The Future of Crypo Assets and underlying Blockchain Technology
In a relatively short period of time, digital assets and block chain technologies have become the buzz of conversation, from coffee shop chat to mainstream global media channels. However, given the nature of these new concepts and technologies there are a great many questions to be asked and risks to be considered. We thought it would be helpful to explore the fundamentals behind these two topics and to expose some of the key areas of discussion.
Global regulators are moving in on crypto-assets and the blockchain networks which underpin them. In terms of both price volatility, weak governance and a total absence of investor protection, this was always going to happen. The asset class attracted enormous investment flows – flows which were not only way beyond the de facto utility of the applications, but which were also frequently diverted into misguided or fraudulent schemes. It is unfair to lay the blame for all of this at the feet of Satoshi Nakamoto even if it was his/her/their 2008 ‘Bitcoin’ paper [1] which first described blockchain. The reality was that, as with any mania, due diligence was overlooked in favour of promised returns when it came to the thousands of copy-cat blockchain applications which followed Bitcoin.
At a certain level blockchain can be understood in relatively simple terms – you have open-source code, a network of computers to run it on, and digital tokens (aka coins) to incentivize key activities. Throw in some neat cryptographic techniques to protect users and preserve their records, and hey presto, you have an electronic peer-to-peer payment system featuring immutability and pseudonymity. Crucially there are no owners, no gatekeepers, and no trusted intermediaries to be relied upon [2].
If that really is all there is to blockchain, then how to explain the astonishing growth in the value of these tokens, and the frenzied media interest? Why are immutability and pseudonymity so prized? How on earth can we reconcile the belief held by some that ‘blockchain is the solution to all that ails the world, especially with regard to censorship, exclusion, cyber-security, data-theft and the overarching evil of the big-tech hegemony’ with the polar-opposite view that ‘blockchain is an egregious waste of energy resources, a bubble of South Sea [3] proportions and a hiding place for money launderers and other ne’er-do-wells’?
It is fascinating to observe just how angry and hung-up some people get in their determination to prove that a crypto asset cannot be considered a currency. The old adage ‘if it waddles and quacks’ springs to mind here – more seriously, perhaps we should consider ‘who stands to lose’ if this upstart concept comes along and seriously threatens governments (the issuers of fiat currency), and large corporations (the keepers of traditional payment rails)? Bitcoin isn’t perfect, but it is revolutionary.
A more passive-aggressive response to crypto currencies has evolved in terms of multiple central banks announcing that they will establish their own digital currencies (CBDCs). The notion of a ‘stablecoin’ is blockchain’s own response to the tendency for digital assets to exhibit crazy price volatility. Both CBDCs and ‘stablecoins’, it is argued, would carry all the useful traits of a digital token, while remaining pegged to fiat currency valuations.
A key difference between a CBDC and a ‘stablecoin’ is that typically central banks are proposing a watered-down version of blockchain based upon private, permissioned networks. Such a network retains certain key aspects of the original public, permissionless networks; for example, a distributed ledger is ‘always-on’, has tamper-proof code, and offers instantaneous settlement. In a private, permissioned network participants are bound by rules and contracts and can be expected to fulfil their roles in respect of underlying transactions without the need for rewards in the form of native tokens. The challenge for a public, permissionless ‘stablecoin’ application is to make sure that it remains stable in value while not relying on a ‘trusted intermediary’[4].
Proponents of public, permissionless networks would argue that we already have the internet for financial applications run by corporations. In their brave new world (dubbed ‘Web3’) trust-less applications will be developed which will deliver decentralized financial applications, based upon smart contracts, and governed by distributed autonomous organizations (DAOs). The achilles-heel of massive consumption of electricity will be overcome by switching from the notorious ‘proof-of-work’ consensus mechanism to the greener ‘proof of stake’ method.
Web3 will face other obstacles however and these will potentially be tougher to overcome than the PR disaster surrounding the fact that bitcoin miners use ‘more electricity than the Netherlands’. It is not just regulators and the environmental lobby that represent pending challenges for blockchain applications. There is a strong body of opinion which believes that neither smart contracts nor DAOs are compatible with existing legal frameworks, and that this incompatibility will eventually render most applications ‘pointless or useless’ [5] – it does appear that it will be incredibly difficult to go beyond the original scope and premise of a peer-to-peer payment system without reliance on one or more trusted intermediaries to provide some form of external input to an application.
By now, we are all familiar with Gartner’s ‘hype cycle [6]’. Recent price falls would suggest that crypto assets are firmly in the ‘trough of disillusionment’ phase, and yet we are witnessing the almost daily announcement of new projects promising to integrate the digital asset class with the traditional financial services of risk management, custody, fund management etc. To complicate matters further, in some cases, these solutions are themselves founded on private, permissioned blockchain applications.
It is important to acknowledge that in our relatively liberal western democracies we may not have the same sense of passion or urgency about financial applications which promise ‘immutability’ and ‘pseudonymity’. Our privilege is to look at the brilliant concepts of blockchain, cherry-pick the features which suit us, and then build currencies and applications which do not challenge existing legal and regulatory frameworks. Not everyone shares that privilege.
The creation of new public, permissionless blockchain ventures continues despite everything. Even much-derided non-fungible tokens [7] may eventually find a practical use. It will be fascinating to see how blockchain technology evolves and whether its public, permissionless version will survive and thrive when regulated. If it does not, will the established financial markets continue to pursue their own digital asset blockchain solutions, or will these offerings stall and regress as the pressure from the alternatives disappears?
Author: Duncan Scott – Markets Strategy and Technology
September 2022
This article has referred to a few of the many complex ideas which form the dynamic world of blockchain. Those who feel they would like to know more may wish to refer to the notes and sources suggested below.
1. The original Bitcoin whitepaper is only 9 pages long – it was published pseudonymously in 2008 by Satoshi Nakamoto – Google it up!
2. I recommend Antony Lewis’ “The Basics of Bitcoins and Blockchains – An introduction to Cryptocurrencies and the Technology that Powers Them” as an excellent primer and one which describes the elegant cryptographic control structures which underpin blockchain.
3. The South Sea Bubble, 1720 – proof that we never learn.
4. Stablecoins require a ‘mechanism’ to maintain a stable peg to a fiat currency value – this means that users get the best of blockchain, but without the unwanted price volatility. The simplest ‘mechanism’ is to lodge a unit of fiat currency in a bank account for every coin that is created. However, this means relying on a trusted intermediary in the form of a bank. Terra and Luna were stablecoins which attempted to solve this by relying on an algorithm instead – some description here (https://boldergroup.com/insights/blogs/terra-luna-crash/) Warning: it didn’t end well.
5. Read at least the abstract of ‘Cloud Crypto Land’ by Edmund Schuster of the LSE. In this paper, Schuster gives a damning conclusion on the utility of blockchain for anything beyond the original payment mechanism described by Nakamoto (https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3476678).
6. Gartner’s hype cycle – (https://www.gartner.com/en/research/methodologies/gartner-hype-cycle).
7. Non-Fungible Tokens (NFTs) – originally native tokens were fungible by design (just like fiat currency). Then came the idea that a unique (non-fungible) token could be created to represent a claim to something notable in the physical world. NFTs may yet have their day, but they have arguably undermined confidence in the broader asset class as many people started to view them as rather like the ‘emperor’s new clothes’.