Blockchain Is a New Model That Makes the Existing Model Obsolete
Blockchain is a very strange thing — simultaneously the most overhyped, least understood and most disruptive technology of our time
Some say it’s the biggest change to finance since the invention of double-entry bookkeeping during the Renaissance. That solved the problem of merchants knowing whether they could trust their own books, and allowed entrepreneurs and investors to form corporations, paving the way for modern capitalism. However, a third, trusted party was still needed to verify that the information in the books was correct. Half a millennium later, blockchain adds another entry to the ledger: a verifiable cryptographic receipt of any transaction, paving the way for a fairer, safer and more transparent global financial system.
Others believe it’s more like the design in the 1970s of TCP/IP, the watershed networking protocol that enabled computers to talk to one another and swap data. That protocol formed the backbone for the creation of the internet. In this view, blockchain is the next evolutionary step that allows for the exchange of value, turning these networks into decentralized marketplaces.
Every major financial institution is now actively carrying out research, creating proofs of concept and looking for talent in the blockchain space. The number of postings on LinkedIn for people with blockchain skills has more than trebled in the past year. It’s not just finance. Businesses in almost every industry, from property to energy to healthcare to food, are starting pilot projects, joining consortiums and actively working trying to figure this thing out. They’re all worried that their survival may be at stake.
SWIFT, the global organisation that processes international payments, is about to complete a pilot project whose results will be validated by 22 other banks. TUI Group, the world’s largest tourism company, has started using a private blockchain to track internal contracts and are saying they’ll eventually manage all their information this way. Airbus is looking to use blockchain to monitor the many complex parts that come together to make a jet plane. Daimler is investigating similar possibilities for its vehicles.
Blockchain seems to be particularly useful for monitoring the movement of goods. Because every transaction goes onto the ledger, and because every node in the system keeps a copy of every transaction, it allows for instant access to information about a product’s source of origin and who handled it at every port. Maersk, the Danish shipping giant, has started testing a blockchain to track its shipments and coordinate with customs officials. Unilever, Walmart and Nestle have started collaborating on a project to drastically cut down the time it takes to pinpoint the source of foodborne illness. In Australia, PwC has teamed up with Blackmores and Alibaba, the Chinese tech giant, to create a blockchain to address food fraud risk in the supply chain for vitamins and baby formula.
Governments are finally getting their act into gear too. Columbia’s central bank has officially joined an international blockchain consortium, and the Russian government has announced plans to start building a combined blockchain and quantum computing research hub. The Bank of Japan and the European Central Bank have launched a joint blockchain research project, Vietnam’s prime minister just approved a plan to recognize bitcoin as a form of payment, a government agency in Brazil started investigating the use of blockchain to verify the legitimacy of ID documents, and the former CEO of South Africa’s central securities division recently quit her job and announced plans to enter the blockchain space full-time.
Hold on, not so fast
For every one of these stories, there’s hundreds of failures you don’t hear about. Companies are discovering that there’s a big difference between saying blockchain and doing something useful with it. In the finance industry in particular, it’s still very much a solution in search of a problem.
That’s because most efforts to date have focused on what are known as ‘permissioned’ blockchains where only authorized operators can participate. These are missing a crucial element: an incentive system for verification that’s explicitly designed to work in the absence of a central authority. To put this another way, permissioned blockchains only work because at some point, an executive entity decides that they’re something worth doing.
This is fundamentally different from the original vision of Satoshi Nakamoto, the creator of the first ever blockchain, and I would argue doesn’t actually count as blockchain at all. It’s just a different way of creating a database, using next-generation data structures with cryptographic signatures and joint stakeholder elements. It should be called what it really is — distributed ledger technology. Sure, it’s a noticeable improvement on the database systems we’ve had in place since the 1970s, but it’s not going to launch a thousand ships and bring the financial system to its knees.
This failure to call a spade a spade is why a lot of people call bullshit on the whole endeavour. My favourite blockchain sceptics are Pete Williams and Pete Evans-Greenwood, both at Deloitte, who have been doing a consistently excellent job at exposing the hype. And over in New York, I cannot recommend Matt Levine enough. His daily newsletter will teach you more about international finance in six months than you’ll learn in four years at university.
Another aspect of blockchain is sociological: Blockchains are cool. If you announce that you are updating the database software used by a consortium of banks to track derivatives trades, the New York Times will not write an article about it. If you say that you are blockchaining the blockchain software used by a blockchain of blockchains to blockchain blockchain blockchains, the New York Times will blockchain a blockchain about it.
Why I am not a sceptic
When it comes to the open-source, free-for-all ecosystems of the big global blockchains like Bitcoin and Ethereum, it’s a whole different ballgame. They’re not just larger, they’re categorically different.
- Their incentive mechanisms for verification are baked into the code itself, meaning they’re self-sustaining.
- They’re public, which means everyone gets access, from your grandmother to the barman at your local pub.
- Most importantly, they’re distributed, and run by their participants. The government and the banks do not run these systems and never will.
Digital on-ramps have now developed to the point at which most non-technical people can get involved. That’s why the space is exploding. The value of the entire crypto market has grown from $10 billion at the beginning of the year to almost $200 billion today. It’s not just Bitcoin and Ethereum anymore either. Litecoin, Zcash, Ripple, Monero and Steem all have solid developer communities behind them, and are rolling in cash. There are now too many vested interests and too many people sitting on newly minted fortunes, for this thing to go away.
The crypto geeks who started this whole thing are now all millionaires. If you’d bought $100 worth of ETH in May 2016, your investment would now be worth almost $3,000. And you would have already been late to the party… the original crowdfunding of Ethereum in mid 2014 started at 2,000 ETH per bitcoin. If you’re a geek who put in $100 back then, your investment would now be worth close to $140,000. In other words, the folks who build the code have all already given up their shitty sys admin day jobs, and have plenty of time on their hands to solve the next batch of problems.
So what is the next batch of problems? To answer that, let’s look a little more closely at what makes blockchain technology special.
Blockchains are NEW
Public, open-source blockchains have a few unique qualities.
The first is consensus. Blockchains create a world where parties to a shared piece of information know that the information they’re seeing is the same as the information that everybody else is seeing. In game theory terms, this eliminates information asymmetry, which in turn allows for better coordination on mutually beneficial outcomes. Consensus systems have of course existed for years, but what’s new about blockchains is that they allow it to happen at a mass, internet level scale, without the need for a centralised governance mechanism, and in spite of the opposition of powerful adversaries.
The second is that they’re tamper-proof. The brilliance of the code is that instead of stopping fraud through punishment, it stops it through incentives that ensure it’s not worth doing in the first place. Conflicted or false copies of the ledger are quickly eliminated through the sheer weight of the math involved in mining, and once the new ledger has been verified through consensus, the chain marches on, without the need for retrospectives. special; prosecutors or investigative committees. Once a transaction or a piece of code is confirmed, the information is immutable — there’s no way an individual or group of individuals can fudge it without taking over millions of computers simultaneously. And each new step going forward can only be valid if it builds upon the unchangeable body of previous activity.
The third feature is authentication. Each action that takes place on the blockchain is associated with a private key that belongs only to individual actors. Unlike traditional enterprise systems, there’s no such thing as administrator privileges. This gives blockchains far better security, something that everyone seems to overlook because of the technology’s early associations with the sale of illegal goods. In an age of massive data breaches and rampant global cybercrime, the timing could not be better.
The fourth, and most important thing about blockchains is that they are digital, which gives them a level of flexibility and dynamism that’s historically unprecedented. This might sound obvious, but it’s a feature that many people, especially in the finance industry, tend to miss. Blockchains are built using code, which means they don’t obey the same economic rules as physical commodities or money. You can build as many derivative instruments, or decrease your fractional reserve requirements as much as you like, but eventually you run up against physical real world constraints. Blockchains, which are the first truly digital form of exchange, don’t have that problem.
The other thing the finance crowd don’t seem to get is that the code is constantly being updated and improved. The problems are slowly but steadily being ironed out by the crypto crowd, who all have nice new houses and plenty of free time on their hands. Here for example, is a visualisation of the commits done on the code for Ethereum’s proposed Raiden Network up until four weeks ago (if you don’t know what that is don’t worry I’m about to explain).
So what are they working on?
The hype around what public blockchains can theoretically do (refugee payments, identity verification, supply chain, prediction markets, property transactions) compared to what they actually do right now (digital currency speculation) boils down to one issue: scalability.
We’ve reached the point where the main bottleneck is no longer a lack of interest, but the technology itself.
That’s because every computer in the network has to keep an up to date copy of every transaction. This is what gives public blockchains their greatest strengths: fault tolerance, a strong guarantee of security, political neutrality and authenticity. However it’s also slow because as the blockchain grows, the requirements for storage, bandwidth and compute power required by fully participating in the network increases.
There’s an inherent trade off. You have to choose either low transaction output, which allows you to maintain decentralisation and security, or high transaction input, which means you have to switch to a more centralised option.
Enterprise level blockchains, which I argued earlier should technically be called distributed ledgers, are centralised. They have a relatively small number of nodes which means they can process many transactions. The decentralised nature of the big, public, global blockchains on the other hand, means they have to run on millions of nodes, which is why they’ve hit a bottleneck. Ethereum can currently handle an average of about 5 transactions per second while Bitcoin, until recently, had a cap of about 7 transactions per second for small transactions and 3 per second for more complex transactions. Compare that to VISA, which averages around 2,000 transactions per second and has a peak capacity of up to 50,000, and you realise why the cynics say blockchain will never be a finance killer.
In Bitcoin’s case, the most obvious fix is to increase block size. More space, more transactions. Easy right? Not so fast. The problem is not technical but political, because there are now so many stakeholders that pleasing them all is impossible. This solution might make perfect sense to the core developers who maintain, update and improve the software, but it isn’t popular with the miners, who run it and secure the network; or the companies that run wallet services; or the end users who have to pay fees to submit transactions; or the large holders and evangelists who are still influential in the space.
To get round that impasse, the Bitcoin community has recently gone with the implementation of something called segregated witness, more commonly known as Segwit. This is where the transaction signatures, or ‘witnesses,’ are stripped off within the input and moved towards the end of a transaction. The code assigns heavier weights to the transaction data and less weight to the witness, meaning you can move more transactions through a block. That update went live in late August, and while adoption will take a while, it should eventually double the block size.
Meanwhile, the Ethereum crew are working on something called the Metropolis upgrade, which comes in two parts. The first part, called Byzantium, has a whole lot of small improvements to the code, which should improve privacy, increase security and allow blocks to be mined around 10 seconds faster. This update is currently scheduled for mid October. The second part, called Constantinople, doesn’t have a release date, but will further increase security and allow for greater flexibility in the programming of smart contracts.
Ultimately though, these solutions just kick the can down the road. In the long run, the big public blockchains don’t need 8X or 20X capacity upgrades. If they want to compete with existing global payment solutions they need 5000X or 10,000X upgrades.
To get there, one proposed solution is to take transactions off the main chain. Bitcoin is calling this the Lightning Network, while Ethereum has named theirs Raiden. These are like mini ledgers that branch off from the main blockchain, and whose activity occurs inside a black box. Many different parties can send funds between themselves inside that box by constructing and cryptographically signing transactions at huge volumes and at practically zero cost, with smart contracts ensuring the results are embedded back into the public blockchain for permanence and security. Not only would this create even greater potential capacity than VISA’s network, it paves the way for the long promised possibility of microtransactions, which would fundamentally alter the nature of all commerce on the internet.
By the way, if you want to really nerd out in this stuff then you need to be following Preethi Kasireddy. Formerly at Andreessen Horowitz and Goldman Sachs, she’s now a full time blockchain engineer and easily the best technical explainer I know of.
Proof of stake
The scaling solution you should really be keeping an eye out for is something called ‘proof of stake.’ To explain this you need to understand that current generation blockchains are secured by ‘proof of work,’ in which the group with the largest total computing power makes the decisions. These groups operate vast data centers to provide this security, in exchange for the currency specific to that particular blockchain. But it comes at a cost. The more difficult the problem, the longer it takes to solve, which means it takes more electricity to compute. Thus the reward costs time and money, and the bigger the blockchain gets, the slower it goes.
Proof of stake does away with this system. Instead of miners spending heavy computing power to solve a mathematical problem to reach consensus, all participating nodes place a bet on blocks. The nodes whose block is the honest block (i.e. contains no fraudulent transactions) get rewarded. The nodes whose block turns out to be dishonest get penalised; the amount of their bet gets debited from their balance. Placing bets doesn’t require high-performing computers and electricity. All a node needs to be eligible to get rewarded is some stake that it can place a bet with. The idea behind this method is, “whoever has the maximum stake in the blockchain must have the loudest voice.”
What’s interesting about this system is that it works in a very similar fashion to traditional financial instruments such as interest. Except unlike traditional interest, there’s no difference between the amount charged by the lender or the borrower. Everyone wins.
Fat and thin protocols
A disruptive technological medium tends to move a system from closed, to open, and then closed again. In the beginning, early adopters and hobbyists praise its decentralising and democratising force. Inevitably though, corporate power takes over and centralises control. Radio, for example, was initially a hobbyist’s paradise that gave everyone an equal voice, but eventually the airwaves were commercialised by stations. The early years of cinema, pioneered by lone filmmakers and small movie studios, gave way to the Hollywood behemoths. In its first decade, the internet looked like it was going to flatten all the middlemen, but instead it turned into walled gardens.
Blockchain is the latest chapter in that story. However, because of the way it works, it’s less susceptible to centralisation than the technologies that came before it.
To explain why, let me go back to something I mentioned in the beginning of this article — protocols.
The internet was created off two protocols, TCP/IP, which allowed computers to speak to each other, and HTTP, which allowed different pieces of text to link to each other. These protocols were designed as an open, common resource, and produced immeasurable amounts of value. However, instead of that value accruing to the public, most of it got captured and aggregated by giant companies (Google, Facebook, Amazon etc.) in the form of data. These companies cleverly used the underlying protocols to build their own, enormous layers of applications over the top. And now that the data is in their silos, they’re very unwilling to share it.
That means that the modern day internet is composed of a ‘thin’ protocol and a ‘fat’ application layer. Protocols, by default, are open, whereas companies, by default, are closed. And since most of the value created by the internet (and by us, its users) now resides in the private, application layer, we’ve ended up with a winner take all situation, as the giant tech companies take advantage of network effects to remain dominant.
Blockchain flips the equation
The layers of the big, global public blockchains that are currently being built are comparable to the early protocol layer of the internet.
However, unlike the internet, the replication and storage of user data happens across the protocol itself, via an open and decentralized network rather than via applications that control access to their separate silos of information. Because most of the data resides in the protocol itself, and since that protocol is a common resource, the private companies building in the applications layer get a much smaller fraction of the overall value.
The blockchain in other words, is the opposite of the internet. It has a fat protocol layer and a thin application layer.
This means that that barriers to entry for new players are way lower. Anyone can come along and take advantage of the blockchain’s data. It means a more vibrant and competitive ecosystem of products and services can get built on top. It also means that users can switch applications more easily. Instead of having to build hundreds of APIs to allow the data in walled gardens to migrate, every application has access to the same database.
Even more importantly, thanks to network effects, the value of the public, protocol layer increases at a greater rate than the applications layer on top. And the greater the value of the protocol, the more incentives there are to build new applications. In contrast to all the other technologies that came before it, a blockchain turns out to be less effective once it’s centralised or commercialised.
This is a big shift. The combination of a shared, open database with permissionless innovation and an incentive system that prevents winner-take-all markets is a total game changer.
That’s why you need to start thinking bigger than just currency, or payments. The blockchain is unprecedented. Once the code improves, and the scaling challenges are solved, we’re going to end up with a new, decentralised digital substrate for the global economy that belongs to all of us.
That’s why so many of us are so passionate about it.
Blockchain is more than a tool, or a currency, or a more efficient way to get things done.
It’s an ideology, a coherent philosophical approach to the kind of world we want to live in.
A world where our systems of exchange are truly global, where resources are more fairly distributed, and where the value of what we create resides in the hands of the many rather than the few.
In the immortal words of Bucky...