In its recent report on digital currencies and payment technologies, the Bank of England referred to the blockchain technology as a “genuine technological innovation” that could have profound implications for the financial sector. What is the block chain, and why are you all so excited about it? The block chain is an online public decentralised ledger that records all digital transactions. It records transactions between two parties and is digital currency’s equivalent to a high-street bank’s ledger. The ability to accurately record digital currency exchanges between parties is crucial to the functioning of a digital network. It is similar to how modern banking systems can’t function without recording fiat currency exchanges between individuals.
It is decentralised because, unlike traditional banks that hold the electronic master ledger of account holders’ savings, the block chain ledger can be shared by all members of the network. This is in contrast to a bank that is the sole holder. What is the point? This is why it is better than our current banking system. Decentralised monetary networks allow one to avoid being part of the ever-connected financial infrastructure and reduce the risk of being affected by it. Credit, liquidity, and operational failure are the three main risks associated with a centralised monetary network that were highlighted by 2008’s financial crisis.
Since 2008, 504 bank collapses in the USA have occurred due to insolvency. In 2010, there were 157. Although such a collapse is unlikely to affect account holders’ savings, due to federal/national backing as well as insurance for the first few hundred thousands dollars/pounds, assets of banks are usually being absorbed into another financial institution. However, the impact of the collapse may cause uncertainty and problems with accessing funds in the short-term.
A decentralised system such as the Bitcoin network does not depend on banks to facilitate funds transfers between two parties. Instead, it relies on its tens or thousands of users to authorise transactions. This makes it more resilient to such failures. It also has as many backups to ensure that transactions are authorized in the event of a member of the network ‘collapsing. However, a bank’s failure to make savings and operational I.T. a priority does not mean that it cannot fail to have an impact on them.
RBS and Lloyds customers can access their accounts for up to a week. This is due to legacy I.T. that dates back 30-40 years. This infrastructure is not necessary for a decentralised system. Instead, it is based on the combined processing power and thousands of users. This allows the system to scale up as needed. Liquidity is a last real risk in centralised systems. In 2001, Argentine banks froze their accounts and introduced capital controls to deal with their debt crisis. Spanish banks changed their small print in 2012 to allow them to block withdrawals above a certain amount. Cypriot banks temporarily froze customers’ accounts and used up 10% of individual savings to pay off the National Debt. Jacob Kirkegaard, an economist from the Peterson Institute for International Economics, stated that the Cyrpiot deal shows that being an unsecured, or even secured, depositor in euro-area banks is no longer as secure as it used to.
A decentralised system allows payments to be made without the involvement of a bank. Payments are only validated by the network if there is sufficient funds. There is no third party that can stop a transaction, take it, or devalue the amount. Okay. You get the point. How does the block chain work? A digital transaction is when an individual pays another user 1 bitcoin. This message consists of three components. It refers to information that the buyer has previously stored. It also contains the address of the digital wallet where the payment will be made.
The buyer can add any conditions to the transaction and the message is’stamped with the buyer’s signature. The digital signature consists of a public and private ‘key or code. The message is encrypted automatically using the private key and sent to the network to verify. Only the buyer’s public keys can decrypt it. This verification process is intended to prevent the destabilizing effect of double spending, which is a risk in digital currencies networks. Double spending is when John gives George PS1 but then gives Ringo the same PS1 (Paul hasn’t had to borrow PS1 for several years). This may seem odd given our current banking system. Although John cannot give away the same PS1 twice by exchanging fiat currency, the physical act of exchanging currency prevents John from doing so.
However, digital currencies are data and can be copied or edited easily. There is a real risk that 1 unit of digital currency could be cloned and used for multiple 1 Bitcoin payments. This would result in the loss of trust in the network and render it useless. To ensure that the system isn’t misused, the network takes every message automatically created by a buyer, and then combines several of them into a block and presents them to network volunteers or “miners” to verify. Competitors are made up of miners who can verify a block’s authenticity.
Specialist software installed on personal computers automatically verifies digital signatures and ensures that transaction messages flow from the block that was used to create them. If the sum of the previous components of a block does not equal the total, it is possible that an unintended modification was made to the block. It can be stopped from being authorized. It takes about 10 minutes to validate a block. To speed up the process of a transaction, the buyer can add a small tip’ to encourage miners faster.