The challenges of cryptocurrencies

Challenges of the Modern Cryptoeconomy

A significant number of financial and technology (fintech) thought leaders believe that virtual currencies represent a serious phenomenon that is already changing how traditional finance and banking works.

However, cryptocurrencies have noticeable challenges both at the technical and the social level, so let’s dive in.

- The first problem is the desire of nation states to control who gets to play in their financial system and, consequently, to counteract (or not validate) cryptocurrencies at the state level. This is the cause of many recurring legal issues associated with cryptocurrencies.

- The second is technical — there is a high degree of complexity associated with Blockchain scalability that eventually could lead to entire system collapses. The main challenges include: vulnerability to DDoS attacks, Blockchain size, and bandwidth TPS (transactions per second).

- The third problem is the architecture of consensus: PoW leads to mining centralization and technological centralization, PoS makes it possible for the attacker to maintain parallel block chains without high costs. I know many of you would love to jump all over this simplistic explanation, but we don’t want to dive all the way down the rabbit hole today.

- Another area of complexity in this field is the increasing Bitcoin fee cost. We should also mention the lack of availability of operating Bitcoin add-ons, which allow you to avoid these pitfalls safely as of the time of writing this material, and the bandwidth issue (Lightning Network , RSK).

- We should mention the challenge of hyper-volatility. In conditions of limited supply, the rate will depend on demand. And this value is directly related to the subjective attitude of the users, which can change as only humans can. You cannot do any kind of quantitative easing with bitcoin, since coins are only created as fast as processing networks can solve blocks.

You can really go drill down into the various cryptoeconomy challenges in the monumental work of Vitalik Buterin “Problems”. (It so happened that Humaniq’s founder, Alex Fork, was able to strike up a professional relationship and work with Vitalik.)

Vitalik writes in his work, “The second part of the cryptoeconomy, where the solutions are much more difficult to check and evaluate, is the actual economy. Cryptocurrencies are not just cryptographic, but also economic systems… At the same time, the economic problems are much more difficult to formulate. It is impossible to understand whether the problem has been resolved without large-scale experiments. Their results are often dependent on cultural factors or external organizational or social structures used by the experimenter. In addition, even if the economic problem can be solved, the solution may be far beyond the actual cryptocurrency”.

The fundamental truth of cryptoeconomics is this: the economy is mathematics plus social psychology.

One of the main disadvantages arresting the adoption of Bitcoin and other cryptocurrencies is their poor incidence.

According to a report by Juniper Research, the number of active Bitcoin users around the world could reach 4.7 million people by the end of 2019, and even now the network has reached the capacity limit of 250 thousand transactions.

At a similar time in its history, PayPal had over 100 million active accounts, despite the fact that it started with a less developed infrastructure and required passport details to use. That’s a massive difference, even though there are stark differences in the ease of use of PayPal compared to Bitcoin. (Full disclosure, Humaniq is all about ease of use)

In addition to security and anonymity, Bitcoin’s value is largely determined by the number of users and the amount of transactions as a confirmation of the demand for it, and when you have 4.7 million people and only 250 thousand transactions, there’s clearly a problem with demand. Many economists would ask what’s the point of having a deflationary supersystem that no one can crack if no one uses it? Even Europe, where virtually the entire population uses smartphones, still has countries where hardly anyone knows about cryptocurrencies, and Bitcoin has been with us for 7 years now.

Perhaps Bitcoin itself is not the ideal solution for for consumer transactions due to the TPS scalability challenge. Where it could really shine is by defining its own role as a sort of international reserve and transfer currency. Digital gold. Where the real promise lies is in the ecosystem of other crypto currencies, developed around Bitcoin, that will somehow be linked to it.

Now let’s focus our attention on elements that are relevant to Humaniq, which can solve some of the challenges that prevent the spread of cryptocurrencies:

  • Loss of your wallet password means you lose your money
  • Very large database file necessary for verifying transactions

Satoshi Nakamoto noted a major problem in the introduction to his program article:

“What is needed is an electronic payment system based on cryptographic proof instead of trust, allowing any two willing parties to transact directly with each other without the need for a trusted third party.”

During the seven years of Bitcoin’s existence, over 98% of the users have adopted mobile wallets. These services are essentially add-ons to the peer-to-peer payment system and represent a convenient intermediary. The main problem is that it is very difficult to store Blockchain and perform computations on a mobile device. Perhaps in the near future this problem will be solved by using lite client apps, but the market has not prioritized this so far.

It is also worth noting that not all the inhabitants of our planet have the opportunity to use Bitcoin Core — many simply do not have a computer, and even if they do the Bitcoin UI is not user friendly.

The injustice of Bitcoin and crytocurrency allocation

A mechanism to stimulate network support and adoption developed by Satoshi Nakomoto turned out to be an interesting phenomenon:.

“By convention, the first transaction in a block is a special transaction that starts a new coin owned by the creator of the block. This adds an incentive for nodes to support the network, and provides a way to initially distribute coins into circulation, since there is no central authority to issue them. The steady addition of a constant of amount of new coins is analogous to gold miners expending resources to add gold to circulation. In our case, it is CPU time and electricity that is expended”.

Let’s face it: the distribution of cryptocurrencies in the world is quite uneven. In countries with high computer literacy and widespread high speed internet access, there are long established communities of Bitcoin users and miners, while in many regions Bitcoin is barely known.

It is often said that Bitcoin could help Africa. Imagine a resident of one of the poorer regions, who has at least one mobile device. How can he use this currency? He would install a Bitcoin mobile wallet, with zero on his account. Where would he get Bitcoins, from whom can he receive them and what for? Nevertheless, these regions have an economy, even if it’s drastically different than what we’re used to seeing in Europe or North America. People work, sell, order services, mostly paying with cash or barter. But the cryptoeconomy has not reached these countries yet, despite all its advantages in not requiring a bank or documents to send or receive money. And we have a feeling that if this pattern continues, it will never penetrate these markets because there is no bitcoin capital in these markets. Nobody mined in these regions because they lacked both the resources and time to do so.

There have been obvious shortcomings with how cryptocurrencies are generated, like the gold standard:

1. Injustice of allocation.

Those who first learned about Bitcoin mining and began doing it were rewarded, in aggregate, with tends of thousands of Bitcoins by using only their PCs, and now regular users cannot earn even thousandths of Bitcoin using similar resources as the early adopters. Much like how the gold standard heavily benefited countries with gold mines, Bitcoin mining has largely benefited early adopters.

2. Insufficient liquidity.

Indonesia, a large market of 250 million people, has struggled to meet the demand due to a lack of digital currency, which has resulted in a low turnover, according to the head of one exchange.

Sometimes it takes a lot of time for sufficient liquidity volume to appear in the local market. Sometimes it’s hard to do, especially if the region is poorly integrated in the international financial system. Nevertheless, there is no doubt that these regions have their own domestic economies.

Satoshi understood this problem and pointed out in 2009:

“To Sepp’s question, indeed there is nobody to act as central bank or federal reserve to adjust the money supply as the population of users grows. That would have required a trusted party to determine the value, because I don’t know a way for software to know the real world value of things. If there was some clever way, or if we wanted to trust someone to actively manage the money supply to peg it to something, the rules could have been programmed for that”.

It is surprising how this incentive system has played a huge role for the network of users. Through this mechanism, a few tens of thousands of miners were involved supporting the network and have automatically become its users. An interesting pattern should be noted: the issuance of money being tied to computing power has led to the exponential growth of such computations, and at the time of writing, the computing power of Bitcoin miners (1 hash/s ~ 12,700 flops) was more than 200,000 times greater than the most high-performance computer in the world in terms of flops, proviso that the miners are highly specialized at solving only one problem, blocks.

And it is objectively clear: to enable the network effect, you need to encourage users of this cryptocurrency payment network.

An interesting example: PayPal’s strategy was to pay new users $20 to connect themselves and invite a friend who also connected. As the network grew to be self-sustainable, remuneration reduced: Thus Elon Musk was able to achieve the network effect.

A more equitable allocation of tokens is to pay out funds to each real user and give small bonuses for activity, which encourages network growth and capitalization.

Complexity of reputation accounting in anonymous communities.

As Vitalik writes in his work:

“The problem is, to some extent related to the reputation system — the problem of creating a system of unique identifiers. However, we would like to have a more elegant and more egalitarian system than “one dollar — one vote’, ideally “one person — one vote”.

At the moment, we can see two strategies to address this problem. One of the possible solutions is to implement a proof-of-work mechanism based on human labor instead of computer operation… These problems can be interactive like a CAPTCHA, although existing implementations of CAPTCHA are far from the level acceptable for this problem, or interactive strategy games like Go.

The second strategy is to use social proof, directing the power of decentralized information to solve a simple problem: do these two accounts correspond to one person? More advanced systems may try to determine fraud attempts by recognizing the stylistic features of language or tracking IP addresses.

… Let’s take for granted that any system can be hacked if the necessary resources are available. However, we want to make sure that it is far more beneficial for the users to have a single token and use it properly, rather than buying tokens in the gray or black market. The problem then is how to significantly increase the prices in the gray and black markets, without complicating the process of receiving an initial token for a new user. IE, you want legitimate users to get their free tokens, but you don’t want people creating loads of duplicate accounts in order to game the system and create unequal distribution.

Objective: To create a mechanism for token allocation to counteract Sybil attacks.

Additional assumptions and requirements

  • Everyone is in a social network with characteristics similar to the social networks that exist today in the real world; social data can be reliably provided to a cryptoeconomic system (for example, through Blockchain or Ethereum contracts).
  • The cost of obtaining one token for a person shall be as low as possible.
  • The cost of obtaining multiple tokens for a person shall be as high as possible.
  • The cost of token ownership for the automated system shall be as high as possible (this is a more important criterion than the high cost of ownership of multiple tokens for a person).
  • The system shall not depend on centralized entities (e.g., government passport offices) that may deceive the system.

The concept of “one person — one vote”” is very close to me. I begin my arguments with it. How do I know that a person (not a bot) connected? At the moment, there are already elegant solutions for highly accurate biometric authentication. If we take a combination of authentication methods, it increases the likelihood of true authentication to near 100%. It is worth noting that the use of hardware solutions, for example, a fingerprint scanner, has a chance of signal counterfeiting at the hardware level. There’s also the issue that most phones equipped with fingerprint scanners are priced out of the market in many parts of the world.

Therefore, a set of data that comes directly from the user to the identification system is important to us. An ideal set contains: facial photo, video recording (to get a 3D composite) and voice recording. And, accordingly, a frontal camera and a microphone are now built into all devices. To avoid counterfeits, it is worth adding the device ID and a random character generator to be pronounced by the user. This authentication method takes less than five seconds and requires no e-mail, telephone number, or passport, and you never have to worry about losing your password.

The cost of each session authentication can be as low as 1 cent. This is the real Proof of Identity. The only outstanding issue is decentralization of this service. Such services have several components: software part, neural network and database. In principle, these components can be decentralized. Perhaps not all of the components can be realized through Blockchain, but some parts will represent a network of independent nodes. It will be required to train the neural network at each node by the entire database each time. In the future, this network can be linked with smart contracts in Ethereum. Probably, the technical capabilities will never be sufficient for processing the data sets of all mankind. The success of this field may allow replacing or improving Proof of work. It’s a long journey ahead which, like everything, begins with the first step. First, Proof of concept: it is necessary to prove the operability of this principle at least in terms of a mobile wallet, and then implement decentralization and integration into a fully featured client-wallet.

For a full description of the Humaniq project, please read our whitepaper or join us on our Slack channel.