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WHERE DO YOU GO WHEN
THE BANKS WON’T LEND?
GLOBAL
TEXT BANKING POWER
UNBLOCK THE
SHARED ECONOMY
Unblock
the shared
economy
FAIL FAST AND PROSPER
DEFINING THE BANK
OF THE FUTURE
Growing trust in mutual distributed ledgers – such as the Blockchain
technology underlying Bitcoin – will change financial services for the
better, writes Professor Michael Mainelli
ILLUSTRATION: NICK LOWNDES
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Dialogue | Sep/Nov 2015
TO UNDERSTAND THE excitement over
Bitcoin currency, we need to understand money.
To understand money, we need to understand
communities. An anthropologist might say that
communities form when people are indebted
to one another. If people meet on the street and
leave without obligation to one another, they do
not form a community. Small communities tend to
hold everything in common. They are completely
and mutually indebted. Slightly larger communities need other mechanisms to record
indebtedness. “Brother John, in our
community you attend church on
Sunday and you missed it. We’ve put a
small mark against you.”
If your community is large and your
forms of indebtedness more complex,
you can trade indebtedness. I owe you
a chicken. You give my indebtedness to
someone else to repay one of your debts.
He or she claims a chicken from me. In
larger communities this indebtedness can
be complex and heterogeneous. We can
trade indebtedness of chickens for indebtedness of shoes, help with house-building,
favours owed, or slights to status. Money is
a technology that communities use to trade
debts across space and time. The ultimate
backing of money is its ability to extinguish
debts in future. The depth and distribution of
debt obligations are what give money value.
Unshackled from government
Many cryptocurrency proponents claim that
AltCoins – Bitcoins and similar cryptocurrencies –
liberate monies from governments. Nations have
a monopoly on the use of force in a geographical
area. To be a nation, you must defend the integrity of your national boundary. This allows you to
impose taxation within your borders. By forcing
citizens to meet taxation obligations, governments create an incentive, a need, for them to
trade. Governments create and vary the supply of
their currencies – fiat currencies – so setting
the trading landscape within their borders.
Is a nation a community? Governments
back their currencies through their
monopoly of force on tax payment,
creating a semi-coerced community
of taxpayers. If you don’t believe there
is coercion, call your tax office and say
you’d like to stop paying your taxes
for a bit. The money in our pockets is
valuable because people with whom we
wish to trade need to extinguish tax debts,
which will be enforced, or know people
with tax debts looming.
Unlike the fiat currencies – created and administered by national governments - Bitcoin set a
maximum fixed supply of 21 million coins. This
fixed supply means that Bitcoin is possibly best
compared with mining and extraction of precious
metals, particularly gold. Gold has a fixed earthly
While monkeys
may not create
monetary
systems, they
understand
money
Money versus currency
If money is a way of trading debt, what is
currency? Monetary technology typically uses
self-referential token systems. These tokens of
indebtedness are social desires and values frozen
at a point in time. The value of the tokens depends
on the future persistence of the community and
its values. Anthropologists analyze money as a
social technology akin to music or telephones.
While primates may not create monetary systems,
they understand money. Capuchin and tamarin
monkeys at Yale grasped the idea of tokens so well
they stopped saving and started raiding, gambling
and prostituting themselves. Currency is anything
that can be used as a token to record and transmit
money around the community. Money is a ledger
entry; currencies are physical tokens.
The US publisher Kay Ingram once said:
“Women prefer men who have something tender
about them – especially legal tender.” So is a man
who has all the money in the world the most
attractive? No, because if you have all the money
in the world, your money has no value. The more
you distribute money, the more value it has,
because more people are able to trade.
Dialogue | Sep/Nov 2015
A BRIEF HISTORY OF BITCOIN
This is the decade of Bitcoin. The
decentralized peer-to-peer digital
cryptocurrency launched on 1 January,
2009. Bitcoin and other cryptocurrencies
– also called AltCoins – gained significant
momentum in 2013 with Bitcoin’s sharp
price rise. It reached an all-time high on 29
November that year, peaking at US$1,125.
The rollercoaster ride continued. Bitcoin
market capitalization dropped from a high
of US$13.9 billion on 4 December 2013 to
around US$3.3 billion during the first half
of 2015 (see infographic, page 27). High
prices and volatility attracted speculation,
as well as proliferation of competitive and
complementary cryptocurrencies.
While there are more than 600 AltCoins,
Bitcoin remains the preponderant
cryptocurrency. The market capitalization
of the top 600 cryptocurrencies is in the
region of US$4bn, so Bitcoin is more than
80% of the capitalization.
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SHADY SHIPPER AND THE STRANGE MYTH OF THE TRUSTED REGISTRAR
Part 1: Validating the ledger
Shady Shipper: “I’d like to register my vessel. Here’s
a photo I took on the island this morning of my
supertanker berthed at the port terminal.”
Scrupulous Registrar: “We need your purchase
certificate, IMO ship registration number, tonnage
certificate, load line certificate …”
Shady Shipper: “Here’s $10,000.”
Scrupulous registrar: “That will do nicely, Sir.”
Part 2: Safeguarding the ledger
Shady Shipper: “I’d like to sell
supply but is mined according to price and
demand. Imagine Bitcoin as a chemical
element like gold, albeit a virtual one.
A community may decide to use this virtual
element for trading debts. So far, many of the
allegations for or against AltCoins focus on
what type of community is perceived to be
trading debts – a Silk Road of Breaking Bad-style
narcotic transactions; quixotic libertarians
damning profligate governments; or hard-pressed
traders in a tight credit environment? An AltCoin
moves from being a virtual element that could be
a currency to real money once it has a community.
When a government accepts an AltCoin for tax
(unlikely) or creates its own AltCoin and accepts it
for tax (more likely), AltCoins become RealCoins.
Boring old ledgers
A ledger is a book, file, or other record of financial transactions. The Sumerians used clay cuneiform tablets to record transactions. Medieval folk
used split tally sticks. In England, when tally sticks
were retired in 1834, the destruction of so many
tallies got out of control and burned down the
Houses of Parliament. Today, the implementation
of choice for a ledger is a database, found in all
modern accounting systems. So far, so boring.
When many parties interact and need to keep
track of complex sets of transactions they have
traditionally found creating a centralized ledger
helpful. A centralized transaction ledger needs a
trusted third party who makes the entries (validates); prevents double counting or double
spending (safeguards); and holds the transaction histories (preserves). Centralized ledgers are
found in registries (land, shipping, tax), exchanges
(stocks, bonds), or libraries (index and borrowing
records) and so on. But while a third party may be
trusted, it doesn’t mean they are trustworthy (see
Shady Shipper box, above).
Mutual distributed ledgers allow groups of
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my vessel once to Otto and once to Maria.”
Sanctimonious Registrar: “But that’s not possible.”
Shady Shipper: “Here’s $10,000.”
Sanctimonious Registrar: “That will do nicely, Sir.”
Part 3: Preserving the ledger
Shady Shipper: “I have to go to court and need you to
change your historical records for me to show that
only Maria owns the ship.”
Shady Registrar: “That could cost you…”
Shady Shipper: “Here’s $10,000.”
Shady Registrar: “That will do nicely, Sir.”
people to validate, record, and track transactions across a network of decentralized computer systems. The ledger itself
is a distributed data structure held in part,
or in its entirety, by each participating computer
system. The computer systems follow a
common protocol to add new transactions.
The protocol is distributed using peer-to-peer
application architecture. Peers are equally privileged participants in the protocol. Mutual distributed ledgers are not new – concurrent and
distributed databases have been a research area
since at least the 1970s. But growing confidence
has led numerous firms, particularly in financial services, to announce interest in using them:
Nasdaq, BNY Mellon, UBS, USAA, IBM, Samsung,
and others.
Mutual distributed ledgers can be implemented
in a number of ways, the most common being:
l public versus private – is reading the ledger
open to all or just to defined members of a
limited community?
l permissioned versus permissionless – are
only people with permission allowed to add
transactions?
l proof-of-stake, proof-of-work, consensus
or identity mechanisms – how are new
transactions authorized?
l true peer-to-peer or merely decentralized –
are all nodes equal/performing the same tasks?
Bitcoin relies on a database of all Bitcoins ever
traded. This database is called Blockchain, a public
transaction record of integrity without central
authority. Bitcoin “mining” is a groundbreaking
way of concurrently validating new transactions
with no central authority, Blockchain is a groundbreaking way of providing pervasive and persistent data storage. Blockchain technology offers
everyone the opportunity to participate in secure
contracts over time, but without being able to
avoid a record of what was agreed at that time.
Dialogue | Sep/Nov 2015
Distributed ledgers
The Blockchain is just one type of public, permissionless, proof-of-work, peer-to-peer distributed ledger. Distributed ledgers are probably the
future of financial services. Consider this statement from the Bank of England (2014 Quarterly
Bulletin Q3): “Although the monetary aspects of
digital currencies have attracted considerable
attention, the distributed ledger underlying their
payment systems is a significant innovation. The
potential impact of the distributed ledger may be
much broader than on payment systems alone.
The majority of financial assets — such as loans,
bonds, stocks and derivatives — now exist only in
electronic form, meaning that the financial system
itself is already simply a set of digital records.”
Collaborative economies or shared economies are all the rage, so why would ledgers be
any different? Economists study the visible hands
of planning, the invisible hands of markets, the
translucent hands of decision makers, the helping
hands of volunteers, and the grabbing hands of
governments – and now the sharing hands of
sharing economies. People are sharing cars (Uber,
Lyft, RelayRides), homes (Airbnb, Onefinestay),
oddjobs (TaskRabbit, Mechanical Turk), office
space (Liquidspace, ShareDesk). In financial
services, we have people sharing consumer insurance (Friendsurance, Guevara), consumer lending
(Lending Club, Zopa), corporate lending (Funding
Circle, ThinCats), and crowdfunding (Kickstarter,
IndieGoGo). One insurer has identified sharing
economies as collaborators to sell temporary
insurance cover for personal cars used as taxis and
homes used as hotels.
In his 1494 treatise on double entry, Fra Luca
Pacioli said “frequent audit maintains friendship”.
Long-term success of a sharing economy stems
from making sure the pie is fairly shared. Without
large numbers of people believing the commercials deals struck are fair, the sharing economy
fails to develop the trust it needs to thrive.
HIGHS AND LOWS
Bitcoin market
capitalization
US$13.9
billion
Q4 2013
Dialogue | Sep/Nov 2015
US$3.3
billion
Q2 2015
The dominant
AltCoin
80%
proportion of total market
capitalization of top 600
cryptocurrencies
commanded by Bitcoin
Regulators are exploring how to regulate the
shared economy. The state of New York is considering a BitLicense. The English Channel Islands
are mooting standards for distributed ledgers.
The persistence and pervasiveness of distributed
ledgers make them ideal for providing a regulator with a full transaction record for both oversight and recovery in the case of a systemically
important financial institution failing, or for
account portability and competition.
The trust factor
If love of money is the root of evil, study of money
must be the source of madness. Trust is another
maddening, self-referential, elusive concept
aligned with money. Financial services exist
because of our mistrust of others in transactions.
Sharing economies need financial services operations at the core. Well-run banks should have lots
to teach sharing economies. However, a centralized third-party banking approach now finds itself
competing with a mutual distributed ledger.
So what does the future hold? To mimic another
metaphor, it’s probably the “temple of financial
services” or the “souk of the shared economies”.
In the temple, the high priests of the Blockchain
maximalists and the banking traditionalists wage
a schismatic war over “the one true coin”. In
the souk there is an explosion of vibrant stalls, a
frenzy of small shopkeepers engaged in animated
discussions about a myriad of ways of trading.
Meanwhile, governments try to make taxing
the church or the market less slippery. While my
heart is with the souk, my head recognizes there
may be room for both. A sensible union would
be a few, competing, “Blockchain-type” services
encircling the globe providing end-of-day validation and recording of transactions, while
thousands of mutual distributed ledgers do the
work of serving thousands of shared economies.
Concepts of trust arise in many philosophical puzzles. Mutual distributed ledgers look like
becoming the system of trust in shared economies. If mutual distributed ledgers displace trusted
third parties, they will change the systems outside
them, most notably today’s financial services.
l Professor Michael Mainelli is executive chairman
of Z/Yen Group, the City of London’s leading
commercial think tank, and principal advisor to
Long Finance, a decade-old initiative asking “when
would we know our financial system is working?”
FURTHER READING
See Dialogue’s digital edition for additional content
on how to use mutually-distributed ledgers.
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