Quick notes on Sidechains “Elements”

I’ve written a lot recently about the potential of replicated, shared ledgers that are private/semi-private. For example, I suggested that industries with duplicated systems across firms might get benefit from adopting this technology.  But I also keep an eye on what’s happening in the Bitcoin world.  So the BlockstreamElements” launch caught my attention this week.

I wrote about the idea behind sidechains late last year and so it’s interesting to see parts of the vision turn into real code. Back then, I said that a way to think about this is as a system that lets you “move” bitcoins from the Bitcoin blockchain onto another bitcoin-like system and back again in a way that doesn’t harm the Bitcoin network and doesn’t require you to trust a central entity like a Bitcoin exchange.

Why would you want to do that?

  • First, it could be a good way to prototype proposed changes to the core Bitcoin protocol with lower risk: the change could first be implemented and tested on a sidechain, a relatively safe environment. And, should the new system work well, those who needed the feature could transfer their coins to that sidechain, knowing they could bring them back again in the future.
  • Secondly, and looking further ahead, this approach could also provide a migration path for existing bitcoin holders to a new version of the network – offering an alternative to a hard-fork.

It’s an attractive idea and one can intuitively sense why it could be valuable. Of course, the idea is not perfect. Developers such as Peter Todd, have argued that sidechains would be vulnerable to attack under various circumstances. But, leaving that to one side for now, what was announced this week and what does it mean?

Sidechains Announcement

What follows is deliberately brief in order to share thoughts quickly:

  • A sidechain is now up and running and accessible from the Bitcoin testnet.
  • The sidechain can be thought of as “just like Bitcoin” (or just like Bitcoin testnet) but with several additional features, or “elements”.
  • These elements include features such as “confidential transactions” and “relative locktime” (full details here and I explore two in a little more detail below)
  • A mechanism for moving coins to and from the sidechain is up and running… but this mechanism currently relies on a network of semi-trusted oracles, or “functionaries”, to validate the return of coins to testnet. This is because the necessary changes to enable this in a decentralized fashion do not yet exist in Bitcoin and one should remember there is no guarantee such a change would ever happen
  • The sidechain is also currently secured by this network of functionaries”. I understand this is a temporary situation but one could argue it means the distinction between permissioned and permissionless ledgers could be becoming somewhat blurred. Preston Byrne of Eris Industries has said something similar.
  • The code is open source so other people could set up their own sidechains and run their own functionaries.
  • In what I think could be a smart move for gaining mindshare, blockstream have signed up several universities with Bitcoin projects/programmes, such as MIT and Princeton to run these “functionaries”.

Elements

The individual features being explored initially have been called “Elements

Of particular interest to my readers might be Confidential Transactions and Issued Assets.

Issued Assets is an attempt to add support for Colored Coins-style assets to the core protocol. This is the one feature that is not yet deployed to the sidechain but it is also one of the most intriguing. I’ll be watching for comment from those projects in the coming days.

Confidential Transactions are a very clever application of cryptography to hide the value of transactions whilst still allowing them to be fully validated by the network. If this works well, it could be a partial solution to the confidentiality issue faced by Replicated, Shared Ledgers.

The fundamental characteristic of these systems – both permissioned and permissionless – is that multiple copies of the ledger are maintained and that these copies are widely distributed. Without features like Confidential Transactions (or related technology such as ZeroCoin or ZeroCash), these systems may be  unsuitable for those with confidentiality and privacy requirements. Do you want everybody in the network knowing your positions?

Based on what I’ve read so far, I’m not sure this is a full solution – financial firms care about more than just the value of transactions – but it’s a good start.

Next Steps

The test for me in coming weeks will be the extent to which non-Blockstream developers engage with this and other sidechains. I’ll also be paying particular attention to the Bitcoin Dev mailing list to see if any debate begins about making changes to the core protocol to allow decentralised pegging to work directly.   [Update 2015-06-11 to correct pegging terminology. Thanks to joeykrug for the correction]

Towards a Unified Model for Replicated, Shared Ledgers

Don’t Say The “B Word”!

I’ve come to the conclusion that saying “blockchain” has become unhelpful. It just confuses people. It means too many different things to different people and so it’s almost impossible to have a conversation in this space without talking past each other. So, as I argued in this piece on permissionless ledgers and this piece on permissioned ledgers, it can be useful to talk in terms of replicated shared ledgerssince I think this gets to the heart of what unifies – and separates – these two worlds.

  • Shared: because multiple actors can read or write to different parts of the ledger
  • Replicated: because everybody who needs a copy can have a copy, rather than relying on a powerful central entity

In this piece, I try to bring it all together – to explain why we should be thinking about permissionless ledgers as a classic example of disruptive innovation and how I think banks could think about permissioned ledgers in the interim.

In what follows, I build up the model below from its constituent parts:

RSL5

A unified model of permissioned and permissionless ledgers?

Permissionless Ledgers: Censorship Resistance

Let’s be clear: the breakthrough of Bitcoin was to create the closest system yet of “digital cash” – something that you can own outright and transfer to anybody else without permission. Its design flows naturally from that objective:

RSL1

Bitcoin’s design follows directly from its objectives. Its replicated, shared ledger is designed to enable the existence of a censorship-resistant digital bearer asset  

As I argued here, it’s little surprise that bankers and regulators look at it with deep suspicion! However, there’s a good reason why the smart observers aren’t dismissing it: censorship resistance implies an open, neutral platform that could be a driver of permissionless innovation:

RSL2

Censorship-resistance enables permissionless innovation in digital ownership  

So, it’s not a surprise that we’re seeing innovation and experimentation in the fields of value transfer – such as micro-micro payments (nanopayments?) for video content – and in the recording and execution of agreements.   This is, almost but not entirely, exclusively being driven by people from outside the traditional financial sector. They’re taking a platform that is, in most meaningful ways, slower and more expensive than today’s financial system and using it for novel purposes.

I think the smart firms are keeping an eye on this because they know how stories like this end:

“Disruptive innovations usually find their first customers at the bottom of the market: as unproved, often unpolished, products, they cannot command a high price. Incumbents are often complacent, slow to recognise the threat that their inferior competitors pose. But as successive refinements improve them to the point that they start to steal customers, they may end up reshaping entire industries” (The Economist)

Permissioned Ledgers: Industry-Level Systems of Record  

Notwithstanding the promise – or threat – of permissionless systems, I sense that many financial firms are looking closely at permissioned systems, by which I mean technologies that allow multiple firms to run a private, shared ledger of some sort.   What most people fail to ask is: why?! If you don’t have censorship-resistance as your business objective, why are you looking at this space at all?

The answer, I argued, in this piece is that replicated, shared ledgers can also solve a different problem:   if you’re in an industry where multiple firms all run similar systems to keep track of records (account balances? derivatives positions? orders?) then you’re probably carrying cost you don’t need: everybody is paying to maintain these duplicated, non-differentiating systems. And, because they’re all slightly different, you need to reconcile them with each other all the time to make sure they agree.

So the argument for applying replicated, shared ledger technology to this problem is that you could mutualise the cost of running and securing a single logical ledger, copied across your firms so you each have your own copy and so aren’t reliant on a powerful central entity for access. So nothing to do with censorship-resistance and nothing to do with cryptocurrencies.   The idea, instead, is to move from each firm having its own systems of record to having systems of record at the level of the industry:

RSL3

Is the promise of permissioned ledger the possibility of industry-level systems of record without a powerful central gatekeeper?

But we can take this thought-process further. Imagine such a platform existed: perhaps a replicated shared ledger that recorded all inter-bank balances or recorded all derivatives positions between firms.   What we would effectively have is a transaction processing system for that industry: if we all agree that this shared ledger is authoritative for records (e.g. who owes what to whom) then could we not also agree that this ledger is something to which we could deploy code that describes our agreements? Could this industry-level ledger also host inter-firm business logic? How much cost and complexity might that remove from firms?

RSL4

Is a common ledger between firms the enabler for a common transaction processing platform for an industry?

And this is where, I think, the two worlds – those of permissioned and permissionless ledgers – come back together:

Unifying the worlds of permissionless and permissioned ledgers

In the permissionless world, some of the most interesting developments are happening at the level of transaction scripting and smart contracts. The Ethereum project is the most obvious example, of course, but even projects like Streamium are showing how Bitcoin features can be used to create interaction models that simply aren’t possible on today’s financial platforms.

Similarly, and as I argued above, the driver of innovation on permissioned ledgers might be the migration of inter-firm business logic from individual firms to a shared ledger between firms: think of code that represents an agreement between two firms, that executes “on” a ledger, which can take custody of assets on that ledger and execute in response to external events: if both firms have signed it off in advance, suddenly they don’t need all the cost and expense of their own systems.  I wrote about this idea in my piece on smart contracts.

So we see that the two worlds of replicated, shard ledgers – permissioned and permissionless – might actually be leading us to the same place: a world where business logic for money – automated fiduciary code, if you like – is deployed to a shared ledger and run autonomously.    

RSL5

Perhaps the permissioned and permissionless worlds aren’t as different as they seem?    

Blockchain is where banks have the most obvious opportunity. But you ignore Bitcoin at your peril

Nasdaq’s recent announcement shows you need a strategy for both

I have argued for some time that the world of “blockchains” is actually two worlds: the permissionless world of “bitcoin-like systems” and the permissioned world of “ripple-like systems”. The reason we so often talk about them together is because they share a common architecture: the “replicated, shared ledger”.

But they solve very different problems. Tim Swanson has written about the permissioned-ledger world and my last post gave an argument for why banks, in particular, should be paying close attention to them.

But this observation can be dangerous if people believe they are building a “blockchain strategy” for their firms when they are actually focusing only on the permissioned world.

As this exchange between Jerry Brito of Coin Center and Michael Casey of the Wall Street Journal shows, Nasdaq’s recent announcement of a blockchain experiment is noteworthy because they are explicitly building on Bitcoin, using a colored coins protocol, not on one of the permissioned/closed ledgers:

I have no inside information into this project. But it should give pause to any who had dismissed bitcoin-based platforms as being irrelevant to finance use-cases.

Forget Bitcoin at your peril?

As I argued in my last post, the world of permissioned ledgers is pretty easy to think about: if you’re in a market where multiple firms in the industry are all building and maintaining undifferentiated systems that do pretty much the same thing – and they have to be reconciled with each other – then it can make sense to replace them with a single system that you all share. But if you’re concerned about having a single central operator then these new blockchain technologies give you an option that didn’t previously exist: you can implement the common infrastructure on a replicated, shared platform that you all help secure/maintain and so mutualise the effort of maintenance rather than delegating it to a separate entity.

But, all too often, the analysis starts and ends there and disregards the “bitcoin-like” world. To see why this could be dangerous, we need to go back to the beginning.

The first nine words of the abstract to the Bitcoin whitepaper tell you everything you need to know to understand its architecture:

Bitcoin 1

Everything you need to know to understand Bitcoin

“A purely peer-to-peer version of electronic cash”

Those nine words seem innocuous but they have profound implications and explain why so many people still steer quite clear of it. The key is “electronic cash”. What can you do with cash that you’d need to emulate in an electronic version?

  • First, cash is a bearer asset. The only way somebody can take away the money in my pocket is by confiscating it from me. Nobody in a central bank can “delete” my cash whilst leaving everybody else’s untouched.
  • Secondly, cash is a peer-to-peer instrument: I can pay you directly. There are no third parties we need to rely on, assuming we’re physically co-located

There’s a phrase for this set of requirements: censorship resistance. A true system of digital cash can only work if it is censorship resistant.  And Bitcoin’s architecture does a pretty good job of achieving this through a very novel architecture. I sketch out some of the details for interested readers at the end of this article.

There’s just one tiny problem…

Censorship resistance is not an objective that is shared by most governments, regulators, banks or most individuals! No wonder there is so much controversy around the system. Perhaps it’s just easier for respectable firms to steer well clear.

And it gets worse when one observes that Bitcoin is worse than existing digital money in pretty much every significant way! It’s slower, it’s more expensive to operate, its value jumps all over the place and it’s really hard for consumers to use safely. So ignoring it is perfectly understandable.

But it could also be a mistake.

Permissionless Innovation

Because it turns out that censorship-resistance implies an even more interesting property: permissionless innovation.

“Permissionless innovation”—the general freedom to experiment with new technologies and business models—has been the secret sauce that fueled the success of the Internet and the digital economy

Think back to the design goal for the bitcoin system: electronic cash. And how that implied a need for a censorship-resistant bearer asset. These scary properties from a regulatory and banking perspective imply some very interesting properties from a technical perspective: this is the world’s first asset that can be held by anybody or anything and transferred to anybody or anything without needing permission.

Why could that be interesting?  Let me sketch three simple scenarios:

The Internet of Things

How do you do KYC on a fridge? Do you really want your washing machine having your credit card details on file? Perhaps the future of machine-to-machine payments is one where the machines hold their own assets on an open system. Sure: you could build a permissioned payments system for device-to-device payments but the simplicity and open-access nature of Bitcoin could mean that it’s just easier to do it that way.

Firms for whom payments are a secondary concern

We often make the mistake of viewing this space through the eyes of incumbents. It can be useful to put ourselves in the shoes of others. For example, imagine you’re building a business for which getting a bank account and payment processing services would be difficult. Maybe you plan to operate in tens of countries. Or perhaps payments are a secondary concern for one of your use-cases… you just need a quick and easy way to make and receive payments. Sure… you could go through the process of getting a merchant account, signing up with a payment processor, proving compliance with various security standards. Or you could just use something with no barrier to adoption: bitcoin may have lots of problems but at least you can be up and running in seconds.

Second-order use-cases

Perhaps the most interesting future scenario is one where bitcoin isn’t used for payments at all. Instead, the security and censorship-resistance of its platform is seen as having value in and of itself – perhaps for notary services in the first instance – recording facts about the outside world – and so Bitcoin becomes nothing more than the token you need to own in order to purchase the services of the network.  It becomes an app-coin, if you like.

Why we need to keep an eye on the Bitcoin world

I accept that none of these use-cases is particularly compelling as I write this piece. There are lots of great counterarguments for all of them. But that’s partly the point: if any of these were obvious, nobody would be dismissing it.

And this is why I find the Nasdaq example so interesting.   Using the inherent security and open-access of the Bitcoin system to “carry” representations of real-world assets – “colored coins” – is an old idea*.  And it also fits into my “second-order use case” category above.

Now, Tim Swanson and others have written convincingly about many theoretical issues with the idea but we now have a brand-name firm experimenting for real and we’ll hopefully all learn from the exercise in time.

So, sure: bitcoin raises all kinds of conceptual, legal, technical and philosophical questions. But it would only take one of these scenarios to drive some adoption and, very quickly, bitcoin might cease to be a sideshow.  And, given that its core design goal of censorship-resistant digital cash has such disruptive potential – good and bad, this possibility alone is reason to keep an eye on it. Dismissing it entirely could be a big mistake.

Coda: How to build a system of digital cash

Note: you don’t need to read this section to understand the main argument of this piece.

Recall the implications of a true digital cash system: censorship resistance. This drives some very strong implications for anybody trying to design such a system:

First, you simply can’t have the concept of an issuer in such a system: the issuer could selectively choose to honour only certain claims.

So, if you can’t have an issuer of the currency on such a platform, it will have to be native to the platform. Hence Bitcoin as the currency unit and the interminable debates about why it has value and what that value should be, if anything.

Bitcoin 2

If you want true electronic cash, there can’t be an issuer. So the asset has to be native to the platform

Secondly, you can’t have an identifiable operator or processor for such a system, either: they could choose to block certain transactions and their central database would be an obvious target for those seeking to exert control. So this means you need to have lots of actors providing the processing services and they need to be able to join and leave. And they probably also all need their own copies of the ledger – we can’t have a single central one, after all:

Bitcoin 3

If you want true electronic cash, its ledger will have to be massively replicated and you’ll need a large pool of “processors”

Thirdly, you’ll need to pay the processors. You obviously can’t pay them with “real” money (since the issuer of that money could simply refuse to allow payments to be made to processors who refuse to co-operate with them). So you’ll need to pay the processors with the platform’s own asset:

Bitcoin 4

If you want true electronic cash, the processors will need to be paid in the currency of that platform.

The breakthrough of bitcoin was figuring out how to put these building blocks together: how to ensure sufficient scarcity of the currency unit? How to keep the multiple ledgers synchronized? How to ensure the processors’ incentives are aligned with those of the users of the system? And so on.

There’s more than one way to talk about it

Of course, this isn’t the only way to think about the system.  If you’re still interested, here’s my attempt to explain how it works by imagining how you could invent digital cash using an email system.

*Disclosure: I am an adviser to a colored coins firm (ChromaWay) in a personal capacity, albeit one that uses a different architecture to the one apparently being explored by Nasdaq

How to explain the value of replicated, shared ledgers from first principles

“Digital currencies” aren’t needed to explain why distributed ledgers are important.

In this post, I develop an argument for replicated shared ledgers from first principles. It is intended to be an “education piece” aimed at those, particularly in the finance industry, who prefer explanations of new technologies to be rooted in a description of a real-world business problem rather than beginning with a description of a purported solution.  So, in this piece, you’ll find no mention of digital currencies, etc., because it turns out you don’t need them to derive an argument for distributed ledger technologies!

(Note to regular readers: see the end of the piece for some context)

We’ll start with banking systems

Start by thinking about today’s banking systems. In what follows, I use a bank deposit and payments example. But the same logic applies everywhere you look, as I’ll argue later.

Let’s imagine a world with three banks: Bank A, Bank B and Bank C and two customers, Customer A and Customer B. Each bank runs their own IT systems that they use to keep track of balances. This is a world very much like today.

So Bank A’s systems record the balances for Bank A’s customers, Bank B’s systems record the balances for Bank B’s customers and so on.

Perhaps the picture looks something like this:

Bank Systems 1

Balances at three banks for two customers.

Two immediate observations jump out:

  • First, look at Banks A and B. Bank A’s systems record that it is owed £1m by Bank B. And Bank B’s systems also record this fact: they record that Bank B owes £1m to Bank A. So the same information is recorded twice, by two independently developed, maintained and operated systems. And in other domains, this duplication is much greater and more expensive, as we’ll discuss below.
  • Secondly, look at Customer A. They are owed money by banks A and C and are overdrawn at Bank B. Put another way, Banks A and C owe money to Customer A. Who records this fact? Banks A and C! We take this situation for granted but it does seem very odd that Customer A has to trust both that the bank will be good for the money and that the bank’s records will be accurate. That feels like a conflict of interest, if ever there was one…

So we have two interesting phenomena: deposit-makers have to trust their banks to be good for the money and to account for things correctly. And the banks themselves have to spend a lot of time and money developing systems that all do pretty much the same thing – and then spend even more time and money checking with each other to make sure their systems agree on common facts.

Even in our simple example, there are potentially 7 separate matching entries to be verified.

Bank Systems 2

Banking “facts” are usually recorded by at least two different entities and an expensive process of reconciliation is needed to make sure each party’s view of the world is the same

It’s not just bank deposits. Securities and Derivatives Markets have the same pattern

This story is about bank deposits. But exactly the same story could be told about securities systems and derivatives systems. Indeed, in the latter case, the problem could be even worse: not only do we need to be sure everybody agrees on who has done which deals with whom, we also need to be sure that their systems agree on the resulting obligations that arise – they also have to agree on the business logic.

Think about how many near-identical systems exist across the financial landscape, each one working slightly differently and producing ever-so-slightly different results that have to be investigated and resolved. It’s hugely expensive.

Back to the banking story

But let’s focus on the banking example for now.

You can do something really interesting with the five ledgers we’ve been working with. You can write them a different way, with all the same information stored in a single table, rather than spread across five different tables:

Bank Systems 3

The five separate ledgers on the left can be written, exactly equivalently, as the single table on the right – and vice versa. You can derive one from the other. The only difference is that the table on the right has an extra column so we can record both the issuer and the holder of a claim .

In other words, rather than having a partial view of the world held by each bank, we could have a single table that records everything and achieve the same outcome.

So why not just have a single banking ledger for the world?

This raises an interesting question. If it’s so expensive and complicated for each bank to run its own system that contains its own narrow view of the world – and then have to check it matches the other systems where the facts overlap – why not just pay somebody to run a single ledger that everybody agrees will be authoritative?

After all, as we showed above, any bank that wanted to could easily derive its own view of the world from this mega-table, completely trivially.

Of course, we’d have to give thought to how to mediate access to the ledger – who is allowed to observe or update which records – but we know how to do that… and it’s not an impossible problem.

Are you mad?!

Now, it is tempting to say that such a thing would be insane: imagine how powerful would be the firm who ran such a system. And imagine the catastrophic implications for the world if there was a system outage! Perhaps the expensive, error-prone, but fundamentally decentralised and robust (anti-fragile?) system we have today is a price worth paying.

But this means an interesting question arises: what if there a way to achieve the benefits of a globally shared system but without having to grapple with the difficult political question of how to control an all-powerful operator or how to deal with the risk of an outage of such an important, central piece of infrastructure?

Perhaps we can achieve this…

The Replicated, Shared Ledger

Remember what we achieved in the diagram above: we created a single table that could describe all bank balances and which was inherently shared: different actors had different permissions to update different parts of it.

But the worry in the section above was that a shared global ledger would be controlled by a single powerful entity and that this centralized system could be a systemic risk. So can we make two tweaks to the model?

  • First, why not replicate the ledger massively. So, rather than one copy, have lots of copies. Perhaps one copy at every bank. So now there isn’t a single point of failure. We would have to worry about how those copies are kept in sync, of course, so this isn’t an unambiguous “win” but having copies at each bank might also make integration with existing infrastructure somewhat easier, too. Perhaps this would also help ease adoption.
  • Secondly, why not have those who participate in the system – maybe just the banks or maybe their customers too – also be jointly responsible for maintaining and securing it. We know who everybody else is in this world, after all, so we know whom to punish if they cheat. So we replace a single powerful entity with a model where everybody contributes to the system’s security.

If so, perhaps the picture would look like this:

Bank Systems 4

If a single copy of the global, shared ledger is undersirable or risky, then replicating it to all the participants could give the best of both worlds. Now the problem becomes one of automatically keeping the systems in sync rather than manually reconciling and dealing with breaks.

The picture above looks superficially like the one I drew at the start of the article. But there’s a critically important difference. In this model, all participants have a copy of the ledger but only have the right to amend entries pertinent to them. So it is both replicated and shared.

And so this is why I call this concept the “replicated, shared ledger”.  I think this wording is better at evoking the right mental model than “distributed ledger”, for example.

And depending on whether you want to model balances, other assets or even agreements between parties, there are startups working on a project.  I wrote a piece last year that attempted to make sense of the various players out there – and many more have emerged since then.

“Smart Contracts”

It it worth paying particular attention to the idea of adding business logic to this concept: so that the “facts” being recorded aren’t just who owns what but actual agreements between parties.

This opens up the intriguing possibility of “smart contracts”: a world where derivatives counterparties agree that a shared piece of code represents the agreement they have made with each other and they execute it on the shared, replicated ledger – perhaps completely eliminating the need to build, maintain, operate and reconcile their own proprietary derivatives platforms? Maybe even allowing the code to take custody of assets on the ledger, to manage cashflows and margin automatically?

Outstanding questions

But I should stress that this approach raises lots of technical questions: it’s not an unambiguously good idea. For example, do we know that the underlying replication technology works as described? Under all plausible threat scenarios? How can we be sure that one bank (or customer) can’t see (or amend…) another’s information? How much data would such a system hold? Would it scale? Is it really a good idea to model legal agreements in code rather than English?!

Conclusion

There do appear to be multiple examples of expensively duplicated systems in multiple areas of the banking system. The idea of a shared ledger holds promise, with replication by participants being a mechanism to reduce risk and mutualise its operation.  But whether this argument holds in practice needs to be tested. So I fully expect to see more and more experimentation by banks and others in the coming months and years.

Thank you: I’m extremely grateful to Lee Braine for input/review of the logical argument in this post

 

Note to regular readers

For the avoidance of doubt, in the piece above, I was not talking about Bitcoin – I’ll post a separate follow-up that attempts a derivation for Bitcoin’s design given some plausible real-world requirements; this post is about the domain I sometimes call the non-“Bitcoin-like-world”, as defined in this post)

 

 

Bitcoin as a Smart Contract Platform

Distributed Ledger Platforms may be Getting All the Hype but the architecture of Bitcoin is more sophisticated than many people realise

I was a guest of the Financial Services Club Scotland last week. I presented an update on the world of cryptocurrencies to an engaged and well-informed audience in the library of the Royal College of Physicians.

I reprised my current theme that the world of “blockchains” is really two distinct worlds – the world of Ripple-like ledgers and the world of Bitcoin-like systems – that happen to be united by a common architecture, the Replicated, Shared Ledger. This unifying concept is based on the idea that each participant has their own copy of the entire ledger – and they trust the “system” – whatever system that is – to ensure their copy is kept in sync with everybody else’s.  The differences are about what the ledger records and how it is secured.

Bitcoin-like and Ripple-like systems

Broadly speaking, Ripple-like systems are focused on the representation of “off-system” assets and are secured by identifiable entities. Systems like Ripple, Hyperledger and Eris are broadly in this world, I think. The security model of these systems is based on knowing who the actors are: if somebody misbehaves, we can punish them because we know who they are!

Bitcoin-like systems are more focused on “on-system” assets and are secured by an anonymous pool of actors. Bitcoin and Ethereum are broadly in this space, I think. The security model here is based more on game-theoretic analyses of incentive structures: the goal is to make it overwhelmingly in the actors’ financial interests to do the “right” thing.

There is, of course, some ambiguity since all platforms have some notion of “smart contracts” – or otherwise recording real-world agreements, as well as asset ownership.  But this makes intuitive sense.  If your platform is concerned with real-world assets and agreements then you necessarily need some concept of identity (who are the issuers?). And if you’re reliant on the performance of real-world actors, why not also rely on them for the overall system security?   Likewise, if the whole purpose of your platform is to create and manage a new asset that can be controlled/subverted by nobody, then giving identifiable entities the power to control your security would seem to defeat the point!

Different design goals, different implementations.  And the value of such systems to banks, corporations or individuals is, ultimately, an empirical question. I imagine 2015 will be the year where we discover many of the answers.

Incrementalism versus “Disruption”

But I went further in my talk. I observed that these two worlds also differ in one other respect: the Bitcoin-like systems could be disruptive to existing institutions if they gained widespread adoption, whereas Ripple-like systems seem, to me, to be far more closely aligned to how things work today and are, perhaps, a source of incremental innovation.

If this observation is correct, then firms looking at this space probably need to assess the technologies through different lenses. The question for banks for Ripple-like systems is: “how could we use this to reduce cost or improve our operations” whereas the question for Bitcoin-like systems is: “how would we respond if this technology gained widespread adoption?”

And to answer the last question, one must be sure to really understand what the system under analysis really is!

Bitcoin as a currency might be to miss the point

For me, it is a mistake to think about Bitcoin solely as a currency. Because the Bitcoin currency system is a masterclass in mirage: underneath the hood, it’s a fascinating smart contract platform.

Or, as I said at the Financial Services Club, every time you make a Bitcoin payment, you’re actually asking over 6000 computers around the world to run a small computer program for you… and your only task is to make sure that the computer program returns “TRUE”.    Within the Bitcoin community, this is well-known, of course.  Indeed, the work done by Mike Hearn and others to document the platform’s capabilities has been around for years.  But I find most people in the broader debate are unaware that the platform is pretty much built on this capability – it’s not an add-on.

Bitcoin is a smart contract platform

I wrote a piece last year offering an intuition for how Bitcoin works, in terms of land. My point was that the fundamental building block of the system is the “unspent transaction output”, or UTXO.   The UTXO is what you get when somebody “pays” you some Bitcoin.  The “output” of their transaction is the money they paid to you. And whilst it sits in your “wallet”, it is, obviously, unspent. Hence “unspent transaction output”.

So you can think of the current state of the Bitcoin system as being a huge pool of UTXOs: all the payments that have been received by Bitcoin users that they have not yet spent:

BitcoinSmCon4

Every payment that has not itself been spent is modeled in the Bitcoin system as an “unspent transaction output”. In general, each UTXO can only be spent by the owner of the “address” to which it was sent (not always, and this is the point; see later).  And each UTXO has an identifier (the transaction it appeared in and its position in the list of outputs of that transaction) and a value: how many Bitcoins are represented by that UTXO.

But what people often miss is that these UTXOs are actually tiny little computer programs that live on the ledger, control access to bitcoins and run in response to specific incoming events. Smart Contracts, if you will. And the only way you get to spend the money controlled by that contract is if you can provide some input data that allows every node on the system to execute the program and check that it returns “TRUE”

If you can make the program return “TRUE”, you get to say what happens to the funds. If you can’t, then you don’t.

So, when you want to spend your money, here’s what you do:

Your wallet software writes a little computer program for you and then sends it into the bitcoin network. It effectively says to the network: “Please run this little program I’ve just given you.  Then please find a program (“smart contract”?) on the platform with this ID for me. When you’ve done that, feed the output from my program into program you just located”.   So this is a two step process:  you provide your own little program… and the output of that is fed to the UTXO program that you want to spend.

BitcoinSmCon2

The way you spend money in Bitcoin is to ask the platform to run a small computer program that you provide and feed the output of that program to the “smart contract” that is storing the funds you want to spend. If you can make this second program run successfully, you get to spend the money. In Bitcoin terminology, the program you provide is “scriptSig” and the UTXO program is “scriptPubKey”. Your goal is to provide a “scriptSig” whose output can be fed into “scriptPubKey” to make it return “TRUE”

So what are these little programs? In the common case, they’re really simple. The “UTXO program” simply says: “provide me with a digital signature that proves you own the key associated with the following Bitcoin address (and please also prove that you know the public key that corresponds to the bitcoin address)”. That’s why it’s called the “scriptPubKey”.

And the program you provide is just a way to ensure the bitcoin system sends this proof into the scriptPubKey program in the right way. It’s a way of providing a digital signature. Hence it’s called the “scriptSig”

If you don’t know the private key then you can’t generate the right signature and so you can’t create the input necessary to get the smart contract (scriptPubKey) to run successfully and you don’t get to spend the funds. So this, seemingly complex model, is just a way to ensure that the only person who can spend money at address 1abcde… is the person who knows the private key… exactly as we would want.

Why is it this complex?

But notice how powerful this is…   because the other thing you do is tell the system to replace the existing scriptPubKey program with one or more new programs. And this is how your payment is modelled in the system.  You pay somebody by creating a new program (a new scriptPubKey) that only they will be able to execute successfully.  In this way, you can pay different people or send change back to yourself.  The program that only you can run is replaced with ones that only the payees can run.  And, in this way, the value has been passed from you to them.

So the result is that the original program living on the ledger is replaced by one or more new programs. In the usual case, one or more of these new ones will be associated with somebody else’s bitcoin address so only they will be able to control it. You have, in effect, paid them that money since the funds are now under their control

BitcoinSmCon3

Paying somebody in Bitcoin is the same as replacing the program you control with ones they control. In this diagram, the funds you controlled have now been split between two new recipients. Only they can spend those funds.

Smart Contracts?

So what does this have to do with smart contracts?   The key is that the model I outlined above is quite generic.   The programming language is (just about) powerful enough to implement some interesting business logic that goes beyond “Richard paying money to Bob”.   For example, you can write a program that will only return “TRUE” if you provide proof that you know the private key to multiple bitcoin addresses.  This is a way to model “a majority of Board Directors must jointly sign before these funds can be spent”, perhaps. The Bitcoin “contracts” wiki page goes into far more depth.

However, the reality is that the capabilities of the platform are actually quite constrained – and I think this explains a lot of the interest in other platforms, such as Ethereum.  However, it should be noted that Gavin Andresen has argued that Bitcoin’s limitations need not be a constraint.

So what?

Some might argue that it’s not necessary to think about Bitcoin in this way. But I think that would be a mistake. Because, while lots of people are getting excited about the potential of smart contracts for business, we’ve had a sophisticated smart contract platform running quite successfully for over half a decade, in the form of the Bitcoin network.

Sure – it’s very limited (that’s why systems like Ethereum are getting built).   But it might be a mistake to bet that it won’t evolve.

Ultimately, my point is this: even if there’s a low probability of success for a potentially disruptive system, it surely makes sense to understand everything possible about what that system can actually do…

[Disclosure – I provide advice to Hyperledger in a personal capacity.]

[Update – 2015-03-30 Typos and replaced first diagram… I accidentally included an older version that used random IDs for UTXOs that looked like bitcoin addresses, which was very confusing…]

A Central Bank “cryptocurrency”? An interesting idea, but maybe not for the reason we think

The retail use-cases get all the press… but the killer-app for digital central bank money might be smart contracts

This post on a concept called “FedCoin” by David Andolfatto of the St Louis Fed raises the really interesting possibility of a world with central-bank-issued digital assets which can be held by a broad range of people.

FedCoin

Andolfatto’s FedCoin post

The core idea is essentially a variation on the digital cash theme: a digital bearer asset that is redeemable for dollars. So, on the surface, just like m-pesa but for dollars, right?

Not quite. Because Andolfatto’s FedCoin idea has two important differences.

  • First, FedCoin would be issued by the central bank. That contrasts with most other digital cash systems, where the holder has a claim against a telecoms firm or a commercial bank. In those systems, you have to trust the central bank not to inflate away the currency (as you do here) but you also have to trust the commercial issuer not to go bust – or any deposit insurance scheme to bail you out if they do. A central bank digital asset doesn’t have that second issue.
  • Secondly, Aldolfatto suggests this currency could be issued on a distributed ledger. As he writes in an update to that post, many people have questioned why that might be necessary. Surely if you trust the fed enough to hold its currency, you trust it to run an accounting system!   However, I wouldn’t dismiss this suggestion just yet, as I’ll argue below.

Robert Sams has an intelligent and thoughtful analysis of the overall idea.

So why am I writing about it now?

It’s not just the US: what about the Bank of England?

No sooner had the FedCoin idea been discussed and dissected, the Bank of England published its 2015 “Research Agenda”: a paper summarizing all the questions they plan to examine this year.

Turn to page 31 and guess what… there’s a section on Digital Currencies. If you haven’t read it, I urge you to do so. Because it doesn’t say what one might expect it to. Most official papers on “digital currencies” are influenced by Bitcoin and talk about volatility, monetary questions, the tedious question of whether cryptocurrencies pass the “money test”, regulation and so forth.

This paper doesn’t. Instead, it follows the same line of reasoning as Andolfatto and focuses directly on the question of what a central bank-issued digital currency might mean. And the paper does something really valuable: it lists a set of questions that anybody planning to do something in this space would have to answer.

Bank of England

The Bank of England’s Research Questions for a Central-Bank-issued digital currency

And these are important questions. Imagine something like FedCoin was built and you were able to hold a digital asset that represented a claim on the Bank of England or the Federal Reserve. The implications for commercial banks could be huge: why would you lend your money to (aka “deposit with”) a retail bank if you could hold the same money in a counterparty-risk-free form?

So the commercial banks would probably have to compete for your deposits with higher interest rates. But wouldn’t that make them more risky and more likely to fail?   So perhaps the central bank would have to charge you to hold their digital asset (a negative interest rate?) to encourage you not to hold too much of it and lend the rest to the commercial banks. But now the digital “cash” isn’t the same as physical cash…

And there’s another question. If everybody has access to central bank money, then why do we need payment systems? I wrote a simplified explanation of how money moves around the banking system a while back – and the noteworthy thing about it is that pretty much all of the payment infrastructure in the world exists because most money isn’t central bank money. If you imagine a world where everybody holds central bank money, suddenly the picture begins to look a lot simpler…

Central Bank Money for all

Do you need need most payment systems in a world with only FedCoin…?

There’s more… Do we really want people having access to unlimited amounts of digital bearer assets denominated in GBP or USD? Do central banks have the culture, systems and experience to oversee such a scheme and spot misuse, fraud and crime?

So perhaps a hybrid implementation, would emerge where consumers have to nominate a “sponsoring” commercial bank, which provides safekeeping services, has oversight responsibilities and, perhaps, has the ability to block suspicious transactions?

Who knows.   And I should stress that I don’t think anybody is proposing a system like this in any case…. These are research questions.   But it suggests that the BOE questions are a very good starting point for thinking about these issues.

A solution looking for a problem?

But there’s a small issue: this intellectual exercise is fascinating but is a central bank digital currency actually needed?   With a few notable exceptions, depositors don’t tend to lose their deposits when commercial banks fail. (But businesses and other large depositors often do…) And aren’t capital rules and prudential supervision designed to solve that problem in any case?

Remember I said the “distributed ledger” aspect of FedCoin was interesting…

Think back to the Andolfatto piece. He mused about building “FedCoin” on a distributed ledger.   On its face, that doesn’t seem to make much sense.

But if we open the topic of distributed ledgers, it also brings Smart Contracts into play. In my recent piece on the topic, I suggested a definition for a smart contract as follows:

“A smart-contract is an event-driven program, with state, which runs on a replicated, shared ledger and which can take custody over assets on that ledger.”

Implicit in my definition was that these “assets” could be native assets to the ledger (e.g. Bitcoin). But , more likely, they would be representations of real-world assets: GBP tokens issued by Barclays or HSBC or Coop, say.

For example, you could imagine consumers paying £50 a month into a “mobile phone insurance smart contract” and, if they can provide proof that they’ve lost their mobile phone, the smart contract will pay out enough money to replace the phone, using the funds that have been paid in by all the policyholders.

Perhaps the “proof” would be in the form of a “proof of purchase”, signed by a retailer and an “attestation of loss”, cosigned by the policy holder and a police officer. The details here don’t matter too much.

But what does matter is the payment.

How would you write a contract like this so that it could be sold to as many consumers as possible?  They probably have accounts with different banks and, if we imagine a world of distributed ledgers, they’d all be holding different tokens: GBP-Barclays, GBP-Coop and so on.

Which tokens should an insurance contract accept from its customers?   Only tokens issued by “safe” banks? Which ones? Who controls the list?   What about a £1000 IOU from me? Would the smart contract accept that?   What about a £1000 IOU from a billionaire?

What happens when the contract pays out?  If you had paid in GBP-Barclays, how would you feel about receiving an arbitrary mix of GBP assets when you made a claim, based on whatever happened to be in the pool at the time?

Too many issuers

Writing a smart contract that deals with GBP issued by multiple issuers gets complicated very quickly…

Systems like Ripple solve this problem by explicitly modeling the idea of an asset and its issuer. 50 GBP-Barclays is different to 50 GBP-HSBC and Ripple is built on that insight.   So you could certainly configure the contract to trust some issuers but not others.

But it gets complicated. What happens if one of those issuers gets taken over? Goes bust? Who updates the list of “trusted” issuers in the smart contract?

And now, scale the problem up to the institutional side of the world, where the sums involved in derivatives contracts are enormous. Suddenly the identity of the issuer really matters.

And this is where I think a central bank digital currency could make sense on a distributed ledger. It would clear away all that complexity.

You could simply write the contract to demand payment in the central bank token.   Policyholders would have the responsibility of converting other GBP assets into the central bank issued asset.

Now, perhaps this wouldn’t be a problem in real life – maybe you could just write the smart contract to only accept GBP-Barclays, say, and insist customers of other banks convert into Barclays tokens in order to use the contract.   But having a counterparty-risk-free representation of fiat currencies on these smart contract systems feels like it could be extremely useful.

But time will tell, as always.

A Simple Model for Smart Contracts

Everybody I ask has a different definition of a “smart contract”; Here’s mine.

I hear more and more people talking about “smart contracts” these days. But when you push them to define the term, the concept often dissolves in their hands.

This isn’t a new observation: Peter Todd made a similar point after sitting through a session at a workshop we both attended last year.

Indeed, I was almost certainly one of the many who failed to impress him that day :)

Now, of course, one answer is to simply point at the intellectual visionaries who foresaw this space decades ago. Nick Szabo’s Smart Contract piece from 1997 is a really succinct and helpful overview. And I really like Ian Grigg’s idea of the “Ricardian Contract”.  Szabo’s “vending machine” model is particularly helpful.

But these ideas predate the world of Bitcoin, blockchains and cryptocurrencies and so it’s not immediately obvious for new people in this space how to bridge the gap. Worse, there are multiple platforms out that purport to implement smart contracts. Indeed, you can argue that Bitcoin itself is actually a smart-ish contract platform. So it becomes even harder to distinguish between the concept and a specific implementation.

In this piece, I try to build a motivation for why something like a smart contract might be a nice idea and use that to produce my definition and model.

The Replicated, Shared Ledger

When I think about block chains and distributed ledgers, I start with what I think is the key innovation of Bitcoin: it taught the world how to transfer value at-a-distance with no trusted third party.   (Yes: I know some people take issue with this and it may not be 100% accurate – but I think it creates the right intuition)

Sure – we could hand physical money to each other face-to-face but, until Bitcoin, there was no way to send value to somebody on the other side of the world without having to trust centralized third parties: the postal service, banks and so forth.

It’s as if the traditional money-movement infrastructure of banks and payment systems had been reimagined as a flat peer-to-peer network of actors. Perhaps moving from the picture on the left to the picture on the right:

SmartContracts1

Bitcoin opened the possibility of peer-to-peer electronic value transfer, in contrast to today’s system of banks, central banks and payment systems.  [I use these Banks merely as examples; I’m not trying to imply they’re doing anything in this space!]

But what this (very naïve!) picture misses is precisely how systems like Bitcoin achieve their claims.

The answer is that Bitcoin-like systems are built on things that I’ve started calling “replicated, shared ledgers”. That is: every full participant in the network has a full copy of the transaction ledger and the “magic” of the system is in how it makes sure that everybody’s copy stays in step with everybody else’s.

So, perhaps the correct picture is this one on the right below, where each participant is shown as having access to the same shared, replicated ledger:

SmartContracts2

The trick of Bitcoin and other decentralised consensus systems is in how they ensure everybody has a copy of the ledger that they know is in step with everybody else’s

Great – leaving aside questions of scalability and so forth, we can see that this architecture can work: if everybody has the same copy of the ledger as everybody else then you no longer need central entities to keep track of who owns what (or who owes what to whom). Instead, you know that when your ledger gets updated to record a change of ownership of an asset then everybody else’s does too.

We need to distinguish between what the ledger records and how it does it

A great deal of the debate and competition in this space is focused on how this ledger is structured and secured. Bitcoin’s mining algorithm? Ethereum’s system? Ripple’s consensus algorithm? What these debates often miss is that these are all “how” questions: how is the ledger secured? How does the consensus process work? How are bad guys kept at bay?   And they’re all different because the platforms make different assumptions about the nature of the threat they are likely to face.

But, for this article, it’s useful to forget that side of things for now and, instead, ask yourself: what does this ledger record? What is it used for?

What does this ledger record?

In one of my recent posts, I explored how this concept of a “shared, replicated ledger” could have application well beyond currency. My point was that once you know for sure that your view of the world is the same as everybody else, it opens up new possibilities in entirely unrelated areas, perhaps even accounting. Ian Grigg has written about this and firms such as triplentry are exploring it today.

One of the driving thoughts here is: if I know that everybody “sees” the same things as me then perhaps I don’t need to spend so much money building my own custom ledgers and perhaps I don’t need to spend so much money auditing and reconciling with everybody else… the ledger does it for me.

OK – so perhaps a shared, replicated ledger could take cost and duplication out of today’s commercial systems.

So where else do we have duplication?

One area is in business logic. There are countless examples in business where two (or more) parties to a contract each independently write computer systems that model the terms of that contract. I sometimes get accused of only talking about banking examples so here are some non-banking examples of what I mean:

  • Large online retailers probably have a system that checks the bill they receive from their delivery companies is correct: have all the negotiated discounts been applied?
  • Large grocers negotiate complicated rebates from their suppliers, based on volumes in a period and plenty of other factors. You can be pretty sure that both sides of those contracts have developed very sophisticated models of the contract in computer code
  • A surprisingly large number of consumer insurance policies in the UK are sold through brokers. These brokers typically use software platforms provided by third party firms. These third-party platforms usually have their own implementations of each insurer’s pricing model: it is not unusual for a single insurance product to be represented in three or more completely independent code bases!

What unites these scenarios and countless others like them is that each party needs an independent means to calculate the value owing (or owed) under the contracts. They can’t realistically trust the other side. So logic dictates that they each have to build their own system. This might be wasteful and drives a need for reconciliations and so forth.

But think back to what I said above: a replicated, shared ledger has the property that everybody knows that everybody else is seeing the same thing without one side having to trust the other side to be scrupulously honest.

So imagine, now, that your ledger could also run computer code.   Here’s what you could do:

  • When you negotiate an agreement with somebody, you also agree on a representation of that agreement in computer code
  • You agree what information sources it will use for external data and how disputes will be resolved
  • You both examine the code in detail to confirm there are no secret backdoors or sneaky loopholes. And you perform testing to check it yields the right answers for the various inputs your provide to it.
  • Satisfied that it does what you want it to, you both sign it and deploy it to the ledger.

And now you have something really interesting: neither of you have to go to the effort of reimplementing the terms of the contract in your own systems: you both know that this single piece of code satisfies both your purposes.   And because it is running on this shared, replicated ledger and using it as its source of information, you can both be sure that whatever the program outputs will be the same for both of you.

Indeed, supervisory authorities, in time, may come to insist that this is how some business is done.

But we can go even further

So far, I’ve outlined a fairly mundane scenario: a computer program that represents the agreement between two or more parties.

But remember: we’re imagining a world where this program runs on the shared, replicated ledger…. the shared, replicated asset ledger.

What if this program could interact with that ledger?   The program could take control of assets on the ledger and you could even send assets to the program. So it’s no longer just a computer program, it’s an economic actor in its own right.

Imagine we’re in the grocery scenario: you could imagine the grocer paying its suppliers by sending payment to this computer program. The program could calculate how much rebate is likely to be due, send the difference to the supplier as payment for the goods but temporarily hold on to the rebate – since we’ll only know for sure at the end of the month what the true discount percentage should have been. At this point, the contract could send the right amount of remaining funds to each party.

It’s as if this program isn’t just a computer program: it’s an actor in its own right. It responds to the receipt of information, it can receive and store value – and it can send out information and send out value.

It would be just like having a human who could be trusted to look after assets temporarily and who always did what they were told.

And this idea is what I think people mean when they talk about Smart Contracts.

The diagram below is my model for this: a piece of code (the smart contract), deployed to the shared, replicated ledger, which can maintain its own state, control its own assets and which responds to the arrival of external information or the receipt of assets:

SmartContracts4

My mental model for a smart contract: a computer program that runs on a shared, replicated ledger, which can process information, and receive, store and send value.

So much for the theory

So that’s the essence of it, I think. Perhaps more formally, my definition might be that:

A smart-contract is an event-driven program, with state, which runs on a replicated, shared ledger and which can take custody over assets on that ledger.

But that’s just my working definition.  And there are lots of conceptual issues. I summarise some of them here, merely as signposts for further study (and future posts)

  • Injecting Real-World State
    • Smart contracts rely utterly on the quality of the information which is sent to them. “Oracles” and “n-of-m” schemes can help. But where I think additional thought is required is in what happens when things change: what happens if information sources go away, if previously independent sources merge, if new and better sources emerge?
  • Modelling
    • There may prove to be examples of business problems that can be modelled in multiple ways – e.g. directly as assets on a ledger or as contracts. Perhaps good practices need to emerge for the “right” way to model different types of real-world phenomena
  • Dealing with bugs, errors
    • Have you ever written a computer program without bugs? So how would one fix a smart contract once deployed if the bug is clearly in the favour of one of the parties?
    • Could this also be the early days of a new profession? Just as lawyers can earn big money finding loopholes in contracts, will there be a cadre of “engineer-lawyers” looking for loopholes in smart-contracts?
  • Liquidity
    • If assets are under the custody of a smart contract, they are, by definition, not available to anybody else. This could change the economics of various businesses.
  • Legal validity
    • Does a smart contract have the same legal force as a “real” contract? What happens if the output of the contract is incompatible with law or a court finds it to conflict with the English-language version of the agreement? Does it depend, in part, in how the ledger is secured?
  • Privacy
    • Most shared, replicated ledgers are public. I don’t know many retailers who want their deals with their suppliers to be public knowledge
  • Technical
    • Does the underlying technology work satisfactorily? Does it scale? And so on
  • … and much more

But I’m pretty sure smart people in the community are looking at all of these things. So perhaps the real test is: what are the compelling business scenarios that will drive adoption/experimentation in this space?

If you’ve reached this far, well done. I’d urge you to study the writings of Szabo, Grigg and countless others on this… they’ve covered this space so much better than me…