Saturday, September 12, 2015

Financial Technology that Makes the World Better - Is the Blockchain an Option? Part I

This article is a joint effort between myself and a blog reader who is an industry expert on payment systems at the global level. Most of the important factual details in this article are provided by the expert, so I will highlight in bold italics the parts of the article provided from the expert source. Comments in regular type are mine.

If you are interested in learning more about Bitcoin and blockchain technology from someone who really understands its pros and cons, this article is one you will want to read. Due to the length of the article, I have broken it into two parts (Part I and Part II)  to make it a little easier on the reader.

I extend my deepest thanks for the time taken by our expert to provide this fascinating look into Bitcoin and blockchain technology. I had already concluded on my own that Bitcoin was not likely to gain widespread adoption for a variety or reasons. The detailed information provided by our expert source for this article shows you in a much more in depth way the challenges facing both Bitcoin and blockchain technology.

In a world that seems to suffer from endless financial uncertainty this blog has been a result of my efforts to find information on the volatility and instability that has impacted us all in one way or another. One of the things we have seen is the relative upsurge in "fin-tech" companies since the 2008 Crisis (GFC), claiming to have solved many "problems" in the banking sector. They also claim the "system is broken" and encourage the average person, such as myself, to adopt "fin-tech" as a solution. The Bitcoin and blockchain technology has gotten a lot of media attention in this regard. Let's let an expert review it for us.

One of the key problems addressed by FinTech companies, is the assertion that problems arise because of secrecy in the consumer and wholesale payments sector, and that a technology called "the blockchain" will make everything in the banking industry open to the public - and therefore better. This technology began with its use of token transfers (the 'bitcoin currency') between software engineers, but claims have since progressed to having the potential to improve every everything currently related to trust and security. The primary premise of "the blockchain" is that like a Greek Jury, or a democratic society, many decision makers are better than a single decision maker - especially if they are autonomous computers.

Recent articles like this one in Bloomberg have claimed that "the blockchain" will improve 'everything' from legal contracts, to buying houses, to international payments, This blog article will not focus on the "geek battles" as to whether the blockchain technology powering bitcoin is the next great thing or not. 

The focus here is on what makes a technology useful to the average person in such a way that it gains widespread acceptance by the public for use in their everyday lives. To me, this is what matters most. Here are four questions to explore.

1) Is the technology easy to use and understand?

2) Does the technology operate cost efficiently (do the benefits of the technology far outweigh what it costs to operate the technology?)

3) Is the technology safe to use?

4) Does the technology serve only a relatively small niche of the population or does it improve the lives of a significant number of people, including those who need it most?

Let's look at Bitcoin and blockchain technology in relation to these four questions. For now we will focus on Bitcoin since that is the main use of the blockchain so far, despite the view that the technology has many other potential uses.

1) Is the technology easy to use and understand? 

For Bitcoin believers, the technology probably feels fairly simple. I exchange a local currency for Bitcoins via a 3rd party, and store them in the blockchain until I want to use them. The blockchain is like a giant network of safety deposit boxes, and each safety deposit box has its own "address" in the blockchain. You can think of the blockchain like a large address book of everyone's safety deposit boxes, that everyone on the internet can see, and use to look inside each safety deposit box, including what the history of every safety deposit box is (how much it has ever held, or is holding now). The exciting part is that although anyone can see inside each box, no one can authorize the removal of its contents without the approval of at least half of all the computers watching the all the boxes. People can try, but the cost of trying is quite high. The cost gets higher as each new computer/user 'joins" the network. 

An unlimited number of "watchers" joining the network increases system resiliency to external attack - but decreases transaction speed, defers transaction finality, and of course reduces overall system efficiency. It is the mechanism of how this "anti-attack" feature is made possible that has technologists so excited, but it comes with some pretty discouraging consequences. Despite the huge scale, and endless investment in "watchers", the "impossible" has already happened. Even as the technology has matured, the unthinkable scenario of an individual or single group becoming able to invalidate this entire security premise was reported last year. (see One Group now controls 51 % here).

Unfortunately, even if caught off-guard, the possibility of the above (let alone the reality of an actual event) makes bitcoin or the block-chain an ill-suited contender for any mass scale use. This is true even setting aside the enormously uncompetitive costs of the blockchain's 'plural computing' or any other points on a long list of potentially terminal flaws. These will be discussed further below and in Part II.

Back at the consumer level, once I get Bitcoin, it is up to me to offer to trade or swap them for other things of value, anywhere they are accepted for payment, including several mechanisms out there offered by third party providers to exchange them back into a local currency to use. While this may seem simple to Bitcoin advocates, for most people this just seems like an extra unnecessary step (added video 6-15-17). Most people just want an easy way to access their money when needed to pay for things. For now, most people are comfortable using a regular bank account, debit cards, or credit cards for this purpose. Going to the trouble to convert their money into and back out of Bitcoins seems pointless or too risky for most people.

Until recently, enthusiasts of Bitcoin foretold a world where everyone would use only Bitcoins and that government issued currencies would become about as relevant in day to day life as weighing precious metal coins to prove their metal content has become. These claims have abated as technical, and economic limitations to the technology have become increasingly self-evident and the discussion has moved away from "bitcoin" to the underlying technology of "the blockchain".

2) Does the underlying technology operate cost efficiently?

This is a question most people would not have any idea how to answer. But it is an important question. If we are going to talk about a technology as being a breakthrough for the future, it needs to show that it can produce the best results for the lowest cost of operation. We have all seen fads and schemes where benefits are highly touted, but over time the results are not there. So what does Bitcoin offer in terms of results in relation to what it costs to run the system? 

Bitcoin and the Blockchain are being run by startups at present. To date, even the largest, most successful bitcoin operations have lost large amounts of money or have gone broke. Coinbase has had over $100 million in losses. Mt Gox, formerly the largest bitcoin 'exchange', closed shop after suffering losses and fraud of over $600 million (see how Mt. Gox lost 600 million in Bitcoins here). 

Contrast this with the cost of developing the most successful mobile payments system, M-Pesa in Kenya. In less than half the time mainstream media have been talking about bitcoin, M-Pesa was launched, and accelerated to 70% market share of electronic payments and 20 million users in Kenya. Many of these are the poor and unbanked. The TOTAL cost?  A joint investment by the UK government and mobile operator SafariCom of £910,000 each or a little over $3 million USD between them. (see - talking-technology-with-my-mum-dfids-role-in-m-pesa here)  

This turns out to be less than the daily cost of bitcoin, despite bitcoin serving less than 500,000 active users (of possibly 2-3 million individual address owners); compared to M-Pesa's 13 million active users (and 20 million+ registrations).

But still, technologists and venture capitalists keep plugging away at Bitcoin. 

In the first 6 months of 2015, approximately USD $400 million of investment was poured into Blockchain related companies on top of the $4 billion invested in "fin-tech" in 2014. This represents between $22 and $38 USD of Venture Capital (VC) money per transaction undertaken on bitcoin; not including investments made in prior years. These are abnormally high overheads for payments being processed on the "virtually free" platform. The block-chain is consuming over $2m per day of VC subsidy at what should be a much lower average cost than many of the very large, profitable, low cost money transfer operators. However, they provide a comparably priced and speedy service to the end users, arguably, with more security (i.e. 

So the "free" aspect of the blockchain clearly has some way to go to being substantiated. Fair questions to ask might be: Why does Bitcoin require so much more capital than other systems? Where is all that excess funding going?

In addition to the overheads paid for by the 'operators' of bitcoin wallets, and other funded block-chain companies, approximately $1 million USD worth of sell-side pressure is placed on the value of Bitcoin every day by the "mining" process. This process compensates the vast number of computers in the system for the heavy processor/computational workload of maintaining the blockchain's accuracy and consensus. This adds an additional USD $7 of social cost to each transaction (according to 

While this may not seem like much in comparison to the USD 5.5 billion value of all bitcoins (at 70,000 to 150,000 transactions per day), it does start to add up. As a percentage, the average social cost per payment is around 0.70%. This is much higher than any formal financial network's wholesale cost. Scaled up to the size of the US economy, it is equivalent to quantitative easing of around 1.2 trillion per month. That would be far greater than the US Fed's controversial USD 80 billion per month Quantitative Easing program, post GFC. 

Bitcoin also charges an average fee to consumers on top of this wholesale social cost of around 0.8%. In addition, the bigger bitcoin gets the more the block-chain will cost.

In comparison, the US government provides a popular, but a technologically polar opposite service with high overhead, non-scalable infrastructure, and no expensive computational costs. This is the common banknote (federal reserve notes). 

Yet, by comparison, the cost to the US government of printing, maintaining, and managing cash, is less than USD $1.81 per transaction according to the Federal reserve. The costs of holding, storing, and accounting for cash for the private sector is roughly the same at about USD $1.79 per transaction (see San Francisco Fed report here). This includes losses for fraud, theft, transportation and counterfeit with USD $1 trillion of physical currency in circulation globally.   (see costs of cash in the US here)

From these numbers, we see bitcoin isn't stacking up at present - so what about the future?

Elsewhere in the world, electronic bank led payment systems are considerably more advanced than in the US. Consumer initiated non-reversible payments in the UK of up to £100,000 (USD 155,000) may be made in real time between any bank account in the country, 7 days a week, 24 hours per day, free of charge (business users may pay small fees). Literally faster than you can press refresh when you change from one bank's computer screen to the other to check the payment arrived. Alternatively, a three day service called BACHs costs corporates pennies to use. 

The UK is on a rapidly expanding list that also includes Mexico, New Zealand, Australia, Singapore, Tonga, Samoa, Kenya and most Scandinavian countries. Here real time or near-real time payments are made in local currency for a few cents per payment. They are generally offered free of charge to consumers. Europe offers the SEPA payment system between approximately 40 member states and 8,000 banks. SEPA is an interbank service that costs less than EUR 0.50 for consumers and under 1c per payment for banks - with a next day guaranteed delivery, and no charge-backs. In addition, it offers debit card processing in real time free of charge to consumers for a fixed price (around 60 US cents) for merchants.

So the benefits of bitcoin still aren't adding up. The next claim to appear was that "bitcoin was for international remittances" and that it would be 100 times faster and 10 times cheaper". But that didn't stack up either (; as many existing providers offer cheaper and faster services than bitcoin. 

Cross currency (which bitcoin is dependent on 3rd parties to facilitate - being unable to do it directly) is a little different. SWIFT, the long time leader in world-wide inter-bank messaging, can enable transactions in real time between any of the 10,000 institutions it serves. Costs to banks vary from €1.00 per message to fixed-cost unlimited-use contracts (of under 1c per payment). However, US banks still tend to charge US consumers upwards of $20 for each payment. Up to 3 or 4 banks may be involved in moving a transaction from one country to another. This angers consumers, and it ultimately fueled regulatory changes like Dodd-Frank in the US. It also arguably drove the belief that bitcoin is revolutionary into the hearts of some US based consumers of banking services. 

Many recent innovators still take advantage of the particularly slow US banking system.  PayPal and Dwolla are examples. But this isn't the case world wide. Many European banks offer free international instant payments between their own branches, or a nominal fee (e.g. HSBC) of £4 (about USD $6) per payment to other banks. Citibank enables free and instant transfers between 20 countries, not including the USA or Canada - but including Mexico, China, Poland, and Egypt

In the South Pacific, SWIFT named a service called KlickEx the Fin-tech innovator of the year in 2013. KlickEx is an eight nation service funded by the United Nations that begun in 2009. It enables inter-bank and mobile money cross currency and local transactions between different banks for under 25c, or cash-to-cash cross border transactions for $3.00. KlickEx has been featured before on this blog <here>, because of its particular interest, and objectives. KlickEx has achieved almost 100% market penetration in small countries that were formerly up to 80% unbanked. This illustrates that people will choose the system that best meets their needs at the lowest cost when given the opportunity.

There is no doubt that traditional private sector cross-border infrastructure providers like Western Union or MoneyGram are coming under considerable price pressure on fees, but the price pressure doesn't appear related to Bitcoin. It is by most accounts, coming from the comparably modern (by Western Union's standards) institutions of SWIFT and the United Nations, and from the national Central Banks themselves.

As reported by the Chief Economist to the Bank of England, Britain's Central Bank, in May 2015, "digital currencies are not new...... and the block-chain offers apparent low private costs, with a high social cost". 

With the recent announcement that a private sector icon like Blythe Masters is following the money, and making moves into the blockchain, it does seem like the private sector is once more rushing in to chase the short term benefits and profits. (Bloomberg hails Blythe Masters in its recent article as the inventor of the credit default swap - one of the debt instruments intrinsically tied to the 2008 financial crisis)

It appears they may be developing new products for personal gain that are promised to have great benefits to the community, without really understanding the social costs of their progress. Yet already, the signals are that this form of advancing technology remains unlikely to benefit those on main street any time soon.

In Part II, we will look at the other two of our four main questions. Click here to go to Part II.
My added comments:

This is a long article, but well worth the time to present. As you can see most of the content comes from our industry expert (in bold italics). It is rare to have someone with this level of expertise in the global monetary system take time to explain these issues for us at this level of detail, so it is important to publish all the information provided. 

The blog post just below is the rest of this article which we will call Part II. It follows the same format with expert comments in bold italics.

Also: A thank you to Willem Middelkoop for mention of this article on his twitter feed.

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