Cryptocurrency products and services will determine adoption of the currency – not the other way round

The critics of Bitcoin-the-currency are right… but only in the sense that the motor-car was a poor imitation of a horse…

I had a light-bulb moment this week. It was triggered by a panel I sat on at Sibos, hosted by the wonderful Adam Shapiro from Promontory Financial Group.

My argument to the audience was the one I usually give: they should simply ignore the currency use-case: it’s the least interesting thing about Bitcoin. They should, instead, look at it as a platform for decentralized value-exchange and focus on the opportunities this enables.

Sibos TV

The panel discussion isn’t online but you can see us debate the issues on Sibos TV.

I then returned to the warm embrace of the Innotribe room and thought little more of it.

I thought little more, that is, until I returned home on Friday and went for a run. I took the opportunity to catch up with a few podcasts, one of which was Dave Birch’s interview with Jeffrey Robinson, author of BitCon. (Aside: everybody I know thinks I’m weird for listening to economics and FinTech podcasts when I run. I can’t be alone… surely?!)

It is fair to say that Jeffrey is not a fan of cryptocurrencies. And he makes some well-aimed shots at the heart of the “Bitcoin is a useful currency” argument in the podcast. For example, he points out that vanishingly few retailers actually accept it, despite the hype (they, instead, receive dollars from BitPay or Coinbase instead).

Now, one could take issue with Robinson’s arguments (he’s very confused on some technical aspects and the Boston Fed does see some evidence that consumers pay marginally less when using Bitcoin rather than payment cards).

But surely this is to miss the point. Whether or not cryptocurrencies are superior than today’s currencies for today’s payment problems isn’t really interesting.

It’s like saying that the automobile is a terrible way of pulling a plough.

Cryptocurrency technology will succeed only to the extent that it enables new products and services that were previously impossible or unimaginable.

And here’s the light-bulb moment: most of the really interesting use-cases turn out to need a payment mechanism – and having a currency and payment mechanism built into the platform turns out to be really, really useful.

Causation runs in the opposite direction to what everybody seems to think: it is new products and services that will drive adoption of the underlying currency. Not the other way around.

Two interesting viewpoints

Perhaps you think I’m setting up a strawman…? Happily, there have been two separate posts this weekend describing what some of these applications might be. So let’s check…

First, Chris Dixon offers some ideas for native Bitcoin apps. If I’m being critical, I thought they were somewhat pedestrian – they all seem to be answers to the question: “if Bitcoin the currency was widely deployed, what could you do with it?” – which I think is the wrong way to look at this. It has causation in the wrong direction.

But Adam Ludwin at Chain.com also blogged on this topic. And his argument is more compelling to me. He acknowledged that we really can’t anticipate where this will go – but he highlights ideas like smart assets and so forth as promising areas of research.

So can we flesh this out some more and identify additional examples?

When the audience takes photos and makes notes, you know they’re excited by the topic…

I hosted five startup CEOs on the Innotribe stage at Sibos on Monday and it’s interesting to me that the demo that created the most excitement was Yoni Assia’s demo of colored coins. He showed the (fake!) example of a large US bank issuing IBM stock on the blockchain so that it could be traded and transferred without the need for the plumbing we take for granted in the securities processing world. I think he used the CoinPrism platform. And it’s worth also checking out ChromaWallet.

coloredcoins

Using the Colored Coins concept to issue, track and transfer securities on a blockchain.

I spoke to various attendees over the following days and this topic clearly excited them. The demo had helped them move from an intellectual, but shallow, understanding of the concept to one that helped them envision a future where custodians, clearing houses, exchanges and brokers work in a completely different way. I’ve written about decentralized securities processing here and seeing it in a live demo made it real for people.

Now the interesting thing is: this use-case has nothing to do with currency. The Bitcoins are just being used as a transport layer. All the intelligence and disruptive power is at higher layers of the stack.

The key insight: what is the best payment mechanism for colored coins?

But now… ask yourself a question: imagine this platform gained adoption. In what currency – and using what mechanism – would participants pay each other?

Sure – you could use whatever you like. But the interesting thing is: if you paid in the native currency of the platform – Bitcoin in this case – some very special possibilities arise. For example, you can use the Bitcoin scripting system to make binding bids and offers without needing a central exchange. And you can achieve atomic swaps of currency for securities – delivery versus payment – without needing a custodian.

So suddenly, a “currency” which may indeed have limited utility for today’s developed markets for today’s problems suddenly becomes utterly superior for this new use-case of decentralized asset exchange.

Now, I should point out that not all of this infrastructure yet exists so I’d advise readers to read an interesting paper by Mark Friedenbach and Jorge Timón on how to modify the underlying Bitcoin system to support it. (My thanks to Ian Grigg for the pointer). In passing, I think these systems also need two other critical pieces of infrastructure:

  • An identity and reputation system: how do I know an issuer of IBM “stock” really is who they say they are? And how do I know they are authorized to make the statement? The complexity here goes beyond narrow concepts of corporate identity
  • What rules are needed to underpin this? Which legal precedents?

But I think it’s examples such as this will lead us to a world of 1) unanticipatable products and services, for which 2) the optimum payment mechanism is the native token of the platform.

To repeat: new apps will drive cryptocurrency usage… not the other way round.

So what are some other potential use-cases?

I’d classify the example above as Smart Property.   I think there are at least two others:

The Economy of Things

I wrote recently about the work we at IBM are doing around the economic model of the Internet of Things. The work is focused on the underlying architecture through which trillions of devices can discover, connect and collaborate. But what would happen if these “things” needed to transact with each other? Wouldn’t the most obvious payment vehicle to use be the native token for the platform? (Usual disclaimer: I raise this as an open question… it’s not a statement of direction or intent by IBM)

Indeed, one potential example of this has already been studied in Switzerland. A recent paper by Dominic Worner and Thomas von Bomhard examines “Exchanging Data for Cash with Bitcoin” – one could easily imagine “things” paying each other for access to trusted data feeds in other scenarios too.

Smart Contracts

Vitalik Buterin’s presentation on Ethereum was a highlight of the first day at Innotribe this week. And I thought his host, Dan Marovitz, showed excellent judgement in allowing him to talk at length and in significant technical depth about his vision. The audience of senior bankers seemed to be completely rapt.

etherscript

Using Ethereum in a world where the there’s been a breakdown in trust between children and the tooth-fairy

At the core of the Ethereum concept is the idea that real-world relationships and contracts can often be reduced to deterministic rules that can be executed by a neutral, unimpeachable platform. And these contracts often (not always) involve the exchange of economic value, usually in the form of the native currency of the platform.

Now… I have some reservations about Ethereum… it is so ambitious and so audacious that I worry that it might prove to be unbuildable – and I note that real-life isn’t always reducible to deterministic rules….   But, as Gavin Andresen has argued, it might be possible to achieve much of what Ethereum aims to do on top of the Bitcoin platform itself. At which point, the world of smart contracts would drive usage of Bitcoin-the-currency.

And I’m sure there are more…

So where next…?

It’s still early days, of course. But the lesson I learned this week was that we need to get away from the sterile “Bitcoin the currency” versus “Bitcoin the platform” debate. Instead, we should consider how one drives the other… and how it’s the platform that is likely to drive the currency, not the other way round.

 

“Device Democracy”: IBM’s IoT Paper – Or “on the blockchain, nobody knows you’re a fridge – made real”

The IBM “Device Democracy” paper is another example of how blockchain technologies could have impacts well beyond currency

I recorded an interview for Finextra last year, where I argued that we should view Bitcoin and cryptocurrencies as far more than just currency and payment systems: they’re enablers for whole new classes of innovation.

One of the example I gave was how they could provide an economic underpinning for the Internet of Things (IoT) and pointed out that if devices in your home each had their own Bitcoin wallet, the Internet of Things could rapidly become the Economy of Things

On the blockchain, nobody knows you’re a fridge (Buy it from teespring.com!)

But talk is cheap. Implementation and delivery is what counts.

So I have been enormously privileged to contribute, in a very small way, to a fascinating project being led by Paul Brody, IBM’s Vice President for our Mobile and Internet of Things consulting team. It has been well-covered by CoinDesk, GigaOm and “Two Bit Idiot” but, as Two Bit Idiot observes, I think its true significance has yet to be understood.

Here’s my simplified take on what this project is all about:

Imagine the predictions of the futurists come true and the Internet of Things becomes a reality: wireless locks controlling our houses, wifi-enabled lightbulbs and internet toasters, all that stuff.

Think about the economics from the manufacturer’s perspective.

My elderly iPhone 4 has finally reached end-of-life: it’s getting slow, iOS 8 will not run on it and I can expect apps to start failing one-by-one as their developers stop updating them for iOS 7. And yet the phone is only four years old. Most other phone manufacturers abandon their customers far more quickly, which means Apple’s four-year support for my phone is industry-leading.

My iPhone 4 served me well – even serving as a prototype for Apple Pay (Not really).  But, after four years, it is obsolete and the latest version of iOS won’t run on it

But, for the internet of things, a four-year old device is barely a child! These devices could last for far longer than anybody expects. How often do you change the locks on your door? When did you last replace your toaster? Some observers claim LED lightbulbs could last for twenty years.

Now imagine what the world would be like if Apple had to support the iPhone 4 for twenty years.  That is a long time to support, maintain and upgrade an internet-connected device.   As Paul and the team write in their very readable whitepaper, we can’t assume that the data produced by these devices will somehow create enough value to fund the ongoing costs.  Consumers seem to be in no mood to give away ever more data in exchange for “free” services… and it’s entirely unclear that this data has as much value as people think, in any case.

Technology Principles for internet-connected devices that could run for decades

So we need to make it as easy as possible for manufacturers and others to support these devices in the field. And part of the answer is surely that we need to make it as easy, cheap and sustainable as possible for manufacturers to do the “right” thing. And the argument that Paul’s paper makes is that the key to doing this is to decentralize as much logic as possible – so that what’s left at the centre is as small as possible.   They capture this intuition in the form of three key “technology principles”:

  • think “peer-to-peer” wherever possible… if two devices can find each other and communicate directly, why route it through a central point?
  • assume you’re operating in a “trustless” world: if you can’t be sure that everything is running perfectly all the time (because it won’t be), then choose a design that needs as little trust as possible
  • decentralize autonomy to the greatest extent possible – if something doesn’t need to be decided at the centre, decide it at the edges. Build on the insight that those with the greatest ongoing incentive to keep these systems running are those closest to them and who depend on them the most.

Device Democracy

This concept inspires the title of the paper: “Device Democracy”. They call the resulting architecture an “Internet of Decentralized, Autonomous Things”. The project’s IBM landing page explains more.

The paper explains the reasoning in more depth but the intriguing result is that the principles above are well-matched to concepts well-understood by the crypto and cryptocurrency worlds. A secure point-to-point messaging system like Telehash is a good candidate for direct device-to-device messaging, for example. Similarly, a trustless decentralized contract platform like Ethereum (a second-generation blockchain technology) could be a way to encode agreements between devices and to enforce rules.

Indeed, the team’s prototype (which has real locks opening and closing – I so wish I had been in the room when they demonstrated it) is based on Ethereum, Telehash and BitTorrent (you need something to distribute billions of firmware updates, after all)

But it’s important to realize that this isn’t a break from the past; it’s incremental. Existing protocols will still be needed and manufacturers will still need a way of communicating with their devices. This is all about making it as easy and secure as possible and to give end-users as much control as possible – hence “Device democracy”.

It’s perhaps likely that we’ll see hybrid models emerge where these peer-to-peer technologies are coupled with centralized services (cloud-based to hit cost objectives).

This is why I say Bitcoin and Cryptocurrencies are about so much more than currency…

For me, this project gives me further reason to believe that the impact of blockchain technologies and cryptocurrencies will be far greater than anybody expects: their applications go beyond the imaginations of any one of us.

We first saw this with Bitcoin. You needed good knowledge of economics, finance, cryptography and computer science to understand the Bitcoin concept in its full breadth. Indeed, I think this is why may academic economists, central bankers and computer scientists were amongst the slowest to grasp its importance: they were, in general, just too specialised and narrow.

So it is with this project: it has taken a team with knowledge of electronics, engineering, manufacturing, decentralized protocols and economics to devise this prototype platform.

The future belongs to the versatilists?

I wonder if this could be further evidence that the future will be owned not by the specialists or the generalists – but by the versatilists?

 

Disclaimer and Notes

1) I know there’s a lot of interest about this project so a quick reminder that this blog contains my views and analyses… not IBM’s.  I am not an official spokesman on IoT or anything else. 

2) I have lost the contact details of the clever person who created the excellent t-shirt design above. Please do get back in touch so I can credit you

 

What happens if Bitcoin mining companies vertically integrate?

Creeping centralization can come in many forms – are the Web Application Server wars a lesson from the past?!

First some history of the IT industry (you can skip this bit if you just want the meat…)

Travel back in time with me to the late nineties…. I started my career during the Web Application Server wars. The web was taking off in the late nineties and companies like WebLogic (quickly acquired by BEA) spotted a need in the marked for a Web Application Server.

They were solving an obvious problem: it was a real pain to write proper applications. Sure: you could write HTML and run it on Apache. And you could use the CGI interface to have scripts run to generate basic dynamic content. But it was painful to do anything more sophisticated

If you were a bank that wanted to build an online banking service that interfaced with your core banking system, it needed a huge amount of effort and care… and you were wholly responsible for figuring out how to manage session state, failover, transactionality and everything else. And what we quickly found was that everybody needed a similar set of code “middleware” services – and were building for themselves each time.

And one solution to this problem was the web application server. This was a server, usually written in Java, that provided a defined set of APIs and an execution environment for web applications.    You could think of it as having two faces: one face spoke “web” – it sent and received HTTP. The other face spoke “enterprise” – it provided a set of APIs, SLAs and common behaviours that app developers could rely on to build their applications.

Products like BEA WebLogic, as it became, Netscape Enterprise Server, IBM WebSphere Application Server and Microsoft’s Internet Information Services platform were all designed to solve this problem… and it became a billion-dollar industry.

Sure – somebody still had to buy, configure, install and manage these platforms (usually in corporate datacenters, running on expensive hardware) but at least there was now a clear separation: and a division of labour emerged: J2EE developers, App Server administrators, infrastructure engineers and so on.

Today is different but not that different!

Fast-forward to today and the world is different: we take a rich execution environment for granted and the state-of-the-art consists of cloud offerings that protect the developer from worrying about anything apart from their code: infrastructure, connectivity, bandwidth, middleware configuration is all delegated to the platform. (IBM’s BlueMix is a recent example of such a service)

But the insight is the same: in any field, we see lower levels of the stack become standardized and commoditized. A small number of specialized players, with economies of scale and benefitting from experience-curve effects, begin to dominate.

So I’ve often wondered if we’ll see something similar in the Bitcoin space.   Are there any parallels we can draw and, if so, what can we learn from them?

Can we see any parallels with Bitcoin infrastructure?

Look back a few years and anybody wanting to build a product or service on Bitcoin had to do it all for themselves.

For example, it seems that Mt.Gox wrote their own custom implementation of the Bitcoin protocol – which is not, perhaps, surprising given the nature of its business and the maturity of the ecosystem when it was founded. I guess that’s similar to people who wrote their own HTTP servers or implemented custom schemes for producing dynamic content back in the nineties.

More recently, APIs like BitcoinJ and platforms like BitsOfProof have emerged as credible abstraction layers upon which interesting products and services can be built. In both cases, developers typically run and maintain their own instance(s) of  Bitcoinj or BitsOfProof, etc. So one could argue this is a parallel to the on-premise app-server days of the web.  

So it’s tempting to ask… are the parallels with the web appropriate? If so, what happens if cloud-based services for Bitcoin developers emerge?

And, of course, we don’t need to imagine. These services already exist. chain.com is one such example.

Chain.com is a cloud-based Bitcoin API for developers. From their website, it appears that they maintain a set of Bitcoin nodes and ensure they are well-run and well-connected, perhaps in the way that Amazon or IBM might maintain app servers, infrastructure, routers and connectivity to major peering points on the internet.

And developers simply write their Bitcoin product or service in a language of their choice, calling the Chain APIs as and when they need to interface with the Bitcoin network.  One can imagine that coding against Chain.com makes it an order of magnitude more easy to get a new Bitcoin company up and running. You don’t need to worry about any of the infrastructure detail: Bitcoin is abstracted away to a set of easy-to-use, well-documented, high-level APIs.  

You might hardly even know you were even using Bitcoin!

And that’s a really important subtlety: if you are not running your own Bitcoin nodes, how do you know the information your service provider is giving you is accurate? How do you know you’re connected to the “real” network and seeing the real blockchain and that your transactions are making it across the network?

Now I’m sure the chain.com team are hugely competent and ethical people. This post is emphatically not a criticism of them or their service. But one does need to be open-eyed about the tradeoffs one is making as an engineer.  And one approach app developers could take might simply be to maintain their own independent copy of Bitcoin core to act as a monitor/sentinel.  It’s probably not a show-stopper.

And I can see this sort of service being immensely popular: it is a lot of effort to install and maintain Bitcoin network infrastructure… keeping it patched, making sure you really are well-connected to the Bitcoin network and so on… and if your business has latency dependencies (mining? Exchanges?) then you also need to worry about making sure your nodes are “close” to other major nodes. And so on and so forth.

Figuring out how to do this sort of stuff well has good scale effects and there will be big learning/experience curves. Just as cloud vendors can run web infrastructure better and cheaper than most companies could do themselves, we should probably expect to see small startups outsourcing their Bitcoin network integration to firms like chain.com – and maybe even hosting providers who include Bitcoin APIs and network abstraction as a core part of their service offering.

So, leaving aside the concerns this might raise around decentralization and ask yourself:

if a cloud-based Bitcoin API/application platform were to become really popular, who is best placed to deliver it?

Until a few weeks ago, I would have said I expected more firms like chain.com to be founded over the coming months and for a handful of them to gain critical mass and become the dominant application platform players of the future.

And then CoinTerra bought BitsOfProof

It was one of those lightbulb moments for me when I heard about it. Of course! How Obvious!

It makes perfect sense. Think about the capabilities and advantages that big mining firms have that they could use to build a powerful hosting proposition for developers:

  • Hosting in low-cost locations
    • They already maintain massive farms of servers, usually in locations with cheap power. They could easily offer colocation to their clients
  • Massive hashing power
    • They could commit SLAs to application clients that nobody else could make – “At this SLA, we will guarantee your transactions make it into a block within x hours”, perhaps?
  • Optimised network connectivity
    • The mining firms must surely have deep knowledge of the Bitcoin network topology so I suspect they could make promises about transaction propagation times and other time-critical requirements that would measure to some clients – “You will see transactions from other people faster on our platform than if you ran your own node”, perhaps?
  • 100% Virgin coins on tap
    • Mining companies can offer businesses who use their APIs access to freshly-minted coins… no taint, no need to ask where they came from
    • … and I’m sure there are more

Many observers, myself included, have tended to ignore mining, regarding it as an infrastructure function, with the main debate being around the threat of concentration of hashing power. What I missed until now is that a well-run mining platform is also a phenomenally powerful platform from which to build up the stack to middleware/APIs and beyond.

So the question for me is: what happens if (when?) one of the mining firms offers a hosted application environment for Bitcoin companies with a really easy-to-use abstraction API over the Bitcoin network?   Commentators such as Tim Swanson have written extensively about the incentive structure of Bitcoin mining but I’ve not yet seen an analysis that thinks through the implications of vertical integration of the sort I outline here – and what it would mean for any security analysis of the system as a whole.  

If anybody’s aware of one, I’d love to read a copy.

Disclaimer: I’ve not spoken to any of the firms named in this post and I have no insight into their product plans

A decentralized securities trading and settlement system is being built hidden in plain sight

Colored coins, chromawallet, coinprism, NXT Asset Exchange, Mastercoin, Counterparty… tens of projects are working on asset tracking, transfer and exchange systems. What are they doing? Will it work?

I wrote a piece last year explaining how today’s securities trading and settlement systems work. The full picture of participants is pretty complex:

Figure 8 csd

There are surprisingly many parties involved in the safekeeping and exchange of securities. What would the picture look like in a “decentralized world”?

At core, I think the system is all about assuring “performance”. That is… it’s all about making sure that people actually deliver on the promises they make when they enter into a trade

Recent controversies might make this seem hopelessly naïve – and they show that ensuring fairness in exchange is important – but assuring performance is the core of the aspiration.

And to deliver on this aspiration, today’s system is based on a closed, centralized model. I talked about it here and also argued  Mt.Gox model was even more centralized than the mainstream system.

We’re now seeing serious projects work on this problem. Perhaps revisiting the fundamentals will help us predict which of these projects will prevail?

Why do we have exchanges in the mainstream world?  There are lots of valid answers (liquidity, fairness, …) but none of this matters if you can’t be sure a trade you make will be settled. After all, what’s the point of agreeing a trade with somebody if they can just change their mind afterwards if it suits them?

In the mainstream world today, the general model for a stock exchange is one where it has members, who are the only entities allowed to trade on that exchange. These members are subject to strict rules. For example, the London Stock Exchange’s rule book has over 100 pages: http://www.londonstockexchange.com/traders-and-brokers/rules-regulations/rules-lse.pdf

Rule G5000 sums captures the critical function of the exchange for me:

G5000

“Obligation to settle: A member firm shall ensure that every on Exchange trade effected by it is duly settled.” Obvious, perhaps… but it needs to be said!

So the exchange helps ensure an orderly market by vetting and monitoring its members. This gives participants confidence: they don’t need to worry about who is on the other side of their trade. They know the trade they agree to will get settled. But other exchanges employ different models:

  • Prefund: Mt. Gox asked everybody to deposit their Bitcoins or fiat with them before they could trade. It guaranteed that trades executed on Gox would settle. Unfortunately, it only guaranteed they would settle on the books of Mt.Gox. As many people discovered to their cost, a settled trade on Gox was not the same as cash the bank or Bitcoins in their wallet
  • Escrow: The model I outlined in my piece earlier this year was essentially an escrow scheme. You place your Bitcoins beyond reach and they are either delivered back to you when your bid/offer expires or are delivered to the buyer. The trick here is in choosing the escrow “agent” (or agents…) carefully.
  • Clearing: This is how the The London Stock Exchange does it. In certain situations, members don’t even need to own the securities they’re selling at the time they trade them; they just need to make sure they deliver them as promised on the day of settlement. This model works because there is a closed group of trusted and well-known entities. However, there is clearly a risk: what happens if one of the participants goes bust between trade and settlement? That’s what a clearing house is there to solve, amongst other things. It keeps a close eye on its members, requires them to contribute to a “default fund” and steps in to make the other members whole if one of them fails.

Now, when we look at some of the most vibrant projects in the Bitcoin and cryptocurrency world, we see something interesting: a large number of them are working on representing non-crypto assets – such as securities – on the blockchain – They’re building out the vision of a decentralized general-purpose asset ledger.

There are two concepts we need to understand:

  • A token – something that represents an asset. Perhaps 100 shares of IBM Common Stock or ownership of a particular car.
  • An issuer – somebody that makes a promise to confer the rights and benefits associated with that asset to whomever holds it at any given point.

A concrete example: imagine I owned 10000 IBM shares (I wish…). I could issue them onto one of these platforms and publish the definition so others could see it and could see it was from me. I would, in effect, be making a promise:

“I will convey whatever benefits I enjoy through my ownership of these shares to whomever holds the token”.

So if I receive a dividend cheque, I pay it to the holder of the token. If you trust me to be good for this promise, you might be willing to purchase the token from me for $2m or so… the price of the IBM shares… owning the token would be just as good as owning the shares… and you could store it in your Bitcoin wallet and not have to deal with your broker any more!

Now, it is unlikely that you’d trust such a promise from me. But if was made by a major custodian bank you might. But note: you do have to trust the issuer.

So why bother? Why bother going to the trouble of building a decentralized asset ledger if you have to trust somebody at the end of the process?

For me, the answer is that this approach might allow increased competition between issuers. Furthermore, moving disparate asset registers (custody records, vehicle registration databases, etc) onto a common architecture might enable innovations we haven’t yet considered.   It’s too early to tell so we can all be grateful to the pioneers who are experimenting so we don’t have to.

I think there are three broad camps:

  • Coloring Bitcoins. Projects such as chromawallet and coinprism are working on systems to “tag” Bitcoins so that they can be tracked across transactions
  • New Protocols Running Over Bitcoin. mastercoin and counterparty piggy-back on Bitcoin’s peer-to-peer network, double-spend protection and consensus system but their tokens are essentially independent of Bitcoins. A counterparty token is not simply a “tagged” Bitcoin.
  • Entirely Separate Protocols. NXT and ethereum fit into this camp.

I have no particular insight into the structure of any of these projects so let’s assume they’re all run by capable, honest people and further assume that we’ll see a future where assets of all types, including securities, will be represented on a blockchain-like decentralized platform.

Then what? Presumably people will want to buy and sell…. To exchange.

And that’s where things get interesting… because we have to solve the performance problem.   We’re now in a decentralized, pseudonymous world… how do we ensure somebody who offers to buy an asset for a given price actually goes through with it and pays up?

What is the crypto-ledger rule G5000?

Is it possible to build a decentralized exchange on any of these platforms that has the strong performance guarantees we need? Can we build a decentralized exchange where a matched bid and offer inevitably lead to a settled trade?

It we look at our three models from previously, “clearing” isn’t going to work (it is, by definition, centralized and reliant on trusted identities). “Prefunding” is also problematic – what happens if the entity you sent your assets to disappears? So it looks like “escrow” is the only game in town.

Now, part of the solution already exists: we can construct “atomic” asset transfers using the Bitcoin protocol today. So I will assume exchanging payment and asset in a single transaction (“Delivery versus payment”) is achievable today on any of the platforms discussed above. But we need to get to a point where creating a valid transaction like this is inevitable once a bid and offer are matched.

Here’s where I think the state of the art is with the three approaches and it’s surprisingly different:

Coloring Bitcoins. The systems I’ve looked at don’t route bids/offers over the Bitcoin system so any matching will be done external to the platform. So it seems to me that “decentralized exchanges” on this model will have to require those posting bids or offers to demonstrate that they have placed the corresponding colored coins/Bitcoins in escrow with one or more acceptable third parties. There’s nothing that will do this automatically. So, it’s worth watchin firms like Xapo in the US and Elliptic in the UK. Professionally-run Bitcoin “cold storage vaults” such as these feel like “proto custodian banks” that could perform this function. The question is: can they devise a service that is sufficiently decentralized yet which still allows them to earn an income?

New Protocols Running Over Bitcoin. My understanding of these systems is that they embed bids/offers in the blockchain and have a protocol definition that means matches can be determined unambiguously. Furthermore, the act of making a bid or offer locks the associated assets until the trade is resolved or a bid/offer expires… automatic escrow, if you like. Assuming I am right, then this does appear to offer the “inevitability” promise that I think is so important. But it is at the expense of polluting the blockchain with bids/offers. It seems inelegant to me that one would store transient data (time-limited bids/offers) in such a permanent form of storage. But perhaps there’s no other way?

Entirely Separate Protocols. My working assumption is that NXT, too, works on the basis of bids/offers encumbering the associated assets until the outcome of the trade is resolved.  With Ethereum, the answer to every question is, of course, “it’s Turing Complete so of course you can do it” but I need to dig a little deeper to be sure….

 

Where is this going?

I think we’re going to see a market test: the colored coin approach is, in many ways, the most elegant as it uses the blockchain solely for storing/transferring the asset.   It means a range of exchange types can be trialled (escrow, pre-funding, reputation-based?)… but none of them will deliver full “inevitability” of settlement.  Perhaps consumers will care. Perhaps they won’t.

Projects like mastercoin and counterparty look able to deliver on the “inevitability” promise but will it be at the cost of blockchain bloat?

It will be an interesting few months ahead.

 

A final thought… What if we simply don’t worry about it and price it instead?!

The other approach is completely radical… instead of trying to force performance, why not model it as an option? We can think of somebody who posts a bid/offer but who then reneges as exercising an option to renege. This option clearly has value – if they would lose money by completing the trade as agreed, the option payoff is at least as much as they stood to lose! So is it possible to model the value of the option to renege and force participants to pay the option value up-front in order to post a bid/offer?

Unanswered questions: to whom would the price be paid? Is there any precedent for modeling the “option to renege” in this way? What would be the liquidity implications?

Conclusion

I said at the start of this piece that a new financial infrastructure is being built “hidden in plain sight”. For the reasons outlined above, I think the “exchange” aspect of this infrastructure still has a long way to go but we’re about to witness a fascinating experiment.

Bitcoin Mining: The First Technology Platform That Works because it goes SLOW?

They key to understanding mining is to realize we need blocks to be produced slowly!

Whenever I present Bitcoin to new audiences, I avoid talking about mining. I find it confuse more than it enlightens. Instead, I simply give some intuition. I say:

“Today’s value-transfer systems rely on central ledgers. Banks, telcos and other firms have a big computer that keeps track of who owns what. And when you want to make a payment, they update this central ledger. Bitcoin does it a completely different way. It doesn’t have a central ledger. Instead, everybody who runs the (full) software has their own copy of the ledger. That’s right: hundreds of thousands of people all have a full copy of the ledger. This means no single person can cut you off, confiscate your assets or charge you an unfair fee. And the genius of Bitcoin was to figure out a way to encourage people to maintain these ledgers and to do so honestly. Exactly how this works takes a long time to explain but the end-result is that we have a system with no trusted third parties.”

The value of this explanation is that skeptics in the audience know what assumptions I am asking them to make (“assume for now that the economic incentives and cryptography do actually work…”) but we avoid getting bogged down in unnecessary technical detail. It lets us move on to the more interesting topics

OK – so we have a way to side-step the mining question. But what if you actually need to talk about it? What then?

I am enlisted on the University of Nicosia’s Digital Currency MOOC, led by Antonis Polemitis and Andreas M. Antonopoulos and I was intrigued to see that they attack this question and the “byzantine generals” problem head-on in module two. It’s a very nice treatment.

In this post, I take a complementary approach and ask: how would I build a digital cash system from scratch if I didn’t know anything about Bitcoin? What might I try first? What might go wrong? How might I fix it?

Let’s go on a journey to build our own digital money system from scratch…

Imagine you wanted to build a system of electronic cash without a third-party. How would you do it?

Here’s one way. You could create some “money files” on your computer hard drive. These would be like bank notes. Maybe they’d look something like this:

DigitalMoney

An early attempt at a digital money system!

In the picture above, I have two “ten pound” files and two “five pound” files. Great – I have £30 of digital money. This is easy… Why did it take so long for Bitcoin to be invented?!

Now… let’s say I wanted to send £10 to a friend. This would also be easy. I’d just need to write an email, attach one of the “ten pound” money files and click “send”. Wonderful! The money has been transferred.

Screen Shot 2014-05-21 at 20.09.09

Emailing £10 to a friend. Who needs Bitcoin?

There’s just one problem…

There’s still a copy of that file on my computer.    So there was £30 in the system before and now there is £40. Now… I am, of course, honest and will delete my copy. But what if I forgot?

Worse, what’s to stop me simply making hundreds of copies of the “ten pound” file on my computer? I’d be RICH!!

This idea simply isn’t going to work and that’s why digital money systems have the idea of a ledger: there needs to be something that everybody trusts to keep proper track of how much money each person has.   We need this ledger to record the fact that I have £10 less and my friend has £10 more.

All systems before Bitcoin did this using a centralized ledger – in a bank or a telecoms firm, say.

But does this ledger really need to be centralized?

But here’s a thought what if I sent the “money file” attachment to my friend – just like before – but I also put everybody else in the entire world on cc?

The rest of the world could see that I had sent the money to my friend and if I tried to send the same file again in the future, they’d see that I was cheating and I’d be in big trouble…

If we leave aside questions of scalability, we could be on to something here…

But… race conditions are our enemy

But there’s an annoying problem. Software engineers call it a “race condition”. It’s still possible for me to cheat, even if the whole world is watching.

Here’s what I could do:

Imagine I owed £10 to each of Alice and Bob and wanted to cheat the system by sending the same £10 money file to them both:

DoubleSpendSetup1

I owe £10 to two people and want to cheat by sending them both the same £10 “money file”

I notice something interesting… Alice and Bob use different email providers….  And I know that information takes time to travel.

What would happen if I use my Gmail account to send Alice’s money to her Gmail account and I use my Hotmail account to send Bob’s money to his Hotmail account, copying everybody in the world on both emails per the rules?

Different people will see the emails arrive in a different order depending on which email provider they use.

Imagine you’re another user of Gmail:

You’ll receive a copy of my email to Alice pretty quickly. After all, I sent it from my Gmail account.   Shortly afterwards, you’ll receive a copy of the email I sent to Bob. It arrives a bit slower because it’s coming across the internet from my Hotmail account.

Now imagine you’re another user of Hotmail.

You’ll receive a copy of my email to Bob pretty quickly. After all, I sent it from my Hotmail account. Shortly afterwards, you’ll receive a copy of the email I sent to Alice. It arrives a bit slower because it’s coming across the internet from my Gmail account.

And now imagine you use a completely different email service. Who knows which email you’ll receive first… it will be effectively random.

So we have a big problem: everybody will see that I’ve tried to spend the same money twice…. that’s something, I guess.   But they won’t agree whether Alice or Bob is the rightful recipient! Some will think I sent it to Alice first – and that the payment to Bob is therefore invalid – and some will think I sent it to Bob first and that the payment to Alice is invalid!

DoubleSpendSetup2

There’s no such thing as total “ordering” in a decentralized system

And there’s no easy way to resolve this… we can’t rely on timestamps since I could fake them(and they might be identical). And we can’t simply say: “if you see a double spend then neither transaction is valid” since it would mean I could always block up the system and “take back” money simply by issuing a new payment to confuse everybody…

Oh dear.

But notice something interesting: it doesn’t matter whether Alice or Bob is judged to be the rightful owner, since one of them was always going to be disappointed. We just want everybody to know who it is.

And this is the insight that allows us to begin to solve the problem.

Because it means we should think of these payment emails to Alice and Bob not as definitive payments but as payments proposals. They might be valid. Or they might not. We need the “system” as a whole to determine it – it needs to come to consensus.

Now… figuring this out on a payment-by-payment basis would be overwhelming. So we’ll settle for a system that batches up these payments proposals into lists – or “blocks” – of confirmed payments.

So where have we got to? We have this idea of directly sending “money files” to recipients – “peer-to-peer”, if you like. And we have the second idea that you also tell everybody else in the world about it so they can see what’s happening. And the key problem to solve is: how do we come to agreement when payment proposals conflict?

Let’s bring the observers into the picture

Here’s something we could do: we could say to all the people on cc:

“hey… help us out here.   You’ve been copied on all these payment proposal emails. Why don’t one of you choose a selection of payment proposals that haven’t already been confirmed in the past and which don’t conflict with each other and email the list to everybody else? We’ll all agree that the list you circulate is the one we’ll go with to resolve the conflicts”

If we’re lucky, somebody might look through their inbox, choose some unconfirmed payment proposals and draw up such a list. Perhaps they decide that they will include the payment to Bob in their list. This means they can’t also include the payment to Alice (since those payments conflict with each other – they use the same underlying payment file). But at least we have a decision! They email this list to everybody else in the world.

Everybody receives a copy of the list and can update their own view of the world… their copy of the “ledger”, if you like…

So we all now know that a decision has been made: We have agreed through this “protocol” that Richard has paid Bob and the payment to Alice is invalid. And we know this because we know everybody else received the same file and will be following the same thought process.

Excellent. We now know Bob has the money and the world moves on. We’ve solved the problem right?

  • We have this idea of “payment files”
  • You “spend” them by emailing them to the recipient and copying everybody else in the world.
  • Somebody on copy periodically produces a list of transactions they’ve seen that are not fraudulent and are not “double-spends” and circulates this list to everybody else.
  • Everybody who receives this list knows that everybody else has also received this list and that everybody else knows that they have received it and so feels confident in updating their own records to record that the payments in this list are now “confirmed”

Except… why on earth would anybody go to the trouble of producing and circulating that list in the first place? What’s their incentive?

There really isn’t one.   So we need to incent them. Perhaps they can earn a small transaction fee or perhaps we could award them some newly created “payment files” in return for their effort. That would be a neat way of introducing these payment files into the system in the first place, in fact.

But now we have the opposite problem… everybody will want to produce these blocks and we’ll be overwhelmed with competing blocks being emailed to everybody… it will be like the worst “reply to all” email tsunami ever and nobody will know which of the competing blocks to use to update their ledgers!

It feels like we’re back to square one.

The world’s first technology platform that works because it goes SLOW

Exceptand this is the genius of Bitcoin. What if we could agree on a system that makes it so difficult to produce one of these lists that, even if everybody is trying really hard, they only produce one every few minutes?

The would give enough time for the list to work its way around the internet. And once you received it, you could be pretty sure there wasn’t a different one flying around because they are only produced every few minutes and if there was another one, you’d have seen it by now in any case…

So now you have the right balance: incentives to ensure somebody produces these lists (Bitcoin calls them “blocks”) and a system that makes it difficult so that they’re not produced so quickly that we end up with multiple competing blocks at any time.

And this is what Bitcoin mining is all about. It’s nothing more than participants in the system competing with each other to find one of these valid blocks in order to earn the reward.

Bitcoin aims for a “block interval” of about ten minutes. Perhaps this is too slow. Perhaps it’s too quick.  But it does achieve the aim of ensuing the blocks usually have time to reach everybody else before the next one is found.

Now… the system in use by Bitcoin is probabilistic… so sometimes two blocks are produced in quick succession. But this is rare… and you can deal with it when it only happens occasionally.

So how do you make things go “slow”?

One way to make block production slow is to make it incredibly difficult to produce one. This is what Bitcoin does. It uses a system called “proof of work”, where participants essentially have to perform nearly identical calculations again and again and again until a solution matching a pre-agreed pattern is discovered… and the difficulty of this problem is periodically adjusted so that a solution is found every ten minutes on average.

This seems wasteful but we need something just like this to achieve our aim of not producing blocks too quickly.

But there are other options. For example, one variant of a scheme called “proof of stake” makes it difficult to find a block unless you own several coins and you haven’t done anything with them for some time. This combination of “stake” and “time” dramatically reduces the opportunity for participants to find blocks and so the rate is kept low, without computers having to burn electricity solving puzzles to the same extent.

The security analysis and design of such schemes is an active area of research.

Conclusion

I have omitted some (lots of) important details and it’s clear that the “payment file” analogy is highly imperfect.   But I think encouraging people to consider “how would I do it” can help impact a considerable degree of understanding.  And the key insight is: “Cryptocurrency systems work because they are the first computing platforms deliberately designed to go slow!”

 

 

Bitcoin and Bankers: Reflections on a panel discussion

Look beyond currency to see the true potential for cryptocurrencies… but don’t forget to apply the lessons to today’s problems too…

I participated in the Bitcoin panel at Finextra’s Future Money conference at Canary Wharf’s Level 39 in London this week. Zilvinas Bareisis of Celent has a succinct write-up of the event here. It was live-scribed by the amazing Mela Atanassova:

Bitcoin

The Finextra team assembled the “who’s who” of the London FinTech scene and it pays to be prepared when speaking in front of that sort of audience… so I gave some thought to my talking points beforehand.

When I reflected on the event afterwards, it struck me that our moderator, Liz Lumley, had expertly led us through most of the key “what Bankers need to know” questions: In what way is Bitcoin different to what went before? Why do cryptocurrencies cause such intense discussion? Why do sensible people get so excited by this stuff? Where might it be going?

So in this blogpost I’ve combined my talking points with observations made by my co-panellists: Stan Stalnaker, Ali Farid Khwaja and Nadav Rosenberg.

How do you bring a diverse audience “up to speed” on Bitcoin?

Elizabeth Lumley kicked off the panel by asking who in the audience had a Bitcoin wallet. Over half of the hands went up. Oh dear… this was not your typical audience. What could we tell these people that they didn’t already know?

Luckily, we had been preceded by a keynote by Allessandro Hatami of Lloyds Banking Group. He’s a very smart guy and he gave a thought-provoking presentation. But I noticed something interesting: although he only mentioned Bitcoin in passing, he referred to it in the same context as Amazon Coins. Now, I’m sure he understands the differences but it highlighted that it’s very easy to lead audiences into “category errors” if we’re not careful.

Luckily, we had planned for this in advance. So I spent a few minutes outlining what I think is the “irreducible core” – or fundamental difference – of cryptocurrencies relative to everything that went before, using my “how I explain Bitcoin to new audiences” piece as the structure.

In short:

  • Bitcoin is audacious: until cryptocurrencies came along, humanity had no ability to transmit value at a distance without the permission and support of a third party. Bitcoin taught us how to do it.
  • Blockchain technology could be as important as the web: if we think of the web as the world’s first “internet-scale open platform for information exchange”, we can think of the blockchain as the world’s first “internet-scale open platform for value-exchange”. And the openness is the key.
  • The implications go beyond payments: think “economy of things” and “smart contracts”

In other words, if you’re thinking Bitcoin means “funny internet money”, you’re missing the point.

OK – it could be a cool piece of computer science. But why are so many serious people talking about it so seriously?

Some very smart, very sensible people have concluded that the “web analogy” is plausible and are investing and working on that basis. Other people have been transfixed by the elegance of the underlying consensus algorithm. So it’s not surprising that Bitcoin has unleashed a storm of commentary.

But I think there’s also another reason. I think that Bitcoin has made large numbers of intelligent, thoughtful people realize that they didn’t understand the things they thought they understood. And they are rather enjoying the intellectual rabbit-hole of discovery it has sent them down as they try to “re-learn” things they thought they already knew… This is certainly the case for me. It makes us think deeply about questions like:

The eye-opener for me was what happened when I published my piece on how payment systems work. I wrote it for Bitcoin users who didn’t know much about the banking system. What surprised me was who read it. It was being linked to from banks’ own internal training sites. The answers to these questions are not obvious and Bitcoin has inspired many of us to really think about them.

And I believe this is a big reason why so many people are talking about cryptocurrencies: they force us to clarify our own thoughts about things we thought we already knew.

OK – so cryptocurrencies are important and have potential. But give me just one good example of how it’s going to replace what we already have

I was challenged by a banker in the audience who had clearly heard the cryptocurrency story several times before and was growing tired of all the hype. Sure – it’s clever. Sure – it lets us do things we couldn’t do before. But so what? What real-world problem does it actually solve?

I answered this in three parts.

First, I pointed out how there is a short-term opportunity to take huge cost out of International Remittances. Not glamorous but a clear area where the technology could make a difference to the world.

Second, I argued Bitcoin helps us think about value: what makes today’s financial institutions valuable? Consider Payment Cards. If Bitcoin allows you to pay anybody else near-instantly for near-zero cost, doesn’t this mean Visa and Mastercard will soon be dead? My answer was no. If you believe all they do is payments then Bitcoin is a mortal threat… but that isn’t why they’re valuable. These networks are valuable to us because they promise universal acceptance – they minimize “acceptance anxiety”* no matter where we are in the world. And they have sophisticated rule-books: disputes and chargebacks give consumers and merchants certainty about what will happen when things go wrong. These things are valuable.

Third, I argued that – regardless of whether cryptocurrencies gain widespread adoption – they are already influencing today’s mainstream banking debates. Companies like XBTerminal have shown us how to route Bitcoin push-payment transactions via the terminal, to overcome the problem of mobile devices with no data connection. Peter Keenan, the Chief Executive of Zapp, was at the event and I pointed out how this approach could solve the problem his service will face when customers try to use it in underground shopping malls…

* An aside on “acceptance anxiety”: this is what I call the fear that your payment instrument won’t work when you try to use it. My prediction is that any retail payment solution has to induce less acceptance anxiety than existing methods if consumers are going to adopt it

By way of example, here’s my attempt at using a Bitcoin ATM in Shoreditch… my colleague’s smartphone wallet wasn’t working so I tried my laptop. This is not quite the seamless consumer experience we aspire to 🙂  (not yet…)

Richard Bitcoin ATM.photo

 

How are Banks supposed to formulate strategy when faced with a bewildering landcape of altcoins, sidechains, treechains and who knows what else?

Answer: by keeping laser-focussed on the principles – and ignoring everything else.

This is why I am so maniacal about hammering home phrases like:

  • “Value transfer at a distance with no third party”
  • “Internet-scale open platform for value exchange”
  • “Solving the problem of coming to consensus with people you don’t know, don’t trust and where many of whom are trying to steal your money”

We have to keep focused on these principles because the reality is that the underlying technical details are constantly changing. It may not be obvious to outsiders but it’s important to realize that the cryptocurrency phenomenon is an experiment. Fire up a copy of Bitcoin Core and look at the “about” dialog. Here’s mine:

BitcoinCore

“This is experimental software”

This point is important: the Bitcoin we see today is not the Bitcoin we will be running in two years’ time. Many of today’s supposed problems (transaction throughput limitations, slow confirmation of transactions, …) will have been addressed through sidechains, treechains or solutions that haven’t even been invented yet.

So the only way to formulate strategy today is to keep focused on the principles and to ignore those details that are purely transient.

Ask yourself: what happens if our customers can send money instantly and for free? What happens if push-payments become universal? What happens if we can settle securities transactions, with finality, without needing clearing houses, custodians and CSDs? …

 

But banks should also bear in mind that widespread adoption could take longer than we expect:

Ask a technologist when the web went “mainstream” and they’ll probably say 1994 or 1995. But this answer is wrong by a decade! Facebook wasn’t even founded until 2004. Twitter? 2006. But even this misses the point. The transformational impact of the web (the internet-scale open platform for information exchange, remember…) was that it enabled the mobile and cloud revolutions. Yet Amazon Web Services didn’t launch until 2006 and the first iPhone wasn’t released until 2007.

And on top of this, the reality is that most mainstream users of cryptocurrency technology won’t even know they’re using it.

The only way to stay sane is to focus on the principles.

What about trust?

After the panel, I was approached by a member of the audience who was astonished that we hadn’t touched on the topic of trust. Fair point. Finextra’s Matt White was nearby and grabbed me for a two-minute follow-up:

 

My thanks to Elizabeth Lumley, Nick Hastings and the Finextra team for organizing such an excellent event.

 

[Updated 2014-05-05 with clearer Live-Scribe image]

Ripple is hard to understand, but it’s worth making the effort: there’s a deep insight at its core

Ten dollars in your pocket is not the same as ten dollars in the bank and neither are the same as a ten dollar credit on your electric bill or the ten dollars your friend owes you. Ripple is simply a manifestation of this insight.

I spent a couple of hours at the Startupbootcamp Fintechathon last weekend. I was there to share ideas on what types of finance problem are a good fit for block chain solutions – and which ones might be best solved using other techniques.

When I arrived, the audience were deep in videoconference with Ryan Terribilini of Ripple Labs. I thought he did a great job of answering their questions about Ripple and I decided it was time I finally tried to get my head around it.

The conclusion I have come to is that Ripple is built on a really deep insight:

Not all dollar, euro and sterling liabilities are the same.

And Ripple is nothing more than a platform that makes this insight explicit.

Here’s how I finally wrapped my head around Ripple

I wrote a piece last year about how money moves around the banking system. I wrote:

Perhaps the most important thing we need to realise about bank deposits is that they are liabilities. When you pay money into a bank, you don’t really have a deposit… you have lent that money to the bank. They owe it to you.  It becomes one of their liabilities. That’s why we say our accounts are in credit: we have extended credit to the bank.  Similarly, if you are overdrawn and owe money to the bank, that becomes your liability and their asset.

I then explained how the payment system is really little more than a bunch of systems for transferring these obligations around.  Where Ripple encourages us to think more deeply is about whose obligations they are.

Imagine I owe my friend Bob £50 and that we are both customers of Barclays bank. When it’s time for me to pay him back, I instruct a “transfer” online. I tell the bank to reduce what they owe me by £50 and increase what they owe to Bob by £50. The bank remains flat… the only difference is to whom they owe the money.

This is the same story I told in my piece about the payments system.

Setup1

Richard and Bob both trust Barclays as an issuer of pounds. So Richard can pay Bob by transferring the money inside Barclays

But think about just happened:

  • Before the transfer, I owed £50 to Bob.
  • After the transfer, the bank owes £50 to Bob.

Bob still doesn’t have the £50 in his hand… all that’s happened is that somebody else now owes him the money.   But this is just fine for Bob…. He trusted me to owe him the money and he also trusts his bank to owe it to him.

Setup2

Bob previously had a £50 “asset” issued by Richard. Now he has a £50 asset issued by Barclays. Richard’s debt to Bob is settled and Bob is happy.

OK – so that’s obvious, perhaps.

But notice how it only worked because Bob trusted both me and the bank.

And also notice that he doesn’t trust us in the same way.   He’d probably be quite happy to have thousands of pounds in his bank account. I suspect he’d be very uncomfortable lending me more than £50.

Not all dollar, euro or sterling asset deposits are the same!  It matters who issues them.

It is highly likely that Bob prefers to be owed money by his bank than by me. £50 owed by me is not the same as £50 owed by the bank.

And this is the Ripple insight.

This is a really powerful observation

Imagine now that the situation is a little more complicated.  Bob and I are sitting in a café. I don’t have any cash and Bob can’t remember his account details. How am I going to pay him?  A Barclays transfer isn’t going to work.

Out of the corner of my eye, I see that the café sells prepaid debit cards. Excellent! I use my own debit card to buy a £50 prepaid debit card and hand it to Bob.   My debt is settled, right?

Not so fast….

What makes me think Bob would be happy to accept a prepaid debit card from an issuer he’s never heard of? Are they insured? What happens if they go bust before he can spend the cash?

£50 on a prepaid debit card is not the same as £50 in cash or a £50 IOU from a friend or £50 owed by Barclays bank.   And it is Bob’s choice whether to trust that card.

It turns out that Bob doesn’t trust this card… So we have a problem. I don’t have his bank account details and he won’t accept a prepaid debit card. How am I going to pay him?

Conveniently for my story, it just so happens that my friend Carol is sitting at the table next to us. Bob doesn’t know Carol so I introduce them to each other.

It turns out that Carol is trying to buy some goods online and has forgotten to bring her credit card. The goods cost £50 and she just happens to have £50 in cash in her purse. (It really is a most amazing coincidence…)

So the situation is something like the diagram below. We see that I have nothing that Bob will accept as payment but that Carol might be able to help us bridge the gap. (I’ve added some detail to show that each person might trust each issuer to different extents – it’s not a yes or no question)

Setup3

How can Richard pay Bob when there are no issuers of pound sterling that Bob trusts that Richard is able to use?

Here’s what we could do: I could give Carol the prepaid debit card (she needs something she can use online and the £50 balance is well below the £1000 limit that she is willing to trust the card company for) and she can then give the £50 in cash to Bob. Bob is happy to take the cash: he also trusts the Bank of England, the issuer of the notes.

Great: Bob now has £50 issued by somebody he trusts. I’ve managed to pay Bob what I owe him by enlisting the help of a prepaid debit card provider and Carol… even though Bob didn’t trust the prepaid debit card and he doesn’t even know Carol.

Setup4

Richard can pay Bob by “rippling” his transaction through multiple issuers and intermediaries, finding a route of trust that wouldn’t have been possible otherwise.

Yes, yes, I know…. It’s an utterly contrived example.  But it makes the point: not all pounds, dollars and euros are the same. It all depends on the issuer: when we open a bank account in the UK, we’re saying we trust that bank to issue GBP liabilities to us.     When we lend £50 to a friend, we’re saying we trust that friend to issue GBP IOUs. And we all trust different groups of issuers and to different extents.

So how does this relate to Ripple?

The answer is that Ripple is a general purpose ledger and payment network based on the key insight that when you try to pay somebody, it’s only going to work if they end up with an asset that was issued by an issuer they trust.

In our case, Bob trusted me, he trusted Barclays and he trusted the Bank of England. But he didn’t trust the prepaid debit provider and he doesn’t trust Carol – so a £50 balance issued by the prepaid debit card provider was never going to satisfy Bob.

But, because Carol and I both trusted the prepaid debit provider and both Carol and Bob trusted the Bank of England – and Carol actually had some notes issued by the Bank of England in her purse – I was able to settle my debt to Bob by routing it through the prepaid debit card provider and through Carol.

The lesson of all this is that if you’re going to build a system that represents real-world currency balances and make payments between them, you really need to think about who issues those balances.

And once you get this point, the point of Ripple becomes clear:  it’s a way for one person to hold funds issued by issuers he or she trusts – and to pay anybody else by transforming those funds into balances issued by issuers that the recipient trusts.

Sure – there’s more to it than that…. But once you get the idea that any individual participant will only trust balances issued by certain issuers, the whole point and design of the network becomes clear.

But this isn’t really about Richard, Bob and Carol: think about the banks themselves and major corporations

The example in this post feels contrived, because it is.  But imagine you’re a major bank.  You have precisely this problem: you have correspondent banking arrangements around the world.  You have separately capitalised and regulated subsidiaries around the world.  And you need to make payments to people and firms all over the world on behalf of yourself and on behalf of your customers.

You need to keep track of balances issued by hundreds of legal entities around the world and need to instruct transfers and exchanges thousands of times per day.

Today, you do this through correspondent banking arrangements, the SWIFT network and multiple other intermediaries and communication platforms.

If I understand the vision correctly, Ripple sees itself as a universal, distributed ledger for simplifying and rationalising this complicated landscape.

Will it work? Will the banks and major firms adopt it? Who knows. But the underlying insight is deep and it feels like they’ve figured out something that is important.

Postscript: What about Bitcoin?

It amuses me when I see Bitcoin and Ripple discussed in the same context because, for me, they’re completely different.   The core of Bitcoin is all about building a trust-free decentralized transaction ledger for tracking the ownership and transfer of scarce tokens – Bitcoins. And the whole point of Bitcoins is that they are counterparty-risk-free assets: my Bitcoin is not somebody else’s liability.

By contrast, Ripple is all about dealing with assets that are somebody else’s liability. So the focus in Ripple is on representing liabilities issued by identifiable issuers and enabling them to be transferred between individuals on a network.

They share some similarities but they’re not the same thing at all.

How I explain Bitcoin and Cryptocurrencies to new audiences

I’ve given several informal talks on Bitcoin and cryptocurrencies recently – mostly to mixed audiences of finance and tech professionals, with varying levels of knowledge about Bitcoin.    I’ve found that the structure below has been working well to so I thought I’d share it in case it helps others explain it to their clients, colleagues or friends.

I don’t claim any of the Bitcoin concepts below are mine… just this approach to explaining them.

Bitcoin’s core idea is audacious

I point out that money is weird: it behaves completely differently when you try to spend it in person to when you try to spend it at a distance.   Here’s what I mean:

If you’re physically with somebody, it’s easy to pay them: you just hand over the cash. You don’t need anybody else’s help and you don’t need anybody’s permission.

But if you’re at a distance, you can’t do the same thing: you always need somebody else’s help…. a bank, a remittance firm, a telco….  Somebody has to be there to transmit the value to the other end.   And they get to set the rules, they get to watch and in some parts of the world, they don’t even exist.

BitcoinPaper

The “audacious announcements”: Nakamoto’s announcement email and Bitcoin whitepaper

And then Satoshi Nakamoto’s white-paper came along and said something utterly audacious.  It said that you could transmit value at a distance with no trusted third party. Five years on, that is still a mind-blowing claim. And it’s all the more mind-blowing because it actually works.   If you take nothing else away from one of my talks, take away the realisation of just how audacious this idea is.  

I also point audiences at this IBM Academy of Technology TechNote, which I co-wrote.  It includes a simple analogy for how Bitcoin works under the covers.  But I don’t talk about the details during the presentation – it simply isn’t necessary.

But forget payments… this is all about a platform

I then say that the amazing thing is that this isn’t even the best bit.  The real story is what you can do with it and what it might mean for the world.  I then make the analogy with the World-Wide Web.

I’m just about old enough to remember the world before the web.  I remember dial-up BBSs, TV “Teletext”, the closed-gardens of AOL and Compuserve.      They were all examples of closed “information-exchange systems” and they were all completely blown away by the web, the world’s first internet-scale open platform for information exchange.

It was owned by nobody, nobody needed permission to build on it and we all know what happened next.

Now look at today’s value exchange networks: the card networks, large bank custody networks, domestic net settlement systems, real-time gross settlement systems, remittance networks.   They look similar:  broadly non-interoperable, closed, proprietary.  Sure: there are good reasons for this – security, financial crime prevention and so on — and those who built them surely deserve to earn a return from running them! But the parallels are eerie.

WebBitcoinAnalogy

The big VC firms investing in Bitcoin are all making the same bet:  Bitcoin will be the world’s pre-eminent internet-scale open platform for value exchange

 

So I invite my listeners to ask themselves:  could Bitcoin and the cryptocurrency revolution be the value-transfer equivalent of the HTTP/HTML/Mosaic information-transfer platform?

If so, it’s not difficult to understand why so many people are so focused on this area.    I also point out that this doesn’t mean the existing value-transfer networks will be replaced – but that it could mean we’re going to see disruption.

What are the implications?

I then share ideas with the audience related to their business…. Perhaps how colored coins could teach us how to build next-generation custody systems.  Or how the openness of the network means non-human systems can become economic actors.  Audiences tend to find Mike Hearn’s self-driving taxis quite amusing and I see eyes open wide when I introduce the idea of the “economy of things”, where a fridge has an internet connection and a Bitcoin wallet

MoreThanPayments

We should expect to see innovation in law, retail, banking, custody, …

So where could this be going?

I then end with a claim…. there are surely only three ways this can go:

Scenario 1:  “It’s all a collective hysteria”

Cryptocurrencies could be a huge collective madness – driven by too many geeks with too much time (and cheap capital) on their hands.  Possible. Plausible.  But it ignores the audacious invention of “peer-to-peer value transfer at a distance”.  I consider this scenario unlikely  (Although, as Ken Tindell points out we should – of course – expect a crash and associated disillusionment at some point)     [Edited 2013-3-27]

Scenario 2: “Banks are doomed; sell everything!”

This scenario invites us to believe that Bitcoin could destroy the banks, replace sovereign currencies as we know them and unleash the era of the feudal geek lords.   Yeah, right.

Scenario 3: Coexistence

So we’re left with only one possibility: we’re going to see co-existence.

This would mean that the winners in the finance sector will probably be the fast (or slow) followers – not the early adopters – and we should regard today as analogous to the web in 1994/1995 when thinking about what infrastructure needs to be built…   Indeed, as I argue in my write-up of a recent panel discussion, we should also remember that the transformational impact of the web wasn’t fully felt for another decade – don’t expect the world to  change overnight.

And that’s why I find this so interesting…

[Updated 2014-05-14]

A Simple Explanation of How Shares Move Around the Securities Settlement System

I explained here how money moves around the banking system and how the Bitcoin system causes us to revisit our assumptions about what a payment system must look like. In this post, I turn my attention to securities settlement: if I sell some shares to you, how do they actually move from my account to yours? What is actually “moving”? What do I mean by “account”? Who is involved? What are the moving parts? 

I have argued for some time that the Bitcoin system is best regarded as a global, decentralized asset register and that some of the assets it could register, track and transfer could be securities (stocks and bonds). In this post, I go back to basics to explain what actually happens behind the scenes today and use that to think through the implications should schemes such as ColoredCoins.org or MasterCoin gain traction. I’ve discussed these systems in a couple of articles here (coloured coins) and here (MasterCoin).

As in the previous article, my focus is on imparting understanding by telling a story and building up a narrative.  This means some of the precise details may be simplified. So please don’t build a securities settlement system for your client using this article as your guide!

First, let’s establish some common ground.

Here are the simplifying assumptions I’m going to make:

  • I’m going to invent a fictional company called MegaCorp
  • I’m going to assume we start back in the days when certificates were in paper form. I’ll move to electronic systems later in the article but I think it helps first to think about paper – it helps us keep track of what’s really going on
  • I’m going to rewrite history to suit the story. If you’re a historian of finance, this article is not for you!
  • Finally, I’m going to assume that MegaCorp already exists, has issued shares and that they are in the hands of a large number of individuals, banks and other firms.  I’m going to assume you’re one of these owners. How these shares were issued would be a fascinating story itself but there isn’t space here to talk about corporate finance, IPOs and all the rest. Google it: “primary market” activity is a really interesting area of investment banking.

So let’s get started. You own some MegaCorp shares and you want to sell them.

Selling shares if everything was paper-based

So… you own some shares in MegaCorp and you have a piece of paper that proves it: a share certificate. You’d like to sell those shares. Now you have a problem. How do you find somebody who is willing to buy them from you?

I guess you could put an advert in the paper or maybe walk around town wearing a sandwich board proclaiming your desire to sell.  But it’s not ideal.

Figure 1 - buyerseller

Figure 1 The fundamental problem: how does a seller find a buyer or a buyer find a seller?

The obvious answer is that it would all be so much easier if there were a place – a venue where people commonly in the business of buying and selling shares could get together and find each other.  Happily, there are and we call such places stock exchanges. In the early days, they were simply coffee houses or under a Buttonwood tree in trading centres such as London. Over time, they became formalized. But the idea is the same: concentrate buyers and sellers in one place to maximize the chance of matching them with each other.

This adds a new box to our diagram: the stock exchange.

Figure 2 - exchange

Figure 2 A stock exchange brings buyers and sellers together to help them execute trades

There are still some problems, however. What if you’re just an occasional buyer or seller? Do you really want to have to trek to London or New York every time you want to buy or sell? And as an out-of-towner, do you really think you’d get a good deal from the locals who spend all their time there? You’d be completely out of your depth.  So you’d probably value the services of an intermediary – somebody who could go to the exchange on your behalf and get you the best deal they could. We call these people stockbrokers (or just brokers).  An example for retail investors may be Charles Schwab. An example for, say, pension funds might be Deutsche Bank or Morgan Stanley.

Figure 3 brokers

Figure 3 Brokers act on behalf of buyers and sellers

You’ll notice that “stock exchange” has become “stock exchange(s)”: this reflects the reality that there could be multiple venues you could visit to trade a particular share.  This creates opportunities for arbitrage (the price may be different at each venue) but we’ll ignore this from now on.

Now this works fine if there is lots of trade in MegaCorp shares: when my broker tries to sell, there will probably be somebody else who wants to buy.  But what happens if there are no buyers just then? Does that mean the share is worthless? Clearly not. So there’s an opportunity to somebody to make a living taking a bit of risk by buying and selling shares on their own account. Whereas a broker is acting in an agency capacity, this new person would make money from their wits: buying low and selling high with their own money. We call these people market-makers – since they literally create a market in the shares in which they specialize. We call firms like Goldman Sachs and Morgan Stanley broker-dealers because some of their subsidiaries engage in both broking and market-making in various markets.

Figure 4 market makers

Figure 4 Market-makers buy and sell shares on their own account, creating liquidity

Guess what: we still have problems! Remember: I’ve asked my broker to sell my shares for me but imagine they succeed.  Then what? We now have the tricky problem of settlement.  Remember: we’re still in the days of paper-based certificates.  So my broker has just sold my MegaCorp shares. Well… the buyer is going to want the certificate pretty soon.  And I would quite like the cash.

Now… I could just trust my broker.  I could leave the paper certificate in their hands and ask them to take receipt of the cash when the buyer’s broker hands over their cash.  But that means placing a lot of trust in that individual. And remember: I chose the broker because they could navigate the rough and tumble of the stock exchange, not because I trusted their book-keeping skills!

Worse, what happens if MegaCorp issues a dividend while the share certificate is in the hands of the broker? Do they really have the ability or inclination to collect the divident, allocate it to my account and report to me about this in a timely manner? Perhaps, but probably not.

But we still have the need for somebody to keep the certificate safe and to be on hand to give it to the purchaser if a sale takes place. It’s just that the skills needed by this person are completely different to those needed by the broker.  The broker needs to be able to negotiate the best price for me. But the person who looks after my certificate needs to be good with accounts, book-keeping, reporting and security.  After all, I’m trusting them with the safekeeping of my share certificate: it’s in their custody.  So we call these people custodians. Examples include State Street and Northern Trust, as well as divisions of Citi and HSBC, etc.

Figure 5 custodians

Figure 5 Custodians are responsible for the safekeeping of shares

So now, when my broker finds a willing buyer at the exchange, they can tell my custodian to expect to receive cash from the buyer’s custodian and to send the certificate to the buyer’s custodian when this happens.

And while the share certificate is sitting at the custodian, they can deal with all the tedious things that can happen to a share during its life: dividends, stock-splits, voting, …  It’s as if the shares need regular attention, like an old car that needs constant servicing: so we call this business the business of securities servicing.  The picture above shows a line from the buyer/seller to their custodians, because the custodian is working on their behalf. However, retail investors will probably not be aware of this relationship as their brokerage will manage the relationship on their behalf.

So… what have we achieved?  I can lodge my share certificate with a custodian, instruct my broker to sell the shares on my behalf by finding a willing buyer at a stock exchange and wait for the cash to arrive. We’re done!

Erm… not so fast.  There are still several problems.    The first becomes obvious when you think about how the picture I’ve described would work in practice. You have loads of brokers shouting at each other, making trades all the time. It would be completely chaotic yet, somehow, we need to get to a point where the buying and selling brokers agree completely on the details of the trade they just did and have communicated matching settlement instructions perfectly to the two custodians so they can settle the trade.  That’s not going to be easy.

In reality, there’s quite some work that must be done post-trade to get it to the point where it can be settled (matching, maybe netting, agreement of settlement details, agreeing on time and place of settlement, etc, etc).  We call this process clearing. (I wrote previously about a real-life example of spontaneous clearing at the world’s first-ever open-outcry Bitcoin exchange.)

And there’s a second, more subtle, problem: how does my broker know that the person they’re selling to is good for the cash? And how does the buyer know that my broker can lay their hands on the shares? In the model I’ve just described, they don’t.  Now, perhaps that’s not a problem: after all, smart custodians are only going to exchange shares and cash at the same time.  But it’s still problematic: sure… if the buyer turns out not to have the cash, I still have my shares… but I wanted to sell them! And the price may drop before I can find a replacement buyer.

A clearing house is intended to solve both these problems. Here’s how: after a trade is matched (both sides agree on the details), the information is sent to the clearing house by the exchange. And here’s the trick: as well as orchestrating the clearing process and getting everything ready for settlement, the clearing house does something clever: it steps into the middle of the trade.  In effect, it tears up the trade and creates two new ones in its place: it becomes my buyer and it becomes the seller to the buyer.  In this way, I have no exposure to the buyer: if they turn out to be a fraud, it’s now the clearing house’s problem.  And the ultimate seller has no exposure to me: if I turn out to be a fraud, the buyer still gets their shares (the clearing house will go into the market and buy them from somebody else if it really has to).  We call this “stepping in” process novation and say that the clearing house is acting as a central counterparty if it performs this service. As an example, the London Stock Exchange uses LCH.Clearnet Ltd as its clearing house.

Of course, this amazing service comes at a price: they charge a fee and, more importantly, impose strict rules on who can be a clearing member of the exchange and how they should be run. In this way, the clearing house acts as a policeman, ensuring only people and firms with a good track record and deep resources are allowed to participate. (I’ll leave to one side whether this privileging of one group over another is a net good or bad!)

So we can update our picture again:

Figure 6 clearing house

Figure 6 A clearing house manages the post-trade process of getting to a point where settlement can take place and often also acts as a central counterparty

We’re almost there… but there are still some loose ends.  To see why, consider this from MegaCorp’s perspective.  We’ve been talking about buying and selling their shares and this all happens without any involvement from them at all.  That’s fine in most circumstances but it does cause problems from time to time. Specifically, what happens when the company issues a dividend or wants its shareholders to vote on something?  How does it know who its shareholders are?  Imagine it knew I was a shareholder.  What happens after I’ve sold the shares using the system above to somebody else? How does the company get to hear about the new owner?

Enter yet another player: the registrar (UK) or share transfer agent (US). These companies work on behalf of the company and are responsible for maintaining a register of shareholders and keeping it up to date. If the company pays a dividend, these companies are responsible for distributing it.  They rely on one of the participants in the process to tell them about share transfer. An example of a registrar in the UK would be Equiniti.

Figure 7 registrar

Figure 7 A registrar (or stock transfer agent) keeps track of who owns a company’s shares on behalf of the company

Now, I assumed up front that we were using paper certificates. And it’s amazing how far you can go in the description without needing to bring IT into the narrative at all.  But, clearly, paper certificates are a complete pain.  They can get lost, you have to move them around, you have to reissue them if the company does a stock split, etc.  It would clearly be easier if they were electronic.

For any given custodian, it’s not a problem: they can just set up an IT book-keeping system to keep track of the share certificates under their safekeeping.  And this can work well:  imagine if the seller of a share uses the same custodian as the buyer: if the custodian is electronic, no paper needs to move at all! The custodian can just update its electronic records to reflect the new owner.  But it doesn’t work if the buyer and seller use different custodians: you’d still need to move paper between them in this case.

So this raises an interesting possibility: what if we had a “custodian to the custodians”?  If the custodians could deposit their paper certificates with a trusted third party, then they could transfer shares between each other simply by asking this “custodian to the custodians” to update its electronic records and we’d never need to move paper again!

And that’s what we have.  We call these organisations central securities depositories.  In the early days, they were just that: a depository where the share certificates were placed in exchange for an equivalent entry on the electronic register. The shares were, in effect, immobilized at the CSD.  Over time, people gained trust in the system and agreed that there really wasn’t any need for paper certificates at all… so we moved from immobilization to dematerialization.  The UK’s CSD is Euroclear (CREST).

This completes our picture (and notice how it is the CSD who informs the registrar when shares change hands… left as an exercise to a reader is thinking through what happens if shares change hands within the same custodian and what it means for the granularity of the data held by registrars):

Figure 8 csd

Figure 8 A CSD acts as the “custodian to the custodians”

This picture also introduces regulators, governments and taxation authorities, for completeness. However, I don’t discuss them here. I also don’t discuss what happens if you’re trading shares cross-border.

So now we have the full story: if I want to sell some MegaCorp shares, here’s what happens:

  • My shares start off in the account of my broker, who uses a custodian for safekeeping
  • The broker executes a sale at an exchange
  • The clearing house establishes everybody’s respective liabilities, steps in as central counterparty and orchestrates the settlement process
  • The buyer’s and seller’s custodians exchange shares for cash (“Delivery versus Payment”), utilizing the CSD if shares need to move between custodians as a result. Assuming so, the company’s registrar is informed.
  • Somebody probably has to pay some tax J

You’ll notice many parallels with the global payments system: lots of intermediaries and lots of specialists – all of them there for a reason but imposing costs nonetheless.

Now, I said I would use this narrative to discuss what it could mean for Bitcoin “colored coins”.  I think there are two key concepts that can help us think through workable models: risk and the meaning of settlement.

Risk

Consider the picture above: what risks are you exposed to as an investor? Ideally, if you buy shares in MegaCorp, the only risks you want to be exposed to are those associated with MegaCorp itself, realized through changes in share price or dividend payments. So, the ideal state is when you just face this market risk.  And that’s broadly what the system above delivers: by depositing your shares in a custodian bank, which should keep them in a segregated account at the CSD, you’re protected even if the custodian goes bust: your shares are not considered part of the custodian bank’s assets. So the only risk you’re exposed to beyond the market risk (which you want) is operational risk that the custodian makes a mistake. (I’ll ignore cash here but note that it’s typically not protected in the same way)

Now, when we look at “colored coin” share representation schemes, we see there is the notion of a colored coin “issuer”: somebody who asserts that a given set of coins represents a particular number of shares in a particular company.  So now we have a big question: who is this somebody?  This matters because if the “somebody” reneges on their promise or goes bust, you’ve lost your shares.

Now, if a colored coin scheme were “grafted on” to today’s system, it could work quite well if done right.  Imagine a firm wanted to offer colored coins representing 100 MegaCorp shares. They could open a custody account, fund it with 100 MegaCorp shares as “backing” and we’d be done: such firms could perhaps compete on the completeness of their transparency.  However, owners of colored MegaCorp coins would have counterparty exposure to this firm, which means the risk profile would be different (worse?) than if they simply owned coins in a regular custody account.

Interestingly, you can’t overcome the problem entirely by having a custodian bank be the issuer because it’s not obvious to me that a coloured MegaCorp coin issued by a custodian bank is the same as a segregated share for the purposes of bankruptcy protection: you’d presumably also need a legal opinion – and I am not a lawyer!

Bottom line: there is work to do for those developing these schemes.

However, there is one intriguing possibility with this approach: think through what happens if MegaCorp themselves were to issue colored coins representing their shares. Any analysis of counterparty risk becomes moot: if MegaCorp went bust, you’d lose your money regardless of how your shares were held!  Perhaps this is the future?  (Note also that I’m not discussing here precisely why anybody would want to issue – or buy – coloured coins! I’ll leave that to others)

Do you actually want settlement?

However, there’s another way of looking at this: you don’t have to own a share to enjoy the benefits of ownership. Contracts for Difference (or, more generally, Equity Swaps) allow you to enjoy the losses or gains from owning a stock without actually owning it. They are, instead, contracts, with a counterparty, in which the counterparty pays (or receives) cash that matches the gain or loss in the share price (and payment of dividends).   Now, the counterparty often hedges their risk by buying the shares – but that becomes their problem, not yours. So this gives you all the benefits of owning the stock without having to go through the pain of actually taking delivery. It also has tax advantages in some jurisdictions.

The downside is that you take on counterparty risk to the party issuing the CFD: if they go bust while you’re in the money, you’re out of luck.  But we’ve already established that there could well be quite considerable counterparty risk with colored coins in any case. So perhaps this is the right model.  I don’t yet have a view on which will prevail but hopefully laying out how today’s system is constructed will help others think this through more clearly.

I’ll end with one final observation: the issuance is the easy part.. but somebody still has to do the servicing.  But notice how this is much easier if you use a technology such as the Block Chain: there’s no need for the arbitrary distinctions between custodian, CSD and registrar:  the issuer can see immediately which addresses own their coins and to whom they should send messages or dividends.  Similarly, the peer-to-peer nature of Bitcoin means the hierarchy of custodians and CSDs could possibly be collapsed.

I know many people think blockchain technology could be hugely disruptive for the world’s banks but I look at it another way: I believe there are huge opportunities for those financial firms that really take the time to study this space.

[Final comment: a reminder to readers that this is my personal blog and the opinions are mine alone… I don’t speak on behalf of my employer]

[Update – 2014-01-07 – One question I failed to address above is precisely why anybody would want to settle share trades using a coloured coin scheme! I think there are two possible answers:

1) if settlement can be effected over the blockchain, the cost potentially reduces to the fee of the Bitcoin transaction in simple cases

2) if opens up the potential for custodians, CSDs and registrars/stock transfer agents to innovate their business models in a new way: do they still need to be separate entities, for example? Further, would ‘regular’ companies see value in becoming their own issuers, etc?

However, I’m not convinced this approach does anything to reduce risk – the challenge would be how to build a system with risk as good as what we have today. ]

The world’s first open outcry Bitcoin exchange and what it teaches us about clearing

I attended BitcoinExpo 2013 in London this weekend.   There were some very interesting talks and I met some great people. I thought there was perhaps a little too much focus on speculation, mining and trading but perhaps that’s just evidence of the maturity of the Bitcoin scene in the UK. Give it time.

That said, even I  couldn’t resist going along to the world’s first ever open outcry Bitcoin exchange.   In the bar of 93 Feet East on Brick Lane, Paul Gordon, a former trader, assembled a group of fifteen or so wannabe Bitcoin traders from amongst the attendees at the conference and created something rather special.

OpenOutcry#1

He explained the rules of the pit, taught everybody the hand gestures, ran a couple of trial runs and then trading began for real.  What I found so fascinating was that all the elements were there:

  • There were buyers: they used “pulling” hand gestures to indicate that they were quoting a price at which they would buy a “lot” of 0.01 Bitcoins (that is: they were quoting a “bid”)
  • There were sellers: they used “pushing” hand gestures to indicate that they were quoting a price at which they would sell (they were quoting an “offer”)
  • There were market-makers: these are people who quoted both a price at which they would buy and at which they would sell
  • There was a short-seller: he borrowed coins from somebody else, which he promptly sold into the market
  • There was a short squeeze: towards the end of the trading session, the other traders all knew he needed to buy back the coins he had sold short (to return to the original owner) and he suddenly found the price moving against him
  • … and there was a lot of paper: once each trade was struck, both parties to the trade filled out pieces of paper with the details of the trade (how many lots, at what price, with whom)

OpenOutcry#2

But what most interested me was what happened once the trading was over: there was then a spontaneous process of clearing.

Clearing

In financial markets, clearing is the process of figuring out who owes what to whom and agreeing how they’re going to settle their obligations to each other.  You can think of it as being everything that needs to happen after a trade is agreed to get it to the point where assets can change hands. And that’s exactly what we saw happen here:

  • First, we saw trade matching: the parties to trades compared their paper slips with each other to make sure they agreed on the details of the trade
  • I also saw some evidence of trade netting: parties who had both bought and sold from each other realised they could cancel out certain trades, just paying the cash difference in the value of the trades
  • And I saw people discussing the mechanics of settlement: how exactly where they going to exchange their pounds and send their Bitcoins?

This is exactly what happens in a regular process of clearing in other, far more formal markets, such as the equity markets – and I thought it was fascinating to see it emerge spontaneously. Of course, clearing for a market such as the London Stock Exchange or in New York is somewhat more complicated than this. In particular, the role of a clearing house to support the concept of novation for netting is very important and the real-world model is hierarchical (involving Central Securities Depositories, Custodian Banks and lots of other players). But the essential character is the same.

In short, the core principles of clearing emerged spontaneously on a Saturday afternoon in a bar on Brick Lane. Amazing.