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Tatjana Winter, head of research at BlockART Institute, explores cryptocurrencies and how they are connected to blockchain technology.
As part of its research into alternative risk transfer, captive solutions and the usage of new technologies in these sectors, the BlockART Institute has got to grips with the use of cryptocurrencies as the payment method of the future. The future? Aren’t bitcoin et al already a fixed component of today’s currency landscape? Yes and no.
Bitcoin futures have been traded on the Chicago Mercantile Exchange (CME), the US derivatives exchange, since December 2017, and even the tabloids of various nations are busying themselves with the value of digital currencies. However, they are currently more of an object of speculation than serious currencies for paying for services or goods.
The following article is intended to give an insight into the status quo in terms of cryptocurrencies and show how cryptocurrencies are connected to blockchain technology.
What is the blockchain?
You can’t talk about cryptocurrencies without mentioning the blockchain. But what is behind this technology? It is a technology that the rather financially conservative World Economic Forum states will “permanently change the financial world in the future”. The blockchain is a very large, distributed database. This is what makes it possible for the bitcoin system, independent of central banks and nations, to exist in the first place.
The necessary trust is placed in cryptography, not in intermediaries, such as banks or contractual partners. Like a gigantic, self-managing accounting system, it saves all the transactions ever carried out with the well-known cryptocurrency.
The peer-to-peer approach
In order to be completely independent of central institutions, the participants must correspond directly, which corresponds to ‘peer-to-peer’ topology. Every active computer can be used as an entry point to execute transactions.
All the computers connected within the network are completely equal. Decentralisation is a basic requirement for a free, transparent currency—the blockchain differs fundamentally from most of the internet in this regard.
As the computers communicate with each other, there is no need for a supervisory body such as a bank—which is its biggest advantage, and also the reason why transfer via blockchain technology is speedy and cheap. The advantages can be quickly summarised: transparency, security and efficiency.
According to the June 2017 study by the World Economic Forum, Realizing the Potential of Blockchain, the blockchain solution “has great potential to promote simplification and efficiency”. Along with other solutions (eg, artificial intelligence [AI]), it will form the basis for the next generation of financial services. This is because the spectrum of potential applications is broad and capable of exposing the traditional financial sector to enormous pressure to modernise. “Blockchain’s execution of international payments could enable precisely timed accounting records and reduce costs,” the study says.
What are cryptocurrencies and how many are there?
“Unlike central bank money, cryptocurrencies are exclusively digital. Payments are processed electronically from point to point without the involvement of an intermediary such as a central bank,” explains Simon Kolkmann, blockchain expert at the BlockART Institute.
The digital currencies are based on blockchain protocols. The transactions are stored in ‘blocks’ in a decentralised network on many different servers (security through redundancy). The chain (blockchain) is extended by one link with each block. Because the exact order of all blocks can be verifiably traced by cryptography, it is impossible to manipulate the blockchain and thus the resulting account balances.
Even experts find it difficult to keep track of all the cryptocurrencies. The specialist website coinmarketcap.com lists almost 1,500 virtual means of payment with a market value of around $530 billion. It is nearly impossible to predict how many and which ones will survive. Nevertheless, the market capitalisation shows in which cybercurrencies investors have particularly high hopes. An overview of current cybercurrencies is shown in Figure 1.
Figure 1: Overview of cryptocurrencies
Bitcoin is the mother of all cryptocurrencies, with the highest market value. The focus is on the approach of creating a payment network without central authority (central bank) or intermediaries (financial institutions) and thus offering a digital alternative to central bank money worldwide. However, prices suffer extreme fluctuations.
On December 17, 2017, investors temporarily paid more than $20,000 for one bitcoin; market capitalisation was at more than $330 billion. The price then collapsed and the value of one bitcoin halved to around $10,000. It is being further developed by a large number of people.
The bitcoin protocol on which the digital currency is based is attributed to a person known as Satoshi Nakamoto. It is still unclear whether the pseudonym refers to an individual or a collective of several developers.
Ether is the digital currency for the blockchain network Ethereum, which was developed in November 2013 by Vitalik Buterin, a programmer with Canadian-Russian roots. While bitcoin is a purely digital means of payment, so-called “smart contracts” can also be processed via the Ethereum network. The platform supports the creation, administration and execution of digital contracts.
Within the network, it is also possible to generate additional cryptocurrencies (known as tokens). For this reason, Ethereum is very popular with startups because they can raise crowdfunding capital by issuing tokens. This is called an initial coin offering (ICO, a low-budget variant of an initial public offering). The platform is operated by the Ethereum Foundation, which is based in Switzerland. Programmers around the world are working on the further development of the network. With a market value of $83 billion (as of January 2018), Ether is the second largest cryptocurrency after bitcoin.
Behind the cryptocurrency IOTA there is a Berlin-based startup that wants to enable communication and payment between two machines via its network—this internet of things (IoT) approach is already in the name. In the future, IOTA will allow machines to pay each other for services without the need for further confirmation. For example, the self-driving car could communicate with the toll station and pay the road toll, or the refrigerator could pay for the food that it has ordered automatically.
Unlike other platforms, IOTA does not use blockchain technology, but a related protocol. IOTA currently has a market value of $8 billion.
Buying and selling cryptocurrencies
“There are trading platforms on the Internet for this, such as bitcoin.de. The principle is the same as with online marketplaces for shares,” Kolkmann explains. Users must register there, then they can view other users’ sales offers.
When they receive a bid, they conclude a kind of sales contract. The buyer transfers the agreed amount to the seller’s account. As soon as the seller has confirmed receipt of payment, the cyber coins will be credited to the buyer’s own user account.
“A brokerage fee is charged for the service of platform use. The concept is based on the current business model of online mail-order companies,” states Kolkmann.
If you want to receive, store or spend cryptomoney without an intermediary platform, you need a digital “wallet” for the currency in question. The application is linked to a unique address—similar to an account number in online banking—to which other people can transfer cyber money. In combination with a so-called ‘private key’, the owner of the wallet can issue digital signatures and prove that he or she is actually the owner of this wallet, thereby authorising the transaction.
Are cryptocurrencies secure?
“The blockchain is forgery-proof, since a cyber criminal would have to control the majority of computers active in the network, and this is impossible in reality,” explains Kolkmann. However, owners of crypto-money must be careful.
“The procedure is secure, but users should not be negligent with their private key. This key allows cyber gangsters to have access to the virtual money. Once the money has been transferred, it cannot be brought back. The money is gone and there is no-one to pay for your loss,” he sums up.
Will cryptocurrencies make banks and/or insurance companies superfluous?
Currently there is no single blockchain model which puts all financial institutions into checkmate. However, blockchain technology and the associated possibilities of smart contracts and payments through cryptocurrencies are constantly discussed at the management levels of banks, insurers, reinsurers and, especially, brokerage houses, and the use of the technology and the benefits associated with it are continuously promoted by the industry leaders.
This is demonstrated in particular by the steady increase in partners in the B3i (Blockchain Insurance Industry Initiative) network. This was founded by five insurance groups: Aegon, Allianz, Munich Re, Swiss Re and Zurich.
Developments in the industrial insurance industry, the extent of this sector in general and in the captive market in particular, will be discussed in a future article. A use case will be presented which shows the benchmark for the use of a cryptocurrency in payment transactions for insurance premiums and claims payments, and which represents a blueprint for the future.
Tatjana Winter is head of research at BlockART Institute and a PhD student in the field of platform and ecosystem solutions in the risk and insurance industry. She can be contacted at: firstname.lastname@example.org
Tatjana Winter, BlockART Institute, Cryptocurrencies, Bitcoin, Ether, Dogecoin, Blockchain, Insurance, Captive insurance, Europe