Virtual currencies such as bitcoins are increasingly becoming the focus of public interest. They work on the basis of blockchain or distributed ledger technology. Volker Brühl explains how they work and shows that these technologies can not only revolutionize the financial sector.

Bitcoins and other so-called virtual currencies or cryptocurrencies are increasingly being targeted by supervisory authorities, as they can be kept anonymously, transferred or exchanged for classic currencies and are therefore suspected of facilitating money laundering as a result of illegal transactions. The European Banking Authority (EBA) has repeatedly pointed out the risks of cryptocurrencies. On May 20, 2015, the fourth European Money Laundering Directive (EU 2015/849) was passed, which initially did not cover virtual currencies. However, on July 5, 2016, the EU Commission proposed including operators of exchange platforms and providers of electronic wallets for virtual currencies in the provisions of the 4th Money Laundering Directive. This would largely eliminate the previous anonymity of users of virtual means of payment. The short-term extension of the 4th Money Laundering Directive makes it clear on the one hand how high the need for action is estimated on the political side. On the other hand, critics fear that stricter regulation of cryptocurrencies will jeopardize the development of an innovative market segment in Europe.

The blockchain technology underlying bitcoins and most other cryptocurrencies, which is based on the principle of a distributed ledger with transaction accounts (distributed ledger), is credited with the potential to not only revolutionize the financial sector, but also to trigger disruptive changes in other industries too be able. In the public discussion, bitcoins, blockchains and distributed ledgers are often not sufficiently differentiated. Therefore, in the following, the functionality, market developments and the ecosystem of virtual currencies will be explained using the example of bitcoins. The potential fields of application for distributed ledger technology are then outlined.

Bitcoins and blockchain at a glance

Blockchain technology was originally developed as a platform for launching so-called “virtual currencies”. Bitcoins or other cryptocurrencies are not money, but accounting units that can be used as a means of payment in multilateral clearing circles on the basis of private-law agreements without requiring approval from the supervisory authorities. However, extended services such as the brokerage of purchases and sales or the operation of trading platforms may be subject to approval.

With cryptocurrencies, electronic payments are processed directly between senders and recipients without the need for a financial intermediary (e.g. a bank). These web-based payment transaction systems use methods of cryptography (encryption technology) in order to be able to process transactions securely and inexpensively with the help of a distributed computer network (so-called peer-to-peer networks). Although the algorithms of the respective cryptocurrencies differ in many details, the transaction processes are largely based on similar basic principles, which are explained below using Bitcoin as an example.

Bitcoin is the first and so far the most widely used cryptocurrency. The associated reference software was published in 2009. All transactions with bitcoins are mapped in a distributed database and combined into blocks and linked together in such a way that a complete and forgery-proof sequence of transaction blocks (the so-called blockchain) is created. All transactions of the blockchain can be viewed by every participant in the network. However, outsiders cannot see who actually owns the virtual monetary units. Transactions, once made, are irreversible. Bitcoins are not created in a classic money creation process through the interaction of monetary policy instruments of central banks, commercial banks and bank customers, but with the help of a defined incentive system that rewards those participants in the payment network with new monetary units who check the authenticity of encrypted transactions particularly quickly with the help of mathematical algorithms. This process of validation and the associated generation of new units of cryptocurrencies is called mining. Bitcoins and other cryptocurrencies are therefore based on the trust of the participants in the integrity and security of a decentralized computer network and not on the credibility of a central bank. While neither the central bank money nor the creation of book money are subject to quantitative limits in traditional monetary systems, the maximum number of units of artificial currencies that can be generated is usually limited by the system. which rewards those participants in the payment network with new monetary units who check the authenticity of encrypted transactions particularly quickly using mathematical algorithms. This process of validation and the associated generation of new units of cryptocurrencies is called mining. Bitcoins and other cryptocurrencies are therefore based on the trust of the participants in the integrity and security of a decentralized computer network and not on the credibility of a central bank. While neither the central bank money nor the creation of book money are subject to quantitative limits in traditional monetary systems, the maximum number of units of artificial currencies that can be generated is usually limited by the system. which rewards those participants in the payment network with new monetary units who check the authenticity of encrypted transactions particularly quickly using mathematical algorithms. This process of validation and the associated generation of new units of cryptocurrencies is called mining. Bitcoins and other cryptocurrencies are therefore based on the trust of the participants in the integrity and security of a decentralized computer network and not on the credibility of a central bank. While neither the central bank money nor the creation of book money are subject to quantitative limits in traditional monetary systems, the maximum number of units of artificial currencies that can be generated is usually limited by the system. which check the authenticity of encrypted transactions particularly quickly using mathematical algorithms. This process of validation and the associated generation of new units of cryptocurrencies is called mining. Bitcoins and other cryptocurrencies are therefore based on the trust of the participants in the integrity and security of a decentralized computer network and not on the credibility of a central bank. While neither the central bank money nor the creation of book money are subject to quantitative limits in traditional monetary systems, the maximum number of units of artificial currencies that can be generated is usually limited by the system. which check the authenticity of encrypted transactions particularly quickly using mathematical algorithms. This process of validation and the associated generation of new units of cryptocurrencies is called mining. Bitcoins and other cryptocurrencies are therefore based on the trust of the participants in the integrity and security of a decentralized computer network and not on the credibility of a central bank. While neither the central bank money nor the creation of book money are subject to quantitative limits in traditional monetary systems, the maximum number of units of artificial currencies that can be generated is usually limited by the system. This process of validation and the associated generation of new units of cryptocurrencies is called mining. Bitcoins and other cryptocurrencies are therefore based on the trust of the participants in the integrity and security of a decentralized computer network and not on the credibility of a central bank. While neither the central bank money nor the creation of book money are subject to quantitative limits in traditional monetary systems, the maximum number of units of artificial currencies that can be generated is usually limited by the system. This process of validation and the associated generation of new units of cryptocurrencies is called mining. Bitcoins and other cryptocurrencies are therefore based on the trust of the participants in the integrity and security of a decentralized computer network and not on the credibility of a central bank. While neither the central bank money nor the creation of book money are subject to quantitative limits in traditional monetary systems, the maximum number of units of artificial currencies that can be generated is usually limited by the system.

Process of a bitcoin transaction

Each participant in the Bitcoin network must have the appropriate software (wallet) that provides access to the Bitcoin reference software and enables transactions to be carried out. There are a variety of different wallet solutions that differ primarily in whether they only enable the basic function of managing Bitcoin addresses and their own transactions or whether they enable the user to replicate a complete Bitcoin client. Figure 1 illustrates the basic process of a bilateral Bitcoin transaction.

1. The sender first generates a “key pair” consisting of a private key and a public key. The private key is used by the sender to generate an encrypted signature, the public key is used by the recipient and the entire Bitcoin network to verify the signature and thus to check the legitimacy of the sender. To transfer bitcoins, you need the recipient’s bitcoin address. Bitcoin addresses are combinations of characters with up to 34 digits that are generated using cryptographic processes. Unlike accounts, bitcoin addresses are typically used only once for a transaction for security reasons.
2. The sender of bitcoins then generates a transaction that has to be generated according to a specified format and, in addition to the destination address, contains, among other things, the amount and the transaction references to all previous bitcoin transactions that identify the sender as the rightful owner of the bitcoins to be issued. The private key then uses a signing algorithm to create a signature for the data, which is then encrypted and sent to the recipient via the Bitcoin network together with the public key.
3. The recipient can now use the sender’s public key to verify the transaction, ie check whether the sender actually sent the bitcoins to the recipient and whether the recipient is the authorized owner of these bitcoins. Because the signature can only have been created by the owner of the private key that matches the public key sent.

The principle of the blockchain

At the same time, new transactions are sent to all network nodes, which in turn check the validity of the transactions decent rally and, if necessary, try to combine them into a new block and add them to the blockchain. In order to ensure that all network nodes always have the same status of the blockchain and are given an incentive to continuously verify the validity of the individual transactions and ultimately the blockchain as a whole, an incentive system for generating new blocks is required. This is done with the help of the so-called mining process, which provides that a mathematical problem has to be solved in order to create a new block.

In order to create a new block, an encryption value (so-called hash value) of the “block header” must be created using a cryptographic function that falls below a specific target value.

Figure 2 shows a simplified representation of the blockchain. Each block has its own encryption score, which is derived from the encryption scores of each transaction in the block and the reference to the previous block. This creates a linear concatenation of the blocks to form a blockchain. The respective hash values ​​are generated by so-called hash functions, with which any character strings are transformed into seemingly random character strings according to predefined algorithms. A popular hash function that is also used by the Bitcoin system is the SHA 256 function, whose output consists of hexadecimal sequences with a length of 256 bits. Even small changes in the output data lead to unpredictable changes in the output data.

Each block contains several new transactions that are stored in the transaction part of the block. Copies of the transactions are then encrypted, i.e. “hashed”, first individually and then in pairs until a single hash value remains. This is also referred to as the “Merkle Root” of the “Merkle Tree” consisting of the transactions. The Merkle Root is stored in the block header. The block header also contains the hash value of the previous block header and a dedicated NONCE (Number Only Used Once) field. The miners now have to use an algorithmic search process to search for random numbers for the NONCE field until the hash value of the new block falls below the required target size. NONCE can only be used once to make future forgery more difficult.

The newly generated block, including the transactions it contains, is then sent to all network nodes, which in turn can then verify the validity of the block and, if necessary, add it to the blockchain as a new element. If competing miners form a new valid block almost simultaneously, temporary forks can arise in the blockchain. However, these quickly resolve as the network always agrees on the longest block. A distributed transaction ledger is created that contains a complete, immutable history of bitcoin ownership and transfer relationships. Although this register is public, it nevertheless enables the confidentiality of individual transaction details, as these can only be viewed with the respective private key of the authorized person.

The cryptographic chaining of transactions and blocks means that not a single transaction can be changed without also changing the block as a whole and all subsequent blocks. The proof-of-work concept thus prevents historical transaction and block data from being easily altered. Because a potential hacker would have to have more than 50% of the computing power of the entire network to be able to manipulate transactions ex post. This would involve enormous costs, but is theoretically possible.

Since the miners guarantee the authenticity of the transactions contained in it and indirectly the entire blockchain when creating a new block, the miners receive a reward in the form of a certain amount of new bitcoins (BTC). This is halved every 210,000 blocks, so that the maximum amount of Bitcoins that can be generated is 21 million. Neither the absolute amount of the mining fee nor the underlying halving algorithm or the selected adjustment period are comprehensibly justified by the Bitcoin developers. When the bitcoins were introduced, the mining wage was still 50 BTC, which was then halved to 25 BTC for the first time in November 2012. Since July 2016, 12.5 BTC have been distributed to miners per block. On September 15, 2016, around 15.8 million BTC were in circulation.

The lower the target value is set, the greater the average computational effort that must be expended in order to determine the corresponding target hash value for a new block. The difficulty level of the proof-of-work is adjusted from time to time in the Bitcoin Core as the processing power of the Bitcoin network increases over time. The level of difficulty is calibrated by the Bitcoin Core in such a way that a new block is generated every ten minutes on average.

Other art currencies

Since bitcoin was invented, there have been a number of attempts to mimic the concept using different encryption technologies. There are now more than 700 such artificial currencies, but only 16 of them have a market capitalization of more than $20 million (as of the end of October 2016). The top three include Ethereum, Ripple and Litecoin:

• Ethereum : The Ethereum platform was only released in mid-2015. In contrast to most other cryptocurrencies, Ethereum offers users the option of mapping so-called “smart contracts” in the Ethereum blockchain in addition to its own artificial currency, ether. Smart contracts are contracts in which rights and obligations, conditions and consequences are structured digitally in algorithms in such a way that they can be implemented as applications on blockchain technology. The monitoring of compliance with the contractual agreements (monitoring) as well as the automatic initiation of consequences in the event of corresponding violations (self-execution) are fundamentally possible.
• Ripple: With “Ripple”, the US company Ripple Labs has developed a technology that enables payments in multiple currencies worldwide using an Inter ledger Protocol (ILP). In contrast to Bitcoin, Ripple does not replace banks as intermediaries, but provides a platform for the efficient networking of banks’ existing payment systems. The artificial currency “Ripple” (XRP) can optionally act as a bridge currency in order to enable payments to be carried out as quickly as possible, even in illiquid foreign exchange markets. The volume of the XRP artificial currency is limited to 100 billion XRP, which, unlike other cryptocurrencies, is not generated by mining.
• Litecoin: Litecoin, the cryptocurrency launched in 2011, is similar to the Bitcoin system as it is also based on a peer-to-peer network and blockchain methodology. The main difference to Bitcoin is the design of specific blockchain parameters. New blocks are created on the Litecoin network every 2.5 minutes, so the maximum number of Litecoins that can be created is converging to 84 million .

The Bitcoin Industry Ecosystem

An overview of the Bitcoin industry ecosystem, which consists of the developers of the Bitcoin core software and the miners, as well as providers of retail services (wallets), operators of trading platforms (Bitcoin exchanges), payment transaction solutions and other value-added services.

Wallets are software solutions that allow end customers to receive, send and manage bitcoins. There are now a large number of wallet providers. The best-known wallets, which are available for all common operating systems, include the Bitcoin Core Armory, MultiBit, Electrum and Mycelium. Miners are computer networks that systematically validate new transactions in competition and combine them into new blocks. Since the probability of generating new blocks increases with computing power and at the same time the mining revenue decreases over time, the business model of the mining pools is geared towards economies of scale. The largest mining pools include F2Pool, Bitfury, CEX-IO and Ant Pool. Due to the high energy consumption, there are numerous mining pools in China. Other providers position themselves as operators of exchanges for cryptocurrencies, through which one can buy and sell cryptocurrencies among themselves or against real currencies. The largest bitcoin exchanges currently include OKCoin, Kraken, Coinbase and Bitfinex. Payment transaction services with extended functionalities are offered, for example, by Circle, bitpay, Coinkite or Gocoin.

Market development and prospects

Although the number of providers in the Bitcoin industry has multiplied in recent years, there can be no talk of a breakthrough in user acceptance. Figure 4 shows that although the average number of Bitcoin transactions per day has grown significantly, it is currently only around 250,000 worldwide. Compared to credit card systems such as Visa or Mastercard, the importance of bitcoins is still marginal . In 2014, for example, the number of transactions from Visa was almost 100 billion. Overall, the growth momentum and the rate of diffusion of bitcoin seem too low to pose a threat to established payment systems in the foreseeable future.

A key reason is likely to be an aspect that the protagonists of Bitcoins repeatedly mention as an advantage of this artificial currency: the lack of a central authority such as a central bank, which ultimately ensures credibility in the currency’s stable value through a monetary policy geared to price stability target. The anonymity of virtual currencies in particular is apparently a key barrier to broader acceptance, since potential causes of financial damage, for example as a result of the theft of private keys during hacker attacks in an anonymous network, can hardly be identified and prosecuted. This has also meant that the Bitcoin network has proven to be particularly suitable for illegal trades in some cases. The most famous case is the “Silk Road” platform, which gained notoriety as ebay for illegal transactions and was shut down in October 2013. Added to this was the bankruptcy of the bitcoin exchange Mt. Gox in 2014 and the loss of an estimated US$ 70 million by the Hong Kong-based bitcoin exchange Bitfinex as a result of a hacker attack, which was only reported in August 2016.

Another aspect is the low market entry barriers for establishing such artificial currencies. Basically, all you need is a cryptographic method for encryption, a mining process and a consensus algorithm, which are coded in open source software and made publicly available. The high number of artificial currencies underlines that in most cases this is not likely to be a viable business model.

The high level of uncertainty about the future of bitcoins is also manifested in the volatile price development. The trading volumes on the various bitcoin exchanges are manageable and investments in virtual currencies can be classified as highly speculative. Figure 6 shows that Bitcoin’s value has peaked at more than $1000 while it currently fluctuates between around $600 and $700.

Disruption through distributed ledgers

The actual potential for disruption does not come from the virtual currencies themselves, but from the blockchain technology used. It should be noted that the blockchain is just one variant of distributed ledger technology. Basically, distributed ledgers are distributed account management systems in which digital data is shared, replicated and synchronized across multiple locations. A forgery-proof mapping of transactions is made possible with the help of cryptographic methods. If the transactions are mapped in interconnected blocks using a proof-of-work method, this is referred to as a blockchain.

There are various design options for distributed ledgers, which differ in terms of the number of users, the cryptographic methods used and the procedures used to check the integrity and correctness of the database at all times. The cryptocurrencies are based on so-called public distributed ledgers, which are basically open to any user who has the necessary software. New transactions that lead to a change in the database are combined into new blocks based on a consensus algorithm and can be validated by each network node. Since the anonymity associated with open distributed ledgers such as Bitcoin must be viewed critically, especially from the point of view of money laundering,

These distributed ledgers, also known as “private” or “permissioned”, are operated by a defined number of members. The use of encryption techniques is intended to ensure that transactions in a closed multilateral settlement system are processed in real time, as far as possible. In addition, increases in efficiency are to be made possible through the joint use of databases (shared ledger). Participation usually takes place via a proof-of-identity procedure in which each participant has to undergo a registration process. This makes it possible to draw conclusions about the identity of the respective user in the event of fraud. However, in individual cases it might be a challenge to structure the access rights in such a way that that transparency and verifiability of the database entries on the one hand and the right to data protection on the other can be reconciled. In the case of private distributed ledgers, the ongoing validation of the transaction directory can also be carried out by network nodes classified as trustworthy or the operators of the database.

The development of distributed ledger technology is still in the early stages, so that the potential of the technology can currently only be grasped in rudimentary form. However, it is to be expected that transaction and information-intensive industries in particular will be exposed to disruptive changes through the use of distributed ledgers. This includes the financial sector and above all “transaction banking”. This includes all services provided by banks in connection with the processing of payment transactions and foreign exchange and securities transactions.

payment transactions

The processing of payment transactions in the euro zone has made significant progress with SEPA (Single Euro Payments Area) and the Target2 system. Because with SEPA, the single euro payment transaction area, uniform procedures for cashless payment transactions were introduced throughout Europe. The Target2 system is the payment system of the central banks of the Eurosystem for the fast processing of transfers in real time. Nevertheless, transfers by end customers, even within the euro zone, are usually only valued on the next bank working day. These settlement periods can be significantly longer when it comes to international transfers via the SWIFT system, where the settlement of payments is processed via correspondent banks.

Payment transactions in particular are predestined for the use of distributed ledger technology. Similar to the bitcoin network, cross-border payments in non-anonymous peer-to-peer networks could also be carried out in real time between the contracting parties in the future, without the need for additional intermediaries. So far, even web-based payment systems such as Paypal still require banks and credit card companies as service providers.

However, such “instant payment systems” do not necessarily have to be based on blockchain technology, but can certainly be based on a further modernization of Target2 or specific transaction-oriented messenger services. In Europe, the European Central Bank and the European Retail Payments Board (ERPB), founded in December 2013, are driving the development of a real-time payment system based on SEPA formats and the development of the associated regulations.

investment services

Significant increases in efficiency are to be expected for investment services, especially in post-trading activities. Although these activities vary depending on the complexity of the financial products, they basically take place in the following steps: After the purchase or sale orders have been received, the order routing of an intermediary (bank/broker) is used to forward them to an electronic or physical trading platform. Then the clearing takes place. This means the determination of mutual claims and liabilities and delivery obligations. During the subsequent settlement, the security is transferred and, in return, the corresponding amount of money is transferred. Banks and brokers act as intermediaries between the buyers or sellers and the central securities depositories.

For example, the settlement time for stock trading with securities held in collective safe custody is currently two days. Money regulation within the euro zone is usually carried out via the Target2 system. With Target2-Securities (T2S), a central securities settlement in central bank money will be implemented in various stages up to 2017, with securities custody and the associated services remaining with the national central depositories (Central Securities Depositories). The T2S concept is based on bringing together the central bank money and securities side on one platform in “delivery versus payment mode”. Cross-border securities settlements remain much more complicated if at least one transaction partner is based outside the euro zone.

Distributed ledger technology can contribute to a significant streamlining of processes here. If it is possible to transmit security transactions in a distributed database using cryptographic methods in a forgery-proof manner, the current time-consuming clearing and settlement processes can be merged in the final stage of development to such an extent that trading and settlement can take place almost in real time. This could mean that today’s central securities depositories mutate into a pure depository and that the custody services of the banks no longer have to exist in this form. Because dividend or coupon payments can also be automated via smart contracts as an application on the blockchain.

Smart Contracts

Smart contracts represent the digital representation of contractual agreements that are encoded in the distributed ledger as executable programs. These enable activities to be triggered automatically if their execution is linked to the occurrence of certain contractual conditions. This can affect interest and principal payments as well as purchase price discounts, credits or the automatic adjustment of insurance premiums depending on the damage history.

The principles of distributed ledger technology can also be applied outside of the financial sector to material transaction objects such as real estate, machinery and equipment or the transfer of intangible assets such as intellectual property rights. If these assets are recorded electronically via sensors, RFID transponders, a QR code or an IP address, transmission processes can be digitally mapped and tracked in a distributed ledger such as a blockchain.

smart government

This makes virtual notary services conceivable for real estate transactions or the sale of companies with the help of cryptographic processes. Distributed ledgers can also help to streamline the efficiency of administrative processes in the public sector (smart government), for example if all tax-relevant data from private individuals, companies and public institutions can be made available in a distributed database and assigned in real time in a tamper-proof manner. This would make tax evasion much more difficult, and tax returns could be created more easily or, ideally, automatically by intelligent apps. The keeping of land registers and cadastres is just as suitable for a blockchain solution as numerous services of the registry offices.

There are similar starting points in healthcare (smart health), for example by making patient data or treatment processes available to clinics, doctors and insurance companies in a distributed database. For data protection reasons, the granting of access rights would remain with the patient. Administrative processes in medical care could be streamlined and data for research projects could be made available more quickly and comprehensively in an anonymous form.

In conjunction with smart contracts, distributed ledgers can also promote the development of Industry 4.0, which is based on the merging of virtual and physical systems into so-called cyber-physical systems in industrial production. Because in numerous industries it is important to reliably record the origin, authenticity, quality or compliance with environmental standards. This applies, for example, to the food industry when verifying organic forms of cultivation, to the raw materials industry when examining mining rights or to the textile industry when examining working conditions in the producing countries. In all of these cases, it is conceivable to document the production, transport and further processing of products completely and forgery-proof in a distributed ledger. The falsification of indications of origin, non-compliance with quality standards or improper disposal of residues would be made considerably more difficult. The distributed ledger technology can therefore trigger disruptive changes in different areas and thus develop into a key technology within IT. Therefore, increased funding for research in this area should be considered.