Crypto-currencies and the network effect

By Darragh O’Grady and JWG.

It is very easy to get confused and overwhelmed by all the crypto-currencies (or math-based currencies) out there. It started out relatively simple with just bitcoin a few years ago. Now other currencies have joined the fray, including but not limited to, Litecoin, Dogecoin, Peercoin, Ethereum, Mastercoin, Counterparty, Ripple, NXT, BitSares and Namecoin. What is one to make of all this innovation? How could it impact the regulatory agenda, and how will the regulatory agenda impact how these technologies evolve?

To make sense of it all, there are a few basic concepts to be clear on. In this article, we will cover the difference between protocols and networks, and why these are key to understanding which crypto-currency technology to focus on from a regulatory perspective.

Bitcoin versus bitcoin

First, Bitcoin (with a capital B) is a protocol: i.e., rules of behaviour encapsulated in software. bitcoin (with a lower-case B) is the unit of value (or crypto-currency) which arises from a set of machines implementing the same Bitcoin protocol collaborating as part of a single network.

Because of the rules encapsulated in the Bitcoin protocol, the more machines there are in a given network, the harder it is to fake transactions that occur on the network.

The bitcoin currency arises from the first implementation of the Bitcoin protocol; since 2009, more and more machines have been added to the original network, increasing the value of bitcoins created through this network.

But why does this increase the value of bitcoins created? Because Bitcoin (the protocol) relies on ‘proof of work’ to validate transactions, and proof of work essentially involves computing power which, in turn, requires electricity, hardware, storage, networks, etc.  There is implicit value in demonstrating proof of work – this is why so-called miners (machines on the network that implement the protocol) get ‘rewarded’ in bitcoins.

Due to the way the protocol works, over time ever more resources are needed to demonstrate proof of work. And the more participants there are on the network, the more resources are required to ‘fake’ transactions. In essence, the cost of being a ‘dishonest’ miner is greatly exceeded by the economic benefits of being an ‘honest’ miner.

So this is why ‘bitcoin’, the currency, is the most important crypto-currency out there.  Its robustness and trust-worthiness exceed that of any other ledger system (physical or digital) by a wide margin.

Altcoins

Technically, so-called ‘altcoins’ are other instances of the Bitcoin protocol. Some of them use the same version of the Bitcoin protocol as bitcoin (i.e., the same software), but others use modified variants of the Bitcoin software.

All Bitcoin-based altcoins, therefore, require their own network of machines to validate transactions, separate from the bitcoin network.  As with bitcoin, the larger the number of machines in the altcoin’s network, the more robust and trustworthy the network and the more valuable the altcoin ‘currency’.

However, most altcoins have a relatively small number of machines on their network (compared to bitcoin), making them much less valuable than bitcoins.

So why create altcoins? Altcoins allow new types of currencies to be experimented on – for example, to implement ‘coloured coins’ (linked to specific assets) or ‘smart contracts’, etc. While the basic Bitcoin protocol allows for changes and improvements to the protocol, changes are expensive to deploy, so only mature, proven enhancements will make their way into the core protocol.

Sidechains

Some crypto-currencies rely on the basic robustness of the bitcoin network to govern value, but are otherwise able to perform some transactions that are not recorded on the primary ‘blockchain’ or ledger. Standards around this are just emerging (called ‘sidechains’), but technologies like Mastercoin and Colored Coins are examples of early implementations. A key feature of sidechains is that they cannot ‘mint’ new coins.

Other crypto-currencies

Other technologies, such as Ripple, Ethereum, NXT, etc., use different protocols to ensure the trustworthiness of the network, and have other features that make them more suitable for use cases that Bitcoin would not be appropriate for.

For wholly decentralised protocols (i.e., where no assumption is made about the trustworthiness of the members of the network), the size of the network is key.

For partially decentralised networks (i.e., where some trusted members are required), the network can be smaller and more efficient. But how decisions are made over which members are ‘trusted’ becomes key.

For regulated environments, it is likely that partially decentralised protocols will be the most appropriate, as trusted participants can be established through rule of law and regulatory oversight. This would work within national or economic boundaries, but any transactions crossing legal jurisdictions would almost certainly need to rely exclusively on trustless networks.

Conclusion

In the short term, there are many routes for banks, governments and market participants to experiment with efficient crypto-currency based solutions to support regulated economic activity (whether existing activity or new activity enabled through these technologies). Which networks and protocols will be used in the end  is impossible to predict right now, but all stakeholders should be experimenting with these initial technologies and their findings will certainly influence the direction to go in.

 

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