Written evidence submitted by Dr Andrea Bracciali (IEF0028)

DISTRIBUTED LEDGER TECHNOLOGIES AND DIGITAL CURRENCIES:

A SUMMARY OF RISKS AND OPPORTUNITIES

Brief for the Foreign Affairs Committee inquiry on responding to illicit and emerging finance.

Summary

• Distributed Ledger Technologies, digital and cryptocurrencies represent a strong innovation opportunity, key for the UK
• There are risks associated to the novel models they enable
• Research and supportive regulation may mitigate risks and foster innovation in a key industrial and socio-economic sector for the UK

Bio

Andrea Bracciali is a Lecturer in Computer Science at the University of Stirling. He is interested in problems and applications of blockchain technologies and has been working on such themes since 2014. The following summary is based on his personal opinions.

DLTs and blockchain technology

1. Distributed ledger technologies (DLTs) enable digital trust and the recording of validated and immutable information. Such information can be publicly available and publicly updated. Forms of access control for reading, updating and validating the information can be adopted, although general settings may cater for free and pseudo-anonymous access.

2. Such system of digital trust is protected by cryptography and organised in a chain of blocks of digital information, called blockchain. The blockchain is maintained by a network of computational nodes over the internet, each one maintaining an identical copy of the blockchain and the information therein contained. Open and (pseudo-)anonymous participation to the network is possible, in which case the framework must be robust against the presence of Byzantine nodes, which try to exploit the system to their own advantage.

3. Consistency of the information across copies of the blockchain held by nodes is guaranteed by a distributed consensus algorithm run by all nodes. Such consensus algorithm caters for decentralisation, i.e. the system is not controlled by a central authority and no node can exploit a dominant position.

4. Currently mainstream consensus algorithms include Proof of Work (PoW) and Proof of Stake (PoS). The former is based on a computationally intensive procedure that selects one node at the time in charge of the next update of the blockchain. The probability of being selected is proportional to the owned computational power. PoW tolerates a high percentage of Byzantine nodes, and has demonstrated to be secure under certain assumptions, both theoretically and practically. It may be slow in terms of processed information and energy demanding. PoS is capable of selecting the node(s) in charge proportionally to the (economic) value that they represent in the network. PoS generally tolerates smaller percentages of Byzantine nodes than PoW, but is faster and energy consumption less problematic.

5. In the case of Bitcoin, which introduced and popularised the idea of blockchain, the information stored is a record of validated payments in Bitcoin (BTC), the cryptocurrency associated to the network. Validation here prevents, among other things, the double spending of virtual coins and guarantees their ownership, making the currency extremely reliable. Noticeably, by means of the associated cryptocurrencies blockchains enable an incentive framework that makes participation as a node of the network attractive, and the blockchain more secure, since its resilience is proportional to the presence of many honest nodes, outnumbering Byzantine nodes.

Evolution, opportunities and risks

6. Within the scope of this inquiry it is important to remark decentralisation as a key innovation introduced by Bitcoin: the network is not centrally controlled. Similar to other earlier attempts, e.g. in the field of file sharing, decentralised peer2peer networks like Bitcoin are not centrally controlled and it may not be straightforward to censor them or shut them down. There have been several earlier attempts towards (independent) digital money in the 80s and 90s, but most of them were controlled or shut down by targeting their centralised servers. Decentralised Bitcoin may also have been particularly timely in embodying aspirations of the many distrusting the centralised financial system in the wake of the 2008-9 crisis.

7. Following Bitcoins, further generations of blockchains have been proposed, with extended functionalities and properties and financial and non-financial applications, including smart contracts and digital agreements, digital identity, decentralised finance, provenance and notarisation, asset tokenisation, and non-fungible tokens.

8. Blockchains have initially developed as a niche technology (when a pizza was paid 10,000 BTC), then associated to dark market (e.g. Silk Road, shut down in 2013) with issues such as money loundering and illegal trafficking, and then become mainstream, attracting commercial and academic interest. A hype phase with substantial, often highly speculative, investment followed, around 2014-18 say. Initial Coin Offers, i.e. the promise of future coins against funds, have supported the development of novel ideas, and the technology matured. Along the hype, a number of scams happened in a rather unregulated context with big risks for consumers and investors. Recent years are witnessing a strong interest of more structured investors and institutions, and the evolution of regulations that have started to be interested in, understand and norm the sector.

9. The last 10+ years, have seen an evolution form an innovative, but risky early-stage anarchy, to a more regulated context of opportunities. It is extremely important to remark how blockchains may bring innovation and efficiency in markets and socio-economic contexts and support novel business models. The development of mature technology and ecosystem, its connection to mainstream financial and industrial systems, and supportive regulations are key to both nurture innovation and reduce risks. In this respect the UK is in a privileged position, with one of the most relevant fintech sector world-wide, a rigorous and supportive regulatory framework (consider for instance the Sandbox programme by FCA, and the study on CBDCs by Bank of England), and its research and academic ecosystem, active in the technical and financial investigation of blockchains (e.g. UCL, Imperial, Edinburgh, Oxbridge, …).

10. Money loundering through cryptocurrencies is a risk, but it does not appear as appealing as it may have been at the time of Silk Road and niche dark markets. Considering for instance Bitcoin, several studies have shown limitations in the possibility of anonymous, un-trackable transactions – it is worth reminding that most of the mainstream DLTs are public and data analytics on the whole set of transactions can be rather informative. Furthermore, exchanges, i.e. the contact points between virtual and fiat currencies, if regulated, represent a precious source of intelligence. The news has recently reported the failure of scams and ransomware requiring payments in crypto. The comparison with cash is also informative: it is cash from illicit activities that the crime is very able to quickly and anonymously transfer in large amounts, more than crypto. Along these lines, a discrepancy between the amount of minted and circulating cash has been recently noted, and a possible contributing factor is the offshore loundering of large cash sums profit of illegal activities. On the other hand, the cross-jurisdiction nature of cryptocurrencies, in the lack of proper transnational regulation, is also a risk: on the internet, cryptocurrencies can for instance cross borders straightforwardly, potentially making the control of a fiat currency difficult.

11. Novel business models enabled by cryptocurrencies, often based on automated instruments, and still to be fully understood and regulated, also represent a risk, both in terms of money loundering and customer protection (several regulators have warned citizens about the risks associated to investments in crypto, including FCA, Consob and SEC). Similar considerations hold for the emerging NFT market. These can be seen as blockchain-based certifications of (digital) ownership. Recently a digital artwork has been auctioned by Christie’s for about 70USD million, paid in crypto. Clearly the implications of such a(n easy and unregulated) creation of digital, but fiat convertible, value need further considerations.

12. Stable coins are cryptocurrencies whose value is stabilised, for instance by means of algorithmic control of the supply or by pegging to a stable value, e.g. USD. These are extremely functional to the cryptocurrency ecosystem in the current phase, facilitating exchanges and payments at predictable rates. Stable coins are generally emitted by private companies, possibly according to undisclosed policies. Such a creation of digital value and associated risks might also be worth of further considerations.

13. An interesting case is represented by the Lybra proposal by Meta (still Facebook at the time): a digital currency issued by a private company with a potential cross-border, cross-jurisdiction market of a couple of billion of accounts. What would be the risks and implications on state economies? The project did not go in production.

14. A large number of Central Banks are studying Central Bank Digital Currencies (CBDCs), an electronic version of the fiat currency that they issue, possibly enabled by DLTs. This is typically a retail currency, with a strong transformational potential, such as redefining the role of banks and relations with customers/citizen. The design of such a currency framework poses several problems, noticeably citizen’s privacy and data protection, and, possibly, international equilibria when national currencies might be easily available on an international digital market – what for instance if payments for oil would be accepted in a CBDC rather than in USD? Several of these problems require a careful design of the supporting technology. Other problems require a clear understanding of the correct functioning of such currencies. Some Central Banks foresee a period of study and validation, others have already run pilots with a substantial number of transactions. This is the case of the digital Yuan from China, which has meanwhile declared illegal Bitcoin transactions. A race for a dominant position in the market of CBDCs may have started, with risks, implications and opportunities for all countries.

15. Finally, the development of a digital world where several human activities may be transferred to, referred by someone as the Metaverse, has to be mentioned as a key potential breakthrough, where digital currencies will definitely play a key role, even if it is currently an idea still under development. What opportunities? What risks?

Final considerations

16. DLTs, blockchains and supported cryptocurrencies have evolved since their inception in 2009. With them, the ecosystem and regulations have also evolved. Cryptocurrencies present a series of risks, from the consumer level to international equilibria. However, appropriate regulation, international agreements and clear understanding of the technological and financial aspects may foster development opportunities of a sector that is key and promising in the UK, thanks to its industrial, research and regulatory ecosystem.

March 2022