400 Billion Dollars Down the Drain?

May 15, 2018         By: Brendan Taylor and Patrick Manasse

The hype around Bitcoin, cryptocurrencies, and ICOs remains at a fever pitch and investors are all in. As of April 30, 2018, the total marketcap of all cryptocurrencies was well above 400 billion dollars. While this phenomenon has been a euphoric playground for speculators, there remain significant issues underlying cryptocurrency and tokens that ultimately could sink the market.
 
There are five categories of concerning issues when looking at cryptocurrencies or tokens, and the resulting ICO phenomenon: 1) tokens as bearer instruments, 2) pricing, 3) settlement risks, 4) data leakage, and 5) regulatory issues.
 

Tokens as Bearer Instruments

Tokens represent bearer instruments using Public Key Infrastructure (PKI). Ownership of a secret key is the same as ownership of the asset. Bearer instruments are something that the financial industry has spent decades getting away from. There used to be bearer stocks and bonds with actual certificates that represented ownership of these assets. That means they could easily be stolen. The exact same thing is true with tokens. Because tokens are bearer instruments, if the secret key is compromised, they can be stolen. That is a fundamental flaw of using a tokenized system for transferring value.
 

Pricing

A lot of ICOs that are supposedly falling within the law are classified as utility tokens meaning they grant the right to use the future service of that network. The problem is when it comes to pricing.
 
Let’s take an example of a distributed network that allows the user to store data on it - and this distributed network is doing an ICO to raise funds for the development. Each of the tokens will ultimately allow users to store a certain amount of data on that network. Since the tokens are freely tradeable, they have a fluctuating price. As a result, there is limited certainty regarding price to store data, be it tomorrow or a year from now.
 
Most people would prefer to use a service with a known and stable price so they can make a decision on the cost rather than rely on the open market. ICOs attract speculators. The price of the service is then driven by speculation instead of the fundamental value of the underlying service itself. That is a critical disconnect between what the ICO is intended to achieve and what every single ICO actually achieves.
 
MonetaGo never thought it appropriate to use the token model. When MonetaGo launched the first production fraud mitigation blockchain platform in India, there was no requirement for a token to be used. The distributed ledger architecture itself added value by providing a secure and immutable service, not controlled by any single entity, where data is being stored and shared while guaranteed to maintain its integrity. Additionally, the client cost does not fluctuate due to market forces.
 
Make no mistake, there may be legitimate uses for tokens. The use cases that MonetaGo is approaching with financial institutions just do not have a need for them.
 

Settlement Risk

When MonetaGo was researching arbitrage opportunities for cross-border transactions, it became apparent that the volatility of the cryptocurrencies as well as lag times on the network made the final settlement uncertain, leading to settlement risk for each transaction.
 
When considering deals and transactions, there’s normally an exchange of money in return for something else. That means, if changing Bitcoins into dollars, the settlement risk cannot be guaranteed by the single blockchain currency. While it can be guaranteed that Bitcoin will be delivered, the blockchain cannot guarantee that US dollars will be delivered in return. Unless the dollars were on a blockchain, risk can only be eliminated from one side. Attempts to address that risk without including the central bank is a mistake.
 
For example, the Ripple network does not actually eliminate settlement risk. The digitized fiat currency is just an IOU made by whoever is supposedly providing that currency in the transaction. The credit risk behind that IOU makes it non-fungible. At some point in the system, there has to be a real world settlement. While Ripple perhaps makes the exchange process more efficient, it does not eliminate settlement risk.
 
Despite the desire to innovate their own financial systems, central banks around the world are not ready to shift their entire infrastructures. That kind of change takes time. Getting the Fed to start issuing crypto US dollars is not something to expect in the near future. That being said, banks and other financial institutions are not going to wait to take advantage of distributed ledger networks. They want the utility and functionality these networks are able to provide - and they don’t want to have to wait around for a decade for the central banks to change.
 

Data Leakages

A critical element that makes cryptocurrencies or tokens hard to use is the data leakages that can come from having an open network. Since financial institutions can’t make transactions public, they are not going to use an open network in order to make payments. Pseudonymity and mixing networks can only hide so much. It is an absolute necessity to be able to provide closed permissioned private networks for financial institutions because they will not broadcast information for the whole world to see.
 
Any tokenized blockchain relies on distributed trust to verify that the transactions are valid. That means that the network as a whole, or potentially a subset of the network, needs to see the details of that transaction. That is a breach of privacy. There are a few solutions that have been floated such as zero knowledge proofs and other proxies for homomorphic encryption, but the problem is that these mechanisms are built on unstable mathematical principles, and have a considerable cost in terms of computing power and latency. There is a reasonable probability that attacks will be found on these types of encryption. As a result, storing private data on an adversary’s computer who is not privy to the information is fundamentally the wrong design choice.
 
Relying on encryption on a public network is generally a bad idea. Most tokenized systems that require the validation of accounting principles and arithmetic are done in a public setting. Financial institutions will always have issues using these types of networks. In MonetaGo’s Fraud Mitigation Network, the issue of data leakage is addressed by completely obscuring information through hashing, which is the transformation of a string of characters into a usually shorter fixed-length value or key that represents the original string. Hashing is different to encryption, being a one-way function that destroys the information it was created from.
 

Regulatory

The one problem area that people are most familiar with these days are the regulatory issues. A lot of capital has been raised by ICOs and almost from the beginning, the SEC qualified many of these as securities. In fact, the SEC chairman Jay Clayton and SEC commissioner Robert Jackson have both recently said they have not yet seen an ICO token which does not look like a security.
 
There are other regulatory issues as well. FinCEN is vocal in the space, and in NY you still have the BitLicense. In Europe, General Data Protection Regulation (GDPR) may have an impact as well. The concept of innovation is used to fight back against regulators but unfortunately, there has already been a huge amount of fraud so having regulators at the table makes sense. In fact, down the road direct engagement with the regulators will likely be an important first step.
It was only  after working with a few different financial institutions and regulators in India that MonetaGo moved forward with developing the Fraud Mitigation Network. While at the time India’s central bank had yet to ban institutions from working with cryptocurrencies, it was clear we should stay away from those kinds of architectures.
 
For the reasons stated above, trying to use cryptocurrencies or tokens and fundraising through ICOs may not be the best path to achieve an enterprise grade system because you will probably run into more hurdles than are required to solve the actual problem. While there are a number of issues surrounding cryptocurrencies, tokens, and ICOs, there are certainly benefits to distributed ledgers which will change the systems that support various transactions.
 

About Patrick Manasse:
Patrick Manasse is MonetaGo's Chief Compliance Officer. His role is to ensure compliance with regulations in various jurisdiction where systems are being taken to production. As an attorney and member of the New York Bar, Patrick has focused much of his career on commercial and cross-border transactions. Patrick holds a Bachelor of Arts in Economics from McGill University as well as an MBA and Juris Doctor.

About Brendan Taylor:
Brendan Taylor is MonetaGo's Chief Technology Officer. He is the principal architect who engineers MonetaGo’s solutions. Brendan started his career at one of Europe’s largest hedge funds, managing the execution of a quant fund with over a billion USD AUM. He later focused on developing automated trading systems from the ground up. Brendan holds a Bachelor of Science in Physics from University College London.