Blockchain changes everything…

Back in 2012 I put in $1,000 into Bitcoin and started trading on MtGox – I was fascinated by the technology but in February 2014 I was burned when MtGox went bankrupt and changed my interests to cybersecurity.   Now several years later much has changed and I’m digging in again.  Here are my notes:

Introduction – Blockchain changes everything…

The world found cryptocurrencies like Bitcoin interesting (more about that below) but when they examined the cryptocurrency iceberg they realized how big of a disruption lies under the water—Blockchain is huge and can wreck every ship that runs into it…

Where are we on the Blockchain maturity curve? –Think 1993 when the Internet was just beginning to get the non-techs excited. Reference this great article by HBR.org about how foundational technologies take hold here.

Blockchain has the same disruptive potential as the internet but will take time to mature—likely a decade or more.  However, some industries such as finance will see disruption sooner while others will take longer.

“distributed ledger technology could reduce
banks’ infrastructure costs attributable to cross-border payments,
securities trading and regulatory compliance by between $15-20 billion
per annum by 2022.” –
link

Blockchain frees transactional records from the need for verification by a centralized authority.   This doesn’t sound that transformational until you realize that almost everything relies on verifications from different central authorities (banks, retailers, iTunes, governments etc..)

The Internet enabled new entities to provide instantaneous access to information by digitizing information and making it accessible—mainly from the same (banks going online) or new central authorities (Google, Facebook, Amazon):

  • Email vs. the post office
  • Wikipedia vs. the encyclopedia
  • Amazon vs. the department store
  • Online banking vs. going to the bank

Public Blockchains in some ways disintermediates the concept of these centralized authorities and has the potential to replace the trust-providing function of traditional institutions like banks, escrow agents, and even the county courthouse.  (more here on disintermediating Apple, Facebook, Microsoft, Amazon, and Google)

Will Amazon be replaced in the next few years? Probably not, but https://openbazaar.org wants to try…

The Value of Blockchain

Ripple calls Blockchain the “Internet of Value” (link).

“Our vision is for value to be exchanged as quickly as information. Although information moves around the world instantly, a single payment from one country to another is slow, expensive and unreliable. In the US, a typical international payment takes 3-5 days to settle, has an error rate of at least 5% and an average cost of $42. Worldwide, there are $180 trillion worth of cross-border payments made every year, with a combined cost of more than $1.7 trillion a year.

With the Internet of Value, a value transaction such as a foreign currency payment can happen instantly, just as how people have been sharing words, images and videos online for decades. And it’s not just money. The Internet of Value will enable the exchange of an asset that is of value to someone, including stocks, votes, frequent flyer points, securities, intellectual property, music, scientific discoveries, and more.”

For more on valuation: here.

What is Blockchain?

As stated previously, blockchains remove the need for trust in a system, ensuring that users can transparently interact with reduced reliance on third-party authorities.  When parties enter into a transaction, the transaction is broadcast across the network of computers. The network validates the transaction, using collectively pre-agreed, trusted consensus protocols. Once validated, the transaction is recorded in a new block of data, which is in turn added to the existing blockchain. Once added, it is permanent, immutable and resides across the entire network.

A blockchain is essentially a distributed ledger technology (DLT)

Imagine a company’s banking statement (ledger) with all the deposits and deductions and ever-changing balance existing on numerous machines versus at a centralized authority (bank).  Imagine then multiple mutually untrusting suppliers exchanging value (appending records or ‘blocks’) without a central coordinator (bank).  This network of computers would need to agree at regular intervals on the true state of a distributed ledger.

How Blockchain Works

On a blockchain, transactions are recorded chronologically, forming a chain (can be more or less private depending on the implementation. The ledger is distributed across many nodes in the network (versus in one place). Copies are simultaneously updated with every fully participating node in the ecosystem. A block could represent transactions and data of many types (currency, digital rights, intellectual property, identity etc..).

Public vs. Private Blockchain Networks

The difference between Public and Private blockchains comes down to who can participate in the network, execute the consensus protocol and maintain the shared ledger.

Public “Permissionless” Blockchain networks are completely open and anyone can participate in the network.

Private Blockchain networks or “Permissioned Blockchains” combine centralized user authorization with a decentralized blockchain transaction ecosystem.  The downside is that users still must place trust in an authority granting permissions as well as the consensus mechanism being utilized by the system.  Example: JP Morgan’s QuorumChain.  The upside is that the Permissioned Blockchain usually permits a couple of orders of magnitude greater scalability in terms of transactional throughput.

You can also have a “Federated” blockchain that operates under the leadership of a group. As opposed to public Blockchains, they don’t allow any person with access to the Internet to participate in the process of verifying transactions. Federated Blockchains are faster (higher scalability) and provide more transaction privacy. Example: R3 (Banks), EWF (Energy), B3i (Insurance) and Corda.

For more information see the coinsutra.com article here.

Consensus models

The most traditional way to reach consensus is a Byzantine Agreement where nodes on a blockchain validate blocks of data by reaching consensus on the solution to a given problem. A Byzantine Agreement is reached when a certain minimum number of nodes (known as a quorum) agrees that the solution presented is correct, thereby validating a block and allowing its inclusion on the blockchain.

More here.

When to use Blockchain

This graphic from Wesley Graham @ Berkeley does a great job of showing the use cases to consider for blockchain:

Another great site that helps you figure out if you need to use Blockchain is http://doyouneedablockchain.com and other models here.

Examples

  • Nasdaq Linq (link) to power capitalization tables
  • Stellar.org (link), a nonprofit that aims to bring affordable financial services, including banking, micropayments, and remittances, to people who’ve never had access to them. Stellar offers its own virtual currency, lumens, and allows users to retain on its system a range of assets, including other currencies, telephone minutes, and data credits.
  • Estonia prescribes blockchain for healthcare data security (link)
  • Musician Imogen Heap used blockchain to release a single directly to her fans (link)
  • P. Morgan (link) payment-processing network
  • BNY Mellon’s BDS360 for U.S. Treasury Settlement
  • Japan Exchange Group (link) is exploring blockchain for capital market infrastructure

We will see a great deal of innovation across all verticals in the years to come.  Here are a few you can expect:

  • Manufacturing and supply chain vertical – Use Blockchain to confirm the origin and movement of materials through the manufacturing process before and after actual production to reduce fraud and delays in the process or to improve financial reconciliation.
  • Healthcare vertical – Use Blockchain to improve transaction monitoring, identity services, and investigation of suspicious activities.
  • Public sector verticals – Use Blockchain to improve data sharing across agencies (examples: tracking birth and death certificates, citizen eligibility for benefits, and enabling the sharing of government employee profiles across government departments).

The Downsides

Public Blockchain network downsides

  • Competing blockchains – Currently there are a multitude of competing blockchains which do not connect with one another allowing assets to be exchanged like information, but industry standards will start to form (example: https://interledger.org)
  • Power – A substantial amount of computational power is necessary to maintain a distributed ledger at a large scale. To achieve consensus each node in a network must solve a complex, resource-intensive algorithm called a “proof of work” to ensure all nodes are in sync.
  • Privacy – which implies little to no privacy for transactions and can be a detriment to a company’s involvement
  • Security – Deep topic—let’s ask MIT: here.
  • Scalability – There are limits currently in the maximum number of transactions some networks can process (here and here)

Private Blockchain network downsides

  • Decentralization – Allows big organizations to retain their control of a market
  • Connectivity to existing systems
  • Regulations – Example: HIPAA, SOX, FDA, and GLBA
  • Privacy – The distributed nature of blockchain ledgers can make it hard to provide the privacy that some customers expect

For more on this topic see the Investopedia article titled Public vs Private Blockchains: Challenges and Gaps or Sorting out the advantages and disadvantages of public vs. private blockchains and Understanding Layer 2 Side-Chains for Scale.

Smart Contracts

A computer protocol intended to digitally facilitate, verify or enforce the negotiation or performance of a contract. Smart contracts allow the performance of credible transactions without third parties. These transactions are trackable and irreversible. Smart contracts were first proposed by Nick Szabo, who coined the term, in 1996.

Ethereum implements a nearly Turing-complete language on its blockchain, a prominent smart contract framework.

More on smart contracts can be found here: Smart Contracts: The Blockchain Technology That Will Replace Lawyers

Example, consider the case of domain name escrow. Currently, if A wants to sell a domain to B, there is the standard counterparty risk problem that needs to be resolved: if A sends first, B may not send the money, and if B sends first then A might not send the domain. To solve this problem, we have centralized escrow intermediaries, but these charge fees of three to six percent. However, if we have a domain name system on a blockchain, and a currency on the same blockchain, then we can cut costs to near-zero with a smart contract: A can send the domain to a program which immediately sends it to the first person to send the program money, and the program is trusted because it runs on a public blockchain.

Solutions

Most Enterprise Cloud Providers (Microsoft, AWS, Google, IBM and Oracle) will provide APIs that allow customers to build enterprise private blockchain solutions leveraging their proprietary distributed ledger and smart contract frameworks.   Like machine learning APIs from these same platform providers, once you use the APIs you are locked into this cloud platform.

There are also many open source Blockchain platforms available.  For example: HyperLedger, Monax/Eris, HydraChain, MultiChain, Corda, and OpenChain

Technically… How does it really work?

Sean Han did a great job explaining blockchain with an example app he published.  You can find the article here.

Haseeb Qureshi also wrote a great article titled “The authoritative guide to blockchain development” that you can find here.

 

Blockchain Business Models

Most Blockchain businesses make money in one or more of the following ways:

  • Software as a Service –  charge a fee for using their infrastructure.
  • Flat Fees & Transaction/Subscription Fees – Maintain networks between a consortium of partners.
  • Service Level Agreements – Host infrastructure for enterprise customers (Microsoft, AWS, IBM etc…).
  • Cryptocurrency Speculation – Issue their own token. These companies do work that makes the market value of their token increase and then sells the token to speculators. <<More on this in the next couple sections…

 

Crypto Currency

You can’t dig into blockchain without mentioning cryptocurrencies as they are what drove blockchains current momentum and much is coming out of this momentum such as smart contracts and ICOs.

Start with this video: https://www.youtube.com/watch?v=bBC-nXj3Ng4

First, let’s define what is money?

Money is not a thing (gold or a dollar bill).  Money is a record adopted by society to record who owns what.  If you use your credit card or PayPal real dollar bills and/or gold is not transferred—ones and zeros are…

FIAT Money (link) – “Fiat money is a currency that a government has declared to be legal tender, but it is not backed by a physical commodity. The value of fiat money is derived from the relationship between supply and demand rather than the value of the material that the money is made of. Historically, most currencies were based on physical commodities such as gold or silver, but fiat money is based solely on the faith and credit of the economy.”

What is Cryptocurrency?

A Cryptocurrency is a medium of exchange, created and stored electronically in the blockchain, using encryption techniques to control the creation of monetary units and to verify the transfer of funds.   It has no intrinsic value in that it’s not redeemable for a commodity such as gold.  It has no physical form.  Its supply is not determined by a central bank as the network is completely decentralized.

Common Native Cryptocurrencies

  • Bitcoin — The first decentralized digital currency
  • Ether – A cryptocurrency whose blockchain is generated by the Ethereum platform (a blockchain-based distributed computing platform and operating system featuring smart contract (scripting) functionality).
  • Ripple — Unlike most cryptocurrencies, it doesn’t use a Blockchain to reach a network-wide consensus for transactions. Instead, an iterative consensus process is implemented, which makes it faster than Bitcoin.
  • Litecoin — A cryptocurrency that was created with an intention to be the ‘digital silver’ compared to Bitcoin’s ‘digital gold.’ It is also a fork of Bitcoin, but unlike its predecessor, it can generate blocks four times faster and have four times the maximum number of coins at 84 mn.
  • NEO — It’s a smart contract network that allows for all kinds of financial contracts and third-party distributed apps to be developed on top of it. It has many of the same goals as Ethereum, but it’s developed in China, which can potentially give it some advantages due to an improved relationship with Chinese regulators and local businesses.

There are many others such as Bitcoin Cash, NEM, IOTA, Dash, Qtum, Monero and Ethereum Classic.

Is this the future of money?  Undetermined.  According to Buffet and Gates, it’s a strong NO (link).  …and if you ask an esteemed economist like Paul Krugman he will tell you “to be successful, money must be both a medium of exchange and a reasonably stable store of value. And it remains completely unclear why Bitcoin should be a stable store of value.”.

…but what if, a country adopted a cryptocurrency as it’s official currency?  Venezuela tried… the Marshall Islands is trying (link)… Sweden (link).  Estonia (link).  Japan/Canada/Germany/Holland (link)…  and to note: Japan recently recognized Bitcoin as legal tender (link).

Net/Net: Cryptocurrencies are not going away as Gates/Buffet/Munger are predicting, however, they are probably correct in the assumption that it won’t replace the US Dollar as the reserve currency any time soon.  More on this argument here.

Pros and Cons of a global cryptocurrency (Coin) as an alternative to FIAT

Pro:

  • Medium of exchange without the use of an intermediary (bank):
    • Rebuttal: Artificial scarcity is essential to cryptocurrency’s speculative value but works against making it a viable medium of exchange. Why would you buy a soda with Bitcoin if one day it’s $1, the next $5, and the day after that $10?
  • Low-cost international money transfers: This is a multibillion-dollar industry that’s mostly set up to exploit working-class immigrants with fees (Western Union, PayPal or Plimus skimming 3-10%). With cryptocurrency, the transfer fees are negligible, and the transfer times are near-instant (usually less than 30 minutes).
  • No government intervention: Allows citizens to not have their capital tracked by governments as a means of control in the case of 1) Seizure resistance by badly acting governments and 2) Ease of transport of currencies across international boundaries (cryptocurrencies allow you to cross a border with literally a billion dollars in your pocket)
  • Ability to sell a digital good: For example Music & Photography
  • Replace central banks:
    • Rebuttal: Well-run central  banks  succeed  in  stabilizing  the  domestic  value  of  their  sovereign  currency  by  adjusting  the  supply  of  the  means  of  payment  in  line  with  transaction

 

Con:

  • Speed: Public permissionless blockchain networks are slow and will not scale to yield transaction throughput on the scale of Visa/Mastercard
    • Rebuttal: Layer 2 solutions (Lightning & Raiden)
  • Use enormous resources: Public permissionless blockchain networks require enormous resources (bandwidth, memory and CPU). The ledger is shared and maintained by every node of the network. To be a node in the network, one needs to download the whole ledger/blockchain and keep it on their system. Distributing a ledger potentially consumes over a hundred times the energy of single databases. Scaling up from relatively niche use could be impossible.
    • Rebuttal: Proof of Stake consensus systems and Layer 2 solutions
  • Won’t pass regulatory scrutiny: Governments won’t tolerate the loss of monetary control. The US government specifically is not going to allow wide-scale movement of money within the United States in which it can’t identify the sources and uses.  Governments also won’t tolerate illegal commerce (especially if used for terrorism).   Eventually, societal pressure to regulate cryptocurrency will increase as more fraud (example: market manipulation) is discovered. Most people want strong governments, and strong governments want to control their own currencies.
  • Cryptocurrencies are not a “stable” store of value. They operate less like a “currency” and more like a “stock” whose price fluctuates. What % of today’s BTC is being used to purchase services? Less than 1%?
    • Rebuttal: In economics, something has value if it checks the following two boxes: scarcity and utility. Scarcity means that something has a finite supply. In the case of bitcoin, the cryptocurrency has a set cap of 21 million bitcoins. Cryptocurrency’s utility lies in the fact that no government, bank or single person has control over it hence it can’t be toppled by corruption at the top.  Gold has underlying utility value in applications such as semiconductors and jewelry. Real estate has underlying value for building, farming, and mining, among others.  Cryptoassets have an enormous amount of potential underlying utility value, promising to disrupt just about everything, including payments, record keeping, legal contracts and many other industries.
  • Country-specific monetary policy is required for a stable society, to offer benefits (Social Security, Medicaid, Medicare) to its population and to finance wars
  • Credit and cryptocurrencies play poorly together.
  • Deflation is bad. Bitcoin caps out at 21 million total BTC in circulation; Litecoin at 84 million LTC. These fixed supply mechanisms give them deflationary characteristics over the long term.
    • Rebuttal: Ethereum (ETH) chose to uncap the total supply of their coins and opt for long-term, pre-determined issuance schedules. No-cap cryptocurrencies are thus inflationary in nature. The risk with inflationary cryptoassets is that new, future coins entering the market will reduce the value of existing coins by increasing the supply relative to demand.
    • Rebuttal: A cryptoasset with deflationary characteristics could theoretically be a better store of value because existing coins are protected from future supply-based dilution.
  • Quantum computing: The entire blockchain assumes that hash problems take a constant time to solve. If someone can solve a hash problem even slightly faster, then the whole blockchain system fails to work.
  • Fragmentation: like Linux, many cryptocurrencies are open-source causing new currencies to appear quickly.
  • Lost keys: Cryptocurrency stored in a public permissionless blockchain can be lost forever if someone loses their key. Hence, most people won’t want to maintain their own private keys, and if you don’t maintain your own private keys, cryptocurrencies are essentially no different from fiat money held in banks.
  • Economics of Proof of Work: For cryptocurrencies that using proof of work (mining) as their consensus mechanism–If the market value of the reward for mining drops below the cost of mining, then miners will stop mining, and nobody will process transactions.
    • Rebuttal: Proof of Stake

 

ICO – Initial Coin Offering or “Token Sale”

It’s import to understand what a “Token” because it is one of the ways that a company can build a business model to fund a ‘Public’ blockchain network.   It’s also important not to confuse a “Token” with a native “Coin” (Bitcoin, Ether, Ripple, Litecoin etc..).

In an ICO a company will sell a quantity of cryptocurrency to investors in the form of “tokens”, in exchange for coins (other cryptocurrencies such as bitcoin or ether). These tokens become functional units of currency if/when the ICO’s funding goal is met.  Most companies develop a decentralized application (Dapp) where the custom token provides a unique utility in using the company’s product.  However, tokens are exchanged freely using the native coin protocol, so users can trade them in for other cryptocurrencies or fiat.

Tokens, in general, are not the same as shares in a company as they do not provide an ownership stake (voting rights) in the company. Tokens are simply vehicles with which to conduct transactions for the goods or services within the company from which they are issued. After the ICO where the company sets the price for the tokens, their value is based on supply and demand.

A token is like a concert ticket. Tickets are bought and sold, and their value depends on the popularity of the band.  The exchanges (StubHub) facilitates the buying and selling of tickets. There are limited numbers of tickets just like there are a limited number of tokens. An ICO is like pre-purchasing tickets for future concerts at a very low cost. The band may or may not be around in the future but if you can spot the diamond in the rough, your tickets could be very valuable in the future. If you pre-purchase tickets to a band that goes nowhere, you lose everything.   <here is another funny analogy that explains and ICO/Token sale>

If a company creates a token in Ethereum, it is created as a smart contract, with each token being governed by a single, unique governing contract.

Types of tokens

  • Utility Token – Provide exclusive access to software utility (or service) by having the token or in exchange of token.
  • App-payment token – Provide means of payment in a technological ecosystem where more than two parties are involved.
  • Security tokens – Provides a return on investment through profit or revenue sharing, it includes voting rights, constitutes a part of equity and may provide buy-back guarantees.

The advantages and disadvantages of a token sale

Advantages:

  • Quick and low cost – ICO’s do not require intermediaries to get involved (in contrast to typical venture capital) so raising funds can be fast and low cost
  • Liquidity – Investors can sell at any time
  • Real-time risk pricing – Investors always know where they stand in regards to the value of their tokens
  • Visibility on an exchange can help the company attract developers and users

Disadvantages:

  • Getting listed on an exchange can be costly (link).  Access to the best exchanges carries a premium because the bigger the liquidity pool, the higher the potential market value of a coin, and the higher the chance of success for a project.  You can find a list of exchanges here https://coinmarketcap.com/exchanges/volume/24-hour
  • Once a cryptocurrency project is launched and listed on an exchange it trades live and faces the public scrutiny that comes with being a publicly listed company
  • The nature of ICOs can attract speculators that do not believe in the long-term potential of the company

 

The ICO Steps

  1. Release a “white paper” which details the plans for a given cryptocurrency, including what it will do, why it is useful, the roadmap for building the project, and a plan to use the funding raised. More on whitepapers can be found on this blog post.  Here are some example of whitepapers.
  2. Allow people to register for the whitelist to gain access to a pre-sale round.  More on whitelists can be found here.
  3. When the pre-sale period occurs investors will contribute funds by sending Bitcoin (BTC) or Ethereum (ETH) to a designated wallet address. If the project reaches its funding goal, tokens of the new cryptocurrency will be sent in return when the coin is launched. If the project does not meet its funding goals, the contributed funds will be returned.
  4. If the project reaches its funding goal and distributes the newly created coins, it will launch on an exchange where it can be traded.

Stable Coins

a ‘Stable Coin’ is a cryptocurrency that is pegged to another stable asset, like gold or the U.S. dollar. It’s a currency that is global but is not tied to a central bank and has low volatility.  For more on stable coins: here.   More on asset-backed tokens (ABT) found here.

Tokenizing real-world assets

More here.

If you are “Long” on Cryptocurrencies then you should really really really read this great article: The Natural Order of Money and Why Abstract Currencies Fail by Roy Sebag.

 

Note: Currently the legal state of an ICO is undefined. Is a token a financial asset (a security) or a digital good? What is the SEC going to do? (link) I’m sure we will hear something soon (link). –“The Securities and Exchange Commission and the agency that Mr. Gensler led from 2009 to 2014, the Commodity Futures Trading Commission, are in the middle of determining how to categorize and crack down on many of the virtual currencies created in recent years. Most of the focus has been on smaller currencies that were issued through so-called initial coin offerings, or I.C.O., a method of fund-raising in which entrepreneurs sell custom virtual currencies.”.  Keep an eye on the Swiss too (FINMA).

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