Fintech solutions are not just about saving money. They can make life easier for the “unbanked.”
That is not to say blockchain ledgers are magically immune to attacks, but the concept of distributed ledgers has been tested for decades under real world conditions, so there is reason to be confident in society’s ability to make them work. Evidence to support this comes from a building block of the internet, itself. Distributed throughout the internet are dynamic name servers, which are essentially ledgers that associate human-friendly names like CTA.tech with computer-friendly numeric addresses like 40.71.11.131. This system has been running for about four decades and, despite attempts by hackers to corrupt it, has continued to accurately send us to the websites we ask for. Since a trustworthy DNS system was achievable, it seems trustworthy blockchain systems should be achievable, too.
While the bitcoin ledger is public, information about the entities transacting business with bitcoin is not. When coins are sent from one account to another the network encrypts the transaction. The transaction is not executed until one of the network’s millions of computers verifies its validity. This verification process involves guessing the encrypted code associated with the transaction – not solving the encryption, but guessing what the transaction looks like *after* it has been encrypted. If a computer on the network is able to do this, then the transaction is validated and gets added to the blockchain. The owner of the computer that validates a transaction is rewarded with bitcoin. People that validate bitcoin transactions and receive bitcoin in return are called miners.
Bitcoin is one of many blockchain applications, and not all blockchain ledgers are public. China’s Blockchain Service Network (BSN) is one of the first blockchain networks created by a central government. It requires all users to go through an identification and verification process, so the identities of everyone using the network are known to the network operators at all times. Network operators have the ability to review transactions on the BSN and block them by using the BSN operator’s key. The BSN can be used for executing different types of transactions but it does not include a cryptocurrency. Instead, China appears poised to use the BSN to improve the efficiency of transactions made over existing banking networks using the new digital version of its traditional currency, the yuan.
This summer, the official website of the Chinese province of Xiong’an reported that the People’s Bank of China completed the country’s first salary payments using the BSN after engineering subcontractors made payments directly to employees’ digital wallets from a public wallet and recorded the relevant data on a blockchain. The employer put the employee’s digital wallet ID, payment amount and other salary information on the BSN and the bank then deposited digital yuan into the employee’s account in accordance with the amount indicated on the blockchain. It was not a direct exchange of cryptocurrency, but rather a blockchain-directed exchange of the digital form of traditional Chinese currency.
China’s work is noteworthy because it offers insight into where the government of a leading world economy may be headed when it comes to blockchains and financial transactions. By itself, using blockchain to pay wages is not that newsworthy.
BitPay, an Atlanta-based cryptocurrency services provider, has been helping companies pay employees in cryptocurrency for about a year. When launching BitPay Send last year, CEO, Stephen Pair commented, “Blockchain payment adoption is growing because it offers an easy way to send and receive payments on a global scale. Traditional international payment methods are cumbersome, costly and slow. With BitPay Send, companies can make mass payouts without having to buy, own or manage crypto and their recipients receive payments quicker and at a lower cost.”
Bitcoin and, by extension, cryptocurrencies generally, have a reputation as a technology criminals like to use to hide their illegal activity. This reputation is enhanced when high profile criminal acts, like the ransomware attack on the Colonial Pipeline on the U.S. East Coast in May, 2021, are accompanied by demands from hackers that extortion be paid in bitcoin. In reality, a cryptocurrency like bitcoin is not a good tool for criminal activity because every transaction is recorded permanently, and stored on numerous copies of the system ledger all over the world.
Although it might not be immediately obvious who is behind a bitcoin transaction, government authorities with the power of subpoena can often piece it together. In the Colonial Pipeline case the U.S. Department of Justice quickly recovered most of the ransom a month after it was paid. The government said by reviewing the bitcoin public ledger it was able to track multiple transfers of bitcoin and identify that roughly 63.7 bitcoins, representing most of the roughly 75 bitcoin ransom payment, had been transferred to a specific address for which the Federal Bureau of Investigation (FBI) had the “private key,” essentially the password needed to access the coins. Bitcoin is not a great way to hide ill-gotten gains.
Some consider bitcoin “digital gold” because the supply of bitcoin is limited, just like the supply of gold on the planet. However, gold has utility beyond its use for storing wealth. It’s used mostly to make jewelry, but it is also used in electronics, dentistry, medicine and more. Bitcoin has no utility beyond its use for storing wealth, except perhaps as a source of satisfaction for those who enjoy owning something so innovative. In that respect, Bitcoin is more like art than gold. The supply of original Van Gogh paintings is limited, just like the supplies of gold and bitcoin.
Neither a Van Gogh nor a bitcoin have much utility beyond bringing satisfaction to people. Satisfaction is important, for sure, but if that is all they do then they are only valuable as long as others appreciate them. If people lose interest and find satisfaction elsewhere, they could become worthless. That is not as likely with gold because it is used to make things.
Some, like those who want the U.S. dollar (USD) back on the gold standard, are intrigued by the possibility of bitcoin replacing fiat currency. It is hard to imagine any government letting that happen. Politicians want voters to reelect them, and they seem to believe this requires that government give more to voters than it takes. This results in an accumulating mountain of debt. If we were on the gold standard – or “the bitcoin standard” – the government’s ability to accumulate debt would be limited because the supply of money would be limited. Money supply, inflation and government debt are major topics on their own. Let’s just say we shouldn’t expect a limited supply cryptocurrency like bitcoin to become the single official currency of a nation anytime soon.
An alternative official currency is another matter. Earlier this year El Salvador became the first country in the world to formally adopt a cryptocurrency (bitcoin) as legal tender. For the past 20 years El Salvador’s official currency has been the USD, and even now that bitcoin has become legal tender, the USD will still be used “as the reference currency” for “accounting purposes.” However, what happens in El Salvador is worth watching.
For its part, the U.S. Government is moving at a measured pace on digital money. The Federal Reserve is exploring the concept of a central bank digital currency (CBDC) and plans to release a research paper on the topic this fall. Some Fed officials have recently expressed skepticism about the need for a CBDC. To learn what the Fed as a whole thinks, we will have to wait and see.
A stablecoin is a cryptocurrency coin that can be exchanged for a specific amount of government-issued currency. For example, Circle offers products that allow people to trade using USD Coin (USDC), a cryptocurrency stablecoin that can be exchanged one-for-one for USD. Unlike bitcoin and other cryptocurrencies that are not stablecoins, there is no risk to users that the dollar value of their cryptocurrency will change over time, though there is risk that the USD, itself, will decline in value over time. USDC is issued by regulated financial institutions and backed by fully reserved assets, meaning the issuers keep sufficient USD on hand to fulfill USDC redemption requests. USDC is governed by the Centre Consortium, a membership-based consortium that sets technical, policy and financial standards for stablecoins. As of August 2021 there were $27.3 billion worth of USDC in circulation, and all-time total transactions on the USDC blockchain totaled $1 trillion.
While there may be little or no risk that the dollar value of a stablecoin will change over time, there are other risks. Tether is another popular USD-linked stablecoin. Earlier this year it and Bitfinex, which are owned and operated by a small group of executives and shareholders located around the world, agreed to pay an $18.5 million penalty to the State of New York after an investigation found the companies failed to alert the public when hundreds of millions of dollars kept on account to back their stablecoins appeared to become unavailable when the third-party institution holding the USD reserves failed to honor requests for redemptions. This illustrates the importance of not only being able to trust the blockchain, but also being able to trust the institutions backing stablecoin cryptocurrencies with fiat currencies.
Blockchains now make it possible for two parties to do business without a trusted third party.
Facebook-backed Diem (formerly known as Libra) tried to establish a global stablecoin tied to a basket of major currencies and debt, but switched focus to multiple stablecoins, each backed one-to-one by different country currencies in an effort to win government approvals. Global policymakers remained skeptical, and in May 2021 Diem announced the withdrawal of its application for a payment system license from the Swiss Financial Market Supervisory Authority (FINMA), the move of its headquarters from Geneva, Switzerland to Washington, D.C., and a partnership with Silvergate Bank to issue a USD stablecoin. Facebook is still active in the Diem Association and plans to launch Novi, a digital wallet for Diem. Novi will let people send and receive money as easily as they message friends, family and businesses.
Coins representing money are not the only things transferred between parties on a blockchain network. Anything digital can be transferred and one such thing capturing much attention is the NFT.
A simple way to understand NFTs is to think of your bank statement. It’s a ledger that shows the transfers into and out of your account over the past month. Each transaction shows a certain number of dollars, but it does not show specifically which dollars were transferred. That is, the serial numbers of individual dollars are not tracked, only the number of dollars transferred. This is how bitcoin and other cryptocurrencies work, too. Only the number of coins transferred is recorded on the blockchain ledger. The coins, themselves, do not have serial numbers.
NFTs are specifically identifiable. When an NFT is transferred from one party to another the identity of that specific NFT is tracked. If your bank did something like this with your money, it would be tracking the serial numbers of the specific dollar bills moving into and out of your account. So, when an NFT is transferred from one party to another, the identity of that specific digital item is tracked along with its ownership information. An NFT could be a picture, a song, a video, or anything else that can be digitized.
It is easy to imagine uses for NFTs beyond collectibles. For example, records documenting the transfer of real estate could be stored on a blockchain as NFTs. So, too, could automobile ownership records. In fact, anything that requires a record of ownership transfers of a specific digital asset could be a good application of NFT technology.
DeFi refers to cutting out the middlemen in financial transactions. Paper money can facilitate DeFi. If people trading with one another all agree to pay only with paper money, and they all keep their money at home, that’s DeFi. There are no banks, brokerages or similar institutions involved.
Transacting in cash can be problematic because storing paper money requires security measures to combat the threat of theft or potential loss from fire, flood, etc. Blockchain technology addresses these problems, making it possible for people to easily transfer money to one another without a bank or brokerage.
Using a blockchain network it is possible for people to have digital wallets full of cryptocurrency on their smartphones. They can move money between accounts without ever dealing with a bank. Obviously, this is a threat to the banking industry. Blockchain-based DeFi is also a concern for governments because banks and brokerages help governments ensure taxes are collected, and help governments catch people running criminal enterprises. This is accomplished by requiring banks and brokerages to report certain transactions to the government, and to comply with “know your customer” rules.
Banks and brokerages must establish each customer’s identity, understand the nature of the customer’s activities, and assess money laundering risks associated with each customer. In a truly DeFi blockchain network, no one is checking on the identity of account owners, though a public blockchain network like bitcoin can have other advantages for governments, since all transactions are visible to the public with no search warrant required. As blockchain and cryptocurrency systems evolve it is safe to assume lawmakers and regulators will look to update regulations so the government can continue to achieve its objectives.
Blockchain-based DeFi networks can have advantages over legacy systems for consumers, too. This is especially true for people without bank accounts (the “unbanked”), who have a new way to give and receive money without the challenges of always dealing in cash. Also, for people with bank accounts who spend a lot of money on transaction fees and do not receive much interest income, using fee-free electronic transactions with stablecoins could be a money saver.
Recent decades have seen widespread adoption of free communication methods (email, messaging, etc.) where companies providing these free services developed business models allowing them to generate income from other aspects of their relationships with the people using the free email services. The next couple of decades are bound to see something similar happen with the movement of money.
China seems headed toward a blockchain that directs the movement of money through existing banking channels. The U.S. seems inclined to allow private development of various stablecoins linked to the USD. Both have major implications. Other countries are looking at blockchain applications, too, with El Salvador being first to adopt bitcoin as legal tender.
In China, it is possible the government will eventually have visibility into every single financial transaction. In the U.S it is possible that payment networks that make money from transaction fees could be replaced by stablecoin networks that make money from interest on the USD held in reserve. Lawmakers and regulators around the world will continue studying new fintech technologies in the coming years and developing new rules for their use. Fintech is an important technology to watch.