Ten years after the publication of the white paper of “Bitcoin: a peer-to-peer system electronic cash system” by Satoshi Nakamoto, perhaps its greatest contribution to society is that it has forced regulators, policymakers, bankers, academics and technologists to have deep-hearted and painful conversations on some very important issues and topics. It has led to soul searching conversations around central banking, money, banking, monetary policies, financial inclusion, and payments as well as other related topics. These are topics central bankers, economists and academics finds delightful, but most members of the general public typically find less appealing or boring.
The year 2017 will be marked as a significant watershed moment in Bitcoin’s history as the price of Bitcoin skyrocketed to over USD $20,000 in December of 2017. Around the same time, public interest in “cryptocurrency” judged by internet searches peaked, outstripping interest in fiat currencies like the US Dollar and the Euro, and gold. Companies (large and small), banks and non-banking entities, central bankers, academics, technologists, and a raft of others have spent countless hours exploring the benefits and usefulness of Bitcoin, and more importantly blockchain. In a Juniper Research survey published in August 2017, 39% of 400 company founders, executives, managers and IT professionals confirmed that their companies were either deploying or considering deploying blockchain technology, while 36% replied “no” to that question and 25% said “don’t know”.
Each of the Big Four accounting and consulting firms has built up blockchain technology advisory teams now staffed in the hundreds, all pushing their clients to engage with the technology. According to the Financial Times, in terms of enterprise development, there were 406 blockchain technology patents filed in 2017 in addition to 602 separate cryptocurrency patents. Large firms such as Accenture, Facebook, Google, IBM and Microsoft are developing patented products and services based on blockchain’s digital-ledger open-source technology that can be accessed and adapted by anyone.
Retrospectively, we can call the price performances of Bitcoin and other cryptocurrencies in 2017 speculative. This is a good example of where both Eugene Fama and Robert Shiller, joint Nobel Prize in Economics winners, are correct. Fama and Shiller had diametrically opposed conclusions on how assets are priced and how prices change. Fama outright denies the existence of speculative “bubbles” on the grounds that there are no econometric tests that allow us to predict when a bubble is forming or when it might burst. According to Fama, all bubbles are only recognized as such retrospectively.
Shiller, on the other hand, consistently refers to the Efficient Market Hypothesis (EMH) as a “half-truth,” and that financial markets are repeatedly subject to fads or social epidemics that cause prices to fluctuate around value. Shiller believes that economics must rely on and integrate theories from other disciplines within the social sciences to develop a more accurate model of human behaviour (i.e. a model of human behaviour that has more explanatory power than the rational expectations model). Shiller asserts that speculative bubbles do indeed occur and are the result of feedback mechanisms between investors and the media that cause asset prices to be bid up beyond fundamental value.
For all sense and purposes, when we look back at the euphoria around Bitcoin and other cryptocurrencies in 2017 it was a speculative bubble. The precipitous fall in prices and market capitalization is quite telling. Bitcoin price, for example, has fallen by almost 80% since its peaked at close to $20,000 in December 2017. On Monday, January 22nd, the price of Bitcoin was about USD3,600 compare to USD16,500 in January 2018. Other cryptocurrencies such as Ripple’s XRP, Ethereum’s Ether (ETH), Bitcoin Cash (BCH), Stellar’s XLM and Litecoin (LTC) have taken similar dramatic falls. In mid-February, the total market capitalization was about USD118bn down from about USD830bn a year ago.
Ten years ago, the first transaction involving bitcoin took place marking a new era for the global monetary system. Since then the cryptocurrency market and the technology behind it, the blockchain, have grown to new levels, with the creation of new altcoins entering the space. However, as if the dramatic fall in price is not bad enough, a recently published Bank for International Settlements (BIS) Working Papers No 765 “Beyond the doomsday economics of “proof-of-work” in cryptocurrencies by Raphael Auer of Monetary and Economic Department was quite terse and incisive in its assessment of Bitcoin.
The purpose of this article is to discuss the some of the key points raised in the BIS Working Paper. The paper analysed the underlying economics of how Bitcoin achieves payment finality, i.e., how it seeks to make a payment unalterable once included in the blockchain, so that it can be considered as irrevocable. It focused on Bitcoin costs and rewards process, and raised two questions: First, how efficient is the fundamental architecture of deterring forgeries via costly proof-of-work? And second, can the market for transactions actually generate rewards that are valuable enough to ensure that payment finality is really achieved?
Auer introduced the concept of “economic payment finality” in the blockchain. That is, a payment can be considered final only once it is unprofitable for any potential adversary to undo it with a double-spending attack. The author noted that although a definition of payment finality was not explicitly spelled out in Satoshi Nakamoto’s white paper conceptually finality in Bitcoin transaction is operational and depends on the degree of computational complexity required to guard against a double-spending attack. In a blockchain network, potentially Byzantine General Problem computers use a system of distributed consensus to agree upon the history of transactions in a ledger.
Distributed consensus is the problem of how multiple, independently run computers can reliably agree on a set of common data in the presence of faults – i.e., where there is a risk that one or more computers are intentionally or unintentionally programmed to introduce false information. Systems with the strongest safety properties assume that the actors in the system might be Byzantine – which means they might be malicious and try to actively subvert agreement and introduce false data into the system. Such systems assume no limits on how faulty actors might act. This problem arises in large distributed networks like the internet, and many software companies employ distributed consensus algorithms to protect access to critical data, including Google, Facebook and Yahoo.
The paper noted that a double-spending attacker stand to gain a much higher bitcoin income than an honest miner. Both the honest miner and the criminal will collect block reward and transaction fees. However, the double-spending attacker will also collect the amount double-spent, i.e., the value of the voided transactions. Auer calls this the “attacker advantage” which ultimately translate into a very high require ratio for miners’ income as compared with the transaction volume that is the amount that can be double-spent.
Auer’s paper is not the first out of the BIS to tackle the issue of nefarious actors and the issue of double-spending on blockchain. According to the BIS Annual Economic Report 2018 Chapter V. Cryptocurrencies: looking beyond the hype, it is costly – though not impossible – for any individual to forge a cryptocurrency. To successfully double-spend, a counterfeiter would have to spend their cryptocurrency with a merchant and secretly produce a forged blockchain in which this transaction was not recorded. Upon receipt of the merchandise, the counterfeiter would then release the forged blockchain, i.e., reverse the payment. But this forged blockchain would only emerge as the commonly accepted chain if it were longer than the blockchain the rest of the network of miners had produced in the meantime. A successful double-spend attack thus requires a substantial share of the mining community’s computing power. Conversely, in the words of the original Bitcoin white paper, a cryptocurrency can overcome the double-spending problem in a decentralised way only if “honest nodes control a majority of [computing] power”.
Hyun Song Shin amplified the point made in the BIS Annual Economic Report by stating “two limitations loom large” over Bitcoin. One is the lack of scalability, which is about providing flexibility and capacity to function as a payment system regardless of the number of transactions. In order to maintain incentives for self-interested bookkeepers to keep the system running, the capacity needs to be small enough to generate user fees. But limits on capacity choke the system through congestion, especially at peak times. Finding the right capacity is like balancing on a knife-edge. The capacity chosen at the outset is unlikely to get it exactly right. The second problem is the lack of finality of payments. A payment being recorded in the ledger does not guarantee that it is final and irrevocable. For cryptocurrencies, what counts as the truth is a matter of agreement among the bookkeepers. If a pack of them collude and rewrite history, the payment could be erased. Payment histories interwoven through the system will then be subject to unravelling, giving rise to a new twist in the systemic risk of payments, where voided payments cascade through the system.
Key Aspects of Payment Finality
According to the Committee on Payment and Market Infrastructure (CPMI), payment finality is ‘the discharge of an obligation by a transfer of funds and a transfer of securities that have become irrevocable and unconditional’. The finality of payment is crucial for the orderly working of modern economic systems given that monetary transactions are the backbone of production and exchange, national as well as international. The large volume and scope of today’s payments imply that problems in their settlement could affect the financial sector and even the economy as a whole.
We need to walk back a step or two to dig a little deeper into the issue of payment finality to see the ramification of Auer’s research and where we are likely to end up with Bitcoin. We noted above that finality of payment is crucial for modern economies. Finality has two distinct though related aspects. First, it signifies the discharge of the interbank obligation to be settled in the interbank settlement process. In this sense, “finality” identifies the point in the settlement process, as well as its time, of achieving the discharge. It is important to keep in mind that pre-Bitcoin, traditional payment systems are centralised and governed by central banks with banks and other financial institutions acting as trusted intermediaries. On the other hand, a key feature of Bitcoin is that it is decentralised meaning no government or central bank is required to issue it. Bitcoin is also trustless and relies on “consensus mechanism” to determine the truth.
The second aspect is the non-reversibility of finality. This is particularly important so as to withstand insolvency laws, and not allowed repudiation or re-opening of settlement and resurrection original interbank obligations. An obvious concern with finality of payment is settlement risk, that is the risk that one party will fail to deliver the terms of a contract with another party at the time of settlement. Settlement risk can also be the risk associated with default, along with any timing differences in settlement between the two parties.
Frequently, when we speak about payments, we make the distinction between wholesale and retail payment systems. Wholesale payments are high-priority and typically large-value transfers that are made between financial institutions for their own accounts or on behalf of their customers. Wholesale payments are usually settled via dedicated interbank settlement systems and are governed by central banks. In contrast, retail payments are lower-value transactions between individuals, businesses and governments in such forms as cash, cheques, credit transfers, and debit and credit card transactions.
An important distinction between wholesale and retail payment systems has traditionally been the speed of settlement finality. It typically took a day or more for a payee to receive funds using a traditional retail payment system, and for some systems payments were revocable within a certain period, adding an element of uncertainty. Hence, time-sensitive payments (even lower-value ones) were directed via the interbank payment system because of its ability to credit and debit accounts with real-time finality.
This concludes part 1 of Mark’s article. Be sure to catch the second part exclusively at Suara SEACEN.
Mark McKenzie is a Senior Financial Sector Specialist in the Financial Stability and Supervision & Payment and Settlement Systems pillar at the SEACEN Centre.
Mark is a Senior Financial Sector Specialist in the Financial Stability, Supervision and Payments pillar at the SEACEN Centre.