Worlds Beyond Bitcoin

You may or may not buy into Bitcoin, but you’re going to love the blockchain. Or so say those who are adopting Bitcoin’s ledger technology for everything from stock exchanges to ticket sales.

When the speculative bubble that had driven the price of a single Bitcoin to four-figure heights burst in 2014, the digital currency’s potential as a replacement for cash cooled considerably. Many payments experts at the time thought that Bitcoin would never recover its momentum.

Turns out that was just Act One of the controversial and much-maligned digital currency’s life.

As the curtain lifts on Act Two, interest is soaring in Bitcoin’s blockchain technology. This is the distributed, software-based ledger that provides an accurate, up-to-the-minute record of every Bitcoin transaction at any point in time.

The financial community is starting to see the potential for the blockchain to speed transaction processing and settlement at a lower cost, and not just for digital currency but for a wide variety of applications. Indeed, because of the blockchain, Bitcoin is hot again, and not because speculators are bidding up its price. Quite a turnaround in a financial industry that once dismissed it out of hand.

Several major global financial institutions, including Barclays, Banco Santander, Citibank, and USAA, either plan to experiment with blockchain technology for applications other than digital currency or are at least discussing ways it might be applied to their businesses.

‘Proven To Work’

The buzz around the blockchain jumped several decibels in April when Goldman Sachs joined Chinese investment firm IDG Capital to collectively pump $50 million into Circle, a Bitcoin startup that allows consumers to move Bitcoins around the world, fast and inexpensively.

What really caught the financial community’s attention wasn’t the size of the investment, but Goldman’s comment that it plans to explore the use of the blockchain to speed many of the processes by which the company does business.

A Goldman spokesperson says it is too early to identify any specific uses of blockchain technology, and adds for good measure that the investment in Circle was merely a bet on an up-and-coming company, as opposed to a foray into digital payments. But George Peabody, a partner with Glenbrook Partners, a Menlo Park, Calif.-based payment consultancy, says Goldman’s interest in the blockchain, along with that of other large financial institutions, is an indication large banks now see a way to make money with it.

Swiss investment bank UBS also sees uses for the blockchain outside of serving as a ledger for digital currency. UBS announced earlier this year it plans to open a blockchain research lab to identify ways the technology can be applied to bring innovation to banking.

Financial institutions aren’t the only companies looking to leverage this technology. Internet retailer Overstock.com plans to launch a stock exchange on which securities are traded and transactions settled using the blockchain. Overstock, which in 2013 became one of the first major retailers to accept Bitcoin for payment, is currently in talks with the Securities and Exchange Commission to get the exchange approved.

That’s just the tip of the iceberg. Several blockchain startups are developing applications for facilitating and recording the sale and transfer of any asset, such as insurance policies, auto and land titles, royalty fees, even tickets to sporting events, performances, and concerts.

“With Bitcoin, the innovation is not in the digital currency itself, but [in] the blockchain technology that brings greater operating efficiencies to the exchange of assets between trading partners,” says Peter Shiau, chief executive and co-founder of San Francisco-based Blockstack.io, a developer of blockchain software. “While any new technology requires a shakedown period to prove itself, the Bitcoin blockchain is proven to work at scale and is supported by a robust development community.”

Blockchain to the Rescue

Still, the sudden surge of interest in blockchain technology is a boost for Bitcoin’s once unsavory reputation. Since its inception, Bitcoin was dismissed in established financial circles as an unregulated, upstart currency looking to buck the system. It was never taken seriously by banks.

The digital currency’s image worsened when it was revealed by the FBI during the break up of the online black market Silk Road that many of the payments for illegal wares purchased on the site, such as drugs, were made using Bitcoin as part of a money-laundering scheme.

When the Mt. Gox exchange, which in 2013 reportedly handled 70% of all Bitcoin transactions, collapsed after news that about 850,000 Bitcoins totaling an estimated $400 million belonging to its customers were reported stolen in February 2014, Bitcoin’s drive for mainstream acceptance seemed like an even longer shot.

Mt. Gox’s founder and chief executive, Mark Karpeles, was arrested in August this year in Tokyo, where the former exchange was headquartered, and was charged in September with embezzlement.

But that’s all in the past. “Bitcoin has a bad reputation in some circles and has been primarily used as a speculative currency up to now, but that’s changing as interest in building new services on top of the blockchain grows,” says Charles Allen, founder and chief executive of BTCS, a new company that secures the blockchain through its transaction-verification business.

Streamlined Process

At its core, Bitcoin is an open-source, mathematically based digital currency managed by a loose confederation of evangelists. These volunteers update the blockchain, which was developed for Bitcoin and serves as a public record of each transaction. It includes encryption keys to allow the owner of one Bitcoin wallet to transfer the currency to another wallet and provide proof the transaction took place.

Because all transactions are registered on the blockchain, any portion of a Bitcoin’s value cannot be spent twice, which eliminates the risk of fraud.

“The blockchain is a cryptographic record of a transaction with mathematical rules that prevent a transaction from being fudged,” says Nakhil Joseph, an analyst with the emerging technology practice at Maynard, Mass.-based Mercator Advisory Group. “For a Bitcoin transaction to be settled, all the public records of the blockchain have to agree.”

What makes the blockchain appealing for other types of transactions is its simplicity. Since, with the blockchain, assets can be moved directly between two trading partners in much the same way data flows across the Internet, the need for intermediaries to help facilitate the transfer falls away. In theory, at least, reducing intermediaries creates a more streamlined and economical process for transferring assets.

Take the blockchain’s role with Bitcoin. To send a Bitcoin to another person or merchant, the payor uses his private encryption key to open his Bitcoin wallet, then designates the address of the wallet to which the Bitcoin is being sent and the amount to be sent. A payor can send a single Bitcoin and or a portion. As of mid-September, Bitcoin was trading around $230. Once the transaction is completed, a so-called miner updates the blockchain, and the update is verified by other miners.

Miners are computers on the network using the algorithmic codes on which Bitcoin is based to find new coins and validate transactions. To mine a Bitcoin and validate a transaction, miners compete to solve a complex mathematical equation or hash function. The miner that solves the equation first adds his proof-of-work to the blockchain.

Other miners on the network then check the proof-of-work and the validity of the transactions updated on the blockchain. If all the ledgers agree, the miner that solved the transaction algorithm is rewarded with newly mined Bitcoin by the Bitcoin community.

What makes the Bitcoin network unique is that transactions are settled and recorded using a decentralized system, as opposed to a central authority to initiate and record the transactions, such as the Federal Reserve System. Transactions are settled within 10 minutes, which is typically how long it takes for miners to complete their work.

As a result, transactions whiz through faster than they do over traditional transaction networks that settle in batch at the end of the day. Transactions are also speedier because they do not involve an intermediary.

No Middleman

This is the model that supporters of blockchain technology believe can be applied to the transfer of other assets to make transactions more efficient.

“Prior to Bitcoin, transactional networks used a central authority to record the transaction, but the blockchain verifies transactions in a way that does not require a central authority,” says Joseph. “Without a middleman, transactions can take place faster and more efficiently.”

For financial institutions and other companies trading assets, that could mean lower operating costs. Distributed ledger technology, such as the blockchain, could reduce banks’ infrastructure costs by $15 billion to $20 billion a year by 2022, according to a report entitled “The FinTech 2.0 Paper: Rebooting Financial Services,” by Santander InnoVentures, the venture-capital arm of Banco Santander, along with Oliver Wyman and Anthemis Group.

Wire transfers are seen as an early use case for blockchain technology. Initiating a wire transfer involves multiple steps and, in the case of international wire transfers, more than one central authority to record the transaction. Consequently, it can take hours, even days, to move money from the payor’s bank account to the payee’s account.

Delays can occur if the transaction cannot be readied the same day during the secure network’s hours of operation. The Fedwire, for example, is open at 9:00 a.m. Eastern Time (ET) and has a 5:00 p.m. ET cutoff for foreign payments and a 6:30 p.m. ET cutoff for domestic payments. It is closed weekends and holidays. Batch processing can further slow settlement.

In addition, the sending and receiving banks must hold the amount sent in escrow to insure the transaction at both ends. Intermediaries, such as the Fedwire, automatically collect fees from the sum sent once the transaction settles. If, for example, a consumer wires $1,000 and the Fedwire charges $6 for the transaction, the payee receives $994. For an international wire transfer, fees can be collected by every central authority that touches the transaction.

It’s a cumbersome, costly process because banks must tie up funds in float until the transaction is settled, and trading partners can get dinged for fees by multiple central authorities along the way.

“The goal of using the blockchain to move assets is to move them the way data moves over a network in real time,” says Nilesh Dusane, head of global sales and client relations for Ripple Labs, a payment network over which any currency, including the company’s Ripple digital currency and Bitcoin, can be transferred.

The Ripple network provides a direct connection between banks in the network, enabling the secure, real-time movement of money 24/7.

Since the Bitcoin network has proven capable of securely and reliably moving assets in volume, it is seen as the most logical starting point to introduce blockchain technology, says Marwan Forzley, founder and chief executive of Align Commerce, a San Francisco-based international money-transfer network.

Like Ripple, Align Commerce connects directly to banks. This eliminates the need for consumers or businesses to go to a bank to fill out a wire-transfer form—which requires account information for the sender and recipient, as well as corresponding bank-routing numbers—and reduces the number of intermediaries involved. The company charges a flat fee for each transaction.

“We remove the friction from money transfers by facilitating them over the Internet and simplifying the timing and cost of settlement using the blockchain,” says Forzley. “As blockchain technology matures and the infrastructure becomes more trusted, businesses, banks, and government will begin to use it to transfer assets.”

Proof of the Protocol

In theory, any asset can be moved using blockchain technology, even a micropayment, because the blockchain is merely a record of the transaction that can be followed backwards to determine the value in the account sending the asset, as well as in the account receiving it. To look at it another way, when consumers or businesses use the blockchain to check a bank balance or the value of a life-insurance policy, they do not hold the physical asset in their hand. Instead, they see a trusted record of the value in their account.

“Legacy systems already provide a way to track an asset, but with blockchain technology there can be instantaneous reporting of when an asset is moved, which is different from the batch transaction settlement that takes place today,” says Victor Pascucci, head of corporate development for San Antonio-based USAA.

Mainstream acceptance of blockchain technology, however, hinges on consumers, businesses, financial institutions, and governments accepting the decentralized nature of the blockchain. Right now that’s a tall order, payments experts say. A possibly acceptable half-way step, however, is to create private networks over which trusted partners trade assets among themselves.

“It would be like the early days of email, when only members of the network could email others on the same network,” says Blockstack.io’s Shiau. “Over time, email networks began to connect and allow messages to flow between them. Blockchain is the technology that theoretically can connect private networks over which assets are exchanged.”

While payments experts say it could take a generation or longer for such a change, they point to the struggles ATMs and debit cards at the point of sale encountered for more than a decade before they gained a toehold in society and eventually became part of everyday payments.

As Bitcoin’s reclusive founder Satoshi Nakamoto has mused over the course of several online postings, Bitcoin and the technology behind it are hard to understand because nothing like it exists, but the proof behind the protocol speaks for itself.

The financial world is awakening to that proof.