FX International Payments
By Frances Coppola
Ranked first (by considerable margin) is the original cryptocurrency, Bitcoin, followed by Ethereum and newer contenders such as Litecoin, Dash, Monero, Primecoin, Nextcoin and Peercoin. Ripple, also among the top 10, is the native “currency” of a blockchain-based international payments protocol being designed in conjunction with existing global payment solutions providers.2 Ethereum is the “token” underpinning a development platform whose potential applications go far beyond international payment solutions.3
These cryptocurrencies broadly divide into two groups: those that limit the number of coins that can ever be created (called “deflationary currencies”) such as Bitcoin, Monero and Dash and those that don’t (“inflationary currencies”); Ethereum, Litecoin and Ripple
All these cryptocurrencies share some characteristics, however. They are entirely digital: although bitcoin has ATM machines, the coins obtained from these are simply a physical representation of a digital asset.4 They all work on a distributed and decentralized basis, with no central intermediary. Payments are made directly from one user to another and verified by the entire network, with copies of transactions held by all computers on the network. To ensure payments are secure, the cryptocurrencies use various cryptographic techniques. Bitcoin, for example, uses the U.S. National Security Agency’s SHA-256d cryptographic hash function,5 whereas Litecoin uses Scrypt, a password-based key derivation function.6 For those interested in such arcania, here’s why Bitcoin’s underlying technology is called "blockchain": each transaction is encrypted into time-stamped blocks, and each block’s SHA-256d hash result becomes a unique identifier that is incorporated into the next block (thus creating the chain) for integrity verification.7
The absence of trusted intermediaries in a cryptocurrency network poses a problem. In existing global payments solutions, trusted intermediaries verify transactions, accepting only those that are complete, accurate and legitimate. But in a cryptocurrency network, in theory any transaction could be accepted. This leaves the system open to spam and “denial of service” attacks.8 It could also allow an owner to issue multiple transactions using the same coins – this is known as “double spending.”9 So most cryptocurrencies have protocols that encourage users to compete to verify transactions in return for a reward. Verification eliminates double spending and helps to protect against spam and malicious transactions.
Broadly, there are two types of verification protocols employed by the cryptocurrencies vying to be the next big global payments solution. Bitcoin’s “proof of work” is a highly innovative solution to the verification problem, and it remains the most popular protocol. It involves solving cryptographic puzzles. When a puzzle is solved, a new “block” of transactions is confirmed and the user, or “miner,” is rewarded with new coins and transactions fees. As more coins are created, the puzzles become progressively more difficult, requiring larger and larger amounts of computing power.10
However, proof-of work verification is relatively slow (at least 10 minutes),11 and its energy-intensive nature encourages the formation of “mining pools” or miner “oligarchs” which can monopolize verification. Effectively, this creates central intermediaries that may be corrupt or become a target for malicious attacks. Because of this, some cryptocurrencies are adopting “proof-of-stake,” where the ability to verify transaction blocks is determined by the size of the miner’s investment. Proof-of-stake is less vulnerable to monopolization and malicious attacks, but on its own it encourages fragmentation of the system, so it is usually combined with some other mechanism to discourage excessive mining.12 Nextcoin, for example, randomly selects the verifier for a new block using a lottery-type mechanism. Clearly, the more coins a user holds, the more likely they are to be selected as the verifier.13 Ethereum is planning to move to its own version of proof-of stake,14 while Peercoin and Dash use a combination of both methods.
In the longer-term, which protocol is used is likely to affect both the security and the speed of B2B payments.
Cryptocurrency payments work in much the same way as cash. The owner keeps their coins in a secure wallet to which only she has the “key” – a digital signature that only she knows. The wallet can receive payments without being opened, but to make a payment the owner must open the wallet with the key. To make things extra safe, some wallets have multiple keys: for example, a wallet might have three digital signatures, one held by the owner, a second held by a trusted third party and a third in offline (“cold”) storage. Making a B2B payment from one of these “multisig” wallets requires two or more keys, not just one. This is not unlike business checks that must be countersigned to be valid for payment.
A cryptocurrency-based global payment solution would thus work very differently from credit cards and other online transfers. Instead of the payment being authorized by the owner and then taken from the account by the recipient, the owner transfers the coins directly to the recipient – a “push” model, rather than an “authorize and pull” model.15 To make the payment, of course, the owner must have enough coins in the wallet.
Cryptocurrency payments typically clear much faster than today’s international B2B payments, since there are no intermediaries. And as the wallet must contain enough coins for the payment to be made at all, in theory the payment cannot fail.
If all international payments were pre-funded and peer-to-peer, there might be no need for very short-term commercial bank credit such as intra-day overdrafts. However, this carries implications for business cash flow, since businesses cannot commit to payments in advance of funds being received. Automated payments may be particularly problematic, since businesses may have to put funds into escrow to ensure that the payments can’t fail, potentially tying up funds for long periods of time. This could make smart management of cash flow more difficult and increase businesses’ general need for credit. The cost savings to businesses due to lower transaction fees in cryptocurrency payments could therefore be partially lost in interest charges on additional credit lines.
Cryptocurrency-based global payment solutions offer the possibility of vastly improving the speed and security of international payments, while reducing transaction costs. However, as cryptocurrencies become more attractive as international payment solutions, businesses may need to fundamentally re-think the way they manage their cash flow.
With 17 years experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.
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