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Bitcoin is a commodity

2/1/2016

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The realization that Bitcoin and the blockchain are different is beginning to sink in, as evidenced by the growing number of financial institutions which are jumping on the blockchain bandwagon. But there is still talk of bitcoin being a currency, and its success/failure (pick your camp) in that respect.

Bitcoin the network is clearly not a currency: if miners collectively or individually choose not to participate in the network, all bitcoin value disappears in a puff of disharmony. And since miners are united in practice by nothing more than the desire to mine, this doesn't seem to be a strong basis on which to convert your fiat savings to Bitcoin.

So, what are folks paying for when they buy Bitcoin? In essence, they are paying for the right to have a transaction written to the Bitcoin ledger. It just so happens that, for the most part, the only information captured is the number of bitcoin transacted and very little else. But that's missing the point.

The question to ask is, given the global network of bitcoin miners, how much am I willing to pay to have a transaction written permanently on the ledger?

The debate about splitting the blockchain (Bitcoin XT etc) seems somewhat misplaced: bitcoin is what it is. If the transaction throughput is too low, then the market will decide: there are many high value transactions that do not need high throughout. All it means is that Bitcoin becomes the ledger of choice for certain transactions that do not require the characteristics of a more flexible, real-time blockchain solution - instead the value is in the network, and knowing the network will reliably record the transaction indefinitely. It is that value which is convertible to fiat currency, and that is, ultimately, dependent on what information can be stored with each Bitcoin transaction.

So, bitcoin has introduced a new commodity class: that of digital notary. It should not be unique to bitcoin, and there is no reason why multiple such networks don't exist, competing on price to commit useful data to a permanent digital ledger - which, if recognized by law as equivalent to a notary public - should be a dynamic marketplace.

People could certainly trade those rights (all but equivalent to a currency), but at the moment prices are still detached from reality: a combination of speculation and criminal/black market economic activity underpins existing bitcoin valuations. But what happens when coins stop being minted by miners (when bitcoin's limit is reached)? Suddenly the cost per transaction increases significantly, as miners lose the built-in incentive to participate. And bitcoin becomes all but useless as a unit of exchange, as its price deviates from any practical fiat currency valuation.


People with bitcoin (or the right to record a permanent digital transaction) will find their bitcoin valuation stabilizes at the value of making a permanent digital record on the network..something certainly of non zero value, and potentially of even higher value than today's valuations.


But first laws need to change and accept that records made on a digital network using blockchain technology are just as valid as those signed and stamped (on paper!) by a human notary. When that happens, the blockchain (as a progression of computer science) will become an accepted solution to many issues related to digital trust, and give rise to whole new business models.


Given the rather nationalistic nature of laws, it suggests the next wave of networks will be either country sponsored / regulated, or perhaps linked to economic or other alliances (e.g EU, NAFTA, etc). A true global network is sometime off, but transactions written on the bitcoin network will be around for some time to come..alas, local laws are unlikely to ever fully recognize those transactions, so caveat emptor...
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On the value of bitcoin #bitcoin #ethereum #blockchain

2/16/2015

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When talking about so-called 'cryptocurrencies' it is useful to think of three distinct concepts:
  • Bitcoin the protocol (with an upper-case 'B')
  • bitcoin the 'currency' (with a lower-case 'b'), and
  • the bitcoin blockchain (the history of bitcoin transactions, or distributed ledger).

The on-going volatility of the 'price' of bitcoins (in fiat or other digital currencies) is likely at least partly a reflection of the confusion surrounding these different concepts.


To be clear, 'Bitcoin' is a protocol which encapsulates a set of rules defined in software. The 'bitcoin'  network represents the set of computers running the software that enforces those rules. While 'Bitcoin' the protcol may evolve over time, the 'bitcoin' network needs to agree by consensus to adopt any changes to the protocol. However, a parallel 'Bitcoin' network may be setup with another set of machines executing a different version of the 'Bitcoin' protocol. (These are called 'alt-coins'.)


A 'blockchain' is an immutable record of all digital transactions that have occurred on the bitcoin network. It is not stored in a single location, but rather exists on the network. A blockchain is also more generally seen as a way to maintain a reliable ledger of digital transactions using cryptography-based protocols, not just the Bitcoin protocol.


Bitcoin Users & Motivations
At the moment, there are primarily two types of users of bitcoin:
  • People who want to use it as a unit of exchange, and
  • People who want to use it as a speculative investment or store of value (i.e., buy/sell on volatility)

The more volatility, the less useful bitcoin is as a unit of exchange - in much the same way that the currency for a nation state which is suffering hyper-inflation becomes useless for everyday transactions when compared to relatively stable currencies such as the US Dollar. 

But the more stable the price of bitcoin, the less interested speculative investors will be in buying the 'currency'.

However, while acknowledging the markets are rarely rational, taking a traditional 'currency' based view of bitcoin is likely to miss the point completely. As knowledge and understanding of bitcoin, Bitcoin and the (bitcoin) blockchain increase, the price of bitcoin should stabilise around one key concept: the value of having a transaction written to the bitcoin blockchain.

The Value of a Blockchain Transaction

The value of the bitcoin blockchain is that it is a (mathematically) irrefutable record of what has happened in the past, at particular points in time. Such facts are recorded and will remain forever on the blockchain, as long as the blockchain continues to exist.


 There is growing recognition that there is considerable value for such digital immutable records - for specific types of applications in particular circumstances. But there is also considerable cost in writing a transaction to the bitcoin blockchain, as somehow, implicit in the transaction, is the cost of maintaining that record indefinitely.

Taken from this perspective, the 'value' of bitcoins should converge to the cost of maintaining the blockchain ledger, both over time and per transaction. 

As it stands today, the bitcoin blockchain is optimised for capturing the fact that an exchange of bitcoin has occurred. However, it can also be used to capture additional information along with the record of the exchange actually having happened, and it is this information that can provide useful context to the exchange of bitcoin - i.e., which can justify the price paid to record the transaction in the first place.

In a rational world, the 'price' of bitcoin should match closely the cost of maintaining the bitcoin blockchain - i.e., the electricity and infrastructure costs of the bitcoin 'miners', as well as the network costs of shipping the blockchain around. This cost is clearly non-zero, and is actually quite substantial. 

Beyond that, the value of bitcoin transactions should be related to the types of applications that use the bitcoin ledger, and the value they get out of having information stored immutably on the ledger for all time. As use cases mature, the value of bitcoin will converge around the most valuable use cases, and the benefit of continuing to use the bitcoin blockchain for many types of transactions will eventually disappear - especially as more 'traditional' systems of record (i.e., storing data with a trusted counter-party that has robust data management services) regain favour in terms of cost and convenience, and more viable bitcoin alternatives appear.

Future Applications of Blockchain

There are many ideas for what future blockchain-dependent applications could look like. Some interesting early players in this space include factom.org and maidsafe.net, as well as more sophisticated concepts such as Smart Contracts and Distributed Autonomous Companies or Organisations (DAC/DAO), as proposed by the folks at Ethereum.

Concepts such as API Coins are intended to enable monetisation of technology services without requiring users to give away information or distract users with advertising. While blockchain technology is still someway from efficiently supporting micro- or nano-transactions, API coins may perhaps be useful to efficiently capture entitlement, rather than as a direct exchange of value. API coins built upon more efficient blockchains (i.e., less dependent on proof-of-work, perhaps using side-chains) which can support nano-transactions may be feasible in the future, but for now the work in this space is still in the early stages.

This blog has also proposed potential applications that could be used to enforce or support regulatory compliance in a more efficient and economically beneficial way than traditional man-in-the-middle means - in particular, allowing multiple, independent service providers participate in a regulated process flow on behalf of one or more regulated entities.

In short, there will likely be no shortage of applications that would benefit from having a publicly available, decentralised immutable digital record of transactions.

The Rise of Application-specific Blockchains

As the value of putting transactions into the 'bitcoin' blockchain get increasingly more expensive (and valuable), there will be many applications for which the cost becomes prohibitive and where it makes sense to establish application-specific ledgers, optimised for a particular application or use case. In this circumstance, market participants need to agree standards and establish basic levels of trust, but otherwise the same economics apply - i.e., the non-zero cost of maintaining the ledger needs to be reflected in transaction cost.  True 'trust-less' networks make less sense in this scenario, as the purpose of the network is narrower, and hence some element of trust is beneficial. It also mean market participants need to guarantee a quorum of 'miners' in order to make the blockchain viable.

In bitcoin terms, this may mean instantiating a new 'Bitcoin'-based network, within which its own miners support the validation of transactions on that network (i.e., an 'altcoin').

Some altcoins solve specific short-comings of the bitcoin network, but many seem to be seeking irrational 'commodity' pricing gains rather than targeted at solving specific needs that would directly benefit from yet another 'reliable' distributed ledger.  All such altcoins rely on trustless miners, and have a very small number of such miners compared to bitcoin, and so are far more susceptible for 51% attacks.

Bitcoin sidechains, on the other hand, can have a subset of trusted participants that can utilise the wider bitcoin blockchain, while optimising for the application-specific purpose of the side-chain. However, alternative protocols such as Ripple may be more efficient and less complex for such scenarios, as they do not assume 100% trustless participants - although Ripple  is optimised for financial currency use cases. Ethereum may also be viable if it can move its consensus-making from proof-of-work to proof-of-stake and scale effectively to support many different use-cases.

Conclusion

There will be continued volatility in the valuations of digital currencies until use cases and applications for distributed ledgers start to become more obvious and established. The cost of individual crypto-currencies will ultimately converge on valuations which will reflect the cost and benefit of maintaining individual blockchains. In effect, with respect to bitcoin, speculators are betting not on the commodity value of bitcoin, but on innovation around the creation and benefits of future bitcoin blockchain-based applications. In that sense, it is no more irrational than, say, buying shares in Google or Facebook, caveated with the understanding that 'bitcoin' will by no means be the only blockchain out there.







































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Digital Currencies  & The Future Role of Banks

1/30/2015

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Headlines have been dominated recently by bitcoin's drop in value, but this hides the activity that continues to happen around bitcoin and blockchain technology in general.

In particular, four startup ventures tell a very interesting story and reflect the general level of activity in this space.

Quantave aims to provide intra-exchange connectivity and liquidity for digital currencies, as well as connect traditional financial institutions to digital liquidity pools.
XBTerminal is a point-of-sale solution to make it easy for merchants to offer digital currencies payments, even for offline transactions.
PayWithBolt aims to provide an online service that make it easier for websites to accept payment in any digital currency.
Kryptonomic is aiming to provide a clearing network for (financial) derivatives, using smart contracts.

All four companies presented at a recent
Nesta-sponsored event in London, celebrating the rise of digital currencies.

While bitcoin (with the most advanced supporting infrastructure) is the primary target for most of these services, all are architected on the basis that there will be other digital currencies, and that they will all require similar services.

In essence, firms like these are building the plumbing for a new payments/money infrastructure that fundamentally changes the role that traditional financial institutions play. In particular, it acknowledges almost all financial transactions today are digital transactions - i.e., a digital record of a promise from a Payer to pay a Payee a certain amount of money. Some of those records are tied to physical evidence (such as a cheque, deposit receipt, signature or physical machine PIN verification) but a large number are not. Hybrid systems like Apple Pay entrust the 'physical' aspect to a digital device (i.e., the phone and capturing a fingerprint or PIN on that device).

So the leap to an all-digital payments infrastructure is, relatively speaking, not a big one, although it does eventually mean replacing large amounts of 'traditional' technology and infrastructure which collectively provide the guarantees and assurances that payment obligations are correctly recorded and met, as indicated in the diagram below (based on information from MasterCard for a simple single-currency transaction):

Picture

Other intermediaries can be involved in this process too - for example, intermediaries that take on currency exchange risk that neither the merchant nor the payer wish to take on, and that the banks may charge too much for.

Digital payments basically allow the payer (or 'cardholder') and payee ('merchant') to exchange value directly with each other, to their respective digital wallets, without any intermediaries. In other words, it works just like cash, but with all the benefits of not having to deal with physical cash.

Will all the intermediaries then disappear? No - but their roles will change, and the whole payments process will get vastly more efficient and cheaper, and enable a lot more people to join in the digital/knowledge economy.

Specifically, banks will (eventually) not be the gatekeepers of payment transactions: instead, they will have a key role in guaranteeing the security of people and business's digital wallets and digital identities. As such, banks will likely have a key role in the new digital payments infrastructure - but it is rather like going back to basics for banks. 

What do banks stand for (at least pre 2008)? People associated banks with trust, security, service and (in days gone by) empathy. Banks are trying to rediscover these values and adapt, but it will take time. 

But these are key value propositions banks can add, even more so in the digital age.  But banks will not need to be involved in every transaction that happens - unless the payers and payees want them to be for reasons of service, etc. 

With respect to 'security', banks need to invest heavily in becoming digital security experts: even more than cloud companies, they need to be by far the experts in the field, in order for people to entrust them with their digital wallets. Part of that is under-writing security risk: if wallets get stolen, banks will be on the hook. Today, if digital wallets get stolen, you have very little legal recourse.

Today, with all the innovation happening, there is still a big gap in who will provide those foundational services of managing digital wallets and identities - both key to a stable financial infrastructure and protecting civil interests against criminal activity. I believe the sooner banks and regulators recognise the huge opportunity here and start building up the capabilities they need to carry out these responsibilities, the better for everyone. 

But in the meantime, we can expect continued innovation in the basic infrastructure and plumbing underpinning digital currencies, albeit in a high-risk/high-return environment.




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Regulated Platforms as Decentralised Applications

12/12/2014

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In this article here, I discuss the the potential for regulated platforms, such as so-called 'multi-lateral trading facilities' (MTFs), to be implemented using blockchain technology.

The existing regulatory guidelines recognise that it is not feasible for a single MTF 'to rule them all' to be created, although, from a regulatory perspective, it would likely be the most convenient solution. At the same time, any MTFs that are built must do certain things consistently in order to comply with regulations.

This would seem to be a  use case calling out for a 'decentralised application' solution: where common rules of process, coupled with a consistent view of history, need to be shared amongst otherwise independent participants.

Such a decentralised application need not implement the full functionality of an MTF; an MTF is a sophisticated capability that most market makers and large market participants already have to support their primary trading business. The 'MTF' moniker (or its equivalent in other jurisdictions) is used to indicate that the capability explicitly complies with specific regulations.

Rather, the decentralised MTF application would implement only those parts of the MTF that need to be shared: i.e., the proof of process and recorded transactions. 

Any market participant could therefore in principle be considered to be MTF-compliant if their transactions were recorded on the MTF decentralised application.

Of course, this assumes that regulators recognised the blockchain as being a reliable, and irrefutable, way to capture and record information that is of material relevance. But, in some ways, this is a smaller step than formally recognising crypto-currencies as a parallel currency to fiat currencies.

But, leaving aside the social implications of blockchain adoption, do existing blockchain technologies have what it takes to realise this vision?

A basic requirement is likely to be the quality of 'Turing Completeness' - i.e., the ability for a technology to simulate a single-tape Turing Machine. Existing technologies like Ethereum and Ripple have this capability built in. Others, such as NXT or BitShares, are potentially able to enhance their core technologies to include this capability.

However, compared to the basic Bitcoin protocol - which is stable and proven - these technologies are very immature, and there is no guarantee that they will scale to be as robust and stable as Bitcoin-based protocols. Potentially Bitcoin sidechain-based solutions may work, but these also will need real-world validation.

In short, as the complexities and challenges of managing MTFs become more evident, and as blockchain technologies mature, it should become more evident precisely how blockchain technologies form a key building block of regulated platforms in the long term.

In the interim, there needs to be many experiments to test the limits of this, as I do believe that a successful blockchain-based approach to regulated platforms will serve society's interest in the long run.

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My first Dapp (Ethereum)

12/1/2014

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Thanks to the folks at Ethereum, I was able to get my very first so-called 'dapp' (decentralized application) up and running.

While the immaturity of the technology is painfully evident in the number of hoops one has to jump through to get it working, the core technology is quite sophisticated and robust, and this is where (quite rightly), the folks at Ethereum have been focusing their efforts.

It started with this post here, purporting to get you up and running with a dapp on Ethereum in under an hour. This is certainly possible, but due to the rapidly evolving and sometimes unstable nature of continuous development, builds do not work on all platforms all the time. Currently, Ubuntu 14.04 seems to be the recommended platform (with builds most likely to work at any given point in time), but other platforms are also supported.

So, what did I learn from building my very first dapp? 

The dapp in question is a general ledger application for reliably keeping track of tokens sent between participants - essentially, the functionality that most people associate with Bitcoin.

First, you must create a 'contract'. This is a document with embedded logic and state. A contract contains instructions (code) - for example, to transfer tokens between participants on the Ethereum network. Such a contract can then carry out instructions such as 'transfer 100 tokens from Alice to Bob'. The contract reliably records how many tokens Alice and Bob have respectively after the transaction has completed. Tokens are allocated according to the logic embedded in the contract. The logic in the example states that tokens can only be transferred between two participants when the sending participant has enough tokens to send, otherwise the transaction fails. 

Contracts are created with initial state - in the example above, an initial 10,000 tokens are in the account of the contract creator (e.g., Alice), who can then reliably transfer some or all of these to any other participant on the Ethereum network (e.g., Bob).

The contract is sent around the Ethereum network. Executing and validating transactions on the contract requires  a quorum of nodes on the network to do that work. Nodes cannot modify contracts, and contract state can only modified by executing pre-defined transactions on the contract.

This transaction execution and validation requires 'gas', a new concept which reflect the cost of executing transactions on Ethereum contracts, which could in some cases be expensive in terms of computation and/or storage. Gas pays for Ethereum 'miners' to execute and validate transactions. Contract execution can be priced ahead of time in terms of gas, and gas itself is priced in terms of ether (the Ethereum's unit of account). 

The example, while trivial, helps bring to life some of the key concepts behind Ethereum and similar distributed blockchain technologies.

In particular, it is important to understand the difference between the underlying 'currency' that represents Ethereum's unit of of account (the 'ether') and contracts that sit on that unit of account. The 'ether' in the end should reflect only the utility cost of providing compute and storage: the value of the contracts however could fluctuate wildly depending on the purpose of the contracts.

For example, in the simple example above, a token could be taken to represent 1 USD, and a commitment from whoever issued that token (Alice) to give you (Bob) 1 USD for each token you have. Ethereum cannot guarantee that Alice will actually give Bob 1 USD, but it can ensure that the token you have is not owned by anyone else. In other words, Alice has a maximum liability of the $10,000 she created the original contract with, and the tokens are worth $1 as long as Alice makes good on the promise to reimburse token holders with equivalent USD. And Alice can rest assured that once all 10,000 tokens have been reimbursed, that nobody else will appear claiming they have a token.

Next up: further experiments with Ethereum's platform.

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Proof of Process as a Strategic Solution for Regulatory Complexity

11/23/2014

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One of the many potential benefits that blockchain can offer is the possibility of efficiently implementing  'proof-of-process' validations. 

A 'proof-of-process' is where some activity has been validated as having occurred against a particular entity, such that subsequent processes which (for various reasons) require that activity to have been performed can proceed.

One particular area where this approach could offer significant efficiencies is in 'know-your-client' (KYC) processes, as explained in this blog post:

http://regtechfs.com/blockchain-to-the-identifier-rescue/

The current rapid and ongoing changes in the financial services regulatory environment create an environment rich for potential applications of 'proof-of-process'. Coupled with the likely rise of 'as-a-service' technology solutions for businesses (see 'The Ten Tenets Driving the As-A-Service Economy'), the need for ways to efficiently leverage multiple participants in a business process becomes more obvious.

The big question, however, is whether the current crop of blockchain-based technologies will be suitable or appropriate for addressing these use cases.

Specifically, 'bitcoin' is based on very expensive 'proof-of-work' algorithms, which, while providing a very trust-worthy blockchain, limits the number of transactions that can be performed per second. Also, as the number of bitcoins is limited, the number of use cases relying on bitcoins must have some absolute maximum before bitcoins become too expensive for practical use.

The introduction of bitcoin 'side-chains' provides a route to address this problem, but within any given side-chain the issue of balancing trust with effort remains an issue. Projects like Ethereum attempt to address this, providing more of a role for 'proof-of-stake' algorithms, but Ethereum has yet to prove itself as sufficiently robust in the hostile environment of the open Internet.

There are many situations in which 'trusted' participants can be identified, such as, for example, in regulated environments where regulators can assess and validate the trust-worthiness of entities. 

The question is whether any solution is able to remain robust if any of those 'trusted' participants is compromised. 

In any event, the solution is likely not to be as free or as cheap as would be preferred: proof-of-work is expensive, but proof-of-stake is theoretically subject to attacks leading to centralisation-bias. Some balance between the two is needed, such that regulated or 'trusted' participants can efficiently, reliably and cost effectively validate blockchain transactions.

The alternatives are obvious:  centralised, regulated, heavily scrutinised central authorities who take on the burden of validating activities for one or more parties at significant process and IT expense. This is obviously a very expensive option. Seen in that light, even a moderately expensive blockchain-based solution is substantially cheaper, lower risk and efficient. 

The path forward is not yet obvious, but the actionable opportunities will become clearer as blockchain innovation continues.




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Crypto-currencies: the network effect

11/1/2014

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This article originally appeared in RegTechFS, in partnership with JWG.

It is very easy to get confused and overwhelmed by all the crypto-currencies (or math-based currencies) out there. It started out relatively simple with just bitcoin a few years ago. Now other currencies have joined the fray, including but not limited to: Litecoin, Dogecoin, Peercoin, Ethereum, Mastercoin, Counterparty, Ripple, NXT, BitSares, Namecoin. What is one to make of all this innovation? How could it impact the regulatory agenda, and how will the regulatory agenda impact how these technologies evolve?

To make sense of it all, there are a few basic concepts to be clear on. In this article, we will cover the difference between protocols and networks, and why these are key to understanding which crypto-currency technology to focus on from a regulatory perspective.

Bitcoin vs bitcoin

First, Bitcoin (with a capital B) is a protocol: i.e., rules of behaviour encapsulated in software. bitcoin  (with a lower-case B) is the unit of value (or crypto-currency) which arises from a set of machines implementing the same Bitcoin protocol collaborating as part of a single network.
 
Because of the rules encapsulated in the Bitcoin protocol, the more machines there are in a given network, the harder it is to fake transactions that occur on the network.

The bitcoin currency arises from the first implementation of the Bitcoin procotol: since 2009, more and more machines have been added to the original network, increasing the value of bitcoins created through this network.

But why does this increase the value of bitcoins created?

Because Bitcoin (the protocol) relies on ‘proof of work’ to validate transactions, and proof of work essentially involves computing power, which in turn requires electricity, hardware, storage, networks, etc, there is implicit value in demonstrating proof of work. This is why so-called miners (machines on the network that implement the protocol) get ‘rewarded’ in bitcoins.

Due to the way the protcol works, over time ever more resources are needed to demonstrate proof of work. And the more participants there are on the network, the more resources are required to ‘fake’ transactions. In essence, the cost of being a ‘dishonest’ miner is greatly exceeded by the economic benefits of being an ‘honest’ miner.

So this is why ‘bitcoin’ the currency is the most important crypto-currency out there: it’s robustness and trust-worthiness exceeds that of any other ledger system (physical or digital) by a wide margin.

Altcoins

Technically, so-called ‘altcoins’ are other instances of the Bitcoin protocol. Some of them use the same version of the Bitcoin protocol as bitcoin (i.e., the same software), but others use modified variants of the Bitcoin software.

All Bitcoin-based altcoins therefore require their own network of machines to validate transactions, separate from the bitcoin network.  As with bitcoin, the larger the number of machines in the altcoin’s network, the more robust and trust-worthy the network and the more valuable the altcoin ‘currency’.

However, most altcoins have a relatively small number of machines on their network (compared to bitcoin), making them much less valuable than bitcoins.

So why create altcoins? Altcoins allow new types of currencies to be experimented on – for example, to implement ‘coloured coins’ (linked to specific assets) or ‘smart contracts’ etc. While the basic Bitcoin protocol allows for changes and improvements to the protocol, changes are expensive to deploy, so only mature, proven enhancements will make their way into the core protocol.

Sidechains

Some crypto-currencies rely on the basic robustness of the bitcoin network to govern value, but are otherwise able to perform some transactions that are not recorded on the primary ‘blockchain’ or ledger. Standards around this are just emerging (called ‘sidechains’), but technologies like Mastercoin and Colored Coins are examples of early implementations. A key feature of sidechains is that they cannot ‘mint’ new coins.

Other crypto-currencies

Other technologies, such as Ripple, Ethereum, NXT, etc, use different protocols to ensure the trustworthiness of the network, and have other features that make them more suitable for use cases that Bitcoin would not be appropriate for.

For wholly decentralised protocols (i.e., where no assumption is made about the trustworthiness of the members of the network), the size of the network is key.

For partially decentralized networks (i.e., where some trusted members are required), the network can be smaller and more efficient. But how decisions are made over which members are ‘trusted’ become key.

For regulated environments, it is likely that partially decentralized protocols will be the most appropriate, as trusted participants can be established through rule of law and regulatory oversight. This would work within national or economic boundaries, but any transactions crossing legal jurisdictions will almost certainly need to rely exclusively on trustless networks.

Conclusion

In the short term, there are many routes for banks, governments and market participants to experiment with efficient crypto-currency based solutions to support regulated economic activity (whether existing activity or new activity enabled through these technlogies). Which networks and protocols in the end will be used is impossible to predict right now, but all stakeholders should be experimenting with many of these initial technologies and their findings will certainly influence the direction to go in.
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Blockchain Technology: part of your regulatory reform picture?

11/1/2014

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This post originally appeared in RegTechFS in partnership with JWG, assessing the role that crypto-currency technology such as the Bitcoin blockchain could help firms meet regulatory challenges.
 
Distributed Ledgers & the Blockchain  

A key concept in any system involving the exchange of value is addressing the ‘double spend’ problem – i.e., preventing the same unit of value from being exchanged in two distinct transactions. Historically, this has been the function of banks or other trusted keepers of value, who maintain a ledger that reliably records all transactions, and that all stakeholders recognise. With digital currencies, the ‘blockchain’ acts as the trusted keeper of records.

The blockchain implements a distributed ledger using cryptography, peer-to-peer networking technology and game theory. The mechanics are beyond the scope of this article, but a recent Bank of England report describes it very well. The key point is that once the blockchain has information recorded in it, refuting its presence is not mathematically possible.

The design of the blockchain technology underpinning Bitcoin allows additional attributes to be associated with each transaction, enabling innovative extensions to Bitcoin. This enables the creation of applications built upon the core Bitcoin protocols that allow for the development of decentralized, middleman free businesses (often termed ‘Bitcoin 2.0’ applications). Other digital currencies (such as Ripple or Ethereum) have similar concepts.

What does this mean for financial system regulators?  

From a regulatoy perspective, there are many perspectives depending on the specific concerns or challenges that the regulator deems to be important. This article focuses on three use cases that may of particular interest to those involved in the regulatory space:

  • Proof of existence
  • Proof of process & control
  • Smart Contracts

Proof of Existence  

Blockchain technology can conclusively prove that a particular document existed at a specific point in time. This may be particularly useful, for example, where two parties entered into a contract with specific financial parameters. The blockchain technology allows the agreement to be rapidly andpermanently recorded without resorting to a third party to record it on their behalf.

This may eliminate or reduce the need for financial transactions (which do not require collateralisation) to remain executed on an OTC basis, while giving the regulators the transparency they require when they need it.

Proof of Process & Control  

Blockchain technology can conclusively prove that given document went through a number of iterations throughout its life, by irrefutably linking each new version of the document in the blockchain with its previous version.

Many regulatory processes require a document to have gone through certain states before any given state (e.g., in anti-money laundering/KYC processes).  Recording these state changes in the blockchain irrefutably demonstrates compliance with those processes, again without the need for a third party middleman.

This concept could be extended to include proof of audit/control, where each new version of a document can be shown to have changed according a defined set of rules. This has the potential to dramatically reduce the cost of governing regulatory compliance in the future.

Smart Contracts  

Smart contracts are a new concept enabled by blockchain technology that could remove or reduce the need for banks as middlemen, and again provide transparency to financial regulators.  A smart contract encapsulates data-driven rules. When the conditions laid down by the rules are met, the smart contract executes the rules – such as issuing a payment from one party to another.

This technology has the potential to enable smart financial contracts based on neutral, objective market data sources; for example, weather derivatives, mortgage rate changes, etc. Banks do not need to act as middlemen, although they may act as counter-parties.

Conclusions 

It is fair to say that the concepts presented here only scratch the surface of how blockchain technology could shape the regulatory environment in the future. In particular, some out of the box thinking will be needed to think about how all the various concerns and challenges faced by regulators and banks could be solved in a mutually beneficial way with this technology.

It may not be obvious in the short term why those neck-deep in meeting existing regulatory deadlines should care about the future impact of blockchain technology: the reality is, the technology in its current form is still immature and not quite fully or widely understood enough to form the basis of regulatory reform, although this is changing.
 
However, if the sustainability of current regulatory initiatives ever comes into question – both in terms of regulator’s ability to effeciently govern them, and bank’s ability to profitably comply with them – then blockchain technologies may provide a timely and useful solution at acceptable cost and risk to all parties.

References  

“Innovations in payment technologies and the emergence of digital currencies”, Bank of England Quarterly Bulletin, Q3 2014.

 


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The Great Chain of Numbers

11/1/2014

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There is a considerable (and growing) amount of freely available content on the topic of crypto-currencies, blockchains and ‘trust-less asset management’ in general.

The challenge is where to start – not so much to understand the technology itself in-depth, but to understand what opportunities and innovations the technology could give rise to.

A key book to read to get started is by Tim Swanson: The Great Chain of Numbers

The start of the book can be found on Tim’s blog here, as well as links to various download formats.

An excellent read on a fascinating topic.

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Decentralised Applications in FinTech

11/1/2014

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This ‘Decentralised Applications in FinTech’ blog is all about how blockchain technology underpinning digital currencies such as Bitcoin can be used to innovate, improve, disrupt and re-invent processes in financial services.

The key concept is ‘decentralised applications’ – applications or systems which do not rely on a single entity to manage the substance of agreements between two or more transacting but otherwise independent counter parties, but rather which delegate such responsibility to the technology and the mathematically robust algorithms underpinning established and emerging digital currencies.

Decentralised applications have the potential to dramatically increase innovation, reduce costs, improve services, reduce risk, improve compliance and generally create a whole class of new economic opportunities for people who may not even be aware that these technologies are involved.

As it stands today, this vision is still only potential: it may not be realised.

This blog will attempt to communicate a shared understanding within the FinTech community of the benefits and opportunities (or not) that Decentralised Applications could bring to Financial Services specifically, and to dependent industries, through innovative payment models.


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    Author

    Darragh O'Grady is a technologist with 30 years commercial technology experience in financial services technologies.

    View my profile on LinkedIn

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