The views expressed are the personal views of authors and are not intended to represent the views of the Financial Times, the Center for Evidence-Based Management or any organisation affiliated to the authors.

Izabella Kaminska

Editor of FT Alphaville at the Financial Times.

Covered cryptocurrency journalistically since 2012, and banking, finance and payments systems since before the global financial crisis.

Associate Producer at CNBC, Reuters Graduate Trainee and Associate Editor of BP’s internal magazine.

Master’s in Journalism from the London College of Printing, Bachelor’s in Ancient History from University College London

Martin Walker

Director of Banking and Finance at the Center for Evidence-Based Management

Former consultant to R3 Blockchain consortium.

● Wrote portions of Series A funding document related to Capital Markets

● Co-Wrote Paper of “FOUNDATIONS OF DLT: CASH”

● Worked on development of Capital Markets products based on Corda DLT

● Trained staff in key banking and banking technology concepts

While in Strategy and Change role in HSBC Markets Operations

● Analysed the potential impact of Blockchain on Post-Trade processing

● Performed Due Diligence on request for funding from Blockchain company

● Reviewed Goldman Sachs patent application

● High level design of mechanism for inter-company foreign exchange settlements using DLT

Multiple papers and articles on Capital Markets technology, Blockchain and cryptocurrencies

Other Experience

● Former Global Head of Securities Finance and Treasury IT at Dresdner Kleinwort

● Former Global Head of Prime Brokerage Technology at RBS Markets

● Former Senior Business Analyst in Equity Finance Technology at Merrill Lynch

● Former economist in Government Economic Service

Education

● MSc and Diploma of Imperial College in Computing Science from Imperial College, London

● BSc Economics from London School of Economics

The role of digital currencies in the UK, including the opportunities and risks digital currencies may bring to consumers, businesses and the Government (and associated bodies).

Conclusions

Digital Currency is used as a precise term by the Bank of England but in more common usage refers to a group of money-like assets that is so broad it is almost meaningless.

Anyone can create their own “private currency” but the problem is getting anyone to accept it has value.

In terms of their core use case, payments, they have largely failed because of innate technical and economic problems with the core design.

Cryptocurrencies and other assets have evolved from the play money of enthusiasts to a tool for supporting criminal activity to a tool for speculation/gambling and tax evasion. At no point, have they had significant adoption in the real world.

Introduction - Uses and Abuses of the term “Digital Currency”

This enquiry looks into “Digital Currency” a term used by the Bank of England since at least 2014 in a way that is synonymous with the more commonly used term cryptocurrency. Most digital currencies are ‘cryptocurrencies’, in that they seek consensus through means of techniques from the field of cryptography. There are also a small number of digital currencies, the most prominent of which is Ripple, that seek consensus through non-cryptographic means.[1]

However, the Bank of England’s use of this otherwise ambiguous term has created some confusion notably due to the fact that:

The vast majority of what is commonly accepted as money (reserves held by banks at the central bank and savings held at commercial banks) are stored and spent digitally i.e. digital money.
Digital money, digital cash and digital currency are terms that over a long period have been used to refer to a variety of actual and theoretical forms of money including stored value cards, mobile phone money such as M-Pesa and mostly theoretical forms of Central Bank Digital Currency (CDBC).
The key feature of many earlier ideas of “digital cash” was that it had two of the key characteristics of physical cash, it could be spent anonymously and it be exchanged on a “peer-to-peer” basis.

To put the all these forms of money into wider context and to allow a more accurate comparison with both electronic (including the broader class of “crypto-assets”) and physical money a detailed list is contained in Appendix 1 identifying the following relevant attributes.

Cryptocurrencies have little in common with any accepted form of money or any of the theoretical forms of Central Bank Digital Cash. The other major problem of the term digital currency is that proponents of cryptocurrencies use any discussion of Central Bank or Commercial Bank digital cash (i.e. electronic money with some of the attributes of physical money) as evidence of and justification for the value of cryptocurrencies. To further confuse matters there are now forms of cryptocurrency called “Stablecoins” (for example Tethers) that have many of the characteristics of a cryptocurrency but which are notionally linked to currencies such as the US Dollar or the Euro.

This document will consistently use the term cryptocurrency but will make special note of the forms of cryptocurrency that have deviated in significant ways from the model set by the original cryptocurrency, Bitcoin.

What makes a cryptocurrency a cryptocurrency and what gives it value?

Private currencies do not confer any rights to:

● Exchange with the issuer for recognised forms of money.

● Receive any income from the issuer.

● Exchange for goods or services provided by the issuer (outside of contract law).

They are not generally considered of any value and the creator of the currency would generally find huge problems in having them accepted as having value.

It is very easy to create a digital version of a private currency. Create a basic database containing tables for account holders, transactions and balances. Set up a simple web server. Create a simple web page allows authentication of users and allows the transfer of the digital private currency between account holders. Implement the appropriate security layer. Most people would still consider the digital version of the currency to have no value because there is no reason for anyone to accept it. The original cryptocurrencies, pioneered by Bitcoin took the basic concept of a digital private currency but “de-centralised” the processing and storage of transactions the creation of the currency. They also provided the minimum use of the cryptocurrency, paying for transactions to transfer the cryptocurrency to another user of the currency.

For the first two years of its existence Bitcoin faced all the problems of acceptability for a private a currency. Enthusiasts creating and accepting Bitcoins for any commercial venture faced the problems that they needed to cover their costs in conventional currencies rather than dollars. There was no significant circular flow of Bitcoins in a “Crypto-Economy”.

2011-2013 saw the formation of the closest thing to a crypto-economy, where websites such as Silk Road made Bitcoin the currency of choice for criminals that wanted to buy and sell, drugs, guns, stolen credit card details etc. on-line as well as for the illicit gambling industry. This period also saw Bitcoin come to the attention of the press and alternative/libertarian groups such as WikiLeaks and the Electronic Frontier Foundation.

The use for Bitcoin in criminal enterprises and greater publicity fed the first spectacular price rises that brought the attention of cryptocurrencies as a form of speculation. Within 2 weeks of the Silk Road coming on line, the price of Bitcoin increased by 100%. When the Silk Road was brought to public attention in an article in “The Gawker” on June 1st 2011 it generated an even more impressive price increase, with prices rising 370% in only ten days. Subsequent price rises were related to speculation driven by views on the future utility of Bitcoin and technologies and in 2017 from the use of Bitcoin as a medium to invest in Initial Coin Offerings (ICOs), generally highly speculative ventures related to creating new cryptocurrency-related businesses.

In almost any other market the sudden price rises (and falls) shown by Bitcoin would be viewed as evidence of market manipulation. For example,

21/05/2011 to 10/06/2011, 530% increase

05/03/2013 to 10/04/2013, 494% increase

17/10/2013 to 04/12/2013, 803% increase

The main drivers of the value of cryptocurrencies (particularly Bitcoin) seen to be based on the facilitation of criminal activity, speculation and a strong probability of systematic market manipulation.

The Role of Cryptocurrencies (aka Digital Currencies) in the UK

Fundamental Usage

As a form of private money (in some cases equivalent to a form of security) with little link to real world activity, little direct acceptance in commerce and little legal recognition, what are the core uses for a Bitcoin (excluding financial speculation).

Ownership of Bitcoin (and the vast majority of other cryptocurrencies) simply gives the owner the right to pay for the transfer of Bitcoins to other people. This is as long as there are miners (or the equivalent in other systems) willing to accept Bitcoins for carrying out this service. A service that requires them to purchase labour, computer hardware and electricity using conventional currencies.

More sophisticated forms of cryptocurrency such as the Ether (used on the Ethereum Blockchain) can be used to pay for transfer of Ethers or to pay for the execution of computer programmes on the Ethereum Blockchain. The most notable of these was Crypto Kitties, a form of electronic collectable cat. Other programmes that run on the Ethereum network include those that exchange Ethereum for new cryptocurrencies or cryptosecurities issued in Initial Coins Offerings (ICOs). The Ethereum network also runs automated pyramid schemes. There is little real world business use of programmes that run on the network.

The most illogical forms of cryptocurrencies/cryptoassets are those that are simply a form of voucher for the provision of real world goods or services such as the notorious Dentacoin. A cryptocurrency designed to pay for dental services. There is no logical, technical or economic reason why these assets need to be represented on a Blockchain with a limited access token, other than cartel incentives.

Actual Usage

Use within UK for actual commerce is minimal with evidence that the number of businesses accepting cryptocurrencies for everyday purchases is declining. With the bubble in valuations between November 2017 and January 2018 the primary purpose of cryptocurrencies has become a form of high risk financial speculation. Other notable uses of cryptocurrencies in the UK include:

● Supporting Criminal Activity (particularly those involving on-line transactions) and including ransomware attacks

● International Payments

● Gambling

● Credit Cards whose issuers convert from cryptocurrency to pounds for everyday purchases

● Pyramid Schemes

● Tax evasion

● Gambling websites

● Speculation/Investment & Trading including

Crypto funds
CFDs
Futures
Copycat Trading funds

● Cryptocurrency Exchanges

● ICOS

Crypto has undoubtedly created work supporting investment and trading in cryptocurrencies. It has also given offshore tax-haven jurisdictions -- recently cracked down upon by the international community - a new raison d’etre by providing safe harbour to assets which might otherwise be taxed onshore.

However, this ultimately diverts productive resources towards supporting zero-sum game. One group of investors ultimately profiting from another group. It could be argued that is this not unique to cryptocurrencies. What uniquely sets the cryptocurrencies apart from other financial assets is that apart from support for the activities of enthusiasts and criminals there is no utility in cryptocurrencies or capability to generate an income.

The Opportunities and Risks from Cryptocurrencies

Outside of the black economy its volatility, illiquidity, cost and entry/exit expense creates little incentive for the creation of a “crypto-economy” i.e. where people sell each other goods services with the new currency.

Cryptocurrencies have undoubtedly created major opportunities for many businesses that facilitate the purchase/sale of cryptocurrencies and trading in cryptocurrencies/related derivatives. Sadly, all this activity can ultimately be seen as supporting zero-sum activities that channel funds from new investors to those cashing out of those investments or creating fresh cryptocurrency. The same criticism can be made of great deal of the conventional financial sector however the worst parts of existing financial sector make some ultimate contribution to the overall economy by generating invisible exports or lubricating the overall operation of the economy. The cryptocurrency industry, however, has quickly replicated the very layer of rent-seeking intermediaries it originally strove to eliminate, on an arguably greater scale. Given that the ultimate beneficiary of most cryptocurrency generation is based off-shore it is quite likely that cryptocurrency speculation is a net drain on the UK economy.

Cryptocurrencies present a number of risks to the overall economy including:

● Making online criminal activity easier including the use of ransomware. Newer forms of cryptocurrency such as Monero have superior privacy features making them even more suitable for supporting criminal activity.

● Creating bubbles including risk of contagion to conventional finance.

● Risk to naïve investors.

● Hugely energy inefficient and damaging to the environment. The mining process is currently estimated to consume the same amount electricity as Switzerland [2] or 5,631,289 average US households.

● Potential funding tool for terrorist groups.

● Undermines confidence in UK regulation if the UK fails to control cryptocurrency related businesses and their associated risks

● Tool for tax evasion including the hiding of undeclared income.

The Opportunities and Risks from Central Bank Digital Cash

Central Bank Digital Currency (mostly theoretical) are digital currencies that have the same credit and legal characteristics of central bank reserves and in some potential implementations the characteristics of physical cash. It can be exchanged on a peer-to-peer basis and can potentially be spent anonymously (unlike spending via credit card, debit card or bank transfer).

In 2015 Ecuador implemented its own form of Central Bank backed electronic money, the Dinero Electronico [3]. The Dinero was frequently cited by enthusiasts for Cryptocurrencies as an example of the growth of digital/virtual currencies. However, it had almost nothing in common with the bulk of cryptocurrencies.

● The Dinero was not a cryptocurrency because it did use any of the cryptographic techniques of Bitcoin

● It was neither de-centralised nor distributed because it was run by the Bank of Ecuador’s central computer systems

● It was backed by the US dollar with which it officially had parity

● It represented a liability on the Central Bank balance of the recipient’s bank.

The Dinero failed to gain widespread acceptance and was terminated in 2018. There are special circumstances for its failure. Ecuador is a “dollarized” economy. The official currency is the US Dollar and the government/central bank consequently have little power over interest rates, monetary policy and are severely constrained in fiscal policies. The Dinero was distrusted from the outset because of the belief that it was an attempt to end dollarization by the back door and devalue people’s savings. The fact it was electronic and spendable by mobile phone had little influence on its success.

Estonia has also considered introducing a “digital currency” separate from the Euro (its official currency) but it was considered incompatible with its membership of the Eurozone.

CDBC presents opportunities to provide the public with a store of value free from credit risk but so does a national savings account. CDBC could also potentially facilitate a payments process that reduces the credit risk exposure to banks.

However, CDBC has a number of risks associated with it

● Risk of accelerated bank runs.

● Crowding out saving with commercial banks.

● Inflation-inducing misallocation of capital.

● Increases burden on state with respect to the management of the asset side of the balance sheet.

● Regression on AML and KYC efforts.

● Potentially more costly to operate than the private sector.

Case Study - The Limits to Usage in International Payments

One of the most talked about uses for cryptocurrencies is in international payments. Transfers by cryptocurrency are claimed to be faster and cheaper. However, these claims are simply untrue. There are also no useful like-for-like comparisons.

In the most common scenario (by value) funds are ultimately transferred from the sender to the recipient’s bank accounts with a foreign exchange transaction in the middle if the two countries used different currencies.

Many of the misconceptions about payments (domestic and international) are based on the idea that money actually moves. The reality is that a payment represents the transformation of one bank’s liability to its customer to another bank’s liability to its customer. The sender’s bank will see a reduction in its assets and liabilities, the recipient’s bank an increase in its assets and liabilities. Intermediate banks (such as a bank providing the foreign exchange conversion) will also see changes in their assets and liabilities.

To consider a cryptocurrency payment on a like-for-like basis you need to consider the cost (and time involved) in,

● Conversion from home currency to cryptocurrency – cost of exchange, market risk, operational costs, profit margin

● Mining and charges (Bitcoin mining cannot guarantee either final settlement, time take or the rate charged).

● Conversion from cryptocurrency to foreign currency - cost of exchange, market risk, operational costs, profit margin

This makes the genuine economic costs of international payments using cryptocurrencies, untenable, particularly if the correct Anti-Money Laundering rules are followed. The cost of international payments is often a reflection of the risk that correspondent banks do not operate to the same standards as domestic ones, requiring additional checks and balances to be placed in the process. Cryptocurrency exchanges (as largely unregulated entities) also add a high degree of risk into the process.

Speeding up the messaging does not by itself improve the speed of international payments or reduce the costs. Existing messaging systems used in International payments such as SWIFT or the Credit card networks currently only take seconds or less. Delays in payments (and additional costs) can be incurred from

● Errors in processing payments

● The need to make a payment via a complex network of correspondent banks

● The need to comply with regulations such as AML and in some cases exchange controls

● The management of liquidity

● The management of credit and market risk

The use of cryptocurrencies, do not solve any of these problems and in many cases, can make them worse.

International payments can be cheaper and/or faster if:

● A bank is used that has its own international network of affiliates and subsidiaries.

● The messaging system provides transparency of issues and status (such as SWIFT’s GPI).

● The payment service provider is effective in managing liquidity and foreign exchange rate risk.

● The payment provider is willing to absorb some of the credit, liquidity and/or foreign exchange rate risk to speed up transfer.

● The service provider has technically and operationally efficient internals systems and processes.

● Has an effective AML/Sanctions Screening process that does not generate large numbers of false negatives that require human investigation.

The potential impact of distributed ledger technology on financial institutions, including the central bank, and financial infrastructure.

Conclusions

Distributed Ledger/Blockchain technology was never a general-purpose technology.

The subsequent divergence of different types of DLT makes it almost meaningless to talk about Blockchain/DLT and its advantages

There have been widespread pilots, experiments and POCs across finance (for the various forms of DLT) but generally they have not resulted in production systems or significant improvements

Blockchain “Magical Thinking” may be a long-term threat to the UK finance and technology sector because it distracts from solving real problems and real innovation

Recommendations

Any Government sponsored work in this area needs to identify the underlying causes of the sector’s problems, have a clear explanation of how solutions propose to solve problems and create baselines to allow the objective measurement of the success of any experiments

Governments and regulators should encourage financial firms to collect and generate objective data about the performance of their systems and supporting processes

Government, Management and Regulators need to understand that simply implementing something in a new technology does not mean it is a better solution

A potential fruitful area of research funding is to understand how socio-economic factors can drive the creation of sub-standard infrastructure

A genuine Fintech revolution could take place in the UK if relevant firms are encouraged to record and assess the outcome of experiments using common standards that include comparison to alternative technical models using the same baseline of performance

What was Bitcoin/Blockchain designed to do?

One of the keys to understanding potential impact of Blockchain/DLT is understand what it was originally designed to do and whether it is a general-purpose technology that can solve problems across a multitude of areas.

The origins of Bitcoin, Blockchain and the enthusiasm for both them originated in “Bitcoin: A Peer-to-Peer Electronic Cash System” written by an individual or group using the pseudonym Satoshi Nakamoto in October 2008. The objective of the paper was to create a peer-to-peer payments system i.e. a system that did not involve the current financial sector, much like the use of physical cash.

Nakamoto had some odd ideas about payments. He seemed to believe that the major problem to be solved was how to make it impossible to reverse transactions. He thought this was a major source of the costs in banking and an obstruction to the introduction of micro-payments (“small casual transactions”). The reality is that there are more important factors influencing the costs and time taken to process transactions. These include the need to manage credit risk, liquidity risk and in the case of cross-currency payments, market risk as well as the cost of dealing with compliance with anti-money laundering and “Know your clients” rules.

The paper drew heavily on pre-existing concepts and technologies from the 1980s and 1990s. In the initial years of existence there was no real attempt to distinguish between Bitcoin as a currency/payments system and “Blockchain” as a technology. The word Blockchain does not appear in the paper.

Explanations of Bitcoin and what was subsequently called “Blockchain” typically start with a discussion of cryptography or solving the “double spend” problem. A simpler way to understand it comes from analysing the original objective, the problems that objective creates, considering how ideas were added that solved those subsequent problems, which in turn created more problems which required more solutions. Rather like a game of “Snakes and Ladders”. An attempt at demonstrating the Snakes and Ladders that drove the design of Bitcoin/Blockchain is shown below. Even the most basic objective of Bitcoin created fundamental problems. Removing banks (Central and Commercial) from a payments process effectively forces the creation of a separate currency because electronic money (as we commonly understand it) fundamentally exists as liabilities on the balance sheets of banks and central banks.

Extracting the core technical and economic characteristics from “Blockchain Snakes and Ladders” provides the key features of what subsequently started to be described as “Blockchain” (from 2014 onwards). The key question after doing this analysis is whether the set of features really constitute a general-purpose technology (like Relational Databases or Programming Languages) or a very specific technical solution to a problem that may not be worth solving.

Figure 1 – Core features of “Blockchain”

The minimal answer to “What is it?” when applied to the original Bitcoin Blockchain is

A set of technologies and economic incentives that were combined to make it possible to create a peer-to-peer payments system that did not involve the financial sector but did involve intermediaries (the Miners).

Whether it constituted a great solution to the objective and the subsequent problems that solution created is debatable. Not only are there the open questions about costs, speed, legality and environmental damage there are some more fundamental issues regarding Bitcoin/Blockchain,

● Why did you really want to get rid of banks in the first place?

● Is it really peer-to-peer if it replaced one group of intermediaries with another group, specifically the miners but also a secondary layer of service provides such as the exchanges, wallet businesses and investment managers?

● Outside of the black economy its volatility, illiquidity, cost and entry/exit expense creates little incentive for the creation of a “crypto-economy” i.e. where people sell each other goods services with the new currency

● Any currency needs a mechanism for conversion into other currencies (particularly if people are paid, charged taxes and buy bills in another currency) this system does not provide it. A gap that was filled by centralised, little regulated and often insecure “Bitcoin Exchanges”.

Was it designed as a multi-purpose technology that can be applied for multiple applications in the real world?

There is a simple two-part test to determine whether the set of features called Blockchain form a genuinely multi-purpose technology.

● Firstly, to what extent did those attempting to use “Blockchain” in other contexts dropped and/or added features to make it work.

● Secondly did the remaining features of the original Blockchain form a coherent technology?

The extent to which features were added or dropped (including Blocks) is one of the reasons a more generic term came into use for related technologies, Distributed Ledger Technology.

Technology feature: the cryptocurrency

● Create a new currency

● Fixed Supply of Bitcoins and progressive reductions in the coins awarded for validation

All of the common Enterprise versions of Distributed Ledger Technology including R3’s Corda, the Enterprise version of Ethereum, Hyperledger’s Fabric and Digital Asset Holdings Digital Asset Platform, Ripple Laboratories’ “Ripple” have abandoned the need for a cryptocurrency. This is because of a combination of attempting use cases that did not require a transfer of value and the use cases involved “real-world” currency and a general unwillingness of their customers/investors to use applications that involved cryptocurrencies.

Other DLT/Blockchain companies and applications created much larger supplies of cryptocurrency (100 Billion in the case of Ripple) or had no limits in the case of the public version of Ethereum.

Technology feature: Public Ledger & Anonymity

● Globally distributed ledger of transactions

● Users can create as many accounts as they like to obscure overall level of holding

● Anonymous Accounts to hide identity of users

Enterprise type Blockchain/DLT have generally abandoned the idea of public networks that anyone can join. They restrict access to authorised parties because of investor/customer concerns about security, performance and energy cost. They have also removed the scope for anonymity. In some cases, the entire ledger is visible to all participants. In the case of Corda and Fabric it is possible to only send transactions to the relevant parties. The Digital Asset Platform can even be run in “centralised” mode.

Technology feature: Blocks and Chains

● Process blocks of transactions and chain them together using a cryptographic technique called a Merkle Tree (invented 1979). Makes tampering evident

● Longest chain accepted by majority of nodes is assumed to be correct

Blockchains can prove a very inefficient and slow medium for storing information. At least one DLT company, R3 has abandoned the use of Blocks, though they still have Chains of transactions.

One of the real-world problems found in the cryptocurrency world is that a Blockchain can accidently “fork” into different versions. There is also the potential for public Blockchains that a disgruntled group of users can fork their own version of the Blockchain of transactions.

Technology feature: Miners and Proof of Work

● Multiple parties incentivised to validate transactions and update ledger - Competitive Mining Process Earn coins for validating transactions

● “Proof of Work” (Invented 1997) Adds need to solve otherwise irrelevant mathematical problem. This slows down processing and adds an element of randomness

● Miners can charge fees per transaction

Proof of work and the use of miners has proved (in the cash of Bitcoin) to be slow, expensive and environmentally damaging. Both public and enterprise versions Distributed Ledgers have to varying degrees abandoned both mining and proof of work. That said, it is yet to be shown whether you can guarantee the security of a public distributed ledger without the expense and complexity of the Proof of Work protocol.

Technology feature: The Extras

● Ability to store additional information in Blockchain

● Basic Scripting capabilities

The desire to record more complex data on Distributed Ledger such as securities, land registers and collections of documents related to trade finance, has various DLTs being modified to record more complex data structures. In the case of R3’s Corda, the key transactional data is no longer stored on the “Node” of the Distributed Ledger, it is stored in an attached relational database.

A common change in emphasis for Distributed Ledgers that attempted to expand to use cases beyond payments/cryptocurrencies has been the implementation of improved functionality to execute programmatic logic. These may be referred to as Smart Contracts, DApps (in the case of Ethereum), CordApps (in the case of Corda) and many other names. The basic idea is that the same programme will be executed on all relevant nodes on the same data producing the same result.

The Extras

Based on the extent to which the original Blockchain functionality has been dropped or supplemented (at a point the family of technologies is still immature) suggests Blockchain never was a flexible multi-purpose technology. The only common theme running through all the technologies the use of Merkle Trees, a technological concept that long preceded Bitcoin or Blockchain.

This does not mean that the evolution of technologies that originated with Blockchain will not produce something of value but it does suggest a significant proportion of technology and financial companies took a very strange starting point to revolutionise financial technology.

Smart Contracts

One of main extensions of the original Bitcoin/Blockchain models that has generated considerable excitement is the “Smart Contract”. Like most things related to the world of Blockchain, the term “Smart Contract” has a range of meanings depending of the beliefs of the people using the term. The term dates back to at least 1996 (12 years before Bitcoin) with a paper [4] by Nick Szabo. His proposal was for a form of computer process that allowed a contract to be specified in computer code and operated by that code. For example, making sure goods are delivered when a payment is received. One of his objectives was to allow small businesses to operate on a multi-national basis, removing the “severe cost of doing business across many jurisdictions.”

To “Blockchain Maximalists” Smart Contracts are unstoppable programmes that enforce the operation of contracts. The “Code is Law”. This view is often associated with Libertarian philosophy that rejects any significant role for the state in general or particularly in economic life.

To more modest Enterprise DLT enthusiasts, a Smart Contract is simply a term for an executable piece of code that is stored in a distributed ledger. Computer programmes in the conventional world have performed actions stipulated by contracts for decades. A banking system may automatically pay bills via a Direct Debit process. A system (or systems) in an investment bank may calculate cash flows in accordance of the terms of an interest rate swap and pay them to the relevant counterparty. None of these things require Blockchains or to be re-labelled as Smart Contracts.

On one level, according to Professor Paech of the London School of Economics the law may look favourably on the concept of a programme that can enforce and action legal contracts (whether it runs as part of a Blockchain or not) because it could create more certainty in transactions. However, the existence of an autonomous, “unstoppable” programmes raises a number of major and probably unsurmountable legal problems.

Coping with every eventuality in the contract is impossible - The current legal system recognises you cannot contract for every eventuality, hence the ability to recourse to lawyers, courts or binding arbitration. What if the server centre stops working, the provider of market date used in your smart contract’s calculations goes bust or provides bad data?
Contracts that try to cover every conceivable eventuality because incredibly expensive and error prone.
The Need for a stop button - There are higher level legal, political and economic reasons why all contracts need the capability of being stopped.
Only legal persons can do lawful things - People, companies and other legal persons can do lawful things. Machines can only be their agent and the legal person ultimately has to take legal responsibility. Unless there is a major change to the legal system.
The legal prose contract is always what the courts will look at - This means the code can only be a representation of what was agreed in the contract. If the code does not implement the contract the aggrieved party is going to sue under the prose contract

The most famous example of the problems of a Smart Contract was the DAO (Distributed Autonomous Organisation) running on the Ethereum Network. The DAO was hacked and a great deal of cryptocurrency was stolen due to a bug in the code. The majority of users of the Ethereum network did not believe that “Code was King” and moved the ledger back to the time before the hack, by performing a “fork” of the ledger.

Applying to the Real World

A very wide range of claims have been made by numerous consultancies, banks and Blockchain related companies about the potential benefits of applying Blockchain/DLT type technologies in the financial services sector. There is common themes in many of these analyses.

● They list areas of finance/finance technology that are considered expensive, complex, difficult to change or high risk. As opposed to identifying areas where there is a clear understanding of how the original Blockchain or its derivatives would be the most suitable solution to the problems.

● Lack clarity regarding which Blockchain/DLT variant would solve the problem.

● Generally, lack of information about what causes the particular areas to be problematic

● Do not explain how “Blockchain” with specifically solve problems or generally make things better

● Generally, assume that Blockchain based solutions will be cheaper. Benefits based on assumed percentage savings or questionnaires asking management in banks “How much they think Blockchain could save.”

● Ignore that Blockchain is a winner takes all system and is unlikely to introduce efficiencies for as long as rival consortia and systems in the market

This type of analysis is common across financial services but seldom has there been such a large gap between the identified solution and how it will solve the identified problem (The Solution – Problem Gap).

In the next section, we look at a specific area where a great many claims have been made and a great deal of work has been done, the infrastructure of capital markets related firms

Sample Use Case - Capital Market Trade Processing

The Needs

The specialist investment banks and the “markets” divisions of the universal banks, execute millions of trades each day, with total notional values running into trillions of dollars. The banks’ trading partners include, fund managers, pension funds, hedge funds, large non-financial corporations and other banks. This vast amount of trading activity is not just dependent on traders. There are complex IT infrastructures inside each bank and large numbers of support staff in critical functions such as Risk, Finance and Operations. Then there are the external organisations (and their infrastructure) including brokers, market data providers, central securities depositories (CSD), trading platforms, exchanges, matching platforms and clearing houses. The “front-to-back” processing of a trade will typically involve many systems (internal and external to the bank) and many parties.

Fundamentally the trading infrastructure within organisations such as investment banks and broker/dealers needs to convert a relatively small number of types inputs in terms of trades, orders, market data etc. into a wide and complex set of outputs include risk and profit calculations, regulatory reporting and instructions to change the ownership of cash and securities.

The large number of parties interacting, the range and complexity of financial products has led to the creation of complex and expensive infrastructures within most organisations.

The following is a subset of the systems involved in processing a single asset class within a typical capital markets division of a bank

The Problems

The Problems in trade processing (both IT and in terms of general supporting processes) fall into three categories

Aspirational – Senior Management (who typically come from a front office/trading background) would like to spend a great deal less on areas that do not directly generate revenues. Research by the Boston Consulting Group estimates the total cost of IT and other support functions at $83.9 Billion in 2015. This is a number that is both remarkably large and remarkably resistant to the cost reduction efforts of the banks, as shown in the chart below.[5]

Figure 3 - Investment Banking Operating Expenses

Senior Management Challenges – There has been a very real pressure to cut costs in order to restore profit margins while at the same time, huge additional regulatory burdens. The additional regulatory requirements have had a major impact on IT. Most financial firms have found compliance both difficult and highly expensive. There is also the on-going challenge of dealing with “Conduct Issues” which have revealed problems in management and infrastructure. Technology and better data are both seen as ways to deal with conduct issues but improving both has proved expensive and difficult.

Specific Problems – Then there are the specific lower level root causes that have been identified by analysis of systems, processes and data. These include,

● Overall infrastructure has grown from being complicated to “Complex” i.e. fundamentally hard to understand, predict, measure or change.

● Inconsistent view of data both within firms and between trading counterparties

● Inconsistent implementation of business logic between and within organisations

● Decades of financial innovation progressing faster than system investment has left numerous gaps and manual processes in most organisations

● The tools for identifying and resolving differences between counterparties and systems are often slow, error prone and reliant on people

● Poor data quality has meant that understanding of specific problems is often obscure and investment has been directed to the wrong places

Blockchain Type Solutions

Accenture estimates DLT can save eight of the ten largest banks 30 percent in costs. Goldman Sachs estimates it can save global capital markets $6 billion annually. And Santander believes it can save the banking sector $15 and $20 billion a year in infrastructure costs. - Clearmatics

With major savings predicted by high profile consultancies and banks, Blockchain type solutions have naturally attracted a great deal of interest from the financial sector, particularly from senior management. There are major problems with most of these reports.

Data on IT and support costs were compiled and then an assumption was made about the percentage that could be saved by applying Blockchain. Normally the missing piece was an explanation of how the technologies could solve detailed problems or the costs of implementing the “solutions”. “The Solution – Problem Gap”
In one case a major consultancy simply asked senior management how much they thought could be saved and then collated the numbers. Given the general lack of understanding of what Blockchain is (or the variant to be used or how it supported a solution) together with a general lack of granular understanding of costs and cost drivers this is a highly flawed approach.

There have been hundreds of millions of dollars invested in capital markets focused Blockchain solutions and dozens, perhaps hundreds of experiments. These include,

● Digital Asset Holdings/DTCC work on Repo

● Digital Asset Holdings project to replace the Back-Office system (CHESS) of the Australian Stock Exchange

● R3/Barclays implementation of Interest Rate Derivatives Logic

● Axoni implementation of Equity Swaps

The key characteristics of these projects are:

● No use of Cryptocurrencies

● Recognition of the need to interface to existing infrastructure

● Attempt to “Tokenise” existing assets whether cash, securities or other financial assets. Tokenisation means the real-world asset is effectively frozen and ownership is transferred by updating a record on a distributed ledger

● Many involve attempts to “issue” assets on a Blockchain i.e. the primary and legally recognised record of a financial assets existence is on a distributed ledger

● Limited number of participants have access to the ledger

● Commonly a central body is responsible for maintenance of the ledger and the granting access to it

● Abandonment of many other key features of Bitcoin/Blockchain

There are several recurring themes across these and many other projects

Even where existing functionality has been re-implemented using Blockchain-type technologies it is not obvious how it is better
Many assumptions have been made to allow projects to work. These assumptions are generally unrealistic such as the creation of the trade on a Distributed Ledger without any errors and the existence of cash on the ledger
The model implemented is so different from the original Blockchain/DLT it becomes meaningless to refer to it as Blockchain/DLT. For example, where the solution is centralised or restricted to a small number of participants with a central party running the network
The full cost of implementing the Blockchain type solution, including meeting bank standards for security and resilience, regulator standards on Financial Market Infrastructure, has not been calculated
The full legal and regulatory work on topics such as the legal status of “tokenised assets” has not been carried out
The implications on the way markets operate from concepts such as, instantaneous settlement of trades as they are executed
A general lack of “Baselines” to measure against to identify success
Assuming that simply using a Blockchain/Distributed Ledger will solve a problem that has nothing to do with technology. A typical example is making it easier to trade illiquid securities or other financial assets

The Alternatives

There are alternative ways of improving the processing of capital markets trades many of which have nothing to do with technology.

● Limiting the ability of firms to create new types of financial products e.g. if it cannot be reported to a regulator it cannot be traded

● Encourage rational centralisation aimed at increasing market efficiency or other societally and economically beneficial objectives. This has worked multiple times in the past

● Control the ability of the industry to convert utilities into profit seeking entities

● Use post-trade processing data (including the quality of data reported to trade depositories) to identify areas for improvement (on commercial grounds) and areas of weakness/high operational risk that need regulatory intervention

● Look at alternative business models that encourage the use of consistent data models and business logic

● Encourage firms to concentrate on getting the basics right e.g. connecting internal systems together and using central reference data systems

Conclusions for Broader Applications in Finance

A similar analysis of other areas where Blockchain type solutions are claimed to be able to provide large benefits such as Trade Finance and Anti-Money Laundering would reveal similar over-hyped claims and significant gap between the underlying problem and the proposed benefits of Blockchain type technologies.

Blockchain/DLT can act as a catalyst but it is not technologically necessary to

Improve consistency of the view of data and mechanics of processing data between parties to a transaction
Digitise paper based processes. This comes from agreeing common standards for documentation and processing in order to turn documents into data
Remove the scope for error in agreeing the terms of a contract

In some cases, it clearly makes matters more complex and generally worse. Simply using Blockchain/DLT also does not remove problems that innate to the business. Regardless of the use of Blockchain, illiquid assets are typically illiquid because there is a limited number of buyers and sellers, they are frequently difficult to price and innate complexity may make them hard to model as data.

A Balanced View

Serendipity Effects – Many historic discoveries and inventions have resulted by accident, the “Serendipity Effect”. The Blockchain Revolution has led to the financial sector, start-ups and financial technology firms re-examining many areas of finance that have not had serious attention or investment. Even if the basic Blockchain concepts do not have any real value, it has generated new thinking and serendipity effects.

Overcoming the Limits of Centralisation - There is a pattern in capital markets of firms working to reduce cost and complexities by implementing common data models and business processes. A proven way to do this has been the implementation of centralised systems.

However, there are economic and/or social limits to the centralisation of financial systems. There are three main models for centralisation

The creation of industry owned utilities, such as CLS in FX market
Government sponsored utilities such as CREST in the UK for Equity settlements
Independently created utilities such as FIS’s Loanet in the US Stock lending market

The limits to centralisation apply to their creation and evolution. Problems in creating centralised systems include,

Different parties may have very different agenda including the preservation of activities that are profitable to them even if no longer required
Collection of requirements for centralised systems may include pointless and irrelevant requirements
Utilities that require integration to a large number of internal systems can be very complex and difficult to implement
Many financial firms are increasingly wary of creating monopolists that could potentially exploit them.

Banks tend to work towards disintermediating centralised systems they regard as monopolists. Even when a centralised system is mutually owned, there has been a tendency for the owners/members to sell it for profit. The now independent utility then tries to maximise profits at the expense of the customers, leading attempts to disintermediate the centralised system.

These problems are not technological they are socio-economic. DLT/Blockchain does not offer an immediate solution but may inspire hybrid technology/socio-economic solutions that allow greater consistency of data and processing on a de-centralised or distributed model.

Blocking Real Innovation – Genuine innovation is hard, it requires understanding of real problems, the ability to be both analytical and imaginative. In areas as finance it also requires people (or teams) that bring together a genuine understanding of technology, finance, regulation and their intersection. Almost every significant sized financial institution (and many regulators) has an “Innovation” team. The danger of the “Blockchain Revolution” is crowding out genuine innovation. If an innovation team wants to look innovative, the simple solution is to say the problem could be solved with Blockchain and embark on experiments with other banks, financial software firms and start-ups. Many of these experiments have now been repeated multiple times with little tangible result. If nobody’s career ever suffers from knowingly embarking upon a pointless Blockchain experiment it will be very bad for the future of the British financial sector.

The Danger of Magical Thinking – Ultimately Blockchain “Magical Thinking” may be a long-term threat to the UK finance and technology sector because it distracts from solving real problems. Countries that are able to demonstrate critical thinking and focus on building real solutions to real problems could outcompete the UK in Financial Sector Technology and ultimately Finance in general.

The regulatory response to digital currencies from the Government, the FCA and the Bank of England in relation to Anti-Money Laundering legislation and how regulation could be balanced to provide adequate protection for consumers and businesses without stifling innovation.

Conclusions

There has been a range of regulatory responses from long-term censure and bans to active encouragement. This does not mean “wait and see” is the ideal compromise position for the UK to take.

From the outset Bitcoin and Cryptocurrencies raised all the red flags that are synonymous with “negative” innovation. Cryptocurrencies and related Initial Coin Offerings have been designed in a way that makes little economic sense except as a way to circumvent the law

The “Crypto” boom has demonstrated that in the absence of effective regulation, all negative features possible in the bad things that can develop in a financial system can rapidly be re-emerge. “The evil crypto laboratory”

Innovation can be bad as well as good. Criminals can be highly innovative. Over many decades “Innovation” has often provided a smoke screen for regulatory arbitrage

There is little if any evidence that Cryptocurrencies, cryptoassets and closely related technologies, have demonstrated any benefits to the overall economy or consumers. There is no real reason to continue taking the risks associated with a “wait and see approach”

Recommendations

Regulators should be proactive in looking for the danger signs in any new financial innovation

Laws and regulations need to be updated wherever a “technological/innovation” smokescreen stops the spirit of the law from taking effect

Where a financial innovation has obvious dangers from the inception but with no obvious economic or societal benefits it would probably be more beneficial to ban it early rather than take a “wait and see” approach

In a post-Brexit world, the UK cannot be seen by the EU to be a promoter of financial “innovation” that only exists to avoid existing rules or confuse regulators

Timing and Features that Indicate Bitcoin’s Criminal Intent

In the previous section, we looked at the initial objective of Bitcoin and how it created a deeply flawed technological/economic model for processing payments. Though there was a stated aim to create a de-centralised payments system it not obvious why anyone would want to completely a completely “peer-to-peer” system (which actually re-introduced intermediaries). Emails attributed to Satoshi Nakamoto after the publication of his paper expressed a strong dislike of the banking sector.

Banks must be trusted to hold our money and transfer it electronically, but they lend it out in waves of credit bubbles with barely a fraction in reserve. We have to trust them with our privacy, trust them not to let identity thieves drain our accounts. Their massive overhead costs make micropayments impossible.

http://satoshi.nakamotoinstitute.org/posts/p2pfoundation/1/

However, there are features in Bitcoin that from the outset that made it suitable for criminal activity.

● The holders of Bitcoins are anonymous.

● The extent of holdings could be disguised by having holdings divided across multiple accounts

● There was no mechanism to retrieve funds or reverse transactions (a feature exploited many times by those who have robbed Bitcoin exchanges)

● There is not scope for authorities to block payments from an account unless they obtain the private keys

● Funds can only be seized by authorities if they access the relevant private keys even the funds can be proven to result from illegal activity

The most notable features of the Bitcoin ecosystem were,

The founder was anonymous
It was not tied to a specific location
It was not covered by US laws on Money Transmitting because Bitcoin was not recognised as money

The period from the publication of the original paper to the initial implementation of first version of Bitcoin may have coincided with the financial crisis. However, it immediately followed the conclusion of a successful two-year investigation and criminal prosecution of the owners of E-Gold [6]. E-Gold was a money transfer service that was both innovative and a major conduit for the transfer of funds derived from illegal activities. E-Gold had attempted to evade existing regulations by expressing payments in terms of a commodity (Gold – though payments could be specified in dollar amounts) instead of a legally recognised currency and by being legally based in a lightly regulated tax haven.

The lessons for future providers of payments services to the criminal were, do not use a form of money that can be classified as a currency, being legally based off-shore (or any known location) was no protection against prosecution by US authorities, the ultimate protection for founders comes from not being known. Perhaps lessons learnt from the persons going under the name Satoshi Nakamoto.

Bitcoin was clearly designed with features that facilitated criminal activity and at a time that a gap was appearing in the market for laundering illegal funds. If that was the intention of Bitcoin, why did it take several years to gain transaction? Perhaps because there was an alternative mechanism for criminals to transfer funds that did not expose the criminal fraternity to the risk of using a currency that lacked acceptance in the real world. That alternative was Liberty Reserve. Liberty Reserve was founded in 2007 (in time to profit from the closure of E-Gold) and not closed down until May 2013, the year that Bitcoin saw a massive increase in price.

Cryptocurrency and Crypto-Asset Red Flags

In general cryptocurrencies and other “Crypto-Assets” (notably “Tokens” sold in Initial Coin Offerings) show all the regulatory red flags that should quickly have gained attention. These include:

● Investment classes that have little or no possibility of generating a positive return, except for investors who benefit from arrival of new investors bringing in additional funds

● Layers of complexity to hide the true nature, risks, revenue streams or beneficial owners of investments.

● Structured to deliberately avoid (or attempt to avoid) the application of existing laws and regulations. Rules that were designed to protect market stability or the interests of individual investors

● Highly asymmetric information between investors and the organisers/beneficiaries of the scheme

The following are examples of red flags raised by “Crypto-Enterprises”. These do not suggest criminal intent by the those running the enterprises but do indicate reasons they should have regulatory attention.

Monero

Monero was founded in 2014 as a combined currency/payments system on a similar model to Bitcoin. It was founded to create more “private” alternative to Bitcoin.

Monero uses ring signatures, ring confidential transactions, and stealth addresses to obfuscate the origins, amounts, and destinations of all transactions. Monero provides all the benefits of a decentralized cryptocurrency, without any of the typical privacy concessions.[7]

In other words, it provides a superior alternative to criminals that want to offer their services over the Internet. In January 2017, Wired magazine published an article describing its appeal to the underworld entitled “MONERO, THE DRUG DEALER'S CRYPTOCURRENCY OF CHOICE, IS ON FIRE”

In August, the darknet market site Alphabay began offering its thousands of vendors the option to accept Monero as an alternative to Bitcoin. [8]

Monero only raises one red flag. A currency/payments system that obscures the payee, payer and the amount spent, offers great value in avoiding controls of money laundering.

XRP (Ripple)

Imagine running a business that can raise money from retail (i.e. non-expert) investors to enrich your founders and fund your businesses without needing to comply with any of the rules relating to listings or issuance of securities. If the financial asset you sell, is labelled as a cryptocurrency it seems none of the laws (across multiple jurisdictions) designed to protect the public apply.

The XRP cryptocurrency was not “mined” but simply created by Ripple Laboratories. 100 Billion XRP have been created in total, mostly shared between Ripple Laboratories and the founders of the company. In 2017 alone, Ripple Laboratories earned over $180m [9] by selling its cryptocurrency to a range of investors by sales on cryptocurrency exchanges. This means that retail investors can directly buy a financial asset from Ripple Laboratories that does not entitle them to any ownership stake in the company, has no right to be converted by Ripple Laboratories back into conventional currencies, does not pay any return and seemingly has no purpose (given its lack of adoption by the banking sector). There is no available data on the income made founders of the company selling their XRP.

XRP is intended to act as “crossing currency” allowing international payments to be exchanged into and out of XRP where there is insufficient liquidity in the relevant pair of currencies. It is also claimed to avoid the need for banks and other companies to maintain large balances in foreign currencies to smooth their international payments process. XRP has not been adopted by banks because the concept does not make sense. Using a highly volatile cryptocurrency, instead of the de-facto crossing currency the US dollar, would ultimately increase the cost of international payments by widening spreads. It would expose any bank holding significant volumes of XRP to colossal market risk. Finally, it would mean the financial sector handing tens of billions of dollars of real currency to Ripple Laboratories for seemingly no benefit. If you are going to place a large amount of “funny money” into a cross-currency payments system, even if based one a Ripple’s technology, why does it have to be XRP? Why not Zimbabwe dollars or Venezuelan Bolivars?

Ripple Laboratories creates a great deal of publicity aimed at the general public about its 100+ customers in the banking and payments sector. As a private company, it does not have to disclose the nature of those relationships or where the company generates revenue from. XRP investors seem to think they are buying into the future of the company as much as the currency,

XRP seems to raise all four red flags.

Tezos

Tezos was one of the early mega-ICOS in 2017 receiving over $200m in cryptocurrencies. To the uneducated observer, the “coins” issued by Tezos resembled securities issued by a conventional company. However, the Tezos “organisation” was organised in a curious manner

As if the complicated structure involving a Swiss non-profit foundation were not sufficient to raise a red flag, the coins do not give any ownership rights over any of the Tezos related organisations, there is no guarantee they could ever be used to purchase a real service and they have been described as “donations”.

Case Study – Utility ICOs

Raising money in the form of cryptocurrencies for new enterprises (or simply personal enrichment) dates back the original funding of the Ethereum cryptocurrency/application platform in 2014. Initial Coin Offerings (ICOs) have they have become known took off on a large scale in 2017 and one of the potential reasons for the bubble cryptocurrency prices in 2017. In January 2018 Reuters reported research claiming ICOs had raised $3.7 Billion [10] in 2017.

The key characteristics of most ICOS (particularly those in early 2017) were

● An attempt to raise money for an enterprise from investors

● Investors believed that they will receive a return on their investment.

● Investors use a form of money without legal recognition (cryptocurrencies) to make the investment, in return for electronic instruments (coins/tokens) that it is claimed are not securities

● There was claimed not be a commercial organisation running the enterprise

● Investors (including nationality and investor classification) were unknown

Organisers of ICOs profits in one or more of the following,

● Taking a direct cut of the cryptocurrency funds raised

● Income earned from involvement (as employees or shareholders) in a “for profit” organisation that provides services to the non-profit organisation

● Receipt of pre-issued “coins” aka securities

ICOs have been typically structured to avoid the following laws (and equivalents in other jurisdictions) the US Securities Act of 1933 and Securities Exchange Act of 1934. The particular aspects of legislation they attempted to avoid were those related to

● Registration of securities in country of issue

● Registration of issuer in country of issue

● Detailed disclosure of financial information about enterprise and any risks or conflicts of interest.

● Restrictions on the types of securities that can be sold to specific categories of investor

Other Laws Avoided that were avoided or potentially broken include those related Anti-Money Laundering and tax evasion.

The key questions ICOs have posed to regulators are

Are coins (aka tokens) securities?
Can you look past the façade of the non-profit organisation and the novelty of the technology to identify the ICO organisers and related parties that financially benefit from the fund raising?
Can you identify the investors?

If the cryptocurrency is purchased by an identified person from a cryptocurrency exchange in a country where there is some degree of regulation or at least the data is accessible, then you can identify some of the specific people who invested, their nationality, investor category and tax status

ICOs create a number of risks.

To investors – increased risk that investors lose money because of failure by issuer to disclose all the information required to make a proper judgement and increased risk the whole enterprise is simply a scam

Risk to issuers – Purchase of instruments (coins) by citizens of countries that would expose them to the relevant country laws e.g. Any person who wilfully violates the Act of 1933 or SEC rules and regulations is subject to five years in prison, a $10,000 fine, or both. The Act also holds the directors, attorneys, accountants, underwriting syndicate, and all persons who signed the registration statement civilly liable for false and misleading statements contained in the registration statement and prospectus. As a result, any one of the participating individuals may be sued by an investor who purchased the new issue and was not aware of any false statements or omissions.

Systemic – banks may find themselves directly or indirectly financing these high risk structures. Ordinary investors may receive exposure to these assets indirectly

The structuring of ICOs also raises the strong possibility of conflicts of interest. Frequently those involved in promoting, secondary sales of the instruments (coins) and initial seed funding are the same parties. In some cases, relationships that have a potential conflict of interest are disclosed in the ICO prospectus in other cases not.

The Fundamental Flaws in the ICO business model

There is an assumption that ICO tokens (that are exchangeable for a good or service provided by the organisation launching the ICO) will have value if the underlying service they are being structured to provide will be popular. Proponents argue that because potential customers will need the tokens to access such services, they will bid them up in value. What this point of view neglects however — especially as exercised in concepts like Dentacoin (a coin that is proposed to provide access to the services of Dentists) — is that this amounts to anti-competitive behaviour and the normalisation of de facto gouging practice as a business concept.

It is basic business theory that if a venture has a product of value, it has an obligation to shareholders and itself to maximise profit. This cannot be achieved if the venture in question discriminates against potential customers bearing conventional currency by requiring them to first acquire a strictly controlled token which is scarce in supply. By definition, the venture is thus limiting potential customers to the number of tokens it has issued. The irony here is that ICO advocates believe the lost value can be made up for via the increased appreciation of the underlying tokens. But this mentality runs against basic business pricing logic. If tokens trade over the face value of the underlying service or product, customers will have no incentive to acquire them. Basic supply and demand law dictates that demand falls when prices rise (other than in the case of Giffen goods -- A Giffen Good, in economic theory, is a good that is in greater demand as its price increases - which does not apply to the world of ICOs since there is almost nothing preventing a copy-cat service coming to market to undercut a would-be monopolist when token prices get too high).

If a venture is bringing a product or service to market which is demanded and popular it is in its interests to sell as much product as possible for the highest price possible, or at least one that falls short of incentivizing competitors to mimic the venture. A venture thus has no interest in limiting access, not least because a system based on controlled vouchers is ultimately circular. Advocates sometimes counter that in the world of digital goods artificial scarcity is necessary to prevent piracy and free distribution. Token Based ICOs are thus in their opinion a good way to ensure digital content and service producers get paid. The problem is that many ICOs -- a la Dentacoin — have nothing to do with digital content. They represent de facto attempts to form industry cartels which regulate prices through collusive control of a gated access token.

Again the logic is flawed because there will always be an incentive (when prices get too high) for a service provider to break out of the cartel to capture market share. In the case of digital goods, the logic is also flawed because of the ultimate circularity of the tokens, which renders the business practice zero-sum. For example, consider a media content business which worries about its content being reproduced for nothing - wherein ICO tokens are deemed a solution to the problem. If the media business decides only to provide access to those who bear their tokens eventually the tokens initially sold to the market under scarcity limitations will all be redeemed. At this point the business will either have to sell new tokens (or resell old ones) to the market on an ongoing basis to continue its business. This undermines any concept of token scarcity being the driver of value. These tokens will still be subject to pricing dynamics and competitive forces meaning if they are priced too high or under supplied the business will lose demand. Equally, if too much product is produced at too high a cost base, token or no token, the venture will not break even.

In short all we end up with is a conventional subscription service which has to adjust prices according to demand and supply and/or a private members club wherein membership is purposefully restricted for exclusivity grounds. At no point, however, will the service have solved its piracy or free content sharing dispersal problem since information gained by token holders can still be copied and reproduced. All that it will have done - by discriminating against those who would otherwise want to buy the service with conventional currency — is limited its potential client base at the cost of reduced revenues.

If a business has a product of true value it has no interest in limiting access through artificial scarcity tactics. The supply of the underlying product or service itself (at break-even cost) should dictate how profitable the venture is, not an arbitrary number of tokens. Tokens do however help disguise below par services by adding a complexity layer which make it more difficult for consumers to cross compare value in the market since there is no longer be a common numéraire between them. It also adds an additional intermediation cost since customers have to acquire tokens before services.

For example, if dental services provided via the Dentacoin network are valued at 2 Dentacoins per hour, a customer would have to convert that price to fiat and then reconvert to the cost of the token offered by a rival network. This world of multiple currencies is extremely consumer unfriendly and inhibits informed market choice. There is a reason why society orientated towards a common measure of value. It encourages competition forces and makes trade and commerce easier as everyone can compare services and products against a common value unit e.g. pounds sterling.

To counter this some services plan to list their products and service in fiat prices, with just the number of tokens changing instead. Again, this adds unnecessary complexity, intermediation cost and potentially puts customers off if - due to dynamic pricing - having acquired the right number of tokens to access a service in the morning they are short of tokens by the afternoon due to a change in price.

The circularity issue

Even if tokens continue to appreciate in value the token provider can’t benefit from that appreciation unless he liquidates pre-stored tokens or redeems tokens for another currency and/or fiat. But if the appreciation is driven by demand for a restricted service, liquidation simply resupplies the market and begs the question why won’t the supplier (if his intent is to generate a fiat denominated profit, which most of these services do) simply ask for fiat directly in exchange for the service itself, thus reducing market, liquidity and balance sheet risk for himself (especially vis a vis his real cost base).

ICO purpose

The other question which has to be asked is what motivates a venture or business to raise funds via ICO as opposed to more traditional methods? In the first instance there is the decreased cost of launching a funding round, since ventures need not comply with the usual legal, consumer protection and vetting processes applied to conventional capital market funding rounds. As a result ICO investors may be being exposed to undue risk, especially given there is also no limitation on what type of investors (sophisticated or unsophisticated) who can invest. Meanwhile, if a venture truly has profit potential, there is no reason why it should easily be able to attract funds via more traditional means. This implies ventures turn to ICOs other because conventional capital markets would likely be closed off to them for risk, business model potential and AML/KYC reasons. As a result, it is clear ICOs are popular because they offer ventures the opportunity to raise money from trapped pools of capital in the global economy. The discrepancy between what such a venture can raise in conventional markets vs ICO markets indicates the desperate state of capital in question, and the huge premium it has to pay for what remains a highly risky and potentially profitless investment.

Regulatory Response around the world

Some regulators and central banks, such as the European Central Bank have issued warnings about Cryptocurrencies from the point they came to prominence. Regulators in many countries have banned cryptocurrencies or ICOs. Others such as the SEC were slower to act but have issued strong warning about both the risks of cryptocurrencies and the need to comply with existing laws. Other countries have taken a largely hands off approach out of the fear of stifling financial innovation. Finally, there are those locations that have taken a strongly positive approach to cryptocurrencies and related assets. These locations are typically also tax havens, areas with strong privacy laws and a history of facilitating money laundering.

The general response of UK regulators and the government has been a cautious “wait and see” type approach that seeks to avoid. This is summed up within the terms of reference of the enquiry - “Is the government striking the right balance between regulating digital currencies to provide adequate protection for consumers and businesses whilst not stifling innovation?”. Though the attitude has grown tougher recently with strong words from the Bank of England, the FCA and the Treasury

“The time has come to hold the crypto-asset ecosystem to the same standards as the rest of the financial system," – Mark Carney

Contracts for differences (CFDs), including financial spread bets, with cryptocurrencies as the underlying investment are increasingly being marketed to consumers. These products are extremely high-risk, speculative products.[11] - FCA

The Treasury said: “We are working to address concerns about the use of cryptocurrencies by negotiating to bring virtual currency exchange platforms and some wallet providers within anti-money laundering and counter-terrorist financing regulation.”[12]

However, previously regulators have regarded overall level of risk as low and looked for value in cryptocurrencies.

This article argues, however, that the key innovation of digital currencies is the ‘distributed ledger’ which allows a payment system to operate in an entirely decentralised way, without intermediaries such as banks. This innovation draws on advances from a range of disciplines including cryptography (secure communication), game theory (strategic decision-making) and peer-to-peer networking (networks of connections formed without central co-ordination).

Bank of England 2014 [13]

Digital currencies do not currently pose a material risk to monetary or financial stability in the

United Kingdom. The Bank continues to monitor developments in this area.

Bank of England 2014 [14]

However, “bad innovation” has a tendency to develop during periods when there is a deliberate policy of financial deregulation or implicit lack of enforcement because regulators, central banks and or/law enforcement agencies are under resourced. The period from 2009 (the birth of Bitcoin) onwards has seen a period of regulatory overload and regulators around the world sought to put in place new regulations to avoid another Great Financial Crisis and the control the conduct issues. The United Kingdom has also tried to position itself as a “Fintech” centre setting up “regulatory sandboxes” where new Fintech companies were not subject to the full range of regulations. This perhaps partly explains the UK worry about stifling innovation, including Cryptocurrencies (or as UK regulators generally describe them as “Digital Currencies”). However, the risks and costs in the very nature of cryptocurrencies do not suggest they can ever have a significant positive benefit to the economy.

April 2018

Appendix 1 – Forms of Money

Type	Funds held at Commercial Banks	Reserves at Central Bank	Central Issued Bank Notes	Commercial Bank Issued Bank Notes	Local Currency Banknotes	Airmiles	Virtual Universe Currency	Stored Value Card	M-Pesa
Format	Electronic	Electronic	Physical	Physical	Physical	Electronic	Electronic	Electronic	Electronic
Primary Record	Core Banking System	Central Bank System	Unique identifier and recognised as liability on central bank balance sheet but no database of holders	Unique identifier and recognised as liability on issuing bank balance sheet but no database of holders	Unique identifier and recognised as liability on issuing organisation balance sheet but no database of holders	Central database of airline or organisation running scheme	Central database of Game company	Central System or combination of central system/stored on card	Central Database
Issuer	Commercial Bank	Central Bank	Central Bank	Issuing Bank	Issuing Organisation	Airline	Computer Game Company	Typically a metro company	Telecom company
Mechanism of Creation	Credit Creation	QE, Central Bank Repo	Printed by Central Bank	Printed on behalf of issuing bank	Printed on behalf of Issuing Organisation	Addition to balance of customer after completing qualifying activity	Addition to balance of character after killing dragons etc. or purchasing in exchange for conventional money	Addition to balance of customer after transfer of conventional world funds	Addition to balance of customer after transfer of conventional world funds
Backing	Assets on balance sheet including reserves at central bank	Acceptability arise from mixture of custom, legal status and willingness of state to accept	Acceptability arise from mixture of custom, legal status and willingness of state to accept	Central bank notes or reserves of equivalent value	Convertible into Official Currency	Willingness of airline to convert into free flights and other benefits	Credit worthiness of game company	Fully backed by equivalent funds at bank	Fully backed by equivalent funds at bank
Credit Risk	Bank may become insolvent subject to limited guarantees from central bank or deposit insurance scheme	None	None	None	Issuing organisation can become insolvent	Arline may become insolvent	Game company may become insolvent	Potentially issue may become insolvent in practice fully backed by funds at as bank	Potentially issue may become insolvent in practice fully backed by funds at as bank
Market Risk	Can fall in real times (inflation) or relative to other currencies (depreciation)	Can fall in real times (inflation) or relative to other currencies (depreciation)	Can fall in real times (inflation) or relative to other currencies (depreciation)	Can fall in real times (inflation) or relative to other currencies (depreciation)	Can fall in real times (inflation) or relative to other currencies (depreciation)	Airlines can devalue air miles	Currency may be overinflated by game company	Same as related real world currency	Same as related real world currency
Primary Purpose	Settlement of debts and making of payments	Reserve requirements may limit on credit creation. Settlement of interbank debts	Settlement of debts and making of payments	Settlement of debts and making of payments	Promote economic activity in local economy be providing method of Settlement of debts and making of payments with local businesses	Purchase of airline tickets	Purchase of virtual items in game including magic swords etc.	Typically purchase of a core good like tickets for a metro system	Transfer for other M-Pesa users. Payment to stores accepting M-Pesa
Other Purposes	Store of value	Payment of state debts to commercial banks	Store of value	Store of value	Souvenir of relevant location	Purchase of other goods or services under the same scheme.	Potentially exchanged for real world money	purchase of good and services from accepting suppliers	None
Anonymity of Use	Known to bank, any legitimate authorities and other party to transaction	Known to central bank and any legitimate authorities	Anonymous	Anonymous	Anonymous	Known to airline and any legitimate authorities	If registration is possible without providing bank or credit cards details	Anonymous	No
Anonymity of Holding	Known to bank and any legitimate authorities. Scope to hide behind front companies and trusts	Known to central bank and any legitimate authorities	Anonymous	Anonymous	Anonymous	Known to airline and any legitimate authorities	If registration is possible without providing bank or credit cards details	Anonymous	No
Notes				Includes Scotland, Northern Ireland and Hong Kong	Examples include, Chiemgauer, Lewes Pound, Brixton Pound, Stroud Pound, Bristol Pound			Octopus in HK

Type	Bitcoin	XRP (Ripple)	Ether (Ethereum)	Tether	ICO Type 1 - Ownership stake	ICO Type 2 - Token for purchase of good or service	ICO Type 3 - Donation	Central Bank Digital Cash	Dinero Electronico
Format	Electronic	Electronic	Electronic	Electronic	Electronic	Electronic	Electronic	Electronic	Electronic
Primary Record	Distributed Blockchain	Centrally controlled Distributed Ledger	Distributed Ledger	Distributed Ledger	Distributed Ledger	Distributed Ledger	Distributed Ledger	Possibly distributed ledger or centralised system	Central Bank of Ecuador centralised system
Issuer	Bitcoin miners	Ripple Labs	Ethereum Miners	Tether Limited	Typically, a Swiss or Singaporean Foundation	Typically, a Swiss or Singaporean Foundation	Typically, a Swiss or Singaporean Foundation	Central bank or potentially commercial bank converting central bank reserves	Central Bank of Ecuador
Mechanism of Creation	Mining Process	Created by Ripple Labs	Mining Process	Created by Tether Limited	Created by related software company	Created by related software company	Created by related software company	TBD	Created in exchange for US dollars
Backing	None	None	None	Notionally by equal quantity of USD. Not audited	Stake in future revenue of enterprise	Potential future value of goods or services provided by organisation	None	same as central bank reserves	In theory US dollars held by central bank
Credit Risk	None as long as miners continue in operation	Ripple Labs may become insolvent and Ripple Network may cease operation	None as long as miners continue in operation	Tether company may become insolvent due lack of reserves	Organisation may become insolvent or be fraudulent	Organisation may become insolvent or be fraudulent	None	None	Risk government cuts link between the Dinero and US Dollar of the Central Bank does not have sufficient US Dollars to refund depositors
Market Risk	Untethered to real world economy leads to extreme volatility relative to official currencies	Not currently used in any significant volume for transactions on Ripple Network. Untethered to real world economy leads to extreme volatility relative to official currencies.	Price swings wildly due to little sue for real world activity other than used in Initial Coin Offerings	Price can fluctuate from USD	Price or instruments issued by largely unregulated organisations with high potential for fraud likely to be very unstable	Price or instruments issued by largely unregulated organisations with high potential for fraud likely to be very unstable	No intrinsic value of any kind. Price driven by sentiment and lack of understanding	same as central bank reserves	Market perception of risk of above may cause divergence in value from US Dollar
Primary Purpose	Payment for transfer of Bitcoin	Payment for transfers of currencies on Ripplenet and as a Crossing Currency	payment for execution of smart contracts	Ease process of exchanging cryptocurrency to fiat currency	Investment for purchasers	Investment for purchasers	None	Settlement of debts and making of payments	Settlement of debts and making of payments
Other Purposes	Settlement of debts and making of payments, paying transaction fees to miners	Purchase of goods and services from parties that accept XRP	Settlement of debts and making of payments, paying transaction fees to miners.	Store of value	None	Potentially forward buying or tokens that will subsequently be used	None	Store of value	Store of value
Anonymity of Use	Anonymous except if trying to exchange via an entity that is in compliance with AML and KYC rules	Potentially	Anonymous except if trying to exchange via an entity that is in compliance with AML and KYC rules	Potentially	Potentially	Potentially	Potentially	Potentially	None
Anonymity of Holding	Anonymous potentially traceable	Potentially	Anonymous potentially traceable	Potentially	Potentially	Potentially	Potentially	Potentially	None
Notes									Announced 2014. Decommissioned 2018

[1] https://www.bankofengland.co.uk/-/media/boe/files/quarterly-bulletin/2014/innovations-in-payment-technologies-and-the-emergence-of-digital-currencies.pdf?la=en&hash=AB46869B3EF355A0486F7B0BAF086F2EEE31554D

[3]https://www.cnbc.com/2015/02/06/ecuador-becomes-the-first-country-to-roll-out-its-own-digital-durrency.html

[4]http://www.fon.hum.uva.nl/rob/Courses/InformationInSpeech/CDROM/Literature/LOTwinterschool2006/szabo.best.vwh.net/smart_contracts_2.html

[5] Source data available at https://www.bcgperspectives.com/content/articles/financial-institutions-technology-digital-value-migration-global-capital-markets-2016/?chapter=3

[8] https://www.wired.com/2017/01/monero-drug-dealers-cryptocurrency-choice-fire/

[10] https://uk.reuters.com/article/us-ico-ernst-young/more-than-10-percent-of-3-7-billion-raised-in-icos-has-been-stolen-ernst-young-idUKKBN1FB1MZ

[11]https://www.fca.org.uk/news/news-stories/consumer-warning-about-risks-investing-cryptocurrency-cfds

[12]https://www.theguardian.com/technology/2017/dec/04/bitcoin-uk-eu-plan-cryptocurrency-price-traders-anonymity

[13]https://www.bankofengland.co.uk/-/media/boe/files/quarterly-bulletin/2014/innovations-in-payment-technologies-and-the-emergence-of-digital-currencies.pdf?la=en&hash=AB46869B3EF355A0486F7B0BAF086F2EEE31554D

[14]https://www.bankofengland.co.uk/-/media/boe/files/quarterly-bulletin/2014/the-economics-of-digital-currencies.pdf