Settlement Risks Involving Public Blockchains

[Note: this article first appeared on Tabb Forum]

Over the past several months there has been a crescendo of pronouncements by several cryptocurrency enthusiasts, entrepreneurs and investors claiming that public blockchains, such as Bitcoin and Ethereum, are an acceptable settlement mechanism and layer for financial instruments. Their vision is often coupled with some type of sidechain or watermarked token such as a colored coin.

The problem with these claims and purported technical wizardry is that they ignore the commercial, legal and regulatory requirements and laws surrounding the need for definitive settlement finality.

For instance, the motivation behind the European Commission’s Directive 98/26/EC was:

“[T]o minimize systemic risk by ensuring that any payment deemed final according to the system rules is indeed final and irreversible, even in the event of insolvency proceedings.

“Without definitive finality, the insolvency of one participant could undo transactions deemed settled and open up a host of credit and liquidity issues for the other participants in the payment system. This results in systemic risk and undermines confidence in all the payments processed by the system.

“Thus, by ensuring definitive settlement, the concept of finality fosters trust in the system and reduces systemic risk. This makes it one of the most important concepts in payments and one that is applied to all clearing and settlement systems, including settlement and high-value payment system Target2 and bulk SEPA clearing system STEP2.”

While many cryptocurrency proponents like to pat themselves on the back for thinking that “immutability” is a characteristic unique to public blockchains, this is untrue. Strong one-way cryptographic hashing (usually via SHA 256) provides immutability to any data that is hashed by it: If Bob changes even one bit of a transaction, its hash changes and Alice knows it has been changed.

What about proof-of-work?

Proof-of-work, utilized by many public blockchains, provides a way to vote on the ordering and inclusion of transactions in a block, in a world where you do not know who is doing the voting. If you know who is doing the voting, then you do not need proof-of-work.

Consequently, with proof-of-work-based chains such as Bitcoin, there is no way to model and predict the future level of their security, or “settlement,” as it is directly proportional to the future value of the token, which is unknowable.

Thus, if the market value of a native token (such as a bitcoin or ether) increases or decreases, so too does the amount of work generated by miners who compete to receive the networks seigniorage and expend or contract capital outlays in proportion to the tokens marginal value. This then leaves open the distinct possibility that, under certain economic conditions, Byzantine actors can and will successfully create block reorgs without legal recourse.

In particular, this means miners can remove a transaction from the history such that a payment you thought had been made is suddenly unmade.

In addition, with public blockchains, miners (or rather mining pools) have full discretion on the ordering and reordering of transactions. While mining pools cannot reverse one-way hashes such as a public key (immutable on any blockchain), they can make it so that any transaction, irrespective of its value, can be censored, blocked or reordered.

To be clear, by reordered, we mean that in the event two conflicting transactions are eligible for block inclusion (e.g., a payment to Bob and a double-spend of the same coins to Alice), the payment to Bob could be mined and then, at any point in the future, replaced by the payment to Alice instead.

In Bitcoin and Ethereum (as well as many others), mining pools have full discretion of organizing and reorganizing blocks, including previous blocks. While there is an economic cost to this type of rewriting of history, there are also tradeoffs in creating censorship-resistant systems such as Bitcoin.

One of the tradeoffs is that entire epochs of value can be removed or reorganized without recourse, as public blockchains were purposefully designed around the notion of securing pseudonymous consensus.

Pseudonymous consensus is a key characteristic that cannot be removed without destroying the core utility of a public blockchain: censorship-resistance. So, as long as Bitcoin miners have full discretion over the transaction validation process, there is always a risk of a reorg.

What if you remove censorship-resistance by vetting the miners and creating “trusted mining”?

If you remove censorship-resistance (pseudonymous consensus) but still utilize proof-of-work, you no longer have a public blockchain, but rather a very expensive hash-generating gossip network.

While this type of quasi-anarchic system may be useful to the original cypherpunk userbase, it is not a desirable attribute for regulated financial institutions that have spent decades removing risks from the settlement process.

Ignoring for the moment the legal and regulatory structures surrounding the clearing and settlement of financial instruments, in our modern world all participants recognize that, from a commercial perspective alone, it makes sense to have definitive – not probabilistic – settlement finality. Because of how the mining process works – miners can reorganize history (and have) – a public blockchain by design cannot definitively guarantee settlement finality.

Markets do not like uncertainty, and consequently mitigating and removing systemic risks has been a key driver by all global settlement platforms for very good apolitical reasons.

Public blockchains may be alluring because of how they are often marketed – as a solution to every problem – but they are not a viable solution for organizations seeking to provide certainty in an uncertain world, and they are currently not a reliable option for the clearing and settling of financial instruments.

There are solutions being built to solve this problem that do not rely on public blockchains for settlement. For example, private and consortium blockchains are specifically being designed to provide users definitive legal settlement finality, among other requirements, because this certainty is necessary for adoption by regulators and regulated financial institutions.

For context, over the past 18 months banks have looked at more than 150 proof-of-concepts and pilots and rejected nearly all of them. Not because they are anti-cryptocurrency, but because public blockchains were not purposefully built around the requirements of financial institutions. So why would they integrate a system that does not provide them utility?

Yet if researchers empirically observe that the failure risks associated with various public blockchains is within an accepted risk profile – in certain niche use-cases – it may be the case that some institutions will consider conducting additional proof-of-concepts on them.

The tradeoffs in designing public blockchains and permissioned ledgers are real. For instance, it is self-defeating to build a network that is both censorship-resistant from traditional legal infrastructure and simultaneously compliant with legal settlement requirements. Yet both types of networks will continue to coexist, and the vibrant communities surrounding the two respective spaces will learn from one another.

And if the goal for fintech startups is to create a new commercial rail for securing many different types of financial instruments, then shipping products that actually satiate the needs of market participants is arguably more important than trying to tie everything back into a pseudonymous network that intentionally lacks the characteristics that institutional customers currently need.

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