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.
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.
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 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.
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.
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
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 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.
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.
“Innovations in payment technologies and the emergence of digital currencies”, Bank of England Quarterly Bulletin, Q3 2014.
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.
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.
Darragh O'Grady is a technologist with 30 years commercial technology experience in financial services technologies.