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The Power of Blockchain (and Sidechains)

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Blockchain has the potential to allow distributed peer-to-peer networks to drive most internet services we use today. In the current sharing economy model, the middle man takes a cut but there is no middle man in a true peer to peer network; the network is self-governing and self-regulatory. Imagine sharing economy services such as Uber, Airbnb, RelayRides and Task Rabbit on a radically decentralised peer to peer network with no central authority. The Blockchain can be used to replace existing centralised systems, such as Dropbox for file sharing and Godaddy for domain registrations. Most of us find these services very useful, but their centralised nature makes them susceptible to hacks, data leaks and downtime. As storage gets cheaper, bandwidth increases and processors grow more powerful, we can imagine a world in which these centralised systems could be replaced with large P2P open-source networks, cryptographically encrypted at each end, all running on the Blockchain. Such is the disruption potential of the Blockchain.
As transactions take place on the network, computers algorithmically verify each transaction and create an open ledger of all activity. Transaction processing is real-time and arguably more secure than relying on a central authority. These computers that collectively form the network are located throughout the world and most importantly are not controlled by a single entity. Developers can build applications on the Blockchain – this makes Blockchain very powerful and the power lies in its distributed nature. There have been several precursors to Bitcoin that failed and succeeded to some extent, but the real technological breakthrough with Bitcoin is the underlying technology that powers it, and the opportunities that this technology creates.

 

Bitcoin-distributed-network

Source: Business Insider

Blockchain could disrupt industries where trust is essential and there are several intermediaries. One use case is the exchange of property: currently several intermediaries are involved in the process, the payment is verified manually and the transaction takes several days to complete. Blockchain will confirm the transaction instantly, transfer ownership to the new owner, and the law will be enforced algorithmically (see smart contracts). Second use case is Blockchain crowdfunding; Naval Ravikant discusses the crowdfunding concept in detail here. These use cases are unharmed by the volatility in the price of Bitcoin and can be enforced by the ‘Code as Law’ using the Blockchain.

The structure of Bitcoin is somewhat limited in its current form but it can be enhanced to do clever things such as smart contracts and smart property. Each one of these applications is likely to be different and therefore it makes more sense to follow a sidechain model instead of a one size fits all. Additionally, it has become somewhat risky to make changes to the core Bitcoin code because of the capital at stake and the traction Bitcoin has gained.

bitcoin-sidechains

Source: Cryptocoinnews

The main idea behind sidechains is to use the existing Blockchain framework and allow developers to build customised applications running off the Blockchain. Bitcoins will be sent to the sidechain and kept there as collateral. The Sidechain will then issue a pre-determined number of coins to be used on that sidechain. Rules of that sidechain will determine when and how the coins can be used. Companies such as Blockstream are working to bring Sidechains to enterprise customers. Other projects such as Ethereum are being built as an open source platform to build and distribute decentralised applications. Blockchain will continue to evolve exponentially and future applications are likely to be radically different from what can be conceived today.

Following is a quote from Peter Diamandis:

“Human development over 150,000 years has been local and linear, your brain is programmed to be linear. But in these next few decades the rate of change is growing so fast that almost everything we can conceive can happen. Every industry is potentially disruptible in the near future. And if you’re not excited or scared, you’re asleep at the wheel.”

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Bitcoin Could Disrupt Money Remittance and Boost Economies in Unbanked World

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More than half of the world’s adult population does not have a bank account. Most of these unbanked adults live in Africa, Asia, Latin America, and the Middle East. People in the unbanked world find travel distances, bureaucratic issues and paperwork associated with opening a bank account to be prohibitive. Banking services have been limited in the developing world because financial institutions struggle to serve customers profitably. Financial exclusion means that these adults cannot borrow for unexpected events such as illnesses, accidents and unemployment; and opportunities for raising entrepreneurial finance are non-existent. Not having a bank account creates problems especially for those who need to transfer money internationally. More than $350 billion was sent through official money remittance channels to developing countries in 2011. The IMF believes that the real figure could be 50% higher as money sent through un-official channels is difficult to quantify. The World Bank estimates that average cost of remittance to an unbanked economy is 9.3% of the amount being sent; this values the unbanked international remittance market at over $30 billion.

The Concept of Mobile money

More than 1 billion people have access to a mobile phone in the developing world. Mobile money services have been gaining popularity because they make life easier for the unbanked. Mobile money allows consumers to use their mobile phones to pay utility bills, send money to family and buy goods and services. The mobile money model enables companies to offer basic financial services to unbanked consumers in a profitable way. There are an estimated 98 million mobile money accounts in the Sub-Sahara African region; twice the number of Facebook users in that region. Mobile money industry relies on a network of agents to facilitate deposits and withdrawals. In June 2013, there were 886,000 mobile money agents in the world; compared to 500,000 western union agents. Most mobile money providers maintain their own network of agents and many of these providers have now started using mini ATM’s.

Mobile Money and International remittance

Despite its localised success, mobile money has not been successful in facilitating international money remittance on a large scale. Even success stories such as M-Pesa have not been successful with international remittances so far. A service that facilitates international money transfer has to comply with a number of regulatory and operational requirements in all jurisdictions involved. Western Union, through partnerships with a number of mobile money providers, launched mobile money transfer services in 9 countries, allowing senders to remit funds to recipient wallets from anywhere in the world. But Western Union’s regulatory compliance comes at an expense that is passed on to the consumer, ultimately reducing the demand for these services. Although cost of compliance is high, lack of transparency is a major reason for high remittance costs worldwide (according to an IMF study). The average cost of sending $200 to the unbanked world is $18. M-Pesa and similar services are closed eco-systems with high transaction fees. The unbanked world is an ideal ground for market disruption by a peer-to-peer de-centralised money remittance technology such as Bitcoin.

Bitcoin: International Remittance and New Opportunities

One of the reasons why there are inefficiencies in international mobile money remittance is that the market is segmented in localised corridors such as US to Mexico and US to Africa. Each corridor has a unique combination of mobile operators and regulatory requirements. Setting up multiple corridors to achieve economies of scale requires significant time and investment, and building up remittance volumes to justify those costs is a challenging task. Bitcoin, with its de-centralised protocol, could bring this large market of unbanked adults together, eliminating the need for money agents and intermediaries between the sender and the receiver. Using a single unified payment network will allow easier access to money and eliminate un-necessary transactions; for example, a migrant worker can pay his/her family’s utility bills and top up mobile phones without routing the money through his/her family.

The adoption of digital currencies and growing internet usage would not only make international remittance cheaper and efficient, but also improve economies of unbanked countries. Bitcoin will encourage online commerce, innovation and entrepreneurship in the unbanked world. For example, one needs a credit card to buy a domain name but getting a Visa or Mastercard in Rwanda is virtually impossible for majority of the residents. With Bitcoin, consumers can spend money online on all sorts of goods and services that are currently not available; Bitcoin would connect a consumer in Kenya to a merchant in the US. Freelancers with Bitcoin wallets can join the world economy and accept payments for services they can render through the Internet. Entrepreneurs will build online / offline services and start accepting payment in Bitcoin without having to open merchant accounts. Entrepreneurs can raise money for new ventures in crowd funding rounds and give away equity in exchange – all done online and facilitated by Bitcoin.

However, consumer education will play a key role in the adoption of Bitcoin in the unbanked world. Many unbanked consumers prefer over-the-counter (OTC) transactions because they struggle to understand new technology. These users find paying an agent to facilitate the transaction easier than downloading wallets and fiddling with technology. The issue could be resolved if everyone had Bitcoin wallets; then the recipient would not have to convert Bitcoins to fiat as he/she could use the coins to buy products and pay bills. Literacy challenges mean that Bitcoin adoption is more likely to start with selected migrant groups. Migrants in the US to Mexico and US to Africa remittance corridors prefer to use cash or similar alternatives as a large percentage of senders and recipients are illiterate. In comparison, the US to India remittance corridor is more likely to adopt Bitcoin because the consumers are more educated and tech savvy. New startups can drive consumer education by tapping into existing networks. Last year Bitcoin startup Kipochi launched an M-Pesa integrated wallet in Africa. Bitcoin’s advantages such as low transaction costs and faster confirmation times are likely to built a network affect that will drive slow but inevitable organic adoption. Digital currencies are likely to present new opportunities, revolutionise money remittance and boost economic development in the unbanked world.

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Multi-signature Transactions: The Future of Bitcoin

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One of the criticisms of Bitcoin is that a Bitcoin transaction is one way and irreversible. However, within the Bitcoin protocol, resides a powerful functionality called “m-of-n” or “multi-signature” transaction. A multi-signature transaction is one that is associated to more than one private key. The ‘n’ is for number of private keys and ‘m’ is the minimum number of signatures needed for that transaction to be successful. For example, in a 2-of-3 transaction, two signatures are needed to send the transaction to blockchain. This functionality has many advantages, especially in wallet security, arbitration and smart contracts.

Wallet Security

Most wallets currently available are single key. If a user looses his/her laptop, hard drive, forgets the password or gets hacked, there is no way to retrieve the coins. In a multi-signature wallet, there are typically three private keys. One key is stored on a web server, second is the user’s main key and third is a backup that can be stored on a paper wallet or USB drive. The wallet can receive funds as normal but when the user wants to withdraw any coins, signatures from atleast 2 of the 3 keys are needed to send the transaction to the blockchain. When the user initiates a withdrawal from his main key, a partially signed signature shows up on other two wallets for approval. Only when one of the other two keys has been signed, the transaction is sent to the blockchain. With a 2-of-3 type wallet, a hacker would have to steal at least 2 keys to withdraw funds. If the user forgets or looses one key, he/she can still withdraw funds using the other two keys.

Arbitration

One of the benefits of making a purchase with a credit card is that in the event of a dispute, the customer can file a chargeback with the credit card company. There are two primary issues with Mastercard and Visa arbitration systems: (1) the system is open to abuse (2) the cost of fraud is split across all consumers.

Card Not Present (CNP) affects all e-commerce transactions, as the card holder is never present at merchant’s premises. All a customer has to do is sign his/her name differently on the courier delivery note. The customer can then file a chargeback and win; the merchant will loose both the money and the product. Credit card companies not only charge merchants an admin fee for processing chargebacks but also factor in a certain percentage in their fees for dispute resolution; hence, due to network affect, everyone ends up paying for fraud. The arbitration service is costly and inefficient. On some occasions, a specialised arbitrator is needed but Mastercard and Visa can only offer a generic standardised service. For some transactions, such as sending money to charities, arbitration is not needed at all.

In a multi-signature Bitcoin transaction, there will be three players: customer, merchant and a third party arbitrator. Customer will transfer funds to the arbitrator and the merchant will ship the goods. If customer is happy with the goods, he/she will sign the transaction and merchant will receive the funds. In case of a dispute, either customer or merchant can appeal to the arbitrator, who like a credit card company, will review evidence and mediate the dispute. The arbitrator can not withdraw the funds and is paid a pre-determined market rate only if he/she is involved. Arbitration service being developed by Bitrated will work in a very similar way. Bitrated’s platform will also allow arbitrators to build reputation over time. Multi-signature makes arbitration cost effective; if there is no dispute, no fee is charged. In the long run, due to competition between merchants, these cost savings will be passed onto customers. The system is also fairer, as unlike Paypal and credit card companies, the arbitrator has no incentive to rule in the favour of the customer.

Smart Contracts

This is when things start to get really interesting. Multi-signature transactions can also be used to draw automated smart contracts. The idea of smart contracts was first discussed in 1997 by George Washington University law professor and computer scientist Nick Szabo. Szabo’s ideas were revolutionary, he argued that smart contracts must be enforced algorithmically, using cryptography and other security principals; not by law. Bitcoin and multi-signature transactions make smart contracts possible.

Consider the example of a will – one of the parties in the will would be a computer server. The computer will have its own unique key, with which it will be able to sign Bitcoin transactions. The computer will determine whether a person is alive by checking a central death certificate database periodically. If the computer finds a certificate, it will sign the transaction and transfer the funds to the beneficiary. Contracts can also be split ‘n’ ways (‘n’ grandchildren or business partners) and to authorise transfer of funds at least ‘m’ signatures would be needed. The functionality can be used to automate mortgages and leases. Automation and verification of contracts by the blockchain will reduce, if not eliminate, brokerage and banking fees. The system can be used to verify and transfer ownership of assets. Szabo described how cars could be made to read the blockchain and disable themselves if a loan payment was not made on time. Szabo explains:

consider a hypothetical digital security system for automobiles. The smart contract design strategy suggests that we successively refine security protocols to more fully embed in a property the contractual terms which deal with it. These protocols would give control of the cryptographic keys for operating the property to the person who rightfully owns that property, based on the terms of the contract. In the most straightforward implementation, the car can be rendered inoperable unless the proper challenge-response protocol is completed with its rightful owner, preventing theft.

The system could be designed to automate ownership of physical assets such as phones and houses (smart property) and non-physical assets such as shares in a company. The ability to put up assets as collateral and give away shares in a company will allow businesses to raise money over the internet. Many of these features are yet to be explored and implemented. As the Bitcoin eco-system grows, entrepreneurs and investors will flock to build new companies to explore full potential of the Bitcoin protocol.

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Bitcoin vs Gold: A Question of Intrinsic Value

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Intrinsic value is independent of the market value of an asset. Market value is based largely on perception of the market, intrinsic value on the other hand calculates the true value of an underlying asset. Most commodities derive their value from market fundamentals of demand and supply. Bitcoin and Gold are both scarce and useful in various forms; although some dispute the usefulness of Bitcoin. Alan Greenspan’s words on Bitcoin – “It has to have intrinsic value. You have to really stretch your imagination to infer what the intrinsic value of Bitcoin is. I haven’t been able to do it.” sparked a debate in the Bitcoin community.

Greenspan said repaying capability of a currency comes from:

a) either the intrinsic value of the currency

b) or the trust of individual/organisation issuing the currency.

Historically, gold and other commodities were used to mint coins; and paper money was backed by a set amount of that commodity. Fiat currencies are no longer backed by commodities and the US dollar has not been redeemable in gold since January 30, 1934. It now costs the US government just 9.2 cents to print a $10 note. With no asset backing, and no intrinsic value of the paper on which it is printed, the dollar derives its intrinsic value from the confidence that the US government will honor its debts. Without that confidence, the entire financial system collapses.

The intrinsic value of Gold

I believe the intrinsic value of gold is, to a large extent, based on perception. Humans have historically seen jewellery made from gold as more valuable than jewellery made from other metals; metals that are just as bright and shiny as gold. Investors have historically seen gold as a store of value, an asset that will continue to rise in value as the demand increases, and use gold to hedge fiat’s inflationary risk. If investors have little confidence in the dollar, then the price of gold rises. Additionally, as the dollar looses its value over time and gold remains scarce, gold is seen as having higher value relative to dollar.

Gold vs USD

Source: Seekingalpha.com

Demand and supply alone can not be used to explain value of gold. Silicon is intrinsically valuable as it is used to produce microchips, yet silicon trades at $0.50 / ounce, and gold trades at $1275 / ounce. Hence, intrinsic value of gold is driven by belief that humans will continue to value gold as a precious shiny metal, that gold is a good store of value and that the price of gold will continue to rise over time.

The intrinsic value of Bitcoin

Bitcoin is not issued by any government and is not backed by a commodity; therefore, when compared to the dollar and gold, Bitcoin has no intrinsic value in the ‘traditional economic sense’. However, Bitcoin is more of a technology than a commodity or a currency, therefore it is not wise to study Bitcoin in the traditional economic sense. Bitcoin is being traded like a commodity and used as a currency, and hence Bitcoin is being compared to gold and currency. But the true value of Bitcoin comes from the de-centralised protocol that powers the Bitcoin network. True potential of that protocol is still un-realised, and trying to determine the intrinsic value of that protocol today is like trying to determine the intrinsic value of the world wide web when the internet was first conceived.

We have seen that the Bitcoin protocol can be used as a payment network to send money to anyone in the world. No other technology or payment network makes it possible to send $150 million over the internet in minutes, at the cost of a few cents. While the payment network has been used to fund illicit activities, studies have shown that considerable effort would be needed to achieve complete anonymity. The blockchain is another element of the protocol that will be used to develop de-centralised products and services. Naval describes how blockchain can be used to verify and automate the ownership of assets, contracts, wills etc. If Bitcoin protocol were developed by a company, would the stock of that company not gain intrinsic value because of this technology? (atleast for a short while before that company would be shut down by regulators for facilitating money laundering). Owning part of a Bitcoin is similar to owning a part of that company, key difference is that Bitcoin runs on a peer-to-peer network, which is very difficult to shut down. Infact, something like Bitcoin can flourish only in a peer-to-peer way. The fact that Bitcoin was developed by an anonymous developer, and that the protocol is de-centralised, does not undermine the intrinsic value of the underlying protocol. Intrinsic value of gold is largely in our perception, whereas Bitcoin protocol is a real technology that has the potential to change the world. Hence, although I do not think it is fair to compare the two, if pushed, I would argue that Bitcoin protocol has more intrinsic value than gold.

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Bitcoin: Speculative Bubble or Future Currency

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The US department of justice took a soft position on virtual currencies at the senate hearings last month. Libertarians, investors, regulators and critics have different views on how Bitcoin should be handled. The European Union’s banking watchdog and many countries including France and China have called Bitcoin “highly speculative”. The two most common views on Bitcoin tend to be either a speculative bubble or a future currency.

Speculative bubble

A speculative bubble is typically defined as a phenomenon when the price of a security or an asset rises so sharply, based on over-exaggerated expectations, that the price far exceeds valuations that can be justified by fundamentals, making a sudden fall in price imminent – the point at which the so called bubble ‘bursts’. Critics dismiss Bitcoin as a ‘speculative bubble’, as the rise in Bitcoin’s price is to a large extent based on expectations of future growth, price appreciation and coin hoarding.

Bitcoin Price Fluctuations

Source: Bitcoinwisdom.com

A research paper by Princeton University states that speculative bubbles are accompanied by large trading volumes and high price volatility, based on overconfidence and optimistic beliefs. These are all characteristics that we are seeing in the Bitcoin economy today. A recent Forbes article compared Bitcoin price to Dr. Jean-Paul Rodrigue’s archetypal bubble stages chart.

stages_bubble

Bitcoin may well in a bubble but having said that, despite negative connotations of the term ‘bubble’ – the existence of a bubble does not in itself discount the value of an underlying asset. Amazon.com stock was in a bubble in the 1990’s, the price rose sharply in 1998 based on analyst predictions, exhibiting all characteristics of a bubble, and then came back down. The bubble did not undermine the underlying value of Amazon’s business. Bitcoin’s technology could prove to be an efficient payment system in the long term (Ben Bernanke agrees). Earlier this month, Bank of America analysts valued the price of a Bitcoin at $1300 and said “Bitcoin can become a major means of payment for e-commerce and may emerge as a serious competitor to traditional money transfer providers”.

Future currency

A fiat currency derives its value from the fact that it is issued by the government as a formal legal tender. But what makes one currency stronger than the other? One of the many reasons is that a lot of people believe in that currency and are willing to accept it as a form of payment. One of the reasons why Saddam Dinars did not work as intended was that people were not willing to accept them. Swiss Dinars stayed in circulation without formal government backing because people believed in the currency and used it as a medium of exchange.

I believe Bitcoin serves a different purpose from fiat currency. As a medium of exchange, Bitcoin has several advantages. Credit cards companies and Paypal charge per transaction fees that make micro payments virtually impossible. For example, a publisher can not charge 10 cents for reading an article if payment processor charges 20 cents for processing the payment. Most media websites that host content rely on advertising as their primary source of revenue, while others rely on a subscription based model. Every so often I land on Financial Times website, but I can not read the full article without an FT subscription. Apple gets around the issue by using its own payment network; however, that is not an option for small publishers who do not handle the volumes that iTunes handles. Bitcoin micro-transactions could open up new media models for publishers, allowing publishers to charge the visitor a small fee for reading an article, watching a video or downloading a file. Having said that, Bitcoin as a medium of exchange is still very small in size and limited in use. Compare Bitcoin’s 42 transactions per minute to Visa’s 165,000 per minute to get an idea of the size of the Bitcoin economy.

Bitcoin will also impact the traditional e-commerce industry. Lower transaction costs and absence of fraudulent chargebacks would encourage merchants to accept Bitcoin. Price volatility can be mitigated easily as payment processors such as Bitpay allow merchants to convert Bitcoins to fiat currency almost instantly, so merchants do not have to hold any Bitcoins if they do not want to. Merchants will incentivise consumers by offering discounts on Bitcoin transactions. It would work well for both the merchant and the consumer, as the merchant could pass off some of the savings made from lower transaction costs to the consumer, and the consumer would get the product cheaper by paying with Bitcoin. There are other incentives for consumers such as not having to share credit card details on the merchant site and anonymity.

I think Bitcoin will impact the $500 billion international money remittance the most. For example, to send money to Kenya, Western Union and other money transfer companies’ charge 8 to 10% of the amount being sent. Bill Gates wrote about a mobile service called M-Pesa that is being used in Kenya by millions of people for storing and transferring money. I believe Bitcoin opens up a huge space for disruption in money remittance, and I see Bitcoin as more of a payment system than a currency; it’s an open ledger and a platform for innovation. Bitcoin is more of a disruptive technology, a platform on which businesses will be built.

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