Virtual Currencies& Blockchain Technology

CyberTexas ConferenceAugust 15, 2018

The views expressed are those of the presenter only and do not necessarily represent the views

of the Federal Reserve Bank of Dallas or the Federal Reserve System

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What is a “Virtual Currency”?

“A type of stored-value product or digital money…issued and usually controlled by its developers, and used and accepted among the members of a virtual community.” (FRB Board)

a.k.a. digital currencies, alternative currencies, cryptocurrencies, altcoins; decentralized Internet protocols

Generally used in electronic, web-based transactions

1,600+ cryptocurrencies in marketplace

Not issued by federal government (“fiat currency”) or backed by a central bank

“Open source”: All rules, algorithms, security scheme, etc., openly available

Launched 2009 (“Satoshi Nakamoto”)

Permits transfer of currency online, directly, anonymously and outside government control

Origins: Fundamentally political; attracted followers among libertarian and anarchist groups

A means of removing the money supply from the hands of government

Subsequently attracted attention from computer developers, venture capitalists, and merchants (alternative to traditional payments)

Bitcoin

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Distributed Ledger Technology / Blockchain

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Underlying technology for Bitcoin and other virtual currency platforms

New approach to processing and settlement of transactions

Enables peer-to-peer payment networks without the need of a trusted intermediary

May involve legal, credit, liquidity, fraud, operational, information security, privacy, law enforcement, and other payment system risks

Shared ledger Shared, replicated ledger where transactions are

recorded on all network nodes‒ Nodes collaborate to reach mutual consensus on the

correct state of shared dataset‒ Blockchain database maintains a continuously-growing list

of data records that are immutable and irrevocable

Smart contracts Programs stored on blockchain along with data Allows for the automatic execution of business logic,

based on data events

Distributed Ledger Technology / Blockchain

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New cryptocurrencies are created through “mining”

The first to perform the complicated hash correctly earns new coins

The amount paid per hash goes down by half about every 4 years

When you request a cryptocurrency transaction, you can increase the incentive for a miner to process it quickly by adding a fee (a.k.a. “tip”)

The average person can’t really be a miner, because of the computing power now required

Cryptocurrency Mining

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Cryptojacking: Scammers use your device’s processing power to “mine” cryptocurrency, which is then converted to cash Malicious code embedded in a website or an ad Phishing emails

How will you know? Device slows down or crashes Battery power quickly drains

Cryptojacking

Transaction security

All transactions cryptographically encrypted Prevents tampering with data

Computers accept the longest block chain, which inhibits hacking Hackers would have to create a longer chain of fraudulent

information faster than the combined effort of all other computers

Public/private cryptography means individual coins are secured when not being transacted.

Bitcoin Ripple Ethereum Bitcoin Cash

Litecoin Dash

Total: 17,180,516 BTC

39,299,874,590 XRP

101, 155,651 ETH

17,264,916 BCH

57,734,221 LTC

8,244,967 DASH

Price: $6,994.11 $0.43 $408.01 $697.75 $74.16 $205.56

MarketCapitalization:

$120,162,383,447 $19,340,221,006 $41,272,195,669 $12,046,541,140 $4,281,844,630 $1,694,829,123

Average Transaction Value:

$44,109 $607.92 $4,6798,290 $6,970 $3,338

Block Time: 9m 40s 14.6s 10m 0s 2m 23s 2m 37s

Reward/Block: $88,135.19 $1,433.97 $8,726.68 $1,856.87 $688.75

Bitcoin and other platforms…A snapshot in time

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August 6, 2018 – 7:18 a.m. CT

Source: bitinfocharts.com

Owning Virtual Currencies

Users create accounts called wallets

Wallets are secured using passwords and contain the private keys used for transferring virtual currencies

Jan/Feb 2018: Several large banks announced they will no longer allow their cardholders to use credit cards to purchase virtual currencies Some issuers charging cash advance fees

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Double Spends

If the VC is just digital codes, why not copy and paste to make more money?

Timestamp Each transaction is packaged and publicly recorded in the

order it was carried out

Hash The time-stamped group of transactions are given a unique,

algorithmically-derived number

Blockchain Transactions are recorded in a community-built record of all

transactions that acts as a proof-of-work

Spending Bitcoins

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Spendbitcoins.com: 100,000+ merchants worldwide accept Bitcoin

Bitcoin does not allow chargebacks At least theoretically, less protection for consumers On the flip side, more protection for merchants

Volatility: +1,700% increase in Bitcoin price in 2017

Slow transactions: Increased blockchain traffic has slowed transaction times, leading to rising fees for users Bitcoin can process ~3 transactions/sec.; Visa: 24,000/sec.

High costs: Miners charge fees to give priority to payments

“If you’re sending a $10 transaction right now, you may see a miner fee of $3 or $4. It’s a big problem for people who want to move smaller payments.” —BitPay spokesperson

Result: low consumer adoption

Barriers to Virtual Currency Payments

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Is this the bottom? Feb 2018: “stunning collapse” Analysts: Too soon to tell – watching the 100-day average

Volatility: Up and Down We Go!

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Are we there yet? Jun 2018: “could post new 2018 lows”

Jun 28, 2018: BTC closed below $6k for the first time since Nov 12, 2017

BTC PriceDec 17, 2017 $19,205.11

Feb 5, 2018 $7,208.66 Jun 28, 2018

$5,904.67

Source: coinbase.com

New cryptocurrency payments start-up company backed by Goldman Sachs

Circle’s USD Coin is meant to solve the volatility problem associated with the digital currencies' use case

Circle customers will be required to hold $1 for every USD Coin to keep the price stable

USD Coin is run on the Ethereum blockchain Future possibility of using other platforms

"It unlocks an incredible amount of power for the dollar, it's basically a dollar that operates on blockchain.” – Jeremy Allaire, CEO of Circle

Circle

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Volatile Transaction Fees

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Other cryptocurrencies are also seeing volatility, just not as dramatic

Source: bitinfocharts.com

Recent message posted on Carder’s Paradise (Dark Web marketplace):

…“If the Bitcoin price continues increasing, this business is not going to be profitable for us anymore because all our revenue is going to be spent on the Bitcoin fees.”

“We urge you to start using Litecoin as much as possible. Litecoin is a very fast and cheap way of depositing funds into the store. We are not going to charge any additional fees if you deposit Litecoins.”

High costs are even squeezing criminals!

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Source: KrebsonSecurity.com

Allow startups to raise money by granting tokens to investors 2017: $3.67B+ raised selling custom-made VCs to investors

SEC attention: July 2017: SEC Bulletin published stating U.S. securities law could

apply to the market

“Any such activity that involves an offering of securities must be accompanied by the important disclosures, processes and other

investor protections that our securities laws require. Investors should understand that to date, no [ICO]s have been registered with the SEC.”

–Jay Clayton, Chairman, SEC

Initial Coin Offerings (ICOs)

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IRS: Bitcoin is property, not currency

Advantage for investors: Bitcoin is treated like stocks, a capital asset subject to a more favorable long-term capital gains rate

Disadvantage for consumers: ALL Bitcoin transactions are technically taxable events, whose gains or losses must be individually tabulated

Virtual Currencies & the IRS

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Are the rumors of the death of Bitcoin greatly exaggerated?

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Most new blockchain proposals are looking at: Limited participant nodes (“permissioned” ledger;

only permitted, known participants can validate transactions);

Centralizing all or part of the blockchain ledger;

Making blockchain sizes and their analysis more variable;

Incorporating data analytics and probabilities into the verification process

Blockchain/DLT Initiatives

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Created a “blockchain-inspired” distributed ledger called Corda

Active open source project that is free to use

Records, manages, executes financial agreements

200+ members and partners across multiple industries from both the private and public sectors

Blockchain Initiatives: R3

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Walmart: Using DLT to manage supply-chain data for mangoes, berries, other products

System built with IBM

Goal: Help trace source of bad food during product recalls

Farmers, packing-house workers and others along the supply chain use a mobile app from Walmart to send details to Walmart’s blockchain e.g. harvest dates, locations and images of their fruit

Result: Simulated recall using blockchain allowed Walmart to trace the origin of a bag of sliced mangoes in 2.2 seconds. Using previous methods, same exercise took 6d, 18h, 26 min

Blockchain Initiatives: Walmart

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2017: British Airways at London Heathrow, Geneva Intl. Airport and Miami Intl. Airport uploaded their flight operations nearly continuously to their blockchain, giving all parties a view of the same information at the same time

Goal: Stop conflicting flight information from appearing at gates, on airport monitors, at airline websites and in customer apps

Result: “one pure, true instance of data”

Blockchain Initiatives: British Airways

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IDEA: The Fed could peg its own digital currency at a rate of 1:1 with the US dollar Would be legal tender

Would be introduced into the economy by swapping them for banknotes—one dollar for one Fedcoin

As demand for Fedcoin fluctuated, the Fed could redeem the public’s banknotes for VC, and vice versa, with the Fedcoin protocolallowing the Fed to dispose of superfluous coins (much as it destroys old paper notes)

“A digital currency issued by a central bank would be a global target for cyber attacks, cyber counterfeiting, and cyber theft.”

— [then] Gov. Powell, in prepared remarks at a 2017 Yale Law School payment technology conference

“FedCoin”

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Remarks by Lael Brainard at Decoding Digital Currencies Conference, May 2018 “…the still relatively small scale of cryptocurrencies in

relation to our broader financial system and relatively limited connections to our banking sector suggest that they do not currently pose a threat to financial stability.”

“Ultimately, a more holistic approach to the security of the broader cryptocurrency ecosystem, along with added layers of security on top of cryptography, are likely to be necessary for cryptocurrencies to be widely adopted.”

https://www.federalreserve.gov/newsevents/speech/files/brainard20180515a.pdf

The Fed & Digital Currencies

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Technical and operational challenges “…unless there is the technological capability for effective

identity authentication, a central bank digital currency would provide no improvement over physical notes and could be worse than current noncash funds transfer systems”

“…putting a central bank currency in digital form could make it a very attractive target for cyberattacks by giving threat actors a prominent platform on which to focus their efforts.”

Challenges for a Fed-issued Digital Currency

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Implications for retail banking “…the parallel coexistence of central bank digital currency

with retail banking deposits could raise the risk of runs on the banking system in times of stress and so have adverse implications for financial stability.”

No compelling need “…a multiplicity of mechanisms are likely to be available for

American consumers to make payments electronically in real time. As such, it is not obvious what additional value a Fed-issued digital currency would provide over and above these options.”

Challenges for a Fed-issued Digital Currency

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Something to keep an eye on “Even if cryptocurrencies prove to have a very limited role in

the future, the technology behind them is likely to live on and offer improvements in the way we transfer and record more traditional financial assets.”

“…perhaps the biggest potential benefit for payments, clearing, and settlement of distributed ledger technology may be resiliency.”

“I remain optimistic that the financial sector will find valuable ways to employ distributed ledger technology in the area of payments, clearing, and settlement in coming years.”

Distributed Ledger Technology

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Questions?

Pam Cerny, AAP, CTPPayments Outreach Analyst II

Federal Reserve Bank of DallasE-mail: pam.cerny@dal.frb.org