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Advocates of blockchain technology see a promising future for the innovation and its application to financial back-office infrastructure. Apart from its role in cryptocurrencies like Bitcoin, distributed ledger technologies are being developed to handle stock trades, clear and settle leveraged loans, handle catastrophe reinsurance, track land titles and transactions, record the ownership of intellectual properties, facilitate peer-to-peer marketplaces—the list goes on and on. Much of the appeal of the blockchain lies in its use of decentralized distributed ledger technology, in which an immutable global record emerges of the various transactions performed on the network. The ability to clear and settle assets in such a setting, along with the rise of new smart contracts that can automatically trigger additional steps, such as recording ownership changes or authorizing payments, can have, in the words of the Bank of England, “far-reaching implications for the financial industry.”1
Although we do not dispute this optimistic outlook, we argue in this article that this new technology comes with some very old problems. In particular, in traditional market settings, traders face the fundamental problem of hiding their trades and trading intentions from other traders. Disguising a trade’s footprint is necessary to keep others from copying or, even worse, front-running your trades, thereby extracting rents that should have been yours. A variety of algorithmic and technological approaches focus on this task in current markets. As we discuss here, the same information leakage can take place in a distributed ledger setting. This problem arises because, even though the transactions in a blockchain are timestamped, there is no actual time priority in the process of getting a transaction validated and onto the distributed ledger. One contribution of our article is showing how information leakage can arise in the interim period between the publication of such a transaction and its validation by miners or designated participants, exposing other participants in a distributed ledger to potential front-running and manipulation.
The second, and more important, contribution of this article is a suggested solution to the problem. We propose a cryptographic approach to solving information leakage problems in trading on distributed ledgers.2 Our two-part process uses a cryptographic hash (essentially a type of digital fingerprint) to secure time priority, which is then followed by a second...