Bitcoin’s dynamite year doesn’t mean banks are doomed.

‘Bitcoin accepted’ sign in the window of Kafi Schoffel, a coffee bar in Zurich that accepts Bitcoin as a means of payment and houses a Bitcoin ATM. Zurich, Switzerland, January 2, 2015. thamerpic/iStock

By Ron Leung | September 26, 2017

It has been an incredible year for Bitcoin and cryptocurrencies. The price of Bitcoin increased from $963 at the beginning of 2017 to more than $4,300 by August, an annualised return of 540%. Bitcoin’s growth in the past five years has been equally incredible: If you invested $2,000 in 2012, your bitcoins would be valued at over $1m today. Its market capitalisation – the value of all Bitcoins in circulation – stands at $75bn.

Meanwhile, cryptocurrencies have grown beyond Bitcoins to a large universe of altcoins, as they are collectively called, which purport to be superior alternatives. For instance, Ethereum is an altcoin that claims to enable smart contracts and a “world computer” that can build corporations as decentralised autonomous organisations on their platform. The altcoins’ growth trajectory is even steeper than that of Bitcoin. At the beginning of 2015, there were 10 cryptocurrencies with a market cap of more than $10m each, and collective market cap of almost $900m. Today, there are 14 altcoins each with a market cap over $900m, and the market cap of the top 10 altcoins is $70bn. An index fund of the top altcoins would have earned an annualised return of 510% over the past three years, and orders of magnitude higher than the major stock indices.

Given the financial returns and an aggregate market cap of more than $150bn, the recent flood of news and interest in cryptocurrencies is unsurprising. However, what are the technologies underlying their core magic?

The power of blockchain

Alongside proof of work and public key infrastructure, blockchain creates a public ledger with an immutable history of transactions that is proof against cheaters, fakers, and hackers. Malicious market participants cannot rewrite history transactions (i.e. immutable history), cannot fake illegitimate transactions (e.g. successfully pretend to be you), and all participants can read this history (i.e. it is public). Hence, it is evident why cryptocurrencies have become as useful as transactional currencies.

Moreover, it is easy to see how they solve a challenge many of us face each day as we wait for financial transfers to clear, whether it be a payment or an international remittance, and the attendant transaction fees and compliance costs. In fact, much of the fees and costs reflect the resources deployed by banks, payment processors, and credit agencies to manage and maintain this complex web of trust and authentication. Furthermore, it is obvious this complexity has flaws, with fraud continuing to be a serious problem and 2bn unbanked people being excluded from the system.

Future according to crypto-evangelists

Crypto-evangelists see great potential in cryptocurrencies. Blockchain technology resolves many of the pain points customers experience in banking, such as making transfers or providing identification and documentation. Moreover, the crypto-evangelists argue blockchain and altcoins can address many of the ills of capitalism, such as lack of access to the legal system. This unequal access puts individuals and small businesses at a severe disadvantage against corporations and governments in disputes and contract enforcement. But altcoins such as Ethereum can, in principle, solve this asymmetry by building the contract into code for execution. In this, many crypto-evangelists speak in euphoric tones of a post-currency, post-bank, or post-corporate economy. Increasingly, these evangelists include central bankers.   

Bitcoin Price, 2012-17

Bitcoin Price, 2012-17

Source: Coinbase, 2017

Trust and authentication technologies

A financial system is much more than retail banking. It involves more than just providing checking accounts and credit cards to consumers. In particular, much of the value add is generated in other areas, such as asset management, investment banking, and capital markets. These activities allow banks and other financial institutions, such as insurance companies and stock exchanges, to monitor and price risk, reallocate and redistribute risk across market participants, and channel money from savers to borrowers and back. These are not activities that have been seriously considered or challenged by the crypto-evangelists.

Crypto naivety

Most reports on the activities of the crypto-evangelists demonstrate an ignorance of the functions of the financial system. One illustrative example is provided in the white paper on Ethereum. The authors cite the case of a smart contract that proposes to replace a currency swap, demonstrating their misunderstanding of form over substance. To guarantee payment, the “invested” funds must be kept in escrow on blockchain, and thereby unavailable for any use. This undermines the objective of any currency swap, which is not to tie up resources until they become available at some future date. For instance, company A receives payments for its services in US dollars, but is based in Indonesia, and needs to pay its bills and staff in local currency. It will purchase a contract of a series of dollar-rupiah swaps and will typically not have the requisite US dollars until the swap dates.

We look beyond the crypto-evangelists for inspiration on the possibilities of blockchain, and it is the very big corporations and banks the evangelists are seeking to disrupt.

Enter Hyperledger

Many of major technology companies such as Microsoft, Amazon, and IBM are working with leading banks around the world to build alternative blockchains. One example is Hyperledger. Around this core, companies have developed Hyperledger Fabric, which is a business blockchain framework for developing applications with a modular architecture. Many of the vast array of altcoin features (e.g. smart contracts) are available and can be selected and plugged into the Hyperledger blockchain.

In this, Hyperledger is designed to remove much of the costs associated with complex systems due to trust and identity requirements, while mitigating two of the main limitations facing altcoins – a limitation on the volume of transactions blockchain can handle and huge energy consumption in the proof of work. This has many transformative applications.

Hyperledger and alt-chains

Hyperledger is the centrepiece of an open-source blockchain ecosystem whose innovations are likely to disrupt the altcoins while transforming all the components of a modern global economy that are connected by trust and identity.

The financial applications are obvious. For instance, leading technology companies and banks have formed the Enterprise Ethereum Alliance, which will create a standard version of Ethereum that businesses around the world can use to track data and financial contracts. Small businesses face enormous friction with payments and trade finance. In 2017, the global average cost for such payments was about 7.4%. Using the SWIFT network owned by the international banks remains the most expensive way of sending money around the world, with the cost averaging 11%. This is an enormous cost to authenticate small and medium companies engaged in international trade.   

However, the applications of blockchain go much further. One major use is in provenance and record of ownership and origins, which has applications for all modern supply chains with a complex logistical hierarchy. Consider the problem of vehicle maintenance and management. Today, it is costly to trace the origin and movement of parts through a complex supply chain (e.g. manufacturer, components, and original sources of the parts that make up a vehicle). Blockchain allows all members of the supply chain to track movement in a common, transparent, and accessible way, enabling much quicker forensics in case of a recall. There is increased trust through tamper-proof records instead of the ad hoc databases and documentation of smaller sub-contractors. This is the objective of a pilot between IBM and Maersk.

The crypto-evangelists are correct in saying blockchain will enable new business models. While these models will definitely be transformative in the near future, this does not necessarily mean we are on the verge of a post-bank, post-corporate world.

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