We are at a historic turning point.
We are witnessing technology disrupt the concepts of money and value. In particular, the way in which money and value are transmitted from one point to another. While what we expect is new and different, we can get a grasp of it by considering another technological evolution that happened not so long ago — the internet.
The Internet began as many LANs that operated independently of one another. In the 1960s and 70s, computer manufacturers and service providers thought it was a good idea not to interoperate their systems with those of competitors. That served well in terms of locking in customers.
However, it soon ceased to be a viable strategy.
The lack of interoperability was a problem in particular because data flow was curtailed. There was a huge need and push from end users to link LANs. However, aside from the lack of desire by service providers to enable integration, another major obstacle existed: how to manage and secure the large centralized network that would emerge.
The solution was to decentralize the internet, and to make this possible the Transmission Control Protocol (TCP) and the Internet Protocol (IP) — or TCP/IP — were created.
TCP/IP is a suite or a family of data transfer protocols — agreed sets of rules — that guide the transfer and sharing of data files over peer-to-peer networks. They make the communication between two end nodes on a network possible without a central control point.
Even where there is no direct link between a source node and a target node, communication can go through one or more intermediate nodes in what is known as multi-hopping.
The protocols allowed the internet to grow into what it is today. With agreed standards by all stakeholders, anyone could design and produce software, hardware or a network, and be sure that it would work or integrate with the existing one in the ecosystem.
Now, how does this relate to money and value?
For efficient, effective, secure and cost less movement of value over the internet to happen, a similar suite of protocols is necessary. It is important that players in the payment and value transmission space have a common suite of protocols.
So far, huge technological strides have been made towards that goal. And we may be close to seeing a level of achievement in money and value movement similar to what has happened with information.
But significant work remains to be done.
Centralized payment systems
The digitization of money and value is not a new concept.
It goes as far back as the 1960s when banks started experimenting with computers and Automated Teller Machines (ATMs). As with the internet, it began on centralized trust-based models. It has, however, taken longer to transition to decentralized peer-to-peer models — or trustless models.
Meanwhile, society has continued to embrace value and money in the digital form. Research released in October 2017 by BNP Paribas, a leading commercial bank, and Capgemini, a consultancy firm, indicated that the annual global increase of the number of transactions settled through digital payment methods was over 13%.
Some countries such as China are experiencing an annual increase as high as 30%. And some, like Sweden, have already achieved as high as 80% settlement of transactions through digital payment methods.
But if the true potential of digital money and value is to be realized, the current model of huge trusted intermediaries holding and maintaining transaction ledgers or databases has to change.
That is because centralized digital money and value systems come with several critical weaknesses. These include:
Insecurity
The security of databases in servers is guaranteed only through access control. However, these databases are often hacked or breached and unauthorized access gained. Annually, commercial banks, financial institutions and individuals lose millions of dollars to hackers.
Some of the latest recorded incidents include the 2016 Bangladesh Bank cyber heist, where close to US$100 million was syphoned from an account the Federal Reserve Bank of New York maintained for the Bangladesh Central bank. This was done through fraudulent messaging via SWIFT, the network that banks use to pass transfer payment instructions.
While this kind of theft does not occur often, especially in the case of major financial institutions, the mere existence of this risk demands huge budgets for security. It is projected that the annual global budget for online security will cross US$170 billion in 2020.
Data regarding the amount the banking sector spends on security is difficult to come by. However, in a 2015 interview Brian Moynihan, CEO at Bank of America Corp., disclosed that his bank — the second largest lending institution in the US — spent over US$400 million on cybersecurity that year.
This cost can be found in the accounting books of all financial institutions — and it is always translated and passed on as fees to the customers.
Expensive
In addition to the security cost, trusted intermediaries have to take care of payroll, cost of hardware and software, electricity bills, auditing bills and other cost items. And since they are profit-making entities, they have to add a mark up to these costs. All of these are passed on to customers in the form of fees and commissions.
For example, if you are a small online enterprise and you accept payment through PayPal, you will be charged a fixed rate of about US$0.30 for every transaction. In addition, you will pay 4.4% of the amount involved, depending on whether the transaction is cross-border. Then you will pay a virtual terminal fee of 3.1%, currency conversion fee, card usage fee — and the list goes on.
This results in the services and products being very expensive. As a result, more than a third of the global adult population remains unbanked due to the fact that those who form this group are too poor to afford financial services.
Lack of privacy
In using most centralized payment systems, users agree to have data about them held not only by the intermediary that serves them, but also other entities. Even more alarming is the question of how this data is used beyond the customer’s control.
The databases which store the personal data are honeypots for hackers. Access to this data can enable attackers to steal not only assets attached to the individuals the data belongs to, but also their identity.
It’s also the case that data is not only stored by the primary service provider. Any other entity the primary service provider interacts with in the process of serving its clients often ends up acquiring sensitive user data and storing it on their own servers. This creates multiple leak points for user data.
This data can also be used by trusted intermediaries themselves to deny users services. This comes in the form of censorship on various grounds, some objective and others subjective.
It’s also important to note that as economies adopt digital payment methods and become cashless, users are losing the cash element; the ability to pass money from one hand to another without exposing the transaction details to entities other than the two parties involved.
One outstanding characteristic of physical notes and coins is enabling users to spend their money without leaving a trail that leads to their doorstep. This element of money is still required, at least in some instances.
Low speed
While it takes seconds for a message to travel from one corner of the globe to another, it can take days for money, even in digital form, to travel the same distance.
The lack of speed in the movement of money and value adds to the slow movement of international trade. For example, if you are in Europe and want to make an import from China, the communication to your supplier will be instant. However, they might not start the shipping process until they receive payment, which will take several days. This is despite the fact that, just like your communication with your supplier, the money will travel in digital form.
However, the money will have to go through your local bank, to the central bank of your country, through a correspondent and liquidity provider bank in Europe, through a correspondent and liquidity provider bank in China, through the Bank of China and then it will show up in your supplier’s account at their local bank.
The delay is often caused by poor interoperability between the different platforms the money has to pass through. In some cases, manual processing is required to complete the transaction.
The peer-to-peer payment dream
The dream of being able to send and receive money through the internet without intermediaries — or replicating cash online — has existed for decades. It has been a subject in scholarly literature going as far back as 1983 when David Chaum published his paper ‘Blind Signatures for Untraceable Payments.’
In 2009, a person or group of persons going by the pseudonym Satoshi Nakamoto ushered in the era of peer-to-peer payment. Satoshi solved the double spend problem and launched Bitcoin, an electronic cash system that could function without the need for intermediaries.
The protocol that powers Bitcoin, often referred to as blockchain, makes it possible for users on a network to maintain a transaction ledger through consensus. It is a trustless model because there is no overarching authority to maintain the transaction ledger.
Because the network has no central control point, the payment method is highly censorship-resistant. In particular, blockchain comes with the capacity to solve some of the biggest challenges that digital payment systems have had over the years.
It fixes security by storing data in the form of time-stamped files that would require an impossible amount of computer power to change. It also brings into the picture the use of high-level cryptography to secure transactions.
Of course, the blockchain ecosystem has had its own share of hacks where, in some instances, tens of millions of dollars have been stolen. It is, however, important to point out that in most or all these cases, it was blockchain assets being stolen from centralized systems — i.e exchanges and trading platforms.
The blockchain has also made it possible to send value from one corner of the globe to another within seconds. The older blockchains like Bitcoin take up to a few minutes to settle payments, but newer blockchains exhibit the capacity to complete transactions in a matter of seconds.
Last but not least, some blockchains offer the capacity to transmit money that can be used as cash in an online environment. It is this technology that is making it possible to spend money online without leaving digital footprints that lead to your door.
The blockchain is certainly a game changer — but a few things about it have to be fixed.
When the technology first emerged, anyone who cared to study it and see it for what it was couldn’t help but be impressed. It seemed poised to change society the way the internet did. And indeed, in every industry you look at, there is a blockchain application being built to solve one problem or another.
Fast forward to 2018 and few would disagree that blockchain can be the technology that disrupts and revolutionizes finance, manufacturing, the service industry and society in general. At least, it can if its most glaring weaknesses are fixed.
The lack of interoperability
The main problem blockchain technology faces at the moment is interoperability and the building of second layer networks. There are over 5,000 blockchains in existence today and they perform various functions. Each one of them is like a local area network (LAN) of the 1970s that does not communicate with others around it. They are closed off because there is no industry-wide standardization of protocols.
If they could all interoperate, moving different crypto assets and converting from one to another could be fast, cheaper and more secure, especially as there would no longer be a need to rely on risky centralized exchanges.
Even if the current financial system adopts blockchain, but each with its own private or public blockchain, not all of the challenges facing the current siloed systems will go away. In fact, the situation with cross-border and inter-bank transactions might remain the same as it may require time-consuming processes for money or value to move from one blockchain to another.
The reasons for the lack of interoperability between blockchains are various but the ones that stand out are the lack of agreed standard protocols to make it possible, as well as the fact that different blockchains have different goals when it comes to how data is handled. They are also built using different languages, protocols and consensus mechanisms.
The internet faced the same issues in its early days. This necessitated the creation of bodies tasked with forming, maintaining and updating the TCP/IP protocol standards. These include the Internet Architecture Board (IAB), which formulates general policies on the management and development of standards, the Internet Engineering Task Force (IETF), which conducts necessary engineering research, and the Internet Corporation for Assigned Names and Numbers (ICANN), which manages IP addresses, domain names and port numbers.
However, stakeholders in the blockchain space might not have to set up bodies to enforce the rules of engagement. The technology has already demonstrated that a decentralized governance structure is possible to achieve.
Possible solutions: Distributed Channel Networks
The crypto and wider financial technology (fintech) industry have begun to look at a future of interoperability among different payment platforms, both centralized and decentralized.
A huge component of this new ecosystem is creating multi-hop channels for the flow of value and money. This is possible through peer-to-peer network mapping so that even when there is no direct link between two users or payment platforms, value or money can go through connecting intermediaries that are guided by robust protocols.
These intermediaries will not have the authority to manage a centralized ledger as we have with centralized digital payment service providers. Their primary function will simply be to pass payment instruction data. And they might not even have the ability to interpret the contents of the data they pass to and from different users and payment platforms.
It’s also important to note that a sending or receiving node could serve as an intermediary for transactions by others on the network. The components of this multi-hop system have begun to take shape. They include trustlines and state channels.
Trustlines
One way platform-agnostic payment channels can be achieved is through the implementation of the concept of trustlines, a means of connecting different digital payment platforms — both blockchain and server-based.
The system functions by relying on a network of users on different blockchains and digital payment platforms who trust one another to issue and settle IOUs (I Owe YOU) between one another. That means one user can borrow from another, who trusts them, then issue a token acknowledging the debt.
Participants can create a large network of users who trust one another in the form of chains. This means that two users who do not trust each other can transact through a common intermediary with whom they both have a trusting relationship.
If, for example, John wants to send money to Aisha but they do not trust each other, he sends the money through Alice, who they both have a trustline with. Because of the need to protect user value, the architecture itself is vastly more technical than the example described above, and smart contracts play a significant role in its design.
Several projects are building protocols to support trustline transactions across networks. They are blockchain-agnostic and put more emphasis on the user-to-user transaction, regardless of the payment platform they are favouring.
One project that stands out in this regard is GEO protocol. It is building an ecosystem for trustlines with supporting features such as network mapping and user addressing support.
Another is Trustline Network, which seeks to provide a platform through which users can move value between fiat and cryptocurrencies by using IOUs issued on blockchains between users trusting one another.
State channels
The concept of state channels entails having payment lines opened between counterparties that allow them to transact as many times as they want but settling only the first and last transaction on the blockchain.
Counterparties using a state channel do not have to trust each other. That is because their interaction is guided and executed by a form of smart contract. Users can open multiple state channels with many others. This allows for infinite scaling of the blockchain.
The primary implementation of state channels has been achieved through the Lightning Network protocol, which Bitcoin and Litecoin have deployed. This solution seeks to decongest blockchains and as a result, reduce the cost of sending and receiving money. There is even more potential in state channels as a means to link and interoperate different blockchains.
Another project that is implementing trust-free, secure and private off-chain transactions through state channels is the Celer Network project. It seeks to extend the benefits of state channels to the deployment and running of a wide range of decentralized applications (dApps).
The end product
As cash dies off around the globe, it is becoming important to explore ways to afford users speed, security and privacy at the lowest possible cost with the digital payment methods that are taking over.
Fortunately, the components for achieving ideal digital payment platforms are already available. In fact, they are being implemented and used independently of one another.
One could view these platforms as competitors and hope that one or more of them will eventually win the battle and become the dominant service. But there is another option — having them communicate with one another and allow value and money to be agnostic of them.
The latter option is the ideal scenario, as we know by looking at what happened with the internet.
To create a peer-to-peer movement of value across different payment platforms, a protocol that enables integration, atomicity and scalability is required. It also has to allow the use of lightweight devices and provide a robust device addressing and identifying the system.
The end result will be similar in structure to that used for sending and receiving email, where the email service that sender and receiver use is irrelevant.
These interoperable protocols will provide components similar to TCP/IP, but for the purpose of sending money and value across centralized and decentralized payment platforms.
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