Cryptosolutions and cryptolimitations

Over the past few weeks I’ve read quite a few articles and papers on Bitcoin and cryptocurrencies. Some positive, some negative, some providing useful insights as to how finance can evolve in the future. Here is a little summary that illustrates rather well the concept of ‘spontaneous order’ in financial services.

On Coin Center, Juan Llanos argues that Bitcoin and the blockchain could revolutionise financial regulation, by providing real-time accounting information, which would replace than the current invasive, after-the-fact, often paper-based, regulatory oversight. Forget about the ‘information asymmetry’ nonsense (in my view) of the article. But he really has a point: transparency and processing speed and effectiveness would be considerably enhanced. There are limitations to this process however: the valuation of a number of financial instruments (what is often called ‘Level 2’ and ‘Level 3’ fair valued assets in the jargon) remains quite subjective. It remains to be seen how any automated blockchain or IT-based system can solve this subjectivity problem.

On Coin Center again, Chris Smith explains how Bitcoin addresses micropayments, which are regularly subject to transaction fees in store. Bitcoin radically reduces the fee, but does not eliminate it. According to him, Bitcoin offers an alternative solution: micropayment channels. They are “a cryptocurrency specific technology that allows for the aggregation of many small transactions into a single transaction, turning many fees into a single fee.” He goes on to explain the underlying technology and provides examples. Interesting read.

In City AM, Jerry Norton says that the blockchain will help you buy your house. He explains that the blockchain transforms the traditional ‘Delivery versus Payment’ protocol, which could particularly come in handy in the case of real estate transactions:

Today, when you’re buying a house you need to do so within working hours and with your solicitor acting as a mechanism for DVP. When the buyer transfers the money to the seller’s solicitor, his or her own solicitor receives the deeds. This process of ‘exchange and completion’ can take several weeks, and only happens during business hours, usually involving a CHAPS payment made in a branch.

With the blockchain concept of a smart contract, the exchange of the deeds and the funds transfer could be proven, linked together automatically, whilst happening in near real time and theoretically on a 24/7 basis.. The same principles are true for many asset types and purchases, such as buying a second-hand car – a process fraught with risk today.

On Alt-M, Larry White believes that cryptocurrencies don’t need regulation but more competition because innovators “need freedom to discover and pursue the most beneficial technologies.” He also thinks that, in a free society, there is no evidence that people prefer a currency that produces a stable price level and, consequently, Bitcoin could well become widely adopted.

On Coindesk, Stan Higgins reports a survey on blockchain technologies conducted by Greenwich Associates (Blomberg also does here). It is clear that bankers are currently reviewing options to implement blockchain-based solutions. However, Bitcoin itself seems to be of little interest. I unfortunately don’t have access to the report, but it seems full of interesting charts such as this one:

It is clear that blockchain-based technologies have multiple financial applications. I’m a little confused about ‘counterparty risk’ though, which seems to me to rely more on qualitative assessment than on automation and transaction recordings. But I might be missing something.

In the latest Cato journal, Larry White published a paper called The Market for Cryptocurrencies. Interesting paper, in particular the description of the cryptocurrency market and the various alternatives to Bitcoins (and their tech differences). He also repeats what he declared about regulatory intervention in the Alt-M interview above:

The market for cryptocurrencies is still evolving, and (to most economists) is full of surprises. Policymakers should therefore be very humble about the prospects for improving economic welfare by restricting the market. Israel Kirzner’s (1985) warning about the perils of regulation strongly applies here: Interventions that block or divert the path of entrepreneurial discovery will prevent the realization of potential breakthroughs such that we will never know what we are missing.

In the same journal, Kevin Dowd and Martin Hutchinson published a rather negative, but very interesting, view of Bitcoin titled Bitcoin Will Bite the Dust, in which they list of the ‘defects’ (at least in their view) of Bitcoin. In particular, they focus on the flaws of the mining system, which they view as leading to natural monopolies leaving the door open for 51% attacks. They however declare that other cryptocurrencies could be technically more elaborated and secure. They conclude:

we should remember that a recurring theme in the history of innovation is that the pioneers rarely, if ever, survive. This is because early models are always flawed and later entrants are able to learn from the mistakes of their predecessors. There is no reason why Bitcoin should be an exception to this historical rule.