The Bank of England’s recent report on payment technologies and digital currencies regarded the blockchain technology that enables digital currencies a ‘genuine technological innovation’ which could have far reaching implications for the financial industry.
So what is the block chain and why are y’all getting excited?
The block chain is an online decentralised public ledger of all digital transactions that have taken place. It is digital currency’s equivalent of a high street bank’s ledger that records transactions between two parties.
Just as our modern banking system couldn’t function without the means to record the exchanges of fiat currency between individuals, so too could a digital network not function without the trust that comes from the ability to accurately record the exchange of digital currency between parties.
It is decentralised in the sense that, unlike a traditional bank which is the sole holder of an electronic master ledger of its account holder’s savings the block chain ledger is shared among all members of the network and is not subject to the terms and conditions of any particular financial institution or country.
So what? Why is this preferable to our current banking system?
A decentralised monetary network ensures that, by sitting outside of the evermore connected current financial infrastructure one can mitigate the risks of being part of it when things go wrong. The 3 main risks of a centralised monetary system that were highlighted as a result of the 2008 financial crisis are credit, liquidity and operational failure. In the US alone since 2008 there have been 504 bank failures due to insolvency, there being 157 in 2010 alone. Typically such a collapse does not jeopardize account holder’s savings due to federal/national backing and insurance for the first few hundred thousand dollars/pounds, the banks assets usually being absorbed by another financial institution but the impact of the collapse can cause uncertainty and short-term issues with accessing funds. Since a decentralised system like the Bitcoin network is not dependent on a bank to facilitate the transfer of funds between 2 parties but rather relies on its tens of thousands of users to authorise transactions it is more resilient to such failures, it having as many backups as there are members of the network to ensure transactions continue to be authorised in the event of one member of the network ‘collapsing’ (see below).
A bank need not fail however to impact on savers, operational I.T. failures such as those that recently stopped RBS and Lloyds’ customers accessing their accounts for weeks can impact on one’s ability to withdraw savings, these being a result of a 30-40 year old legacy I.T. infrastructure that is groaning under the strain of keeping up with the growth of customer spending and a lack of investment in general. A decentralised system is not reliant on this kind of infrastructure, it instead being based on the combined processing power of its tens of thousands of users which ensures the ability to scale up as necessary, a fault in any part of the system not causing the network to grind to a halt.
Liquidity is a final real risk of centralised systems, in 2001 Argentine banks froze accounts and introduced capital controls as a result of their debt crisis, Spanish banks in 2012 changed their small print to allow them to block withdrawals over a certain amount and Cypriot banks briefly froze customer accounts and used up to 10% of individual’s savings to help pay off the National Debt.
As Jacob Kirkegaard, an economist at the Peterson Institute for International Economics told the New York Times on the Cyrpiot example, “What the deal reflects is that being an unsecured or even secured depositor in euro area banks is not as safe as it used to be.” In a decentralised system payment takes place without a bank facilitating and authorising the transaction, payments only being validated by the network where there are sufficient funds, there being no 3rd party to stop a transaction, misappropriate it or devalue the amount one holds.
OK. You make a point. So, how does the block chain work?
When an individual makes a digital transaction, paying another user 1 Bitcoin for example, a message comprised of 3 components is created; a reference to a previous record of information proving the buyer has the funds to make the payment, the address of the digital wallet of the recipient into which the payment will be made and the amount to pay. Any conditions on the transaction that the buyer may set are finally added and the message is ‘stamped’ with the buyer’s digital signature. The digital signature is comprised of a public and a private ‘key’ or code, the message is encrypted automatically with the private ‘key’ and then sent to the network for verification, only the buyer’s public key being able to decrypt the message.
This verification process is designed to ensure that the destabilising effect of ‘double spend’ which is a risk in digital currency networks does not occur. Double spend is where John gives George £1 and then goes on to give Ringo the same £1 as well (Paul hasn’t needed to borrow £1 for a few years). This may seem incongruous with our current banking system and indeed, the physical act of an exchange of fiat currency stops John giving away the same £1 twice but when dealing with digital currencies which are mere data and where there exists the ability to copy or edit information relatively easily, the risk of 1 unit of digital currency being cloned and used to make multiple 1 Bitcoin payments is a real one. The ability to do this would destroy any trust in the network and render it worthless.
“What the deal reflects is that being an unsecured or even secured depositor in euro area banks is not as safe as it used to be.”
To ensure the system is not abused the network takes each message automatically created by a buyer and combines several of these into a ‘block’ and presents them to network volunteers or ‘miners’ to verify. Miners compete with each other to be the first to validate a block’s authenticity, specialist software on home computers automatically seeking to verify digital signatures and ensure that the components of a transaction message logically flow from the one preceding it that was used in its creation and that it in turn reflects the block preceding it that was used in its creation and so on and so forth. Should the sum of the preceding components of a block not equal the whole then it is likely that an unintended change was made to a block and it can be stopped from being authorised. A typical block takes 10 minutes to validate and therefore for a transaction to go through though this can be sped up by the buyer adding a small ‘tip’ to encourage miners to validate their request more quickly, the miner solving the block ‘puzzle’ being rewarded with 25 Bitcoins plus any ‘tips’, thus is new currency released into circulation, this incentivisation ensuring that volunteers continue to maintain the network’s integrity.
By allowing anyone to check a proposed change against the ledger and validate it the block chain removes the need for a central authority like a bank to manage this. By removing this middleman from the equation a host of savings in terms of prescribed transaction fees, processing times and limits on how much and to whom a transaction can be made can be negated.
Sounds to good to be true.
It is, every type of system has its own particular risks, a decentralised one being no different. The main threat to Bitcoin’s decentralised network is the ‘51% threat’, 51% referring to the amount of the network’s total miners working collaboratively in a mining ‘pool’ to validate transactions. Due to it becoming more costly in terms of time and processing power for an individual to successfully validate a transaction as a result of the network becoming bigger and more mature individual miners are now joining ‘pools’ where they combine their processing power to ensure a smaller but more regular and consistent return. In theory, should a pool grow large enough to comprise of 51% or more of total network users it would have the ability to validate massive double spend transactions or refuse to validate authentic transactions en mass, effectively destroying trust in the network. While there is more incentive built into the system to lawfully mine Bitcoin than destroy it through fraud the 51% threat represents a risk to such a decentralised system. To date mining pools are taking a responsible approach to this issue and voluntary steps are being taken to restrict monopolies forming, it being in everyone’s interests to maintain a stable system that can be trusted.
So… despite this risk the Bank of England likes the thing that sounds like it could put them out of business?
The BoE are looking beyond Bitcoin and digital currency payments specifically and envisioning ways that the block chain can make existing financial products and platforms more efficient and add value to them. One needs only to look at existing financial assets such as stocks, loans or derivatives which are already digitised but which sit on centralised networks to appreciate the opportunities that exist for the individual by removing the middleman…
… and becoming your own stockbroker. Coloured Coins is a project that aims to allow anyone to turn any of their assets or property into something they can trade. Think ‘The Antiques Roadshow’. I love that show, especially when a little ol’ dear finds that she’s been using a 14th Century Ming dish worth £200,000 to keep fruit in on her sideboard. Coloured Coins would allow the owner of the dish (or their car or house) to have one or more of their Bitcoins represent a part or whole of the value of their asset so that they could be traded in exchange for other goods and services, a single Bitcoin holding a value of the entire £200,000 or they issuing 200 coins each with a value of £1000.
Similarly, a business could issue shares represented by digital currency directly to the public which could in turn then be traded without the need for an expensive IPO or traditional stock exchange and shareholders could vote using a secure system similar to how transaction messages are currently created. Patrick Byrne, CEO of one of the US’s largest retailers which was the 1st major on-line retailer to accept international Bitcoin payments is currently exploring plans to create such a stock exchange powered by the block chain which he hopes will negate current inherent problems such as ‘abusive naked short selling’ where traders can sell shares they don’t own which drives down share prices and which was felt contributed to the fall of Lehman Brothers.
The digitising of assets could also revolutionise the crowdfunding industry. Kickstarter is an example of a platform that facilitates the funding of products by micro-payments from interested members, often in return for small mementos upon completion of the project such as signed merchandise or a copy of one of the first products to be produced. With the ability to easily digitise an asset and issue shares in it and all future profits for example investors may be more inclined to invest more heavily.
The potential of the block chain to improve the way we communicate, bank, manage our assets etc is huge and only limited by the imagination of people like Vitalik Buterin and the Ethereum community and the willingness of current institutions to change.
by Phil Sturgeon