Blockchain’s weakest links
Billions of dollars are riding on a technology that could revolutionize how business is done—if glitches don’t break it
CHANA R. SCHOENBERGER | NOV 26, 2018
Blockchain” has become a business buzzword. Commentators, thought leaders, and business experts are highlighting how the distributed-ledger technology promises to revolutionize business and logistics. Universities are teaching courses in blockchain. Blockchain jobs are “booming in Asia,” reports CNBC. Blockchain “lets us imagine a world that’s not dominated by Google, Facebook, or, for that matter, the [US National Security Agency], one where we, the people, the core components of global society, get to say how our data is managed,” reads The Truth Machine: The Blockchain and the Future of Everything. It’s a lot of attention for what is essentially an accounting technology. The plumbing behind financial services is generally unaccustomed to such publicity.
Blockchain rose to public prominence as the technology underpinning Bitcoin, but it could end up having more lasting value than the cryptocurrency. To some, the first era of the internet was about exchanging information, and the second era, which we are now entering, is about exchanging value. Blockchains could use computer science to create “smart contracts” through which business can be conducted online more safely, securely, and reliably.
Billions of dollars are already riding on this future. Companies are expected to spend $2.1 billion on blockchains by 2018, and $9.2 billion by 2021, according to research firm IDC. But first, like any new technology or market—and blockchain is both, in some sense—it has to overcome a few issues to prove its staying power.
For starters, there are different types of blockchains, and researchers have identified some potentially severe challenges facing the most ubiquitous type, known as “proof-of-work.” The choices companies and others make in the near future about which system to use, and how to use it, will determine how blockchain systems progress—and if blockchain does indeed mark a next era of tech.
Weak link #1: The reliability of ‘private’ blockchains
The term “blockchain” lacks a common definition. Many confuse blockchain—a decentralized, distributed-ledger technology—with cryptocurrencies or other accounting systems. But Bitcoin is one of some 1,600 digital currencies and tokens. It runs on a blockchain system, and users receive bitcoins as rewards for doing work on the system. This is the most mature application of blockchain, and the one with which many companies and investors are most familiar.
Satoshi Nakamoto, a pseudonym for the anonymous author or authors of the 2008 white paper that first described Bitcoin and this first iteration of blockchain, wrote about “blocks” of transactions, each appended in sequence to a never-ending “blockchain.” If two people or companies did business, their agreement would be recorded, grouped into a block, and verified by anonymous “miners.” When verified, a block would attach immutably to the previous block, lengthening the chain. The miners, as a reward for verifying the transaction, would receive tokens, or “bitcoins.”
What made this method revolutionary is that it decentralized trust. For millennia, business transactions have required trust between the parties involved. For two people to complete a transaction, the seller had to trust the buyer, and vice versa. Both parties had to trust that money and goods would be transferred as promised. Clubs, exchanges, and myriad networks have been created to essentially vet and verify that the people doing business are trustworthy and, if they act inappropriately, will be held accountable.
This had been hard to replicate in a global, digital world, where computers meet instead of people and don’t always know, much less trust, each other. In Nakamoto’s blockchain transactions, however, users put their trust in anonymous miners—and in the proof-of-work system itself. In it, sophisticated cryptography generates difficult math problems that miners’ computers race to solve. When one miner’s computer successfully solves a problem, the answer, verified by the slower miners, serves as validation that a block with accurate information is being added to the chain.
The system is decentralized and produces a distributed ledger: a copy of the verified chain sits on every computer on the network, which is different from a typical centralized record-keeping system. Because everyone keeps a copy of the ledger, no one has to place trust in a third party; all information in question has been verified and stored in blocks on the chain.
Riding Bitcoin’s wave
Hundreds of thousands of transactions are confirmed daily on Bitcoin’s famous blockchain.
Number of daily transactions on the Bitcoin blockchain
But not all systems being called blockchains work the way Nakamoto described, and not all are decentralized. When some companies talk about integrating blockchain into their operations, they’re describing something with a central authority—a database that does not involve mining or maintaining trust between anonymous parties, says Chicago Booth’s Eric Budish. On this type of blockchain, transactions are recorded and a database is maintained by a central authority, such as a computer or person at the company. A copy of the verified chain sits on every computer on the network, making the system distributed but not decentralized.
Some researchers call these “private” blockchains, and Budish questions whether they should be called blockchains at all, rather than simply better databases. “A lot of the excitement about blockchain is [actually] excitement about better data-management processes,” he says.
The business applications of this technology could still improve how companies interact and run their operations, and represent better record keeping. But centralized databases may not be as safe, as each has a single point at which its system could potentially fail. One of the cornerstone precepts of blockchains is that they operate at the highest levels of security, but that’s not true of private blockchains, says Imperial College PhD candidate Engin Iyidogan, one of dozens of researchers who have been studying blockchains from every angle.
Moreover, if private blockchains fail, it could tarnish all blockchains by diminishing people’s faith in them—although it could also spur innovation. “If people realize that private blockchains are not disruptive or efficiently implementable, the hype over blockchain technology vanishes and we focus more on applications of true decentralized systems,” Iyidogan says.
Weak link #2: Transaction fees
Private blockchains aside, much of—if not most—economics research taking place looks at Nakamoto’s proof-of-work system, which many economists treat as the default blockchain design. One celebrated advantage of the proof-of-work blockchain: it can make markets more efficient by helping transactions to settle more quickly, eliminating the time between when parties agree and when the deal closes, and by extension the costs. “Most people agree the potential for blockchain is very high as a mechanism for streamlining the transaction costs of settlement,” Cornell’s Maureen O’Hara says.
If deals were to close more quickly, the money tied up in a pending transaction could be put to better use. In the leveraged-loan market, for instance, where companies borrow cash at steep rates, it reportedly takes 27 days to settle a transaction, compared to just two or three days for a stock trade, and agents spend a quarter of their overhead expenses on answering investors’ calls to confirm the details of loans. Distributed-ledger settlement would obviate these problems, experts say.
But it won’t be easy for the Nakamoto blockchain to evolve into a mostly seamless market like the major stock exchanges. Some research suggests the transaction fees involved will be an impediment that prevents blockchain from growing.
Transaction fees are an increasingly important component of these blockchain systems, and they are closely related to transaction times. Today, if you want to make a transaction, you offer miners a fee to include your transaction in a block. The fee you offer depends on how quickly you need that transaction processed; if you want your transaction prioritized, you pay a higher fee. In addition to the miners’ fee, you may pay a fee to a bitcoin exchange to process the transaction and, if wanted, to transfer bitcoin back into dollars or another noncryptocurrency.
Transaction fees can be volatile
Miners on the Bitcoin blockchain enjoyed a surge in transaction fees earned during the recent run-up in Bitcoin’s market value.
Daily amount in transaction fees paid to miners on the Bitcoin blockchain. US dollars
However, only 21 million bitcoins can be mined under Nakamoto’s design, and about 17 million are already in existence, according to blockchain.com. When the final bitcoin is created, the market will switch to a purely transaction-fee-based system. At this point, these fees will be the only way to attract miners to a block. The higher the fees offered, the more mining power will be directed to the blockchain.
Transaction fees help the market reach equilibrium by allowing miners to earn more for processing some blocks faster—while helping more time-crucial transactions to be processed more quickly than others. But O’Hara, Cornell’s David Easley, and Cornell PhD candidate Soumya Basu find that transaction fees are an impediment to bitcoin holders who want to use the cryptocurrency as a medium of exchange to pay for real-world things, rather than to hold as a speculative investment. “As users battle to get transactions posted on the blockchain, transaction fees are rising to levels that discourage bitcoin usage, highlighting an important structural issue confronting the blockchain,” O’Hara, Easley, and Basu write.
According to the researchers’ economic model, transaction fees make mining profitable over time—but these fees won’t speed up transaction times enough to counteract the number of users who get fed up with waiting and leave the system. “The fees directly induce some users to drop out, while increasing wait times cause other fee-paying users to depart as well,” they write. The researchers identify the problem, but they don’t propose any remedies for it.
Moreover, according to another group, once all bitcoins are mined, transaction fees may not raise enough money to support the system’s infrastructure. In a comparison of bitcoin’s payment mechanisms and those of a traditional company, Columbia’s Gur Huberman and Ciamac C. Moallemi and Chicago Booth’s Jacob Leshno find that the transaction delays and high fees that plague blockchain-based settlement are an inherent part of the proof-of-work system.
Nakamoto’s system has some congestion baked in. It makes people wait for transactions to be compiled into blocks, and then wait again for the grouped transactions to be verified. And it will eventually make some people wait longer than others, if they’re unwilling to pay higher fees for faster service. “Congestion is not merely an engineering necessity, but also a device to motivate users to pay transaction fees,” they write.
In the Bitcoin system, no single party sets transaction fees. Instead, they are the result of supply and demand. The transaction fees-for-service operate in a nonlinear fashion. When blocks of transactions are less than half of their maximum size, users pay low transaction fees, as there is less competition for miners’ attention. At 80 percent of maximum block size, the fees shoot up as the block approaches its top size.
A blockchain can work well when there’s relatively low congestion, and charges fees that are relatively low but sufficient to keep the system functioning smoothly and efficiently, says Leshno. What complicates matters is that rising transaction fees affect the market’s demand but not supply: higher prices may deter some users from sending transactions for processing, but they will not change the fact that the system can process only one block of transactions every 10 minutes, regardless of the number of miners who compete to add the block to the chain.
And there’s no limit to how low or high the fees can go. When a company such as PayPal processes transactions, it charges what consumers are willing to pay, not what it costs to process the transaction. In the case of a bitcoin-based blockchain, says Leshno, paying market rather than monopoly prices for transaction services may be efficient, but those market prices might not serve the system well. There’s no guarantee fees won’t be so low that miners have no incentive to mine, or, more likely, be so high that transactions become unaffordable. Thus, while blockchain-based payment solves many problems, it isn’t necessarily cheaper than regular payments, the study finds.
“The costs of operating the [blockchain payment system] are likely to be higher than those of a traditional firm: its decentralized architecture requires duplication of computations and expenditure of efforts in the random selection tournament; the aggregate mining level can be too high; costly delays are necessary to induce users to pay transaction fees,” the researchers write.
Weak link #3: Energy use
Because bitcoin mining is a proof-of-work system, miners use electricity to run computers as they race to solve math problems to earn the right to validate the next block in a blockchain, and thereby win a bitcoin reward. This has raised another big concern with Nakamoto’s system: energy use.
As Bitcoin prices surged, so did mining and its impact on the power grid. If Bitcoin were a country, it would rank 39th in worldwide energy usage, behind the Philippines (38th) and ahead of Austria (40th), according to Digiconomist’s Bitcoin Energy Consumption Index. Yet it facilitates fewer transactions annually than the Visa credit-card network does each day, according to Australian National University’s June Maand Rabee Tourky and University of Toronto’s Joshua S. Gans.
Nakamoto’s design leads directly to this intense resource consumption, the researchers find, because miners have to play a game every time they mine a block, and making the game’s math equations harder doesn’t tamp down energy usage. While buying more expensive computer chips to perform the equations could in theory discourage some miners from participating, this hasn’t happened, according to the researchers.
Miners’ swelling electricity usage
Even by conservative calculations, Bitcoin miners’ demand on the power grid has at least quadrupled since 2017.
Bitcoin Energy Consumption Index. Terawatt hours per year
In a theory paper, Ma, Gans, and Tourky argue that the Nakamoto system allows anybody to mine—granting free entry to whomever has the software to compete. If the system instead were to limit the number of miners, this would do more to reduce the amount of computing power, and electricity, that miners expend. Granted, that would require Nakamoto, if still alive, to make changes to the system.
Another trio of researchers—Chicago Booth’s Lin William Cong and Zhiguo He and George Mason’s Jiasun Li—say that Nakamoto’s system creates a wasteful energy arms race. Miners, to stay competitive, invest in computing capabilities by spending heavily on networks, as well as electricity and cooling. The investment may improve a miner’s chances of winning a computational competition. However, Nakamoto’s system is a zero-sum game, so if investment benefits one miner, it directly hurts the chances of other miners.
But regardless of who wins a competition, or how many miners compete, or how much energy they use, one block will be added to the chain every 10 minutes, on average. The effort that goes in may grow ever larger, but the outcome remains the same. So the intense competition produces no benefit for the system or end users. “The arms race nature of this technology is what’s underlying the electricity usage,” says He. He and his coresearchers point out that risk-sharing considerations lead miners to work together in the form of large mining “pools.” The rise of mining pools is a financial innovation that improves miners’ risk sharing; but it enables miners in a pool to devote greater computation power, aggravating the arms race that consumes a tremendous amount of energy. (For more, see “Are blockchain mining pools problematic?” page 31.) Excessive competition, say the researchers, is an inherent part and problem of Nakamoto’s design.
But again, not all blockchains resemble Nakamoto’s original vision. Some competing cryptocurrencies are based on proof-of-stake, which validates transactions differently. The proof-of-stake system doesn’t involve races to solve mathematical puzzles, and thus there is no reward for doing so. Instead, the amount of cryptocurrency a miner holds serves as a validation of trustworthiness and functions something like a bond: a miner has to hold a certain amount of cryptocurrency before being allowed to verify and add blocks to the chain. Miners with more cryptocurrency have more mining power, and they make money simply through transaction fees. This system is still a public blockchain, not a private one, because it has a distributed ledger and no central authority. But because it doesn’t require many computers to run the same equations as they race to solve a puzzle, proof-of-stake uses less electricity.
Ethereum is reportedly switching to a proof-of-stake system, in part to mitigate the environmental costs of proof-of-work’s massive electricity bills.
McGill’s Fahad Saleh argues that such blockchains using proof-of-stake can be economically viable because this system can achieve consensus: miners agree that a block is valid and allow the blockchain to continue. It’s important, however, that proof-of-stake systems incorporate rules that require users to have a sufficient stake of cryptocurrency to participate in validation, he writes. Otherwise, users could get in the way of consensus to drive up their own rewards.
“My conclusions emphasize the need for developers to heed economic guidance when designing consensus protocols,” Saleh writes. If participants own a lot of the cryptocurrency being used to run the blockchain, they have an incentive to not tank the currency’s value.
Weak link #4: The cost of security
Sabotage is another looming issue, according to Booth’s Budish. He took a theoretical look at the economics and security of Nakamoto’s blockchain, focusing on the large relative cost required to make blockchain secure. In a series of equations, Budish lays out his concerns.
He started by asking how much computational power miners are buying for tournaments. The answer, he says, is that it depends on how much miners are compensated. The more miners can make, the more they will mine.
But for miners to stay honest, they have to know that they will make more money by mining than by sabotaging the system, Budish notes. The amount miners receive over time as they help to run and maintain the blockchain is known as a “flow,” while the one-time haul from an attack is known as a “stock.” “The recurring ‘flow’ payments to miners for running the blockchain must be large relative to the one-off ‘stock’ benefits of attacking it,” Budish writes.
And to keep a blockchain secure, miners have to be convinced regularly—every 10 minutes, essentially, which is how often miners compete—to stay honest. If Bitcoin were to become a store of value and transactions were to grow, the temptation to sabotage the system would also grow, he points out. Users trying to maintain security would have to offer miners an increasingly large amount almost 150 times a day.
Moreover, miners currently use expensive, specialized chips to participate in tournaments. But if the price of those were to fall, or if miners were able to rent chips rather than buy them, the cost of attacking would fall. It would then become more tempting for miners to sabotage the blockchain, steal bitcoins, and drive down values. These problems will get worse if the “Bitcoin blockchain gets economically important enough to tempt a saboteur,” Budish writes.
Small-scale transfers made up the earliest bitcoin transactions—think black-market transactions, purchases by computer hobbyists, and intrafamily international transfers such as sending money to a child studying abroad. But as the value of Bitcoin grows, the system runs into trouble, according to Budish’s model, and he is skeptical it can really scale up.
The issues Budish described have already been realized. In mid-May, a market participant with sufficient computing power was able to take control of the underlying ledger of the Bitcoin Gold market. Soon news site CoinDesk reported that at least four other cryptocurrencies had also been hit.
Weak link #5: Regulation
While computer science has created a decentralized system of trust, regulation could offer peace of mind to wary market participants. But Nakamoto’s original description of blockchain didn’t mention regulation, and regulators have been slow to catch up with cryptocurrency trading and blockchain adoption, Cornell’s O’Hara says.
The regulatory outlook for all blockchain systems and cryptocurrencies is highly uncertain. A half dozen regulators in the United States, as well as their counterparts overseas, have issued a series of often contradictory announcements and enforcement actions that touch blockchain companies issuing tokens or operating a cryptocurrency exchange. The regulators don’t agree on whether cryptocurrencies should be legally considered commodities, currencies, or securities, which affects what rules cryptocurrency holders and issuers need to follow.
Take initial coin offerings, or ICOs, a form of financing (or is it securities issuance?) that involves a company selling digital tokens that can be used to buy and sell things on a blockchain it is setting up. The company is often a start-up, but is sometimes an established corporation such as Kodak, which has announced it will use a blockchain to protect digital rights for images. While regulators at the US Securities and Exchange Commission have said ICOs are flouting regulations that apply to companies that issue shares, blockchain enthusiasts have snapped up the new tokens.
Academics are clearly thinking about the regulatory implications of blockchain. More than 120 academic papers have been written on the subject in the past three years. And businesses have been just as prolific: analyzing 1,000 white papers describing companies’ ICO plans, University of Luxembourg’s Dirk A. Zetzsche and Linus Föhr, University of New South Wales’s Ross Buckley, and University of Hong Kong’s Douglas W. Arner found a vast gulf in disclosure levels between them and traditional securities documents.
“Many ICOs are offered on the basis of utterly inadequate disclosure of information; more than half the ICO white papers are either silent on the initiators or backers or do not provide contact details, and an even greater share do not elaborate on the applicable law, segregation or pooling of client funds, and the existence of an external auditor,” they write.
Because existing regulations don’t address many of the issues, the researchers recommend that governments require more disclosures and lean on intermediaries, such as the exchanges where the tokens trade, to help enforce these standards.
Cong and He also say regulators need to pay attention to the possibility of collusion in some blockchains. In a study, they look at permissioned blockchains—not private, but in which parties need permission to participate. This type of blockchain is popular in industry, for example to enable a retailer such as Wal-Mart to conduct business more easily, quickly, and safely with companies in its supply chain—but without revealing sensitive information to competitors.
However, when information is shared on a blockchain, it is harder to keep secret some details of contracts, or simply secure data that could be revealing, say the researchers. Parties on a blockchain might use the now-public information to collude. Even if they don’t collude, they might make different decisions than they would have otherwise—to the potential detriment of customers. Regulators, they say, need to understand this, and regulate accordingly.
Despite the regulatory uncertainty, the move to use blockchain technology within institutions and even within governments has gained some traction, as well as some pushback. In 2016, Delaware, headquarters to the majority of large US companies, started a program to transition much of its corporate-oversight infrastructure onto a blockchain, the idea being that as registrations were recorded on a blockchain, regulators would be able to easily monitor details such as who owned a company and when it was registered.
But corporate-registration agents could lose money if documents can be registered and transferred automatically (during a merger, for example). And in February 2018, Governor John Carney slowed the blockchain initiative. State officials said they’re still considering implementing some parts of the plan. Now, while Delaware would like to maintain its position as the headquarters of incorporation, Wyoming has emerged as a pioneer in blockchain-driven corporate registration.
This sort of back-and-forth is inevitable in any kind of innovation, O’Hara says. In Delaware, introducing blockchain at first seemed ideal, until registration-agent lobbyists said otherwise. “First, everyone’s in favor of it—‘It’s a great idea!’—until one group realizes, ‘This is a bad idea for me,’” says O’Hara.
In theory, private blockchains could be regulated more easily than public ones. Because a blockchain-based database run by a company or a consortium does not involve maintaining trust between anonymous parties, a central authority can take responsibility for updating the blocks. This setup also eliminates most of the enormous electricity costs that go into bitcoin mining. On a blockchain run by Company A, say, a user would trust the central computer managing the system, as well as other colleagues or vendors on the network. Regulatory agencies could also maintain a node on a private-blockchain network to supervise operations, O’Hara says.
Regulating public blockchains could be trickier, but Columbia’s R. A. Farrokhnia says that it’s possible. Farrokhnia, who teaches at the business and engineering schools and is the founding director of Columbia’s Fintech Initiative, sees parallels between the rise of cryptocurrencies and the development of the commodity futures markets in the 1970s—a huge financial innovation that was, however, accompanied by rampant fraud at first. The newly created Commodity Futures Trading Commission intervened in the late 1970s, shutting down trading at times for futures on coffee, wheat, and gold and silver while regulators worked out rules intended to improve the markets’ functionality. By the early 1980s, with these rules in place, futures trading had been adopted by more mainstream financial players and spawned both more volume and innovative markets.
Farrokhnia speculates that blockchain may follow a similar path, although he predicts its growth will take years and require the support of ancillary industries—much as the growth of the internet hinged on the ability of companies such as Cisco and Sun Microsystems to first build some foundational technology. He compares such dynamics to building a city in the desert, which is possible only once someone has built roads and moved equipment and materials to the site. For now, he says, blockchain technology is still overwhelmingly used to support cryptocurrencies and digital tokens that are speculative at best and are years away from being used as an ubiquitous exchange of value or service. Blockchain is not yet ready to achieve the promise of the second era of the internet, and won’t be until its user base is broadened and the industry is regulated in a transparent, well-defined way.
As Bitcoin gets more expensive and volatile, it moves away from Nakamoto’s vision of it being a currency used for exchanging real goods, suggests Australian National University’s Ma. In December 2017, bitcoin futures contracts became available, which is likely to have led to yet more speculation, she says.
Or, could it be that Nakamoto’s blockchain is going in the direction of speculation, while other versions are not? “Many economists are still talking about proof-of-work as the default blockchain design, which it’s not anymore,” offers Booth’s Cong, who argues that researchers doing deep dives into blockchain should make a distinction between the different protocols being used.
While Nakamoto’s blockchain dominates early cryptocurrency applications, Cong says, many new applications are employing alternative consensus protocols with names such as “delegated proof-of-stake” or “practical-Byzantine-fault-tolerance.” Moreover, in addition to the technological innovations these new systems represent, practitioners and researchers should think about the new business models and economic insights the technologies enable. For example, together with Ohio State University’s Ye Li and Columbia’s Neng Wang, Cong finds that introducing tokens on decentralized platforms can accelerate user adoptions—a concept of “bootstrapping” that entrepreneurs often talk about when raising financing through ICOs.
“There’s a lot of room for this market to get more developed, and it’s pretty hard to predict now, given how much is in this space and how little knowledge there is, what it will look like eventually,” according to McGill’s Saleh. Even so, the research collectively suggests that blockchain—some version of it—has the potential to mature into an ecosystem connecting a wide variety of records and transactions. But for that to happen, some parts of Nakamoto’s original design may have to change.
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