protections as the reason. However, there is a tension between blockchain being a solution and introducing new operational risks. S&P Global Ratings believes blockchain applications could reduce cyber risk, by using a distributed ledger technology and ensuring accuracy and efficiency, which reduces costs. However, blockchain could also introduce risk, by making any changes harder, eliminating a centralized operational safety net, or introducing regulatory uncertainty.

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Why Blockchain?

Blockchain is a peer-to-peer network that uses a system of nodes and a consensus algorithm to implement decentralized control, approve transactions, and identify fraudulent activity. It is a type of "distributed ledger," meaning it is a shared database that is replicated and synchronized by a decentralized network. Transactions on a blockchain (also referred to as distributed ledger technology [DLT]) are permanently committed to a ledger by groups of transactions called blocks. Rated entities are using public blockchains, such as cryptocurrencies, to diversify investments and make payment transactions easier, but they are also using private blockchains to record data, track access, provide transparency, and adhere to regulations (for more information, please see "Digitalization Of Markets: Framing The Emerging Ecosystem," published Sept. 16, 2021, on RatingsDirect). Blockchain solutions are designed to address specific challenges; however, the risks are not always specific and should be considered in all cases.

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Blockchain Offers Cyber Security Protections

Blockchain's immutable, decentralized design allows it to help mitigate cyber risk. Blockchain at its core is akin to a general distributed ledger. Information is recorded and transparent to all with access. Blockchain's core building blocks are hash cryptography (including digital signatures), immutable ledgers, a peer-to-peer network, mining, and a consensus protocol to allow new blocks. The system works based on a consensus algorithm; all actions are traceable, and all data is immutable. The nodes do not know each other, and each node has access to the entire blockchain database. The network of nodes uses a decentralized trustless verification based on cryptography.

In a centralized system where all the information goes through one node, it is possible to overload the node and freeze the entire system. This might be done maliciously in what is called a DDOS attack. Due to blockchain's distributed ledger, this is much harder to achieve, and therefore some cyber risk might be mitigated.

Blockchain allows users to replace siloed databases in each organization with a shared database that is accessible by all parties. Verification is established using a certain protocol by a distributed network of computers and not a trusted centralized institution. Transactions are immutable. They cannot be deleted, therefore preserving data integrity. The robustness of the blockchain resides in its distributed nature. The peer-to-peer network has a set of rules on how to enter the network; how to connect, send, receive information; and how to make payments. All nodes are equally important; no node has special privileges, which makes the network more difficult to attack.

Blockchain increases transparency by making transactions visible to all nodes. One can rapidly see if the network is being manipulated and can react immediately. As a result, it is hard to corrupt a blockchain through manipulation or malware.

Key to cyber protections, there is no central control node that could bring the entire network to a halt. If one of the nodes goes down, the network will find new ways of functioning and correct itself. It takes a considerable number of nodes to stop working to put the entire network on hold. The 51% attack on a blockchain is one scenario in which a group of miners or a single entity controls more than 50% of the network's mining hash rate or computing power. (For more information on control, see "Cryptocurrency: U.S. Public Finance Issuers Cautiously Consider Its Applications," published Sept. 15, 2021, on RatingsDirect).

Blockchain Can Introduce Credit Risks

Cyber risk

Cyberattacks are now commonplace and such events could have a negative impact on an entity's operations. We have mentioned aspects of blockchain usage that can help to mitigate the risks of attacks, but blockchain adoption does not guarantee protection. Even though cryptocurrency is built on a blockchain, its broad accessibility could provide multiple access points to enable ransomware attacks. In addition, crypto's designed privacy allowances could foster payment mechanisms that support cyber extortion, money laundering, and tax evasion. In addition, smart contracts on a blockchain require a blockchain oracle to communicate with off-chain systems. Any off-chain activity would not have the same protections as those on-chain and so malicious actors could hack these varied access points through the oracle to manipulate the contract for their benefit. Cyber protocols must be maintained to protect users from these new risks.

Regulatory risk

Due to its decentralized and intangible structure, applications based on blockchain technology can sometimes avoid regulatory requirements. This feature has reportedly allowed malicious actors to use cryptocurrencies to facilitate criminal activity. The U.S. federal government and many states are considering new regulatory, taxation, and reporting requirements for cryptocurrencies. In addition, sanctions in the financial sector are harder to implement on blockchain transactions. In a centralized financial system, penalties, including sanctions, can be administered upon command, but in a decentralized system there is no enforcement.

Sovereign risk

If more than half of the blockchain verification power resides in a single country, the network could be subject to the sovereign risk of that country, increasing its vulnerability.

Data privacy is another risk for blockchain when nodes reside in many countries. The blockchain protocol ensures the integrity and immutability of data but different geographic locations have different jurisdictions over the data, making data privacy more complex. While the blockchain may be private, the access points may not.

Legal risk

Implementation in multiple jurisdictions can be challenging in the decentralized network of a blockchain. Resolving disputes and investor protection could also be challenging in the context of a system that lacks regulation and a clear legal framework.

Administrative Risks Affect Blockchain's Functionality And Indirectly Could Increase Credit Risk

User-based security risk

The security risks of blockchain can often be user-based, posed by access management of the transactions. Blockchain and smart contracts reduce the risk of human error in processing transactions--but there is instead the risk of deficient coding at the heart of the smart contract--opening the way for potential hackers to exploit weaknesses in the code. Smart contracts are just code, and code is rarely fault-free upon first release.

An additional risk surrounds access through public and private keys (in essence, passwords); the strength of access controls is dependent on the secure nature of the key. If users lose the private-access key, they lose access to all previous data and essentially all funds are irrevocably gone. If lost, the access is denied. If stolen, the access can be gain by whomever holds the key. Malicious actors could try to access the keys through the user's personal devices if they lack sufficient cyber protection, which could be used to steal their funds. Hackers attack the points of entry in the blockchain; that is, the wallets or browsers. In recent ransomware cases handled by the FBI, it has been able to gain a key to recover cryptocurrency paid to the cybercriminal, although to date this has been a rare event and there is no guarantee that law enforcement can retrieve the money.

Network and hardware deficiencies

If a blockchain needs internet availability, a lack of internet can cause the network to malfunction, although solutions are continually being developed that might reduce this risk. Another limit of the network is related to hardware. The network transactions could be slowed by both process design and deficient nodes.

Related Research

This report does not constitute a rating action.

Primary Credit Analysts:Geoffrey E Buswick, Boston + 1 (617) 530 8311;
geoffrey.buswick@spglobal.com
Cristina Polizu, PhD, New York + 1 (212) 438 2576;
cristina.polizu@spglobal.com
Secondary Contact:Todd D Kanaster, ASA, FCA, MAAA, Centennial + 1 (303) 721 4490;
Todd.Kanaster@spglobal.com

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