Today the People’s Bank of China, the central bank, published a report analyzing the pros and cons of blockchain stretching from public to permissioned applications. Below is a summary of the paper written by Xu Zhong, the Director of Research.
It starts by outlining some generic blockchain functionality and enterprise applications. It then explores public blockchains and concludes that cryptocurrencies will not disrupt the modern financial system, but blockchain may help by making business processes more efficient.
The paper initially addresses a blockchain myth about the truth of data. Because data is on a blockchain doesn’t mean it’s correct as the source may not be reliable. However, it’s hard to tamper with data once it’s stored on a blockchain.
The document distinguishes between three different types of consensus: machine, governance and market consensus. The latter two are “human consensus”. Machine consensus in blockchains refers to machines agreeing about token status and transactions.
Governance consensus refers to how the group governs a blockchain. This involves subjectivity and in the past has resulted in forks or splits within blockchain communities.
Market consensus refers to the equilibrium price of a token. The paper also notes that the three are not independent. For example, the price will be influenced by the machine and governance consensus. If security issues compromised Bitcoin’s machine consensus, it would have a devastating impact on Bitcoin’s price.
Unless a trade immediately transfers goods or services in exchange for money or tokens, there is always some counterparty risk. i.e., a risk that the person who has received payment does not deliver, or vice versa.
Hence the paper concludes that if you move away from a native token transaction, it creates a trust problem and needs a trusted central mechanism outside of the blockchain to assist.
The document outlines the functions of a smart contract in transferring ownership or running a process and other applications.
However, some drawbacks are highlighted. Particularly when a smart contract needs an external data source (e.g., a foreign exchange rate). One route is to rely on a feed, but that introduces centralization. Another is to use the wisdom of the crowd to agree on that data first and write it to the blockchain and then use it. However, sometimes the crowd could be biased.
Another problem is a future financial commitment such as a guaranteed debt performance. If a loan is made from one party to another with the expectation of repayment with interest at a future data, it’s not possible to guarantee the correct token amount will be available at a future date. A workaround is to set over-collateralization at the repayment address, but this creates idle resources. For derivatives, because risk exposure can change significantly, the amount of over-collateralization is hard to assess.
Additionally, there’s the problem of incomplete contracts. It’s impossible to foresee every scenario which is one of the reasons for judicial arbitration in ‘real’ contracts.
The first type of blockchain doesn’t have a token and is more like a distributed database. These tend to be permissioned networks and help to alleviate information asymmetry between participants. The weakness is to ensure the authenticity of the data being written to the blockchain. But because real identities are known in the permissioned network, writing false information carries a high reputational risk.
The second type of blockchain uses tokens to represent rights outside the blockchain. An example given is in supply chain finance. This involves a three-way triangle of the supplier, buyer, and financial institution. The token represents the debt, and the institution functions like a central counterparty responsible for exchanging the toke with fiat currency.
Another application is for using blockchain as a clearing and settlement system. So-called Delivery versus Payment, where a tokenized security is traded for tokenized cash or digital currency (as opposed to cryptocurrency).
The third type of blockchain uses a token as the unit of valuation but relies on a legal framework outside the blockchain and mainstream economic contracts. The problem here is volatility and hence the attempt at creating stable coins.
The fourth type of blockchain attempts to construct a distributed autonomous organisation or DAO. The paper points to the lack of evidence that this has worked, the problems of public blockchain scalability, the shortcomings of smart contracts already described, and the high volatility of token prices.
Dismantling public blockchains
Much of the rest of the paper analyzes the shortcomings of public blockchain applications, both the performance and economics. It states that Bitcoin is used for illicit purposes though claims that much of that has moved to other cryptocurrencies with greater anonymity. Hence there are problems with money laundering. Plus the bank notes that there are suspected price manipulations and prices are overly volatile.
The report moves on to tokens which are issued in an ICO. It points to the dual role of acting as a funding mechanism and also as a payment tool for economic activities.
The conclusion is that few blockchain projects produce social benefits. The bank does not believe that blockchain or cryptocurrencies will have a disruptive impact on the modern financial system. It does see potential advantages where the technology can offer efficiencies.
The paper states that decentralization may be an idealized purpose which is impractical or even impossible.
Finally, the paper states that the bubble in blockchain investment and financing is obvious, as are market manipulation and legal transgressions, especially with ICOs. Hence there’s a need to strengthen government supervision to prevent financial risks.