Blockchain – the ultimate financial crash

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Financial institutions are facing the difficult dilemma of whether to support or fight the development of blockchain and cryptocurrencies. Regardless of their views on the matter, they realize that the new system that is emerging will inevitably undermine their raison d'etre.

The disappearance of cash

Work, transportation, medicine, shopping, entertainment – digital technologies impact all of these and just about every other aspect of our lives. In recent years, people’s approach to physical money has also been changing. Cash is no longer king. Whether we like it or not, a wallet bulging with cash is becoming a thing of the past. Power has passed to electronic transactions, Internet transfers, virtual money transactions, payment cards and virtual wallets. The world is moving ever closer to becoming a cashless society.

However, the growing dominance of commercial chains and the elimination of cash transactions is giving state governments, supervisory institutions and tax authorities the ability to monitor our transaction and purchase histories, as well as to follow our buying preferences, and shopping patterns and habits. They are gaining greater control and eliminating the gray market.

The banking era before the advent of cryptocurrencies

The key pillars of a cashless society are systems, tools, platforms and legal regulations. These make it possible to digitize the circulation of goods, services and money. Despite continuing advances in the level of sophistication of various forms of cashless exchange, the biggest barriers today to a cashless society are the major financial institutions. The reason is simple – modern means of exchange undermine their status. In the future, the importance of today’s major financial institutions may be substantially reduced, or even marginalized.

When it launched the first credit card in 1958, little did the leaders of Bank of America know they had sparked a revolution that would wipe out paper checks, which at the time accounted for 80% of financial transactions. Similarly, when opening the first automated teller machine in 1971, MasterCard had no inkling it was establishing a new channel for customer relations that would eventually allow people to use banking services without visiting bank branches. Later, text messages in cellular phones gave rise to mobile banking, which – thanks to the WAP technology in smartphones – has grown into the mobile banking we know today. However, each of these innovations was developed either by financial institutions themselves or with their direct involvement.

The birth of the blockchain and the creeping rise of cryptocurrencies

2008 was the year blockchain was born. At its heart, the blockchain technology is a means for maintaining a shared collective ledger of transactions concluded between computers. The digital ledger is dispersed across the entire web in identical copies. Open to all, it is nevertheless fully secured with advanced cryptography. Users are only allowed to access their own transactions.

Then came bitcoin, a truly digital currency. Suddenly, it became clear that commercial exchanges, settlements and money flows could all proceed safely without the help of the existing financial system. Their role could be assumed by public channels, the Internet, generally available shared transaction ledgers and blockchain-based transaction authentication systems. Bitcoin is an electronic currency, a cryptocurrency. Having bitcoin data recorded in a chain of blocks prevents the duplication of even a single bitcoin. All transactions are public, and their entire history is available for viewing and verification. The blockchains that serve as transaction ledgers cannot be counterfeited due to a cap placed on the number of bitcoins and protections that prevent their number from ever exceeding a predetermined ceiling. The transactions recorded in a blockchain are also irreversible.

I presume that when the founder of blockchain Satoshi Nakamoto announced in October 2008 his idea (which is what he then called it) to create a new entirely-peer-to-peer electronic cashless system that would eliminate third-party fiduciaries, he never suspected he was starting a revolution that would wipe out the financial system as we know it today and transform its fundamental operating principles.

Blockchain and the blockchain-based cryptocurrency bitcoin is the first financial system invention developed outside of financial institutions without even the slightest contribution on their part. It is novel, simple and completely independent of the existing financial system. The phasing in of blockchain will thoroughly influence not only the financial services sector, but also a whole range of commercial operations across the world.

How much is bitcoin worth?

One of the obstacles to the widespread use of cryptocurrencies is the issue of valuation. Bitcoins have a value because of the steadily growing number of people who are confident that the technology that underpins it, i.e. blockchain, is valuable. In the future, bitcoin technology may be used in a wide range of applications in the financial services sector for transactions, settlements, contracting, share trading, currency conversion and stock exchange management. Contrary to existing conventional currencies, whose real value may be raised or reduced at the discretion of central banks, there can only be a finite number of bitcoins. Theoretically, this means that the currency is safe from manipulation, deflation or inflation. Although with each year passing, bitcoin is becoming a fully-fledged means of exchange recognized by state governments, its value is being created by the buyers who choose to use bitcoins for their transactions. In other words, bitcoin is only worth as much as it is widespread. And although I can't use it today to pay for a hamburger in any restaurant in Warsaw, Paris or New York City, I will increasingly be able to do so in the future.

Easy transaction handling, system capacity 

Changes in the global financial model, the resulting reluctance of financial institution to accept bitcoin, and the limited availability of places that accept cryptocurrency transactions, all hamper blockchain’s expansion. However, slowly but surely, financial institutions are jumping on the bandwagon and joining the revolution, some because they have become aware of the new trend and the emergence of this new market; others because they know their significance is bound to diminish in the near future unless they do. Similarly, the number of physical and virtual places that accept the cryptocurrency is growing steadily. The greatest potential hindrance looking forward may lie in the processing capacity of the global blockchain system and how easy it is going to be to have bitcoin transactions supported, if they are supported at all.

One of the stages in designing and testing complex systems are stress tests, i.e. performance tests run at what is expected to be the maximum load. Note that in relation to the bitcoin system, which spans the globe, such tests would have to target its dispersed data processing sites, and, in fact the entire Internet, with a range of conventional peer-to-peer networks. Unfortunately, tests have found that bitcoin is unable to support capacities greater than 20 transactions per second (TPS). Visa and PayPal, for instance, handle an average of 2000 TPS and 115 TPS respectively. This may be a problem of system scalability, or of the relatively young age of the blockchain network compared to that operated by Visa. Either way, the network’s capacity lags far behind those available to the existing financial systems. The answer may thus be not only to gradually increase the computational power of network nodes, but also to enlarge blockchain blocks from 1MB to 2 or even 5 MB. This would require a technological modification of the algorithms that support blockchain management, computing and encoding.

Neither is the ease of transaction handling anywhere close to ideal. Due to the high complexity of the mathematical management and control algorithms in use, blockchain technology is difficult to manage and operate. It takes highly advanced knowledge to write even the simplest of applications. The same goes for bitcoin. Not only is it complex, being a cryptocurrency, it also comes with confined availability limited by exchange points, network nodes, the places that accept the cryptocurrency, stock exchanges and the entire financial ecosystem. Granted, the system is growing rapidly. Nevertheless, were I to go on a proverbial trip around the world, I would rather bring a payment card loaded with US dollars and euros than virtual bitcoins. This said, it is nevertheless true that Felix Weiss circumvented the globe in 2015 crossing 27 countries while relying exclusively on the cryptocurrency to pay his way.

Creating new blocks in the blockchain

The fundamental idea about the blockchain is to create new blocks for transaction sets by arranging them into blockchains and sending them into the network. Across the entire network, a new block with 1 MB of authorized transactions is created at an average frequency of one every 10 minutes. New block creation is referred to as mining (to mining of gold). It is managed by specialized network nodes which are high capacity computers. Since the entire blockchain network relies on peer-to-peer transactions, and there is no specialized data processing hub paid to keep the system running, everyone who owns a computer with the required capacity may, once they are authorized in the network, engage in creating new blocks that store a list of authorized transactions. As the process is highly complex and requires powerful computers, such network nodes are rewarded or paid for with bitcoin.

The rewards are to help retain miners and ensure that blockchain network transactions are created, authorized and set up in the blockchain with a certain regularity. Currently, the blockchain community considers the reward system to be sufficiently high to offset the network and network node maintenance costs incurred by computer owners. However, as is the case with any other currency, bitcoin may appreciate or depreciate rapidly and substantially. It is entirely plausible that bitcoin will depreciate to the point where it can no longer pay for network maintenance. Meanwhile, creating new blocks in the blockchain network is becoming increasingly more difficult as many maintainers are forced to acquire specialized equipment and software.

Needless to say, the moment new block creation ceases, the network will grind to a halt, deprived of its ability to send transactions. Understandably, the prospect is unnerving to major organizations that have considered switching their business to blockchain. On the other hand, new alternative systems to manage block creation are being developed. Contrary to their predecessors, they are going to be based on accurately defined SLAs managed by private institutions offering adequate rewards to network block creators and transaction managers. Unfortunately, the new system’s tradeoffs compromise the blockchain ideal of running a decentralized self-regulating peer-to-peer network. 

What’s the next step towards creating a cashless society?

Blockchain is not humanity’s last word in creating decentralized financial systems that are globally accessible and independent of state governments, stock exchanges, financial institutions, banks and other middlemen. The current sophistication of blockchains and cryptocurrencies and the innovations they have sparked suggest we are on the right track to creating a truly independent financial system. Will it be ideal? Time will tell. However, what is almost certain is that the precepts of blockchain will help humanity develop new systems and safe transaction protocols and bring it closer to realizing the vision of a truly digital cashless society.

New technologies like blockchain have enabled small organizations, small businesses and individuals willing to make a relatively small investment to upset the fundamental operating principles that underpin economies and shake up a well-entrenched and firmly-established global financial system. There is another phenomenon related to this development that Satoshi Nakamoto had no way of predicting: the devaluation of patents. When it comes to patents, blockchain competes against a financial system backed by powerful state governments. Patent rights can hardly stand up to the power wielded by global organizations and national governments. Elon Musk, the founder and author of SpaceX – a company, concept and technology that includes a whole array of innovations that allow spacecraft to return to Earth and be reused – says he is not patenting his inventions and innovations due to the fact that he is competing against governments. The way today’s system is stacked up, patents offer no protection whatsoever. Pitted against a global financial system backed by state authorities, blockchain is in a similar position. 

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- What are the bitcoins? All you need to know

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- Blockchain has a potential to upend the key pillars of our society

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- Blockchain – the Holy Grail of the financial system?

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Cryptocurreny market share and capitalization (dated: 24 Feb 2017) https://coinmarketcap.com

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 Example of public cryptocurrencies