The year 2020 is shaping up to be a defining moment in the epoch of virtual assets. With the FATF global regulatory guidance slated for implementation, state-issued digital currency poised to go live in China, the Facebook initiated Libra cryptocurrency drawing global regulatory attention, and my passion – the social utility of cryptocurrency to drive financial inclusion for the 1.7 billion unbanked – entering the narrative, I suspect that in the year ahead we will witness a meaningful movement in the needle of progress. Repeatedly, I am asked to take a zero knowledge approach to initiate the steady flow of new individuals taking interest in cryptocurrency. This article aims to demystify cryptocurrency and blockchain.
To the layperson, cryptocurrency and blockchain are often thought of as two separate entities. It may surprise some to know that both technologies came into existence at the same time through the innovation of Bitcoin. Without Bitcoin there would be no blockchain. Let’s take a look at what these technologies are, and why they are gaining so much attention.
For reasons of simplicity, a blockchain is sometimes described as a new type of database. However, while a blockchain is a system that stores information in some ways similar to a database, it operates more like a revolutionary ledger that store transactions. A blockchain is a protocol for storing transactions that track tangible and intangible assets in a decentralized, immutable, and censorship-resistant digital ledger. The asset (such as lettuce, a diamond, money, or a patent) is depicted in the blockchain as a transaction that is sometimes referred to as a token representing the underlying asset. For example, a transaction with a unique reference number stating that a diamond with a specific serial number and characteristics which was at a specific GPS coordinate at a specific date and time, would represent a single unique diamond. As transactions are added to the ledger, they are grouped into blocks of data, hence the term “block” in blockchain. An algorithm is applied to each block, giving it a unique cryptographic hash or signature. Within the block, transactions are cryptographically connected to each other in such a way that the slightest change will alter the signature of the block. This is part of what gives the blockchain its immutable characteristic. As a new block of data is added to the ledger, it is cryptographically linked to the previous block, in a similar way that transactions within blocks are linked. This connecting of blocks of data creates a virtual chain of blocks – hence the “chain” in blockchain.
What makes a blockchain censorship-resistant is the consensus mechanism for validating and adding transactions. The blockchain protocol, or rules built into the code, enables and rewards thousands of people to maintain a complete copy of the blockchain on computers running the code – for the purpose of validating transactions and voting on data integrity before adding new information to its read and write-only ledger. An attacker would need to summon computing power equivalent to 51% of the network to compromise it. The larger a blockchain network is, the more impractical it is to compromise[i]. What is also remarkable about the protocol is that it enables permissionless participation without relying on trust. Anyone can install a decentralized blockchain code on a computer and run a node on its network. These participants are known as miners, and for all of their efforts securing the network, they are rewarded with a digital token that is perceived to have value. Under this framework, the blockchain is not owned by any person or entity; it simply exists by incenting unrelated people to keep it alive.
The definition that I describe above is based on the original blockchain i.e., Bitcoin (upper case for the protocol and network, and lower case for the cryptocurrency). The Bitcoin blockchain, was introduced to the world on January 3, 2009 by the creator of bitcoin; an unidentified person or entity using the name Satoshi Nakamoto. Since its introduction, other iterations have been developed by centrally controlled entities. Known as permissioned blockchains, these systems are subject to censorship by the entities that own them. As such, these centrally controlled networks do not qualify as blockchains to some purists. For the remainder of this article, I will adopt the broader interpretation that includes both permissioned and permissionless blockchains, however it is important to note that the use of one versus the other has significant and material implications[ii].
When the asset represented by a transaction on a blockchain is money, the token is called cryptocurrency. The idea of digital cash was introduced about three decades ago. Among the greatest challenges was solving the double spend problem. If a dollar is represented by a digital file, how do we prevent someone from copying it, or sending the same file to two different recipients as payment? Bitcoin – the first manifestation of a cryptocurrency – solved this problem and more. Cryptocurrency employs the use of cryptography and a decentralized ledger system to create digital tokens that represent money. Cryptography ensures that each token is unique, while a decentralized network of thousands of computers around the globe – each validating every transaction – renders double spend statistically improbable. The Bitcoin network has been securely storing digital tokens and processing transactions since January 2009.
Blockchain was introduced to the world as a component of Bitcoin, however, today it has many other practical applications that exceed cryptocurrency. One such application is the field of supply chain, as adopted by Walmart. Amid concerns over an E coli outbreak in the United States that resulted in deaths, hospitalizations, an inability to determine the source of the outbreak in a timely fashion, and the ultimate mass purge of lettuce from the marketplace, Walmart announced a blockchain solution; the Walmart Food Traceability Initiative. In partnership with IBM and suppliers, Walmart demonstrated that it was possible to determine provenance of tainted produce within seconds – instead of days or weeks, using the blockchain-enabled IBM Food Trust network. The successful pilot resulted in Walmart adopting the technology, and in doing so compelling all direct suppliers to conform to their blockchain network solution by January 31, 2019[iii].
The world’s biggest retailer is not alone; there is a growing list of organizations that recognize the transformative potential of blockchain. As they adopt blockchain solutions that lie outside the purview of regulators, they pave the way for a token economy, where assets are represented as tokens, and financial transactions are executed on the blockchain. It is at this juncture that regulators start to take notice of the technology and its implications. This nascent innovation comes with benefits and risks that can be significantly advanced or impaired by regulatory regimes. Lessons can be learned from the various approaches taken by regulators thus far, and the community responses in different regions of the globe. The regulatory approaches range from wait-and-see to comprehensive regulate-first regimes. Realizing a balanced framework that maximizes the benefits of this evolving technology while minimizing its risks, will require the engagement of stakeholders across a broad spectrum of interests.
Mainstream adoption of blockchain and cryptocurrency has not yet been established, however the pipeline is packed with industry re-defining innovations that hinge on the rails of blockchain. Gaging from initiatives of leading solutions providers such as Microsoft, Amazon, IBM, Facebook (Libra Association), Intercontinental Exchange, E&Y, Deloitte and others, we can expect to see a continued uptick in blockchain activity in the years ahead.
Why blockchain and cryptocurrency matter
As the global financial crisis began to take hold in September of 2008, with the bankruptcy filing of Lehman Brothers, a loosely connected lofty proclamation gained all the attention of a molecule of sand on a distant beach. Satoshi Nakamoto published a white paper entitled “Bitcoin: A Peer-to-Peer Electronic Cash System” on October 31, 2008. In his opening remarks, Satoshi noted: “A purely peer-to-peer version of electronic cash would allow online payments to be sent directly from one party to another without going through a financial institution.” His closing comments declared: “We have proposed a system for electronic transactions without relying on trust[iv].” With the introduction of Bitcoin, Satoshi demonstrated to the world that he was acutely aware of developments in the global financial system. He did so by inserting into Bitcoin’s genesis block the message: “The Times 03/Jan/2009 Chancellor on brink of second bailout for banks”; a message permanently inscribed in an immutable ledger. By the end of 2010, Satoshi faded into obscurity – never to be heard from again, leaving his work as an infant to survive in a hostile environment with powerful adversaries.
Fast-forward ten years, and the infant not only survived – but flourished. Bitcoin has demonstrably excelled as a system for electronic transactions without relying on trust. To be sure, there is plenty of room for improvement, but the achievement of this experiment under unrelenting headwinds is truly remarkable. The technology has demonstrated that it is capable of securely storing over $100 Billion in value and executing billions of dollars in transactions daily. All without the backing of a state or entity to ward off the constant barrage of negative attacks, and sentiments vying for its demise. Regardless of one’s perspective on the utility of bitcoin – the cryptocurrency – the achievements of Bitcoin – the protocol – is undeniable.
Bitcoin was just the first use case of the blockchain. Its success has inspired the creation of over 1,000 cryptocurrencies and hundreds of blockchains which are currently being tracked by coinmarketcap.com. Some of these blockchains support alternative digital currencies capable of controlling and surveilling monetary transactions in ways that can significantly reduce money laundering, tax evasion and other undesirable activities with great cost and performance efficiencies. With several states, including Canada[v], the United Kingdom[vi], Norway[vii], Sweden[viii], and Thailand[ix] evaluating central bank digital currency (CBDC), money on the blockchain may become as ubiquitous as the fiat currency in use today.
As states contemplate possibilities, some large multinational conservative financial institutions are slowly dipping their toes into the blockchain lake, and this provides opportunities for others to vicariously enter the space and see what the technology has to offer. HSBC employed blockchain technology throughout 2018 to process 3 million foreign-exchange transactions valued at $250 Billion. The bank credited their distributed ledger technology, which is a family of technologies that includes blockchain, with reducing friction caused by intermediaries and manual processes, and with drastically increasing efficiencies of related internal flows[x].
With each new use case, regulators are challenged to assess not only the obvious ramifications of the new technology, but also the novel and unintended consequences – that are sometimes not immediately evident – and their implications for a healthy functioning society.
On May 22, 2010, two pizzas were purchased at Papa John’s for 10,000 bitcoins – worth about $30 or $0.003 per bitcoin. Less than a year later, in February 2011, the price of bitcoin achieved parity with the U.S. dollar. Regulation began to take form in 2013 as the U.S. government classified bitcoin miners and exchanges as money services businesses. At about the same time the FBI seized 26,000 bitcoins from Silk Road, the dark web marketplace. North of the boarder in Canada the first bitcoin ATM was launched in Vancouver. December of 2017 was the height of bitcoin mania as the price hit USD $20,000; those two pizzas at Papa John’s were now worth USD $200 million.
As early observers unpacked Bitcoin, they discovered new applications for its underlying blockchain technology; a computer that spanned the globe, frictionless global transactions, supply chain management, self-executing contracts, the tokenization of securities, real assets and intellectual property, financial inclusion for the 1.7 billion unbanked and cost savings for the millions who send over $600 billion in remittances annually. A hodgepodge of regulatory reactions worked to stymie progress in some regions of the globe and enhance it in others.
The state of cryptocurrency and blockchain regulation is evolving, with new use cases repeatedly sending regulators into deliberation. Stakeholders intimately engaged with technologies powered by blockchain are ideally situated to understand the implications of different regulatory approaches, and to offer guidance based in part on governance employed in their practices. As regulators collectively ponder their next step, it is incumbent on stakeholders to familiarize themselves with the technology, so that they are positioned to influence regulations in ways that bring about positive outcomes for their industry, society at large, and the continued advancement of blockchain innovation.
About the author: Jeff Bryan is a cryptocurrency thought leader with a professional background in financial compliance, investigations and cyber forensics. Jeff is currently pursuing a Master’s degree in Socio-Legal Studies with a major research focus on social utility and regulation of cryptocurrencies at York University, Toronto, Canada.
References:
[i] Burniske, Chris, and Jack Tatar. Cryptoassets: The innovative Investor’s Guide to Bitcoin and Beyond. McGraw Hill, 2018, pp. 186-188.
[ii] Casey, Michael J., and Paul Vigna. The Truth Machine: The Blockchain and the Future of Everything. St. Martin’s Press, 2018, pp. 162-173.
[iii] Walmart. Food Traceability Initiative Fresh Leafy Greens. September 24, 2018, https://corporate.walmart.com/media-library/document/blockchain-supplier-letter-september-2018/_proxyDocument?id=00000166-088d-dc77-a7ff-4dff689f0001.
[iv] Nakamoto, Satoshi. “Bitcoin: A Peer-to-Peer Electronic Cash System”, Bitcoin.org, October 31, 2008, https://bitcoin.org/bitcoin.pdf.
[v] Engert, Walter, and Ben S. C. Fung. Central Bank Digital Currency: Motivations and Implications. Bank of Canada Staff Discussion Paper, November 2017, https://www.bankofcanada.ca/wp-content/uploads/2017/11/sdp2017-16.pdf.
[vi] Kumhof, Michael, and Clare Noone. Central bank digital currencies – design principles and balance sheet implications. Staff Working Paper, No. 725, May 2018, https://www.bankofengland.co.uk/-/media/boe/files/working-paper/2018/central-bank-digital-currencies-design-principles-and-balance-sheet-implications.pdf?la=en&hash=11469281B32821BCFD85B4A5483AB3577E38B2DD.
[vii] Norway, Norges Bank. Central bank digital currencies. November 1, 2018, https://static.norges-bank.no/contentassets/166efadb3d73419c8c50f9471be26402/nbpapers-1-2018-centralbankdigitalcurrencies.pdf?v=05/18/2018121950&ft=.pdf.
[viii] Sweden, Sveriges Riksbank. The Riksbank’s e-krona project: Action plan for 2018. December 2017, https://www.riksbank.se/globalassets/media/rapporter/e-krona/2017/handlingsplan_ekrona_171221_eng.pdf.
[ix] Santiprabhob, Veerathai. “Thai Economy: The Current State and the Way Forward.” Bank For International Settlements, June 5, 2018, pp. 8, Keynote Address, https://www.bis.org/review/r180606g.pdf.
[x] HSBC Holdings plc. HSBC settles $250bn of FX transactions using distributed ledger technology. February 26, 2019, https://www.hsbc.com/media/media-releases/2019/fx-everywhere.