New Cryptocurrencies, Same Old Problems
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Strategy Finance & Accounting Feb 2, 2018

New Cryp­tocur­ren­cies, Same Old Problems

Why we won’t see a Bit­coin takeover any time soon.

Cryptocurrency miners mine for cryptocurrencies.

Michael Meier

Based on insights from

Sarit Markovich

Recent­ly there has been an explo­sion of glob­al inter­est in blockchain, the dis­trib­uted ledger tech­nol­o­gy at the heart of cryp­tocur­ren­cies like Bit­coin and Ethereum. Pro­po­nents see blockchain’s impact even­tu­al­ly stretch­ing beyond Bit­coin to real estate and sup­ply chains. But most of the cur­rent hype is in finance and bank­ing, with some pre­dict­ing this new method of trans­fer­ring and record­ing assets will democ­ra­tize” the industry. 

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And the­o­ret­i­cal­ly, it could. The pub­lic ledger sys­tem pio­neered by cryp­tocur­ren­cies — decen­tral­ized, trans­par­ent, and acces­si­ble to any­one — is designed to empow­er indi­vid­u­als who would oth­er­wise be at the mer­cy of large banks and cen­tral governments. 

But is that the direc­tion blockchain is heading? 

Not nec­es­sar­i­ly, accord­ing to Sar­it Markovich, a clin­i­cal asso­ciate pro­fes­sor of strat­e­gy at the Kel­logg School and an expert on fin­tech innovation. 

There are cer­tain­ly huge advan­tages to blockchain tech­nol­o­gy, espe­cial­ly when it comes to cross-bor­der trans­ac­tions,” Markovich says. But I doubt we’re going to reach the point where decen­tral­ized cryp­tocur­ren­cies replace cash or dis­trib­uted ledgers replace cen­tral banks. There’s too much room for manip­u­la­tion. Instead, it looks like the real inno­va­tion will occur with­in large insti­tu­tions, which is not exact­ly democratization.” 

New Cur­ren­cies, Old Problems

The appeal of decen­tral­ized cryp­tocur­ren­cies is that they are run by indi­vid­u­als in a trans­par­ent mar­ket­place, with no cen­tral bank to print mon­ey (or manip­u­late rates), and no finan­cial insti­tu­tion to col­lect its cut in fees. Ide­al­ly, this low­ers access bar­ri­ers and helps rid the finan­cial sys­tem of cor­rupt or monop­o­liz­ing forces. 

But the evo­lu­tion of cryp­tocur­ren­cies has shown that these dig­i­tal net­works are vul­ner­a­ble to some of the same prob­lems all finan­cial mar­kets face, includ­ing price manip­u­la­tion, insid­er trad­ing, and lack of trust in the system. 

Con­sid­er the case of Bit­coin. At first, any­one who joined the net­work could mine” for bit­coins by using soft­ware to solve com­plex math­e­mat­i­cal puz­zles. Solv­ing these puz­zles cre­at­ed coins” (the Bit­coin network’s equiv­a­lent of print­ing paper mon­ey), which the min­er could keep or sell. Ini­tial­ly, the reward for solv­ing one of these puz­zles was 50 bit­coins; it is now 12.5 (the reward was designed to be cut in half after every 210,000 blocks mined and, even­tu­al­ly, be reduced to zero after 64 halv­ing events). 

But over time, groups of min­ers com­bined their pro­cess­ing pow­er and began to dom­i­nate the net­work. These min­ing pools” have tend­ed to crop up in places where cheap ener­gy and hard­ware makes it pos­si­ble to run min­ing soft­ware on hun­dreds of machines in large ware­hous­es, great­ly improv­ing the odds of suc­cess — as of Sep­tem­ber 2017, more than two-thirds of bit­coins were mined in Chi­na. That meant bit­coins were being mined more quick­ly than expect­ed, and in a way that con­cen­trat­ed pow­er in the hands of a few ear­ly movers. 

In addi­tion to min­ing pools,” there is also the prob­lem of whales”: rough­ly 1,000 peo­ple own around 40 per­cent of all bit­coins. As the mar­ket con­tin­ues to rise, there is a risk that some may be in a posi­tion to manip­u­late the mar­ket. For exam­ple, they could col­lude in an effort to dri­ve the price of Bit­coin up, then cash out all at once — and per­haps even bet against the futures market. 

Essen­tial­ly, you would have some­thing that looks a lot like insid­er trad­ing,” Markovich says. And there’s no reg­u­la­tion to stop it.” 

One oth­er issue is that under the cur­rent sys­tem, Bit­coin users can get pri­or­i­ty on the net­work by adding a fee to their trans­ac­tions, there­by incen­tiviz­ing min­ers to add their trans­ac­tions to the blockchain before any oth­ers. And since the num­ber of bit­coins was always meant to be capped at 21 mil­lion — a cap observers think the net­work may reach soon­er than expect­ed — the net­work will even­tu­al­ly move to a fee-based mod­el. This could threat­en the blockchain’s secu­ri­ty, because, with so many min­ers, fees would be low, and many would like­ly exit the mar­ket, result­ing in con­ges­tion until the min­ing fees increased enough to attract those min­ers back to the net­work. Such cycles of excess sup­ply or demand make Bit­coin an unre­li­able, unat­trac­tive pay­ment system. 

I doubt we’re going to reach the point where decen­tral­ized cryp­tocur­ren­cies replace cash or dis­trib­uted ledgers replace cen­tral banks.”

These kinks in the sys­tem point towards what is per­haps a more fun­da­men­tal prob­lem with using a pub­lic ledger: with­out a cen­tral author­i­ty, it can be dif­fi­cult to set­tle dis­putes. The Bit­coin com­mu­ni­ty nev­er com­plete­ly agreed on how to scale its net­work, and even­tu­al­ly, this dis­agree­ment led to what is known as a hard fork” in the blockchain. In August, one group — wor­ried that Bit­coin trans­ac­tions had become too expen­sive and too slow — branched off and cre­at­ed a sep­a­rate cryp­tocur­ren­cy, Bit­coin Cash. 

The only way to reg­u­late a democ­ra­tized cur­ren­cy is to reach agree­ment among the com­mu­ni­ty,” Markovich says, but there’s not real­ly a mech­a­nism to do that, so it’s not exact­ly demo­c­ra­t­ic, or not sus­tain­ably so. If enough peo­ple want to make a change, they just fork the chain or intro­duce a new currency.” 

So although the idea behind democ­ra­tized cryp­tocur­ren­cies is to decen­tral­ize pow­er and make trans­ac­tions more secure, the case of Bit­coin sug­gests that there will always be some on the net­work who (thanks to exper­tise, high­er capac­i­ty, or strong incen­tives to max­i­mize their returns) can accu­mu­late pow­er and manip­u­late the sys­tem in their favor. 

A Reg­u­la­to­ry Headache

Bit­coin, of course, is only one exam­ple of how blockchain can work, and few are pre­dict­ing that it will become the cur­ren­cy of the future. But the spread of cryp­tocur­ren­cies does raise the ques­tion of blockchain’s stability. 

As a dis­trib­uted ledger that keeps an auto­mat­ic, immutable record, it is the­o­ret­i­cal­ly a secure method for track­ing assets. But the sys­tem is not with­out its skep­tics. The Finan­cial Sta­bil­i­ty Over­sight Coun­cil, a U.S. gov­ern­ment body, warned about blockchain tech­nolo­gies in its 2016 annu­al report, cit­ing the poten­tial for fraud and the chal­lenge of deal­ing with mul­ti­ple reg­u­la­to­ry juris­dic­tions. And in Sep­tem­ber 2017, Chi­na announced that it was ban­ning ini­tial coin offer­ings (ICOs), a pop­u­lar fundrais­ing method for star­tups using dig­i­tal currency. 

The sharp rise in Bitcoin’s price — from $1,000 in Jan­u­ary to near­ly $20,000 in mid-Decem­ber — has fueled reg­u­la­tors’ con­cerns. And with so much mon­ey now at stake, investors fear the blockchain could be vul­ner­a­ble to hacks. 

Some­one in the U.S. might think such cur­ren­cies are too volatile, where­as some­one in a dif­fer­ent part of the world might say, Well, it’s less volatile than my own nation­al currency.’” 

Markovich does not view hack­ing as the pri­ma­ry issue — any open-access soft­ware is vul­ner­a­ble to hacks. The real issue, as she sees it, is con­tain­ing the network’s dam­age if things start to go wrong. 

We saw how dif­fi­cult it was to con­tain the glob­al cri­sis in 2008,” she says. This could also be a prob­lem for blockchain, in the sense that one can’t lim­it it to a sin­gle geo­graph­ic area.” 

Adding to the chal­lenge is the fact that atti­tudes towards cryp­tocur­ren­cies vary accord­ing to people’s trust in cen­tral­ized institutions. 

Some­one in the U.S. might think such cur­ren­cies are too volatile, where­as some­one in a dif­fer­ent part of the world might say, Well, it’s less volatile than my own nation­al cur­ren­cy, and I don’t trust my cen­tral bank.’” 

Reg­u­la­tors, too, might view the threat dif­fer­ent­ly, depend­ing on the region or nation. Some still con­sid­er the tech­nol­o­gy as a tool for crim­i­nals on the dark web; oth­ers see it as the next Inter­net. But even if most coun­tries decid­ed to ban cer­tain uses of blockchain tech­nol­o­gy, there is no guar­an­tee that a pop­u­lar net­work would not con­tin­ue to spread. Bit­Fly­er, a Japan­ese exchange, appears to have been a major source of the recent price surge. 

As long as one reg­u­la­to­ry body allows it, it’s poten­tial­ly open to every­one,” Markovich says. 

Effi­cien­cy, Not Democracy

So if cryp­tocur­ren­cies are too decen­tral­ized to be effec­tive­ly reg­u­lat­ed, at least for the time being, where might this dis­trib­uted ledger tech­nol­o­gy have the biggest impact? 

Markovich says we are more like­ly to see the rise of pri­vate blockchains with­in large orga­ni­za­tions — sys­tems that might be anal­o­gous to a com­pa­ny-wide intranet. For exam­ple, Maer­sk is using blockchain tech­nol­o­gy to man­age its ship­ments, Airbnb is using it to authen­ti­cate the iden­ti­ty of its mem­bers, and IBM is exper­i­ment­ing with the use of dig­i­tal cur­ren­cy for glob­al mon­ey transfers. 

But the great­est com­mit­ment is com­ing from banks. JPMor­gan Chase has cre­at­ed its own pri­vate blockchain plat­form, known as Quo­rum, and a num­ber of blockchain star­tups are build­ing plat­forms designed to help banks con­duct trans­ac­tions on a dis­trib­uted ledger. Rely­ing on this com­mon ledger instead of a third par­ty saves both sides time and money. 

We’re see­ing an inter­est from big banks, as well as sup­ply chain and real estate com­pa­nies, because the real val­ue of a dis­trib­uted ledger is the effi­cient, trust­wor­thy record of trans­ac­tions between coun­ter­parts,” Markovich says. 

One of the most com­pet­i­tive fields is that of cross-bor­der pay­ments. Rip­ple, found­ed in 2012, is just one of a grow­ing num­ber of firms help­ing busi­ness­es trans­fer mon­ey glob­al­ly at low cost using its own cryp­tocur­ren­cy, XRP. (In late 2017, XRP rose to become the sec­ond most pop­u­lar cryp­tocur­ren­cy by mar­ket cap). Among Ripple’s many cus­tomers are Stan­dard Char­tered and Bank of America. 

Inter­est is also spread­ing quick­ly in cap­i­tal mar­kets around the world. Australia’s pri­ma­ry stock exchange is already exper­i­ment­ing with blockchain tech­nol­o­gy, and late last year the cen­tral banks of Hong Kong and Sin­ga­pore announced plans to incor­po­rate blockchain into trad­ing plat­forms — to reduce fraud, errors, and costs. 

But even if blockchain becomes the new stan­dard for all finan­cial exchange, it seems unlike­ly to be demo­c­ra­t­ic.”

It’s cer­tain­ly going to add val­ue, but it won’t be the answer to everything.” 

About the Writer

Drew Calvert is a freelance writer based in Houston, Texas.

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