Blockchain – Considerations for Policymakers and the Actuarial Profession

What is blockchain?

Nowadays, one could hardly open up the financial section of a newspaper without encountering an article mentioning bitcoin, cryptocurrency or blockchain. Bitcoin and cryptocurrency are full of drama. The huge price volatility, the ongoing debate about their legitimacy and the regular hacking attacks towards the crytpocurrency exchanges are all excellent news reporting materials.

Despite the constant media bombardment, the underlying technology is still not very well understood by the general public. Often people regard bitcoin and blockchain the same thing. While it is true that the blockchain technology underpins bitcoin, there are now in fact three generations of blockchain.

The first generation of blockchain is represented by Bitcoin. It is essentially a digital currency which can be transferred easily between two parties. The supply of this currency is pre-determined. Bitcoin has a fixed total supply of 21 million.

The second generation, smart contracts, is represented by Ethereum. It is a platform similar to a computer, but on a global scale. Programs can be written on top of it, with each block of data storing the state of the computer programs. Unlike an individual computer, the Ethereum can be considered as a computer shared by all users around the world, with a single source of truth.

This is what makes a lot of interesting applications (such as blockchain based insurance) possible. Business rules can be all built into a smart contract. Once deployed, nobody can change it, not even the owner. The third generation tries to tackle issues like scalability and self-governance and has a few contenders. We wont address that here.

Why do we need blockchain?

Let’s examine three daily activities: 

1. Use a credit card to do shopping
2. Take out an insurance policy
3. Make a post on our Facebook account

When carrying out these activities, we rely on trusted third parties – banks, insurance companies and large technology companies. We choose to trust these middle-men who have spent many years building up their reputation. We trust that they will meet our consumer needs, treat us fairly, not charge us too much fees, and make sure our privacy is respected.

However, again and again, we are seeing our trust being breached. Let’s take a look at three recent news article headlines.

• Inquiry shows shocking extent to which our big banks have put profits before their customers (Sean Smith, The West Australian, 23 Mar 2018)
• Banking royal commission: Commonwealth Bank pushed junk insurance to students, pensioners and unemployed (Nick Evans, The West Australian, 20 Mar 2018)
• ‘We made mistakes’: Mark Zuckerberg apologises for Facebook data breach (AAP and ABC, The New Daily, 22 Mar 2018)

Consumer’s trust are breached by the misconduct of big corporates which may be driven by the sharemarket’s mandate to maximise profit, sometimes at the expense of consumer’s interest.

Blockchain might just provide an alternative, as it gives power back to the individuals.
In a blockchain world, there are typically (depending on the actual implementation) no large centralised bodies or middle-men. Every transaction is done in a peer-to-peer, decentralised manner, without involving an intermediary. A payment made in cryptocurrency can go directly from the shopper to the seller; insurance policies are built on top of smart contracts which automatically takes funds and pays claims based on pre-determined business rules; a social media post is uploaded to a blockchain without involving facebook.

This illustrates the first key feature of blockchain:

No middle-man sits in between individuals who directly transact with each other

This gives the power back to the individuals. Payments can be made almost instantly between two parties sitting anywhere around the world with internet access, incurring minimal transaction fees. The premium a customer pays can go almost entirely towards paying claims, as opposed to paying excessive commission, operating expense or insurer’s profits.

The huge amount of personal data that Facebook collects can also be truly owned by each individual customer, who can allow or deny third party access to their private data. If they do choose to allow third party to access their data, they, not facebook, will get rewarded for this. They can also track every third party who has ever had access to their data using the blockchain (VeChain Foundation, 23 Mar 2018).

One might wonder, how can we trust the other party who might be sitting in front of a computer on the other end of the world? This brings us to the second feature of blockchain:

A trustless environment

Blockchain minimises the amount of trust that we need to place on any individual or organisation. Instead of trusting one individual party, we are trusting everyone in aggregate, through

• public-key cryptography, and
• mechanisms by which all parties can reach a consensus (Preethi Kasireddy, 4 Feb 2018)

Public-key cryptography involves a private key and a corresponding public key. The public key is a unique identifier, like an email address or a bank account, and is visible to everyone. The private key allows the owner to generate digital signatures to approve transactions (such as sending funds, or sending transactions to a smart contract).

One mechanims that everyone can reach consensus is called “proof-of-work”, which is currently used by both bitcoin and ethereum. The mechanism is as follows.

Miners (computer resources) compete to gather a block of transactions and solve complex mathematical problems. Once the first miner solves the problem, the block of transactions are broadcast to the network, and verified by everyone to be the truth. The blocks are constructed on top of each other, and “chained” together through hashing functions. A tiny change in any data contained in any block would invalidate all the blocks of data “chained” after it. In bitcoin’s case, there are 514,895 blocks (blockchain.info, accessed 24 Mar 2018) at the time of writing. These blocks go all the way back to the very first “genesis block” created by Satoshi Nakamoto around 3 Jan, 2009 (bitcoin wiki, accessed 24 Mar 2018). As each block of data takes significant computing resources to produce, we have another key feature of blockchain:

Immutability

Once on the blockchain, the data is extremely difficult to be tampered with.

This feature can be quite powerful.

For example, there has been significant backlog in the Australian citizenship application process (Shamsher Kainth, 20 Oct 2017). Applicants who passed the test in early 2017 and are still waiting for approval today. At the same time, there are anecdotal suggestions that some people who sat the test in Jan 2018 may have been approved after a mere 2 hours (whirlpool lifestyle forum, accessed 24 Mar 2018). The official response, of course, is this could never possibly happen as applicants should always be processed in chronological order. However, the general public is not able to verify this. The data may never be collected in the first place. Even if data is collected, having it locked in a database behind firewalls gives the immigration department tremendous amount of power. The outside world has limited visibility of what’s going on.

Imagine having this system built on a blockchain. With each step of the process, a new transaction is written to the blockchain, and the transaction could never be changed. In this case, everyone would be able to verify the processing timeline themselves. There is no need to call up the immigration department as everything is transparent. This also promotes efficiency and accountability. If the target processing timeline is not met, someone has to take responsibility.

In a blockchain world, power shifts from the immigration department back to the individuals.

This is just one use case, and there are countless other equally powerful use cases such as:

• Reduce corruption
• Eliminate the cash economy
• Stop counterfeiting
• Protecting intellectual properties
• Reduce compliance overhead

Blockchain has the potential to change how the world works.

What are the current challenges?

Despite the huge potentials, blockchain is still at its infancy and not without it’s challenges. Some of these challenges are so serious that some dismiss the technology of blockchain altogether.

Hacks and Scams

A lot of money has been lost to hackers. Here are three of them as an example: (Emma Avon, 2017)

1. The Decentralized Autonomous Organisation – 3.6M ether lost (~$1.9B)
2. Mt. Gox – 850K bitcoin lost (~$9.8B)
3. Parity Wallet – 150K ether lost (~$81M)

At the time of writing, there are 3,054 scams identified on the ethereum blockchain alone, with 304 being currently active scams (etherscamdb.info, accessed Mar 2018). Vitalik Buterim, the co-founder of Ethereum, recently had to change his twitter account name to Vitalik “Not giving away ETH” Buterin, to counter the high volume of scam accounts on twitter trying to impersonate him (Ryan Browne, 19 Feb 2018).

Why are there so many hacks and scams? On the one hand, consumers and organisations lack risk awareness. On the other hand, the “bad guys” often do not get punished as law enforcements are still trying to catch up with this new form of crime. Combined with the significant appreciation in cryptocurrency value, hackers and scammers have a huge incentive to keep going.

Lack of risk awareness

This happens to both individuals and organisations alike. There are individuals who have minimal understanding of the basic safety measures to protect their key credentials by owning a hardware wallet, or not leaving significant amount of funds on an exchange.

Some startup companies, despite their rapid growth, are relatively inexperienced with cybersecurity risk management practices. As an example, the Japanese exchange Coindesk was hacked in Jan 2018 with $532M stolen (Reuters, 29 Jan 2018). The company had failed to apply the most basic risk management measure – using a “cold wallet” – instead of a “hot wallet” connected to the internet which are much more vulnerable to attacks.

Lack of law enforcement to disincentivise hackers and scammers.

The nature of blockchain makes it highly difficult to track down the hackers and scammers. When there is a credit card fraud, the bank often compensates the customers (although this has already been priced into the credit card fees and fraud cost is effectively worn by the whole network). With cryptocurrency, once a transaction is validated there is generally no recourse.

What does this mean for the policymakers?

My personal view is that policymakers should fully embrace the blockchain technology. Early adopters of this new technology has the ability to set the rules, and latecomers can only follow.

Embracing it early attracts foreign investments and more jobs to this new economy. It also allows policymakers to be more confident with adapting to the future world if blockchain does become a significant part of our lives.

Some of the specific measures worth considering in my personal view are:

• set up innovation hubs focusing on blockchain and create a safe legal environment for entrepreneurs to experiment with new ideas
• encourage the creation of an industry self-regulating body
• be clear regarding licensing requirements
• encourage professional bodies to develop local talent (software developers, lawyers, accountants, actuaries)
• encourage blockchain education to the general public
• explore ways that regulators and central banks could work with blockchain (for example, how does monetary policy work with a cryptocurrency with a fixed supply?)

Most importantly, policymakers need to strike a fine balance between having just enough regulations in place to protect the public interest, and not putting too many regulations to stifle innovation.

How could actuaries help?

As actuaries, we;

• have a history of serving the public interest, which is not often specifically considered by blockchain start-up companies
• are able to assess short and long term risks from different stakeholders’ perspective
• are experts in risk modelling in financial services, which could be significantly disrupted by blockchain innovation

I encourage the profession to take a keen interest in this new technology, get involved with the blockchain communities early on, and work with various other professions to help policymakers and the general public understand potential implications of this rapidly developing new industry.

Watch this short video to help you understand how Blockchain works. 

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