Blockchain: Taking cues from cloud computing playbook
Bitcoin cornered significant press coverage both for good and bad reasons. Some of the prominent naysayers have termed bitcoin as “mirage” , “bubble” or “another digital currency”. On the jingoistic side, entrepreneurs and academicians have jumped onto the bandwagon hailing it for liberation from centralized regulatory burden and equating Bitcoin to Internet in its infancy stage. There may be merits in both sides but the increasing innovation in the bitcoin and its derivative technologies is promising paradigm shift to the way financial transactions will be maintained in the future.
I admit the article is anachronistic but to refresh history lane I briefly introduce bitcoin before shifting the focus to the evolution of divergent paths for “bitcoin” as a crypto-currency and the “blockchain” which potentially holds future for next generation of inter-mediation. This evolution has lot of resemblance with the growth of cloud computing that offers value through flexibility in assorted deployment plans and un-bundling of computing elements.
Let me recap the four components of Bitcoin ecosystem to explain how bitcoins are injected into the network:
bitcoin: is the underlying cryptocurrency
blockchain: is the distributed ledger to securely and reliably record transactions ordered by timestamp from cradle to grave
proof-of-work: a decentralized consensus-based mechanism that lends authenticity to each transaction
miners: army of globally spread volunteers who get economic incentives for putting their skin in the game
Unlike fiat currency printed by the central banks, bitcoins are created by miners using the computing power. The process of bitcoin creation is nebulous and doesn’t produce any physical asset. The bitcoins are added to the network when a miner solves a puzzle to discover a random number. This puzzle is to combine the random number with the header of last discovered block to produce a hash using a cryptographic algorithm such as SHA56, MD5. The hash is a fixed length text and should be compliant with the pre-determined format among all the network miners.
The effort expended by the miner is only rewarded after other miners on the network verify the proof-of-work. After the majority of the network verifies the legitimacy of the new block, the block is added the blockchain and becomes history. The miner is awarded 25 bitcoin for the discovery of each new block and this reward value is halved every 4 years or roughly 210,000 blocks. These magic numbers exist because the reference implementation imposes a maximum cap of 21 million to the bitcoins to be ever issued. Currently the bitcoin network supports addition of new block every 10 min and block size is 1M.
Adoption curve for Bitcoin emphasizes the potential for disruptive innovation
Source: http://blockchain.info
The above chart highlights significant growth in the number of transactions using bitcoin over last six years. This growth illustrates the network effect as more entities have developed confidence in Bitcoin. The bitcoin network also has improved on technical flaws by operating in learn and revive mode over last six years.
Although bitcoin as an exchange medium has gained significant traction, the financial industry has so far balked at the adoption of bitcoin technology. Yes, bitcoin comes with its share of challenges in terms of security, privacy, scalability, deflationary concerns, and loss of political hegemony over money supply et al. The chief concerns impeding adoption in financial services industry is scalability, security and privacy concerns.
Scalability — As mentioned above, new blocks are added roughly after 10 minutes constraining the throughput between 3 transactions/ second to 7 transactions/sec. Some of the financial services such as payment processing, order management that operate at much higher rates and may be run into bottlenecks with current bitcoin infrastructure. As bitcoin transactions are verified by all nodes on the network, the transaction fee is another scalability concern for an industry where millions of daily transactions are a norm.
Security — Despite strong security model of the bitcoin protocol, there are numerous touch points present in the decentralized ecosystem. A minor weakness in any one of these entities can open vulnerability attacks. Such security breaches happened with Mt. Gox and Inputs.io exchanges which were attributed to transaction malleability. In such attack, an operationally weak exchange will receive a failure message even though transaction happened successfully and causing the exchange to repeat the transaction multiple times.
Privacy — This has been touted as the most serious concerns by the financial institutions. The bitcoin publishes the entire transaction history in the public domain through blockchain. This alarms the banks and government agencies whose business relies on masking the identity of the benefactors. In the original bitcoin paper by Satoshi Nakata proposes that a new key pair should be used for each transaction to conceal the identity of the owner. This approach is not only cumbersome for a high volume business but can opens avenues for fraudulent activities such as money laundering.
Not too far back in the history of the software industry, similar challenges were encountered in the evolution of cloud computing. Issues such as security, privacy and scalability were at the forefront of the discussion forums and threatened widespread cloud adoption in a regulated world of financial services. But the economic benefits from cloud computing such as elimination of capital expenditure, reduced total cost of ownership and business agility in product release were enormously significant to dismiss the cloud computing models. As per one of the IDC report, both public and private clouds grew at a a healthy CAGR of 18% in recent times. The cloud computing advanced through multiple deployment variants intended to meet the requirements of different customer segments. The deployment options ranged from public cloud suitable for small businesses to private cloud for large enterprises. In the continuum the vendors also offered hybrid plans to optimize the cost. In the hybrid plans, low risk applications are hosted on the public cloud but time and security sensitive applications are hosted on the private cloud. Another key innovation from the cloud vendors was to dismantle the monolithic software architecture and instead sell services through delivery models such as Infrastructure as a Service (IaaS), Platform as a Service (PaaS) and Software as a Service (SaaS). This led to proliferation of specialized vendors and increasing penetration of cloud services in the financial sector.
Bitcoin community is now directionally heading on the same path as cloud computing by unbundling the currency and the underlying infrastructure. Financial players are now realizing the micro value that could be unleashed by paving independent path of blockchain infrastructure and the crypto currency. Not only digital currencies such as lite coins, alt coins have altered bitcoin design but the underlying block chain and network has emerged as an independent implementation. The alternative block chain such as Ethereum, Ripple and Namecoin have modified implementation of consensus algorithm and distributed ledger customized for specific cases payments, contracts or name registration.
The deployment models for blockchain are also transforming to allow granular access control and to authorize the visibility of transactional data. The different categories of blockchain evolved recently are covered below.
Private (permissioned) blockchain — These blockchains implement proprietary protocols and explicitly authorize read operation or transaction creation access for only certain clients. This model is going to be promoted through consortium of banks or intermediaries who can enforce governance models and achieve cost efficiencies through infrastructure consolidation. As the number of participants will be throttled through the governing body, the explicit requirement of proof-of-work and mining effort will be redundant in this model. This will overcome some of the inherent shortcomings of the bitcoin network related to throughput and latency of the transactions. The financial intermediary services such as clearing, syndicated borrowing and collateral management are ideal use-case for integration with block chains in this model. Mizunho bank announced trial of blockchain for processing of syndicated loan.
Public (permission less) blockchain –These blockchains extend the bitcoin mechanism and allows anyone to create a transaction or view the prior transaction without need for explicit membership. These blockchain will continue to be fertile grounds of innovations in the blockchain technology. All the variants of permissioned blockchains will have an equivalent counterpart in the public domain albeit one that would be must more cost-effective but the trade-off would be lack of privacy and absence of rubber stamp of a centralized authority. The public blockchain will gain even wider traction among the retail online businesses and crowd sourcing platform that transcend geographical boundaries and resolve issues related to “trust” and “exchange fees”. Imagine the possibility of a health care provider from U.K getting compensated for his expert advice to a remote location in Brazil without having to go through a money transfer agent or service.
Hybrid blockchain (Blockchain as a service) — As evidenced from the cloud computing, the firms seek out to merge public and private infrastructure to maximize cost savings. The blockchain services will mushroom to enable the co-existence of permission and permission-less blockchains. These services will offer unified deployment of private and public blockchain that will allow a seamless changeover for the firms based on specific use-cases. Eris platform promises to deliver such hybrid infrastructure that will allow the public blockchain such bitcoin to co-exist with private blockchain provided by Ethereum or Zcash.
To show the blockchain use-case in action, a current business of collateral management is overlaid within a blockchain infrastructure. Collateral management has seen fundamental shift since the financial events of 2009 and now both buy and sell side participants employ cash and security based collateral routinely to minimize the funding cost and effective management of counter party and credit risk. Blockchain infrastructure offers the mechanism to consolidate a unified pool where ownership of collateral is transparent to all the market participants and hypothecation, pledge or title transfer for collateral is done reliably fast and at lower cost.
Above image displays the business-as-usual scenario for transfer of collateral between the trading parties either through pledge or title transfer. In the current setup there is duplication of rules to validate the ownership, quality and value of the collateral across multiple systems. There are numerous systems involved even in this simplified business scenario and the fixed costs to maintain these systems drags down the profitability of the trading entities and financial intermediaries.
In the contrasting infrastructure based on blockchain, a distributed ledger system will enable the ownership and market value of the collaterals to be published transparently. In a permissioned blockchain, the consortium of financial players will provide oversight and govern the access privileges for parties to read and write. The operational costs for the blockchain will be mutually shared by the trading parties and costs are expected to be a fraction of expenses to maintain the existing infrastructure. In a permissioned blockchain the replication and addition of new blocks will be confined over a private network. As shown in the diagram, trading parties will be able to transact collateral in a peer-to-peer mode and all the network participants will be able to access the ownership records in the general ledger.
A permissionless blockchain will not have any controlling authority to perform functions of authorization, provisioning and replication. Instead blockchain will be a fully peer to peer network where independent miners will validate the validity of each transaction.
Bitcoin growth story that began as an alternative to fiat currency has diffused to more compelling business functions in financial services through the blockchain innovation. A number of investments have recently poured in to enforce smart contracts through blockchain infrastructure for number of back office functions. A growing number of applications in areas of settlements, clearing, payments and reporting are slated to adopt blockchain. The trends are strong signals that blockchain technology is ready for the long haul. However, as blockchain applications cannot co-habitat with the legacy infrastructure, the tipping point for blockchain requires longer term horizon.
