FROM BITCOIN TO BLOCKCHAIN: BITCOIN IS DYING, WHILE BIG FINANCE EMBRACES THE DISTRIBUTED LEDGER


Few years back Bitcoin took the world by surprise and quickly gained significant traction. To refresh your memory Bitcoin is based on a blockchain technology, a form of distributed ledger shared by all participants. New transactions are pooled in blocks up to 1 MB in size and before being added to the ledger. The integrity of the system is maintained via users called miners by solving of artificially created mathematical problems essentially designed to make the opportunity costs of cheating the system higher than playing by the rules. The miners perform this service for a reward, which in the case of Bitcoin halves in predefined intervals (next halving is in just about 40 days). The verification of each new block takes appr. 10 minutes

Coming back to Bitcoin the initial adopters were opportunists seeking to escape the traditional financial system, while soon after it spread to a much wider audience. Universal acceptance for everything including the morning cup of coffee was just around the corner.

A couple of years later in 2016 this dream is already dead. The reason is simple - the Bitcoin design is not very suitable for a currency with just a few of the design flaws being:

  • The bitcoin has a scaling issue. Since the size of each block is limited to 1MB, it can quickly fill up as the popularity of the currency grows. At the same time the currency supports a voluntary fee system. Logically miners prefer to verify the transactions with the highest fees first. This leads to certain transactions not getting verified at all, while the average time is well above the 10 min. by design at above 40 minutes.

  • The mathematical problem used to verify transactions becomes exponentially more difficult with time, in order to keep up with increasing computing power. SInce the solving is basically the running of a random number generator the verification can be seen as the expenditure of electricity and computing capacity for the upkeep of the integrity of the system. Economic logic dictates that the bulk of this activity will take place in places, where these resources are the cheapest - in China. Following this dynamic today more than 50% of the mining capacity is concentrated in organized Chinese pools, which essentially means that the ledger is no longer distributed, but centralized. If one considers the possibility that some of these miners are not trustworthy, the reality looks increasingly grim.

  • In general a verified transaction is never really 'verified', but verified with a certain probability that usually is very close to 100%. Considering the last two points, it would make sense to wait for the validation of a couple of more blocks, before accepting the transaction, further increasing transaction time. In fact companies exist, which take over the credit risk over this verification period for a fee. Quite ironic considering that some use Bitcoin to escape traditional financial intermediaries.

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As outlined above Bitcoin is not very suitable for medium with an infinite size and high volume of transactions like a currency. The distributed ledger technology however is very intriguing for a number of other applications, since it allows for the verification of transactions without a centralized authority. If transaction volumes are not an issue and the trustworthiness of all counterparties is assured the blockchain technology can be utilized for all kind of activities settlement and clearing activities are required. The distributed ledger could especially useful, if:

  • One has to keep track of complex transactions. In Example a financial asset that is frequently sold and resold. The blockchain offers an easy way to verify the chain of transactions.

  • The identification of an asset is essential. This is the original reason for big finance to get involved. Some of the biggest fraud cases in Finance in recent years involve the rehypothecation of the same assets several times or even the usage of collateral that never existed in the first place (mostly commodities financing in China). The adoption of a system for the verification of assets, shared by all financial institutions, would offer significant benefits for the system as whole. It can be compared to the benefits of rating agencies or credit bureaus in the world of corporate and retail banking. The first big finance application of blockchain technology was actually in this area in the form of a pilot project between Standard Chartered and DBS.

  • To save cost in settlement via centralized means.

  • A secured audit trail is required. In reality authorities like blockchain solutions, since all transactions can be traced.

Many companies both startups and traditional players alike are already in the explanatory phase, with some pilots underway mostly in the settlement/collateral verification space. At the same other applications in the KYC/Anti-money-laundering areas are starting to attract interest, further contributing to the blockchain technology status as one of the main focuses of Fintech investment in coming years.

#Bitcoin #Blockchain #Fintech #Finance #TheETechBlog

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