Monday, April 4, 2016

The Next Big Thing

Asked to name an event that has reshaped finance in recent years, bankers will point to the collapse of Lehman Brothers on September 15th 2008, the nadir of the financial crisis. Fintech types are more likely to mention something that happened six weeks later. On October 31st 2008 Satoshi Nakamoto, a pseudonymous cryptography buff whose real identity remains a mystery, unveiled a project he dubbed bitcoin, “a new electronic cash system that’s fully peer-to-peer, with no trusted third party”. It described what appeared to be a robust framework for a currency that could run without the backing of any government. Enthusiasts proclaimed that finance was about to enter the era of crypto-currencies. Since the need for a trusted third party has traditionally been a large part of the banks’ raison d’ĂȘtre, this could mean that in future they will no longer be required—potentially a much more radical change than the other inroads fintech has made on their business.

Six-and-a-half years on, the bankers may feel they can relax a little. Interest in bitcoin has waned. After spiking at $1,100 in November 2013, its value has dropped to $225 (see chart). A few online retailers and trendy coffee bars accept it, but its yo-yoing value is one reason why its use in the legitimate economy is barely measurable (though it remains a favourite with drug-dealers). The general public has not forsaken cash or credit cards.

Interest in the underlying mechanics of the currency, however, has continued to grow. The technological breakthroughs that made bitcoin possible, using cryptography to organise a complex network, fascinate leading figures in Silicon Valley. Many of them believe parts of Mr Nakamoto’s idea can be recycled for other uses. The “blockchain” technology that underpins bitcoin, a sort of peer-to-peer system of running a currency, is presented as a piece of innovation on a par with the introduction of limited liability for corporations, or private property rights, or the internet itself.

In essence, the blockchain is a giant ledger that keeps track of who owns how much bitcoin. The coins themselves are not physical objects, nor even digital files, but entries in the blockchain ledger: owning bitcoin is merely having a claim on a piece of information sitting on the blockchain.

The same could be said of how a bank keeps track of how much money is kept in each of its accounts. But there the similarities end. Unlike a bank’s ledger, which is centralised and private, the blockchain is public and distributed widely. Anyone can download a copy of it. Identities are protected by clever cryptography; beyond that the system is entirely transparent.

As well as keeping track of who owns bitcoin today, the blockchain is a record of who has owned every bitcoin since its inception. Units of currency are transferred from one party to another as part of a new “block” of transactions added to the existing chain—hence the name. New blocks are tacked on to the blockchain every ten minutes or so, extending it by a few hundred lines (it is already over 8,000 times the length of the Bible).

The proposed transactions contained in new blocks do not have to be approved by some central arbiter, as in conventional banking. Rather, a large number of computers dedicate themselves to keeping the system running. Rewards are high enough for vast data centres across the world to want to participate. Known as “miners”, they authenticate transactions by reaching a consensus on what the latest version of the blockchain should look like. In exchange, they are given newly minted bitcoin.

Chaining blocks together sequentially prevents anyone spending the same bitcoin twice, a bane of previous digital currencies. And the system is beyond tampering by any one party. Unlike a bank ledger, which can be altered by its owner (or a government), the blockchain cannot be changed without simultaneously overwriting all of the thousands of copies used by the miners at any one time. The definitive version of the blockchain is whatever a majority of the participating computers accepts. None of them is connected to any centralised organisation. There is no bitcoin central bank to sway them. To overwhelm the system, someone would need to control 51% of the computing capacity of the 10,000 or so “miners”—not impossible but unlikely.

This system of consensus by distributed co-operation sounds complicated, but it allows something of value to be transferred from one person to another without a middleman to verify the transaction. Fans think this is a way of changing the centralised, institution-dominated shape of modern finance. It is genuinely new. The question is whether it is useful.

by The Economist |  Read more:
Image: Satoshi Kamayashi