LEVERAGING BITCOIN BLOCKCHAIN TECHNOLOGY TO … - UCC Blockchain - Cleaned.pdfdistributed data-store...

LEVERAGING BITCOIN BLOCKCHAIN TECHNOLOGY TO MODERNIZE

SECURITY PERFECTION UNDER THE UNIFORM COMMERCIAL CODE

David S. GerstlFarmingdale State College (SUNY, USA)

© 2016, David S. Gerstl. All rights reserved

The government is releasing lots of data

■ There is an increasing amount of “public” government data, much of it aggregated and anonymized from records that contain individually identifiable information

The government is releasing lots of data

In the Context of Software Business“ Software as a New Way of Providing Cutting-edge Solutions”

■ There is an increasing amount of “public” government data, much of it aggregated and anonymized from records that contain individually identifiable information

■ There is a subset of this government data that is not redacted (e.g., real property ownership record)

■ In cases where the contents of this data is consistent across many jurisdictions, a distributed data-store based on the Bitcoin Blockchain algorithm

– A good example of the government records of this type is the Article 9 perfection records filed with states under the UCC (Uniform Commercial Code)

– This is a good opportunity for tailored software to infiltrate a system that vacillates between the 19th (paper) and 20th (relational databases) centuries

Basic Structure of this Talk

■ What is a Security Interest and why is it necessary■ The UCC, how does perfection [usually] function, and how is

the status-quo broken■ The Bitcoin algorithm■ Using the Bitcoin Blockchain algorithm as a storage

structure to solve some of the problems with the status quo■ Why hasn’t this happened yet?

Risk A bank’s risk on a loan is governed by:

Expected Loss = PD * LGD * EAD

Probability of Default

Probably of a default (failure to pay in full) by this borrower

on this loan (e.g., 20%)

Derived both qualitatively and quantitatively

Loss Given Default

Fraction representing the loss in value of the bank’s

stake in the event of a default (e.g., 50%)

May be less than 100% due to credit supports (collateral)

Exposure At Default

Value of the bank’s stake in some currency (e.g., $150

Billion)

May be less than the face value as the loan may be

syndicated

Source: Hull, 2012

Secured TransactionsCollateral

Collateral (“security”) are assets to which only some creditors have preferential access

? ?

Making Collateral FairIn order to make the notion of collateral fair• Collateral priority depends on timing – The first party gets the first bite• A party effected by the collateral must be given notice before they make a claim

to the item as collateral

? ?

The UCCCollateral (and the loans) are functions of state law, not federal law, and thus 50+ jurisdictions had 50+ sets of laws

The UCC is a model code that governs commercial transactions, and that has been adopted (in whole or part) by all 50 states

Article 9 of the UCC governs secured transactions

Two-Phase Process: Attachment and Perfection

A borrower can bind themselves to hand over collateral

The attachment is a contractual matter between the borrower and secured party (lender)

Attachment Perfection

How:

If order for the attachment to effect the rights of other borrowers (both secured and unsecured), the security interest needs to be perfected

The method of perfection varies with the type of collateral

Perfecting Security: The theory

Perfection methods vary depending on the type of collateral, but for most collateral:• You file a UCC-1 with the state that is the “main place of business”

[UCC §9-307] giving the “exact full legal name” [UCC1 instructions] of the debtor and a textual description of the collateral

• A prospective lender then searches in the “main place of business” giving the “exact full legal name” and gets your textual description of the collateral

This is constructive notice. It’s sometimes not real notice since the either lender might get the jurisdiction or the name wrong (e.g., [In re tyringham holdings inc. (2006)])

Perfecting Security: The practiceFile a UCC-11 to find records relating to debtor

File a UCC-1 to perfect the security interest

File a UCC-3 to renew (if necessary)

File a UCC-3 to terminate or let expire

How it’s often done

A paper/PDF form

A paper/PDF form

A search followed by a paper/PDF form

A search followed by a paper/PDF form

Famous Last

Words (i.e., what

could go wrong)

Name or State Mismatch misses records

Name or State Mismatch leads to ineffective perfection

Forgotten continuance leads to lapse in perfection

Release of wrong security leads to loss of collateral

Perfecting Security: The practice

• The UCC has allowed for Electronic filing since at least 1996 (), but it was not until recently that states have started accepting electronic filings

• Only five states “require” electronic filing, but…

• In these states, accredited third parties are set up as intermediaries and accept paper copies for transcription into electronics

Perfecting Security [poorly]: ConsequencesReleasing security interests is still a largely manual process and the incidents of error is obscured because errors are only publically disclosed in cases where recourse to security is sought

In a recent case, a clerical error by a paralegal went through multiple levels of attorney and was not caught

JP Morgan Chase inadvertently released a $1.5Bn security interest immediately before the GM bankruptcy (In Re Motors, 2015)

What we have and what we wantWhat we have• A “public” set of databases• A limited set of parties able to upload transactions• Transactions that do not get overwritten, but overridden

What we want• A better way to identify parties• A consistent single interface to the many many systems• A database that enforces the historical nature of these records • Resistance from hacking• East of access

This is a Common Problem in Established ProcessesThe obvious question is: Does it have to be this way? The machinery is complicated in part to make the abstraction simple, but also because it has accreted over decades to respond to particular problems in more or less ad-hoc ways, and because decisions made to simplify one thing, like stock transfers, have complicated other things, like voting. But computers are better now than they were when DTC was invented, or for that matter when proxy cards were invented.

-(Bloomberg View, 2016)

One fix: A Distributed, replicated, tamper resistant DB with immutable history


“…there is nothing new under the sun” Ecclesiastes 1:9

This kind of problem has been solved before…in the context of eCash

Bitcoin Primer: The problem of double spend and the problems with a ledger

Relies on the difficulty of forging coins and bills

Relies on a central authority to track the movement of money

Cash Credit

Advantages:

Problems:

• Anonymous• No Refunds

• Works remotely

• Doesn’t work remotely • No anonymity• No certainty (undos)

Bitcoin Primer: The problem of double spend and the problems with a ledger

Relies on the difficulty of forging coins and bills

Relies on a central authority to track the movement of money

We can’t do this because there is no difficulty in duplicating electronic coins

Cash Credit

We don’t want to do this because we want anonymity

Bitcoin Primer: The problem of double spend and the problems with a ledgerWhat we want is a distributed ledger with anonymity

Basic Architecture of the Bitcoin Data Structures

Source: Nakamoto, 2008

Bitcoin

A Bitcoin is a sequence of ledger entries denoting the transfer of a unit of virtual cash from its original creation to the present owner



Block

A Block is a collection of these ledger entries belonging to a variety of Bitcoin

Nodes create blocks from collected transactions and then distribute them



BlockBl

ockc

hain

Bitcoin

The Blockchain is a fully ordered sequence of blocks containing all the valid blocks thus far

Bitcoin: Transfer of a coin

* or any public key for which the private key is knownFigure: Adapted version from (Nakamoto, 2008)

A Bitcoin is a chain of transfer transactions, from the creation of a bitcoin to the present.

Each transfer is encoded in a block, and contains the ECDSA public key of the recipient* and is signed using the private key of the sender

Bitcoin: Validating a transfer

Figure: Adapted version from (Nakamoto, 2008)

Any interested party can:• Check the

signature against the public key in the prior transfer to validate that the transfer is authorized

• Check that no other transfers have occurred in the interim

Blocks: Assembling transactions

Block Figure Source: (Nakamoto, 2008)

Transactions are grouped in blocks by nodes

Blocks: Assembling transactions


We want block creation to be computationally difficult• Block creators reap rewards (mining) which should be proportional to

the amount of computational power you bring• It makes changing history difficult

How could B still cheat?

Figure: Adapted version from (Nakamoto, 2008)

History is not immutable – if you can build a longer Blockchain

B could allow this transaction into the Blockchain, wait a while and later try to erase the right side here by overwriting history

The Blockchain: Grouping blocks

Blockchain Figure Source: (Nakamoto, 2008)

So if the transaction B wants to disappear is in this block, and they waited 30 minutes, B needs to create 3 blocks

The Blockchain: Grouping blocks

Blockchain Figure Source: (Nakamoto, 2008) 1. Some sources put the lower bound at 1/3 of the power, some at 1/2

So if the transaction B wants to disappear is in this block, and they waited 30 minutes, B needs to create 3 blocks

or more, because its chasing a moving target

It will not succeed unless it has more1 computational power than the rest of the network combined

The nonce makes block creation difficult


A block contains a group of transactions and a nonce, which is a filler value that will make the block hash resolve to a specific range. We also restrict the range of valid block hashes. Since valid nonces cannot be analytically determined. It acts as a proxy for computational effort

The fix: A Distributed, replicated, tamper resistant DB with immutable historyBy adopting a version of the Blockchain algorithm as a storage engine for UCC modified records, we can leverage many of the advantages of Bitcoin


Applying the Blockchain to the UCC: Principles• The format of UCC records is more-or-less consistent, so a single

database would be possible. Replicating that database by putting filings into blocks on a single Blockchain makes them more secure from both inadvertent mistakes and intentional interference

• By unifying the database, we can eliminate the jurisdictional mistakes that occur. We still care about where a UCC should be filed, but only from a fee standpoint (more on this later)

Applying the Blockchain to the UCC: PrinciplesThere is an existing XML specification for electronic interchange of UCC records (Ose, 2013) that would require some minor modification detailed in the paper

Applying the Blockchain to the UCC: Names of Debtors

In Bitcoin, we canuse a different public/private key combination for each set of transactions

Applying the Blockchain to the UCC: Names of Debtors

In Bitcoin, we can use a different public/private key combination for each set of transactions

In the UCC, for the secured party you might want anonymity, but for the debtor, you use a well known public key

Applying the Blockchain to the UCC: Constructing transactions

The data structures look somewhat similar, but the nature of a transaction is not the same

In the UCC we only have 3 types of transactions: creation of an interest (mining), modification of an interest, termination

Applying the Blockchain to the UCC: Constructing Blocks

The parts of a block are almost identical to that in Bitcoin

Applying the Blockchain to the UCC: Constructing Blocks

The parts of a block are almost identical to that in Bitcoinbut• The number of nodes is small compared to Bitcoin (5000 vs 60)• The computation power is very limited compared to Bitcoin • The parties are know and somewhat trusted• If there's a partition, it will be known quicklySo the nonce doesn't serve the security function of preventing changes

Network PartitionsThe Bitcoin algorithm instructs nodes to adopt the longest version of the Blockchain. Consider the implication if a node finds that it has a shorter or variant Blockchain:

ID=0X2334

ID=0X2377

ID=0X2354

Network PartitionsThe Bitcoin algorithm instructs nodes to adopt the longest version of the Blockchain. Consider the implication if a node finds that it has a shorter or variant Blockchain:

In Bitcoin, the implication is that a large partition of the network occurred and that the node was likely on the smaller side of the partition

ID=0X2334

ID=0X2377

ID=0X2354

Network PartitionsIn the case of the UCC, the nodes are known and somewhat trusted. If a partition occurs, it will be known almost immediately

So what are the implications if a node sees this?

ID=0X2334

ID=0X2377

ID=0X2354

Network PartitionsIn the case of the UCC, the nodes are known and somewhat trusted. If a partition occurs, it will be known almost immediately

So what are the implications if a node sees this?This is likely someone trying to “change history”

ID=0X2334

ID=0X2377

ID=0X2354

The nonce with the UCCThe nodes storing UCC transactions are somewhat trusted. Thus we don’t need the nonce to create a measure of the MIPS belonging to a party since the UCC will need to be one state, one vote

We can use the nonce, however, to smooth the release of blocks and to distribute the block creation across different syndicates of states in proportion to their investment

There is No Mining HereIn Bitcoin, the person creating the node gets is able to create some new coin that will be effective as long as the block creating them is in the Blockchain (the number is specified in the protocol)

There are also fees that can be attached to transactions

Here, we only have the fees

PricingNote that the implication of having a distributed and duplicated Blockchainis that lookup can performed at any node

The result is that no party has pricing power over lookups and therefore that lookups will be free or almost free

Since the original filing jurisdiction of the registration still has the power over its validity, we presume that revenue sharing will emerge

Applying the Blockchain to the UCC: Indexing the Blockchain for fast lookupIn addition to UCC filings, the major UCC activity is the UCC query. A log-like structure without an index would make lookups prohibitive

Lookups are currently done either by the specific record (rarely) or (more frequently) by debtor name

Applying the Blockchain to the UCC: Creating the IndicesTo support these two types of queries, We need two indices—one on the security interest (the original UCC record number) and one on the borrower ID

Construction of each index is iterative, and only requires a single scan of each new block as it’s received

Applying the Blockchain to the UCC: Creating the IndicesFirst, note that we can only accept a block if the entire prior blockchainmatches that of the creator of the block

So the block itself can contain pointers (references) in each record to prior records

Applying the Blockchain to the UCC: Creating the IndicesScanning forward, we can find that (for example) debtor 999 appears twice. If we update the index going forward, we simply update or insert the new borrower information

Applying the Blockchain to the UCC: Creating the IndicesThe index change for the particular UCC1 security filing is similar

Applying the Blockchain to the UCC: Creating the IndicesIn the unlikely event that a block needs to be removed, for example in the case of a partition, the block can be scanned backwards and the pointers within the block used to rebuild the index

We discuss this in slightly more detail in the paper

What would need to change for this to be implementedSo why hasn’t this happened already?

First, perhaps it might be soon. There has been little incentive since cases of imperfect perfection rarely blow up. The $1.5 billion judgment against Chase may push law fims and banks to modernize their processes

There are a few entrenched interests and one big elephant in the room

What would need to change for this to be implementedWho cares about the system

• Attorneys: Not so much-the bulk of billed hours are in the preparation of the credit agreement, not the filing of the UCC forms. Most larger firms and banks would be fine switching

• States: Some states collect significant revenue from filings. They will continue to do so due to revenue sharing

• Service Providers: These parties will lose significant revenue from a change in the system, but are not likely to wield sufficient power to stop change if the remaining stakeholders want to move forward

As to that elephant in the room:

There is an undercurrent in US politics relating to the rights of states

While usually, this applies to US Federal law, many state officials have extended this to mean that any cooperative arrangement that limits the freedom of state officials should be discouraged. This resistance to conformity is likely the biggest reason no one has unified the UCC databases

Could Europe do this too?

As long as the sizes are roughly equivalent, this scheme could be used for any type of record that is publically releasable

Nevertheless, the European system (unlike that in the US, Australia, most of Canada and New Zealand) is currently distinguished by a number of variations on security documentation, even with the same country (Tajti, 2014). There seems little prospect of this changing in the near future, and thus a scheme like this is unsuitable.

Selected References:Bloomberg View (2016), T. Rowe Price Voted for the Dell Buyout by Accident

Hull, J. (2012). Risk Management and Financial Institutions (Vol. 733). John Wiley & Sons.

In re Motors Liquidation Co (2015), 2d Cir Court of Appeals, 777 F.3d 100

In re tyringham holdings inc. (2006). US Bankruptcy Court, E.D. Virginia.

Nakamoto, S. (2008). Bitcoin: A peer-to-peer electronic cash system.

Ose, T. (2013): XML Technical Specifications for the Uniform Commercial Code Revised Article 9. Technical report, IACA

Tajti, T. (2014). Could Continental Europe Adopt a Uniform Commercial Code Article 9-Type Secured Transactions System? The Effects of the Differing Legal Platforms. Adelaide Law Review, 35(1).

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