“We need a version 2.0 of the financial system.”
— Andrew Lo, Financial Times, 27 August 2012
Johann Gevers, Founder and CEO of Monetas
3 January 2009: Bitcoin bursts onto the scene, catalyzing a fundamental shift in how the global financial system of the future will operate. This article examines where we’ve come from, where we’re going, and why it matters.
Bitcoin did not emerge ex nihilo. It was the culmination of important advances in many fields — financial cryptography, smart contracts, distributed computing, etc. — by pioneers including David Chaum, Hal Finney, Wei Dai, Nick Szabo, Adam Back, and Ralph Merkle.
HISTORY OF FINANCE
Stepping back, we’ve had finance for at least 10 000 years. The ancient Sumerians developed business entities, mathematics, and accounting to keep track of business transactions. Not much changed for thousands of years.
Then about 50 years ago with the invention of computers, we saw the emergence of electronic finance. This automated many manual procedures, but transaction integrity was vulnerable to errors and fraud, because entries in an electronic database could easily be manipulated. To prevent such errors and abuses, expensive intermediary systems and compliance infrastructures were developed. The cost of these systems led to increasing centralization, which in turn created attractive targets for attackers, and abusers of power.
Only recently with the invention of cryptofinance has it become possible to use cryptographic techniques to guarantee transaction integrity and thereby to enable secure remote transactions in a decentralized way without an intermediary. This is an absolutely revolutionary advance that completely changes the balance of power — from provider-centric intermediary-based systems to user-centric peer-to-peer systems.
THE CRYPTOFINANCE ECOSYSTEM
Many people identify cryptofinance with Bitcoin, or more broadly with blockchains. As important as blockchains are, the cryptofinance space is much bigger. But let’s first understand what blockchains, fundamentally, are. They are a kind of consensus system. In consensus systems, millions of computers in a distributed global network must vote on all the transactions that occur in the system, and reach consensus on which transactions are valid, and which are not.
Once this massive globally distributed network has reached consensus, the state of its database is very secure (hard to change, and thus also censorship-resistant). But the other side of the coin is that consensus systems, by their very nature, are slow and expensive. On the Bitcoin network, transactions achieve a reasonable level of security in about 10 minutes, and an ultimate level of security after 18 hours. The cost of a transaction is roughly USD 5 (the mining cost plus the transaction fee). And the maximum number of transactions the entire global network can process is about 7 transactions per second. For comparison, the VISA card network processes about 2 000 transactions per second, and the total number of global transactions (including cash transactions) is roughly 500 000 transactions per second. So blockchains do not scale well — and are thus not a good solution for retail transactions.
There are also non-blockchain consensus systems, such as Ripple. These systems too — like all consensus systems — suffer scalability issues. And they are more centralized and less secure than blockchain systems, and still depend on intermediaries. So they don’t represent a fundamental advance the way blockchains do. Ripple is being tested by traditional financial institutions, but is unlikely to become a successful mainstream transaction platform — because far superior alternatives exist.
This brings us to the second category of cryptofinance technologies: contracting systems. Unlike consensus systems, that require a massive global network of computers to vote and reach consensus on all transactions (a slow and expensive process), contracting systems only require the contracting parties to agree — a process that can be completed by two or three computers (one for each contracting party) in milliseconds (a thousand times faster than consensus systems such as Bitcoin), and can cost less than 1/10 000th of a cent (a million times less than consensus systems such as Bitcoin). Such a contracting platform is being developed by Monetas. The Monetas system scales effortlessly to handle the entire world’s transactions in real time on a collection of servers no bigger than a few refrigerators.
One of the issues with blockchain systems is that while they can securely store digital assets, they are not suited for securely transacting those assets. This is why the Bitcoin ecosystem has been plagued by a long series of scams, thefts, and losses the past seven years, totalling hundreds of millions of dollars. By contrast, contracting platforms such as Monetas are ideally suited for secure transactions.
On the other hand, globally distributed consensus systems provide very strong protection against loss of information, because the information is redundantly replicated on millions of computers worldwide. In contracting platforms, only the contracting parties and the notary have a copy of the contract. While this is good for privacy (in consensus systems, by contrast, all transactions are generally public), it means that if all the contracting parties and the notary lose their copy of the contract, there is no backup. This risk is essentially eliminated, however, by the use of professional notaries that use redundant, geographically distributed mirroring and backup systems, and through the integration of independent notaries into a global notary network with additional redundancy.
So both consensus systems and contracting systems have their unique strengths and weaknesses. By combining these two types of cryptofinance technologies, it’s possible to have the best of both worlds:
- secure storage of digital assets in consensus systems (asset layer), and
- secure, efficient trading of digital assets in contracting systems (transaction layer).
Consensus systems and contracting systems are thus not competitive — they are complementary and synergistic — they are stronger and more versatile together.
It should be mentioned that some blockchains, such as Ethereum, also incorporate contracting features. But these suffer the same limitations as consensus transactions in general — they do not scale well, so they are not a good solution as a generalized contracting platform.
There are various initiatives, such as the Bitcoin Lightning Network, and Ethereum’s Raiden Network, that are attempting to solve the blockchain scaling issues by building “off-chain” systems on top of the blockchain infrastructure. But it is by no means clear that these attempts are viable — they likely involve inescapable and unacceptable security compromises.
So instead of attempting to twist one kind of technology into a “jack of all trades, master of none”, a better solution is to let each kind of technology focus on its strengths, and combine the different technologies into a complete, powerful ecosystem, compromising neither security nor efficiency nor scalability nor usability.
Consensus systems are best suited for securely storing low-volume, high-value assets and information — for example: asset registries, inflation-proof non-political currencies, secure voting systems, information that is at risk of being censored, etc.
Contracting systems are best suited for securely and efficiently transacting high-volume, low-value assets and information — this includes virtually all regular financial transactions (over 99% of global transactions by volume), as well as legal transactions.
Both kinds of cryptofinance systems enable the creation of true digital wallets, where the user’s assets are stored in a wallet on the user’s device — not in an account at a bank or other intermediary. In fact, just like a traditional physical wallet, these true digital wallets do not require a bank account, making these systems accessible to the world’s billions of unbanked. This means users are in control of their assets, making these systems user-centric, not provider-centric. While these wallet-based systems can be connected to legacy account-based systems, this is optional — thus shifting the balance of power from providers to users.
THE FUTURE OF CONSENSUS SYSTEMS
Bitcoin (and its hundreds of clones) is a first-generation blockchain that has only rudimentary smart contracting capabilities. Ethereum is a second-generation blockchain that has powerful smart contracting capabilities (though as pointed out above, like all consensus systems, it doesn’t scale well).
Both first-generation and second-generation blockchains lack built-in decentralized governance, making it difficult to efficiently evolve the systems. This has caused serious issues and rifts in both the Bitcoin and Ethereum ecosystems — for example, the Bitcoin block size debate, and the Ethereum DAO fork controversy.
Tezos is a third-generation blockchain that incorporates an efficient decentralized governance model, enabling it to flexibly evolve and assimilate any future blockchain technology innovations without forking. Tezos has a flexible architecture that allows it to instantiate all types of blockchains (for example, it can operate both with proof-of-work and with proof-of-stake algorithms). This means Tezos may well turn out to be the ultimate blockchain — since all useful future innovations are easily assimilated without forking and fragmenting the ecosystem, thus building ever greater hash power and security into the reference implementation. Tezos is also the only blockchain with a smart contracting language that allows formal verification, mathematically guaranteeing the correctness of the code. This is critical given the potentially large amounts at stake in financial contracts.
THE FUTURE OF CONTRACTING PLATFORMS
What is a transaction? A transaction is a contract. The economy is essentially a complex, dynamic network of contracts. Today, the financial ecosystem is fragmented. Many different platforms are specialized for particular niches — narrow categories of contract types. This fragmentation is inefficient, and causes high transaction costs, slow transaction speeds, errors, and failures.
Cryptofinance enables, for the first time, universal contracting platforms that can flexibly handle not just particular contract types, but the entire spectrum of commercial contracts — all types of financial and legal transactions, all types of currencies, assets, and instruments — on a single, integrated, unified global platform. Just like the internet gave us a single, global platform for communications, cryptofinance now enables a single, global platform for finance. Monetas has built just such a universal platform for global commerce.
But this is just the beginning. Willi Brammertz, a Swiss quantitative finance pioneer, has made a major breakthrough — he discovered the financial equivalent of the periodic table in chemistry. The periodic table revealed the hidden elegant simplicity behind the vast variety of materials in the natural world, thereby transforming mystical alchemy into modern scientific chemistry. Brammertz has accomplished a similar feat in the world of finance. It turns out today’s countless millions of financial instruments and financial contracts all consist of just ten building blocks — five input elements and five analysis elements. Everything that happens in the global financial system can be completely and accurately modeled with this small handful of elements.
Then Brammertz went further — in an application of the 80/20 rule, he discovered that well over 80% of all financial contracts are simply variations of just six standard algorithmic contract types. And extending this to thirty standard contract types covers essentially everything (over 99%) that happens in the global financial system.
This is revolutionary. It means the entire spectrum of financial instruments and contracts — all currency types, all asset types, from simple payments to the most sophisticated derivatives — will in future be available as a platform-independent, language-independent, jurisdiction-independent global standard in a simple, easy-to-use interface accessible to everyone in the world from a mobile phone, no lawyer necessary.
Because the contracts are completely standardized and algorithmic, they can be automated as smart contracts — and the analysis of the contracts (calculation of value, cash flows, risks, etc.) can also be automated, so contract parties and financial institutions always know in real time the exact status of their financial portfolio, their risk profile, etc. This will lead to dramatic simplification, efficiency gains, and risk reduction across the entire financial system.
Now observe that financial institutions are essentially simply organizations that produce and process financial contracts of various kinds — savings products, insurance products, investment products. All of these — everything that happens in a financial institution — can be automated using Brammertz’s standardized financial contracts running on a generalized contracting platform such as Monetas. This means it is now possible to create a “bank in a box” — replacing virtually everything a bank does with a piece of automated software. This cuts the cost of starting and running a bank to a tiny fraction of what it was before, while simultaneously also dramatically reducing its risk and greatly improving its products and services.
Monetas is integrating Brammertz’s standardized contracts into version 2 of its global transaction platform, bringing these advanced financial services to everyone with a mobile phone. This will enable banks and other financial institutions to expand their reach to the world’s billions of un(der)banked, opening up profitable new markets at virtually zero cost (no brick-and-mortar infrastructure required).
What will the financial institutions of the future look like? They will be much smaller and leaner, focusing on two roles — trust and integration:
- Trusted advisor
- Provider of integrated financial services.
These are the same two roles that financial institutions have fulfilled historically. The difference is that in future virtually everything will be automated. The advisory role will focus on high-value clients or deals. Product specialists will scan the environment to identify innovative new concepts and technologies, and integrate them into a convenient one-stop products and services portfolio. Customers will, as before, choose brands they trust. But switching costs and loyalty will be much lower, and competition will be much higher — driving improved quality, service, and cost. Especially because, as mentioned above, cryptofinance systems enable user-centric, user-controlled wallets that are provider-independent — so providers will have to offer compelling service quality at competitive prices to attract and retain customers.
THE FUTURE OF IDENTITY
Identity is an essential requirement for social and commercial interaction and accountability. Today, we still use archaic paper-based identity systems such as passports and driver licenses which are:
(1) easily forged, (2) not usable online, and (3) not available to over a billion unregistered people worldwide. It is time to bring identity into the digital age.
There are three ways for us to authenticate ourselves — through:
- something we know (like a password)
- something we have (like a key)
- something we are (like a fingerprint).
The problem with the first two kinds of identity systems listed above is that they can be lost, stolen, or forgotten. And the problem with the third type of identity listed above (called biometric identity) is that traditional kinds of biometric identity (such as fingerprints, iris scans, etc.) require the user to register with a centralized system (such as a government fingerprint database) which can be abused by people in power, or stolen by criminals (identity theft). And once such a biometric identity is stolen, the user cannot get a new one (one cannot change one’s fingerprints or iris).
In September 2015 I developed a new concept for identity — a special case of biometric identity — that I call behavioral identity. Virtually everyone now carries a mobile phone wherever he or she goes. Mobile phones have a variety of sensors, such as accelerometers, gyroscopes, GPS, time of day, keyboards, etc. These sensors can be used to automatically and rapidly build a unique user profile. Each of us has a unique way of moving, typing, etc. and we live, work, and travel in a unique pattern of locations and times of day. Studies show that within a few seconds or minutes (depending on which behavioral metric is used) enough data is generated to uniquely identify a user with greater accuracy and robustness than fingerprints.
Such behavioral identities are essentially impossible to forge, impossible to steal, and impossible to lose — and the user doesn’t need to remember anything. And through the use of cryptographic techniques such as hashes, stored only on the user’s device, the authentication happens locally, thus preserving the user’s privacy. The identity solution can be developed in such a way that the user has the option of choosing which dimensions (movement, location, time, typing patterns, etc.) to share with which applications. (High-security applications will require more dimensions / more data for more robust identity verification.) And these identities can be deleted and rapidly recreated at any time.
This means behavioral identity is a universal solution, accessible for free to everyone, stronger (more accurate) than any traditional form of identity, with better privacy and security than any other form of identity, and more user-friendly than any other form of identity.
In our increasingly digital world, we all leave a digital trail wherever we go, whatever we do. This means it’s essentially impossible to do things in a way that cannot be tracked. This leads to greater transparency throughout society — which is a good thing, because it discourages bad actors (they’re unlikely to get away with it). But this also creates the risk of abuse of power (surveillance, censorship, etc. by government and other powerful entities). So laws and technologies must be developed that prohibit and prevent automatic universal surveillance, that respect the privacy of innocents by default (based on the presumption of innocence), and that permit only targeted investigation of suspected criminals based on reasonable evidence.
Combining the above elements, we can create an identity solution for the digital age that balances privacy, security, transparency, and accountability in a way that is consistent with a free society.
THE IMPACT ON SOCIETY
The synergistic confluence of the above cryptofinance technologies will create a new global financial infrastructure that is decentralized, highly secure, extremely efficient, highly automated, universally accessible, and user-centric.
The decentralization of finance will reduce the size and power of financial institutions and governments, and increase the freedom of citizens.
We’re seeing a deep democratization of finance, making the most advanced financial services accessible to everyone, integrating people everywhere into the global economy. The combination of security of property, low transaction costs, and global financial inclusion will dramatically boost wealth creation and result in a rapidly rising standard of living and high quality of life worldwide.