Recently we have been hearing a lot about Bitcoin and blockchain. What are they and what is the difference between the two?
The blockchain, sometimes called the ‘distributed ledger’, is a software model which creates a new way of storing, allocating and interacting with digital assets, such as digital currencies, smart property or coupons, in a secure manner. In principle, one can imagine it as a distributed peer to peer (P2P) network, like torrents, but with public key cryptography capabilities to secure and authenticate content.
Bitcoin is probably the most popular application that makes use of this technology. It is essentially digital money in which computational techniques, typically referred as mining, rather than central banks, are used to regulate the generation of units of currency and verify the transfer of funds. There are many other cryptocurrencies which are similar, however Bitcoin is by far the most popular. Cryptocurrencies form the first wave of blockchain technology applications, known as Blockchain 1.0.
The technology is not, however, limited to just cryptocurrencies, but it provides a new technical model that acts as a seamless layer along the traditional web, providing an infrastructure for payments, token earning and spending, digital asset registration and transfer, and smart contract issuance and enforcement.
In my opinion, this application of the technology can lead to more groundbreaking innovation than cryptocurrencies. This gave rise to Blockchain 2.0, which focuses mainly on contract applications, used in areas like stocks, bonds, derivatives and smart property.
More recently, we are seeing the Blockchain 3.0 wave, which extends the idea of distributed applications and embraces wider adoption particularly in the areas of government, healthcare, transportation and energy, to name a few.
When compared to other technologies, what are the key differences and benefits that blockchain technology can bring about?
The blockchain technology saw its origins in a paper published in 2008 by Satoshi Nakamoto, a pseudonymous name and no one really knows who the person is. Rather than a new technology per se, it is mostly an innovative way of how existing technologies are combined to implement solutions in a decentralised fashion. To bring things into perspective, firstly one must remember that during that period the world was enduring the worst financial crisis, which as a result raised serious concerns on the financial system and authorities. Secondly, I feel that sometimes I read articles that are mostly driven by hype rather than feasible technical and economical reasoning. It is important to state that blockchain is not a technology that is intended to replace all existing technologies, however it does provide several features that present a solution to a number of problems.
Satoshi’s original vision was driven by the idea of creating more efficient systems that require minimal trust, meaning that it allows people, or machines/software programmes, to exchange value between each other securely without the need of costly controlling intermediaries. The aim is hence to reduce the dependency, and therefore the uncertainty, on intermediaries in the processing of transactions.
This also brings about less risk because of possible fraud or irregular manoeuvres. For example, with existing approaches, if one needs to pass a payment to a third party his transaction typically needs to pass through many intermediaries such as payment gateways, card processing services, banks and interbank networks.
The more intermediaries typically mean higher transaction fees. By proposing a solution that encourages less intermediaries, a transaction has less friction, resulting in more efficiency and a reduction in fees. For example, in the cryptocurrency world, if person A needs to transfer funds to person B, person A just needs to have one of the public addresses linked to person B and transfers the funds accordingly. No intermediary is involved and the transaction is immediately and permanently logged on the blockchain.
The idea of using the blockchain technology for smart contracts is to create a technical platform to formalise and secure relationships that are typically governed by manual legal contracts. In simple terms, a smart contract can be described as a computer programme that can define and enforce agreement clauses and obligations. For example, a smart contract can automatically calculate and distribute royalty payments to artists when someone downloads music according to conditions specified in the contract.
There are many other cryptocurrencies, however Bitcoin is by far the most popular
A smart contract can be devised to calculate and pay periodic coupon payments and return principal upon bond expiration. A car leasing company can apply a smart contract to manage charging based on car usage policies that can be communicated by the car sensors. Can these be implemented using existing technologies? Yes, they can, however the blockchain technology provides a neater technical approach that is innately secure, efficient, easily verifiable and transparent.
Another aspect is robustness. One can imagine the blockchain network as a mesh of computer nodes, like P2P networks. A copy of the blockchain, or ledger, exists on all the nodes. Being distributed, it provides built-in redundancy and has no single point of failure.
How can one obtain Bitcoins?
Typically, one can buy Bitcoins from a Bitcoin exchange. If one searches on the internet one can find many of them. Normally, this also involves going through a Know-Your-Customer process. Alternatively, one can earn bitcoins by participating in what is called the mining process. This involves using computational techniques that can help the network to validate and process transactions on the blockchain.
Although there are different mining approaches, in the case of Bitcoin, node earnings from mining are proportional to the ratio between the dedicated computational power of a specific node and the overall computational power of all the nodes. Since this process is computationally intensive, it is very difficult to earn money this way unless one purchases special hardware that is built specifically for this task, rather than normal computers. Another method is to participate in what are called pools, which are groups of computers that together participate in solving a computational problem and then benefit from shared earnings.
Who controls the blockchain network?
No formal body controls the blockchain technology or else, to provide a more specific example, the bitcoin network. Bitcoin is controlled by Bitcoin nodes across a decentralised network around the world and can only work correctly by reaching a majority consensus, programmatically, across these nodes. Hence, it cannot be controlled by any single entity. Thousands of distributed nodes on the network collaborate to verify the transactions, group them into blocks, and finally add them to the blockchain, a copy of which is kept synchronised on each node.
This means that there is no physical intermediary in the traditional sense, like banks, controlling the validity of transactions, but this is done computationally in a decentralised fashion. One can imagine this as a self-auditing ecosystem.
In addition, one has to mention two important blockchain properties, transparency, because by definition all blockchain activity is securely logged and in many cases public, and the fact that it cannot be altered.
From an investment perspective, is it risky to invest in cryptocurrencies such as Bitcoin?
It is not my intention to offer financial advice, so I will try to stick to current facts. Traditional currencies such as the euro, called fiat currencies, are technically backed by the governmental institutions or central banks. Currently, many countries do not offer this level of backing for cryptocurrencies, including Malta. Nonetheless, governments are having to turn their attention to the digital currency to see what it’s worth, and whether it can be used. This level of government backing might be more difficult to achieve at a country level due to economic or political unions to which they pertain, such as the EU.
As an example, the European Central Bank recently rejected the idea that Estonia, which is part of the eurozone, could issue and manage its own State-backed cryptocurrency. That does not imply that cryptocurrencies cannot be used by citizens in the country but that they would lack the government or central bank backing, hence merchants are not obliged by law to accept the specific cryptocurrency as a method of payment for the provision of goods or services.
Additionally, cryptocurrencies’ level of volatility is very high, meaning that their value is experiencing wide fluctuations. This may be an opportunity for high profits, however, and this is important. This also makes cryptocurrencies susceptible to huge losses in value. So, an investor must appreciate that in comparison to other financial assets, cryptocurrencies are at the moment very risky. Some analysts even extend this to a possible bubble that at some point might collapse. That being said, an educated investor might be interested in cryptocurrencies as part of a wider investments portfolio which also includes a mix of more traditional financial assets.
What are the main challenges ahead for wider adoption?
There are still several challenges. Firstly, from a technical perspective there are still a number of areas, like throughput, latency, interoperability, wasted resources for mining and hard forks that pose challenges. The technology is still evolving at a very rapid pace and a lot of research is being conducted by a wide community of technical experts globally. Secondly, the technology needs to be supported by governments and legal frameworks.
Bridging the legal and technical perspectives is not an easy feat and the wider adoption of both cryptocurrencies and blockchain applications, such as smart contracts, demands a harmonisation of both realms. A simple example is defining, in a legally binding manner, how manual contracts and smart contracts can co-exist, replace or complement each other. In this area, I remember that back in 2006, Malta went through a similar experience when the MFSA adopted digitally signed documents as legally binding documents within the Registry of Companies.
Malta was at the time one of the first in the EU region to adopt such an approach. If blockchain needs to be adopted to automate and enforce legally binding agreements then a similar legal and technical harmonisation needs to happen in this regard, depending on the specific use case. Other regulatory aspects around anti-money laundering, know-your-customer processes, taxation structures and initial coin offerings need to be clearly positioned.
In my view, even though cryptocurrencies and blockchain technology still pose a number of challenges, I believe that the investment that is happening in the area, including the participation by the major global IT players, the attention being received by bodies like the IMF and ESMA, and the activity happening in a number of countries such as Estonia, Denmark, Norway, Australia, US and Sweden will definitely not be futile. In addition, we are experiencing other parallel trends such as Internet of Things and Artificial Intelligence for which blockchain technology can offer a supportive role.
In conclusion, at the moment there is a wide consensus on the possibilities of blockchain technology around smart contracts and distributed applications. I believe that in its current form or in an improved state, the paradigm around decentralised models will continue to evolve and increase in adoption. Questions and disputes around the future of cryptocurrencies are stronger at this stage.
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