Cryptocurrencies: The Digital Financial Revolution

This is the transcript of a talk I gave at the International Policy Centre for Inclusive Growth (IPC-IG) Seminar Series 2017 in July 14th 2017. As I wrote my entire presentation, I thought it would be fun to share it with the world. I hope you enjoy reading it as much as I enjoyed writing it.

I would like to thank IPC-IG for the invitation to speak about this thrilling subject.

The slides that I used at the event are available at this Slideshare link.

1st slide

Ladies and gentleman, thank you for the opportunity to speak at the International Policy Centre for Inclusive Growth. Initially, I would like to share important information about this presentation:

First, the views expressed in this presentation are my own and not necessarily those of my employers;

And finally, this is not a strictly technical presentation; some simplification was made to fit a broader audience.

2nd slide

The first topic I would like to address seems simple, but it´s actually a very complicated and fragile social construct: Money.

The first history I want to share is about the island of Yap in Micronesia. This common island had a very peculiar form of currency in the Middle Ages: Giant limestone disks called Rai Stones. As Yap does not have this kind of mineral, the disks were carved in Palau, another island approximately three hundred miles away. So Yap natives jumped on their rafts and sailed for days to return to their homes a lot richer. This way, Yap currency was only produced through hard, although not very useful, work, keeping inflation rates.

Obviously, this incarnation of money has a very high transaction cost, it is very difficult to move heavy stones. The solution to this dilemma was simple: They simply did not physically move the disks as they were negotiated to a new owner. A diffuse knowledge about the ownership was created just by propagating the transaction orally throughout the island, establishing a diffuse distributed ledger, a registry with all transactions.

This convenient solution was so effective that only the knowledge about the physical existence of a stone was needed to create a new unit of currency, making the physical access to the stones unimportant. This way, Rai stones dropped accidentally in the sea during the journey back were accepted. This is an example of a functional currency that lasted for centuries.

3rd slide

However, history has shown that money is also very fragile and, unfortunately, we have seen some cases of currency destruction by hyperinflation. One of the most notorious examples is the post-World War II Germany. Economically depressed by the heavy penalties imposed by the war winners, German leaders started to print huge sums of their currency, the German mark. Here we can see the “evolution” of the face values of the bills on the course of 1923, going from fifty thousand to fifty billion marks. By the end of year, the national fiat currency had lost so much value that we now can see this historical picture of German mark notes being used as wallpaper.

4th slide

How can paper currency remain valuable?

To answer this question, first we need to understand what turns anything desirable. In general, value derives from the combination of utility and scarcity. But when all the basic needs are fulfilled, people tend to attribute psychological value to the most diverse materials and objects. Designer clothes, art objects, diamonds and even gold, all have disproportional evaluation when compared to their real needs in our lives.

As we have seen, physical form is absolutely unimportant. In digital form, the only way to keep data scarce is to maintain it private. Once it´s released on the internet, it is trivial to create infinite copies and eliminate the scarcity factor in a matter of minutes. We have seen this on the never-ending battle of the entertainment industry against piracy. There is even an interesting phenomenon that happens on the internet that is called the Streisand effect, that is, any attempt to hide information will only amplify its dissemination. The term derives from a Barbra Streisand lawsuit to remove her mansion photograph from a public collection. Before the lawsuit, the image had been downloaded only four times, but over the following month more than 400 thousand downloads were made.

I know what you are all thinking, so there it is.

The photo contributes to my point: Digital scarcity is a very complicated attribute to achieve in an open network and that´s why we have not seen a digital fiat dollar bill that we can store in our hard.

5th slide

Now that we know what makes anything valuable, we can return to our question: “What exactly is money?”

Money is a social construct that must be relatively scarce so it can function as a store of value medium. Without it, we could not delay our consumption needs as there would be no way to save for an expensive desired object. This is the unfortunate fate of citizens in countries that suffer with hyperinflation in their economies, where they have to run to spend all their salaries as fast as possible before it turns into valueless wallpaper in their pockets.

Besides storing value, money value must be stable enough to serve as a unit of account in a society, so different items costs can be compared.

Finally, money must be the instrument used to facilitate trade of goods between parties, acting as a medium of exchange.

6th slide

So, if money should be scarce and digital scarcity is very difficult to achieve, can digital money exist?

Actually, digital money exists and it is not new, but it was only possible relying on intermediaries like Banks, Credit Card and Technology companies. They maintain internal ledgers that store all transactions and balances of each participant and the ledger privacy and security is enforced by cybersecurity processes like firewalls, passwords and encryption. Unfortunately, it is not rare to see hacking and data theft from these companies.

7th slide

Security concerns aside, intermediaries sitting on this privilege position can exclude, censor and commit fraud.

There is low incentive for many players in the financial sector to deal with the poorer population, denying benefits of a formal financial life like savings and credit.

Censorship is another problem we have already seen and it is illustrated by the Wikileaks banking blockade in 2010. Whether you sympathize or not with Wikileaks, the financial disablement of an organization was proven to be possible.

Finally, intermediaries can always tamper with its internal registries. As we have seen in the 2008 financial crisis, lack of proper visibility to assess risk of securities played a big role in all we have seen.

Even when playing by the rules, intermediaries add friction and cost to the financial sector. A single cross-border payment can pass through four or more financial intermediaries, take almost a week to complete and carry a high fees. The average remittance cost for a busy corridor like United States to Mexico is almost 5%. Exotic corridors are way more expensive, for example, Lebanese people living in Australia must pay a whopping 13% fee to send money to their families.

8th slide

This need of intermediation is not compatible with the virtual community that was made possible by the internet. A free and equalitarian society desire emerged, as seen on John Perry Barlow´s Declaration of the Independence of Cyberspace, which, I partially quote:

“Cyberspace consists of transactions, relationships, and thought itself, arrayed like a standing wave in the web of our communications. Ours is a world that is both everywhere and nowhere, but it is not where bodies live.

We are creating a world that all may enter without privilege or prejudice accorded by race, economic power, military force, or station of birth.

We are creating a world where anyone, anywhere may express his or her beliefs, no matter how singular, without fear of being coerced into silence or conformity.”

John Perry Barlow

This new world still lacked a fundamental human construct: Money. A new currency was needed, one that was

anonymous like paper currency,

anarchic like gold,

censorship resistant

and free as the internet.

In other words, they needed internet money.

9th slide

What the crypto-anarchists needed was some kind of digital Rai Stone. A currency that could be owned by any virtual citizen, does not rely on any intermediary to maintain the diffuse ownership information and its supply could not be inflated.

Remembering the digital scarcity problem, it looked like they would need some kind of alien technology to solve this conundrum.

10th slide

And in 2008, ladies and gentlemen, came Bitcoin to implement a worldwide digital “Rai Stone” without a trusted central authority. It is the first cryptocurrency and has come into existence with the publication of an eight page paper called “Bitcoin: A Peer-to-Peer Electronic Cash System”, published under the pseudonym Satoshi Nakamoto.

11th slide

And what kind of alien technology does it use? Amazingly, not a single new cryptographic algorithm was developed, but the document describes an innovative way to organize the existing techniques. The resulting technology maintains the diffuse bitcoin ownership information in a distributed public ledger. This data structure is composed by a chain of blocks, thus the name “blockchain”.

As all ownership information is public, anyone can download the blockchain that is exchanged between nodes using peer-to-peer technology similar to Bittorrent.

Finally, as the bitcoins keep changing hands, the blockchain is constantly updated with new transactions that are double checked by all network participants against well-known update rules.

12th slide

Remember one important feature of the Rai Stones: it can be anyone´s property. Similarly, Bitcoin can be owned by anyone with a computer. The only prerequisite to receive a bitcoin is to have a bitcoin address. The 26 to 35 long alphanumeric code derives from an asymmetric public key internally generated by a computer or smartphone running the appropriate software: A Bitcoin Wallet. The absence of information linking bitcoin addresses and real identities makes this payment system pseudonymous.

13th slide

As asymmetric keys are generated in pairs, the second key must be kept private and will be used to unlock any bitcoin sent to the respective address. The private key is used to sign any transaction that spends a previously received bitcoin. Following peer to peer mode of operation, signed transactions are broadcasted to random connected peers and propagated to every node of the network.

14th slide

When transactions reach a special node called “Miner”, they are verified upon all protocol update rules like

· the signature correctness and

· funds availability.

Legitimate transactions are grouped into blocks, propagated again to the network in this new form and attached to the blockchain, updating the distributed ledger with the most up-to-date ownership information. Simple, right?

However, knowing the troll and hacker hordes that reside in the Cyberspace depths, no public database on the Internet can survive without a write access control. The ingenious solution proposed by Nakamoto is a difficult crypto puzzle that implements a proof of work system.

The crypto-puzzle is similar to a lottery where the chances of winning are proportional to the Miner processing power. Participating in this lottery today requires huge investments in hardware and energy and a one-time winning ticket must be attached to every published block, proving that an investment has been staked in the update proposal. That way, it is expensive to try to tamper with the blockchain.

15th slide

If a proposed new block is accepted by the network and appended to the blockchain, its miner is rewarded with newly created bitcoins and transaction fees for included transactions. This is the only way bitcoins are created. As nodes locally check the received block thoroughly and will discard it in case of any protocol discrepancy, there is a strong incentive to produce blocks without any fraudulent transactions or currency overcreation.

If a proposed block is accepted by a node, it is cryptographically chained to the previous block and appended to the blockchain. This interconnection between every block makes it very difficult to tamper with any part of the past blocks because it would invalidate the whole cryptographic chain. In practice, the blockchain data is considered immutable.

If everything is running as supposed, all nodes are using the same set of consensus rules to evaluate the broadcasted blocks. Using the same input and algorithm, independent nodes will ultimately share a single blockchain view and a single transaction history.

The blockchain is the digital form of Yap´s Rai stones diffuse ownership information and made digital scarcity possible.

16th slide

To illustrate what I am talking about, this is a very simple representation of a blockchain. Transactions are stored on each block and the full transaction history can be retrieved simply by reading transactions on each dark green block sequentially. They are in the longest block path where the most work has been staked.

The light green blocks represent past transient racing conditions. They occur if two blocks are broadcasted at almost the same time, making what path to extend temporarily unclear. When the blockchain is in this state, recent transaction history is undefined until the broadcast of a new block that extends one of the possible paths.

Malicious nodes can try to fork the blockchain to create a longer path and undo recent transactions, but they must have the majority of the processing power of the network to win the crypto puzzle lottery. Even if they can beat the rest of the network by a couple percent, it is unfeasible to undo transactions on older blocks.

17th slide

As the only pseudonymous global payment rail at the time, Bitcoin quickly found its perfect use case on the Dark Web, the part of the World Wide Web that is not indexed by standard search engines. It is only accessible by using special software and allows anonymous hosting of websites. Some of these sites are marketplaces for illicit goods like drugs and weapons. As we can all imagine, payments in these global markets were a real problem and Bitcoin was a perfect match for the job. Even with the absolute transparency of the transactions on the blockchain, linking between addresses and real identities is not an easy task.

That was the first strong use case of the new technology and really boosted its usage outside the libertarian community. This large user base created a market opportunity in exchanging the cryptocurrency for fiduciary money, so the cryptocurrency exchange was born.

18th slide

The first exchange to trade bitcoins was MtGox, short for “Magic: The Gathering Online eXchange”. What started as a fantasy-based game card exchange service became a multi-million bitcoin exchange handling over 70% of the world´s bitcoin trades. In 2014 the company went bankrupt after an alleged computer hack.

However, cryptocurrency trading had arrived to stay and now it is a multi-billion market with many huge exchanges operating in different countries.

19th slide

Not only new exchanges were created, but new cryptocurrencies kept pouring in. Today we know more than 800 different cryptocurrencies in circulation, some are mere copies of the bitcoin reference code, but others implement new features like transaction obfuscation in Zcash and programmability in Ethereum.

20th slide

The consequence of the development of this ecosystem is a global payment rail that any person can use just a mobile phone to send value globally. A

mobile,

private,

borderless,

fraud and censorship resistant,

irreversible and

programmable payment system was born.

Just to put this breakthrough in perspective, let´s ask ourselves what thing we would carry if we ever needed to run for our lives. I think we would certainly agree: We would carry our smartphones. International Rescue Committee arrived at the same conclusion when they surveyed the bags of refugees: They all carried a smartphone. And now, besides communication and information, they can carry value in their smartphones and receive aid from any person in the world without an intermediary.

This, ladies and gentleman, is truly amazing.

21st slide

And it does not stop there. Blockchain technology can disrupt many sectors with new and ingenious use cases that previously required a trusted third party. Digital rights, title records, digital global identity, crowdfunding, p2p lending, property ownership; all these uses are being actively researched and some of them are already available.

In a near future we might interact with a blockchain to secure a rental deposit while an Internet of Things lock allows access to a shared car or vacation apartment. This would be a new marketplace intermediated only by a blockchain.

22nd slide

As we all know, innovation is never a bed of roses. Like in old movies, we always have the good, the bad and the ugly sides.

On the good side, value movement freedom allows us to boost good actions like refugee aid and lower remittance cost and time.

However, on the bad side, the same freedom that allows us to reach the underprivileged can assist criminals. The free flow of value can be exploited to launder money and finance terrorists.

Finally, the ugly side: The blockchain technology is still very immature, sketchy and inefficient. Bitcoin miners, for example, collectively consume as much energy as a small country to secure only around FIVE to SEVEN transactions per second globally.

23th slide

As in many technological disruptions, regulators are called to address the bad side. They must protect citizens mitigating unacceptable risks while encouraging the beneficial innovation disruption. It has happened with Uber, it is happening with cryptocurrencies.

That way, financial regulators must evolve from risk managers to responsible innovation gateways, acting very carefully to address harmful activity while fomenting beneficial technology.

It may look like an easy task, but achieving the right balance is very difficult.

24th slide

On the ugly side, let´s remember:

The first car was inefficient, slow, dangerous and unreliable.

However, today we can have a clean, fast, safe and reliable one.

25th slide

The same happened with first browser. It was very slow and limited, but it proved the amazing potential of the World Wide Web.

But today we have full featured browsers that can handle complex web pages with animation, scripts, sound, video and even 3D rendering. However, no browser was ever able to transfer value without intermediaries.

26th slide

Well, Bitcoin closed this gap, but it was built on top of the first blockchain ever designed. It is slow, inefficient and awkward, but people have tasted freedom.

The genie won´t go back to the bottle.

So, what lies ahead in this technology?

I see no other path other than constant improvement that will power the Digital Financial Revolution.

27th slide

Thank you.