London Workshop Explores Blockchain Identity in Finance

The Identity & KYC conference in London hosted a workshop on using blockchain technology to improve know-your-customer processes earlier this week.
Led by blockchain compliance consultant Siân Jones, the workshop was attended by a group drawn from banks, financial institutions, startups and regulators.
The group discussed several challenges faced by banks and financial institutions when it comes to identity, and whether or not the blockchain can help solve these problems. The overwhelming consensus was that even though the blockchain is very promising, it has many real-world limitations around identity.
The discussion was exploratory in nature, focusing on the needs of current financial industry participants and exploring the use of potential blockchain technologies.

KYC moving beyond simple identity

The group discussed the impact on the financial industry of the trend of moving away from simply looking at government-issued identity cards, like passports and driver's licenses. Attendees looked at exploring more holistic datasets around individual identity that involve everything from purchase history to utilities connections to assess an individual’s identity.
These third-party data points already provide an important source of identification information beyond simple identification systems and are becoming increasingly popular in the financial industry and elsewhere to supplement government-provided identification data. They are also more nebulous in nature, giving a 'probability score' for how strongly the algorithm believes the individual is who she says she is.
The trend is expected to accelerate in the future, with simple identification mechanisms becoming less important for financial institutions.
In such a world, an identity on the blockchain, like a tokenized version of a driver’s license, may not be sufficient for most businesses and financial institutions. Any blockchain solution will therefore need to gather information on the individual available via third-parties, a considerably harder problem for blockchains to solve.

Where blockchains fall short

There are many challenges faced by the financial industry involving identity, and some of the key issues are hard problems to solve. The initial on-boarding process, when the issuing of identity is first conducted by a government or financial body after verifying information about the individual, still remains a challenge.
This is especially true on a global level, where a significant portion of the developing world is without any form of government-issued identification.
The reliability of any identity, whether on the blockchain or outside, is only as good as the authority issuing that identity. An identity verified and issued by the UK government, for example, would likely be considered more reliable than one issued by a bank in Somalia.

Advantages of blockchain-based identity

There are several advantages of using blockchain-based identity, especially around the quick dissemination of information about an individual in a global context.
This is true when identity needs to be revoked and reissued, especially in the event that someone's identity is stolen. For example, if a passport gets stolen, the issuing country might replace it, but it takes much longer for a financial institution in another country to know about the status of this identity revocation. Blockchain allows this process to be quick and efficient.
In addition, blockchain-based identity systems have the possibility of selectively revealing information about an individual’s identity. This could help prevent identity theft and enhance end-user privacy.
There could also be efficiency gains by larger institutions around issuing blockchain identities, especially because a lot of verification processes today are repetitive.
Although not a current concern to the nascent Internet of Things industry, several institutions are looking into how digital identity will play out when identity is not restricted to individuals and legally defined entities but also includes physical things.
A blockchain seems like an efficient solution to handle such large-scale identities that need to be shared among multiple stakeholders.

Starting point

Although many financial institutions are exploring blockchain technology for identity solutions, most of the rules and regulations around KYC and identity for regulated financial companies revolve around government-issued identity as the preliminary requirement. Therefore, the use of blockchain for identity will need to start with a government body deciding that it would issue some form of identity on the blockchain.
There are many unsolved problems around this, from privacy to access. For example, even though an identity document like a passport is issued to the individual, it isn’t owned by the individual in a legal sense.
It is unclear how the identity data on a blockchain will be owned — whether the individual or the identity issuing body will ultimately own the identity and data around it.
As Jones put it:

"The fundamental challenge in identity is the intents of various participants are not aligned. Governments, businesses and individuals have conflicting interests."

Anonymous crowd image via Shutterstock

Why ABN Amro Wants to Separate Bitcoin from the Blockchain

For ABN Amro’s director of transaction banking, the company’s strategy on blockchain tech can be best described with a restaurant analogy.
If you were looking to enter the business, Karin Kersten argues, you might first invest in a restaurant. Next, you might try to get a feel for the workflow, washing dishes and observing existing staff. It's then, she said, that you might be ready to enter the kitchen.
It’s that final last stage that Kersten contends is most indicative of the activity at the Dutch bank, which boasts more than 22,000 employees across business lines including retail, private and corporate banking. A member of banking consortium R3CEV and the Linux-led Hyperledger project, and an investor in Digital Asset Holdings, ABN Amro has 30 employees actively working in the proverbial kitchen to investigate blockchain applications.
Kersten told CoinDesk:

"We are doing experiments and seeing if they work. We are learning by doing, and working on different levels. There’s not just one team working on the blockchain."

That’s not to say that ABN doesn’t have a more clear strategy for how it intends to move forward and which versions of the technology it deems more relevant for its business. As with many other major global banks, ABN is focused on distributed ledger aspects of the technology, and isn’t working with digital currencies such as bitcoin.
"If you look at our view regarding the blockchain, we want to clearly separate bitcoin from the blockchain. There’s bitcoin as a method of payment, and blockchain as the technology behind it. The latter we find interesting to explore," she said.
Kersten indicated that ABN is investigating matters related to trade finance and transaction banking, and how blockchain smart contracts can be applied to problems in these areas.
In line with its focus on distributed ledgers, Kersten said that ABN is not as focused on payments applications of the tech, which she said the company views as being more problematic from a regulatory perspective today.

Letters of credit

That’s not to say that ABN Amro isn’t looking to better develop an understanding of how the tech could be applied broadly.
One area of study for the bank, Kersten said, is how the technology could play a role in the issuance of letters of credit, in which a bank guarantees that a buyer’s payment will be received according to an agreed set of conditions.
However, to start, Kersten explained how the ABN team approached this challenge by first talking with clients to understand the issues with current versions of this product. In the end, Kersten said this method found the bank deviating from its standard strategy, in which IT requirements dictate what is built.
"Here the experiment is completely different. We had a hypothesis and tested it, then pivoted," she said.
Kersten said that ABN is now entering the second phase on this prototype and that it could advance this concept to the minimum viable product (MVP) stage, but that this process is taking time, a willingness to iterate and patience.
"We want to learn about the content of the blockchain and see if there are interesting MVPs for clients. In the end, we want to add value," she continued.
The proof-of-concept is currently being built on the Ethereum blockchain.

Product over tech

While Kersten said that ABN Amro is working with the technology, along with IT vendors such as IBM and Tata Consultancy Services, she said that the company wants to focus less on lower-level parts of the stack, such as blockchain consensus methods.
Rather, she would like to see ABN Amro work on other components of its tests, namely, the top- and mid-level applications that facilitate communication between an application and a blockchain.
"You have to make a basis choice per application if you want open-source or closed-source technology, but we want to make valuable applications which are relevant for our customer base," she said.
Still, Kersten acknowledged that ABN will likely need to deepen its understanding of parts of this process, such as when to select a public or private blockchain platform, and which design will best allow the necessary parties to access the ledger system.
But, Kersten said that projects like this don’t necessarily lead her to conclude that the technology will be ready for consumers soon.
Kersten told CoinDesk:

"When will it be on the market? When will it have scale? We don’t know. What we know is that it’s a promising technology."

Image credit: JPstock / Shutterstock.com

The Law of The DAO

Andrew "Drew" Hinkes is Counsel at Berger Singerman LLP, a business law firm in Florida. Hinkes represents companies and entrepreneurs in state and federal commercial litigation matters, representation of court-appointed fiduciaries, and electronic discovery issues.
In this opinion piece, Drew takes a deep dive into the legal structures that surround distributed autonomous organizations, or DAOs.

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The DAO leapt into the headlines earlier this month after it captured nearly $150m in funding, constituting almost 12% of the total amount of ether tokens in the Ethereum network.
The DAO’s structure attempts to emulate the behavior of a crowdfunding business entity, and allows its investors to choose how The DAO will invest the collective ether (ETH) contributions among specific target projects.
The idea and structure of The DAO presents significant legal challenges. Specifically, courts will be forced to grapple with the implications of a web of contracts imitating an entity, instead of a legally incorporated entity.
The law is simply unprepared for DAOs. However, based upon the structure of The DAO, it is foreseeable that the US Securities and Exchange Commission (SEC) would view its tokens purchased by investors as a security or investment contract, subject to its jurisdiction.
The voting system implemented for The DAO is likewise problematic due to its mixed incentives and propensity to depress the value of ETH and its own tokens. Because investment in The DAO is laden with risk and seems to implicate SEC jurisdiction, The DAO may attract regulatory attention.

What is a DAO? What is The DAO?

The DAO is an example of a decentralized or distributed autonomous organization (“DAO”). Generally speaking, DAOs are structures that use smart contracts to provide additional features and functionality to blockchains.
Implementations of DAOs, like The DAO, can include sophisticated arrangements of rights and powers encoded through smart contracts that emulate the attributes and activities of business entities or regulated financial contracts, including insurance, futures, options, etc. The DAO is attempting to emulate a crowdfunding entity where its backers vote to choose on which project The DAO’s aggregate investment should be spent.
DAOs are said to offer advantages to conventional business entities because (a) their activities are limited to that of the code used to operate them, (b) all terms, conditions, and governance are expressly disclosed to the investors, and (c) DAOs are based on blockchains, which generally provide increased transparency.
The DAO is intended to three primary functions. First, it is expressly intended to aggregate investor assets by taking ETH in exchange for DAO tokens. Second, it enters into contracts to use the ETH invested for projects selected by investor vote. Third, it pays returns on those investments back to DAO token holders.
As stated in the organization's manifesto:

"The goal of The DAO is to diligently use the ETH it controls to support projects that will: …[p]rovide a return on investment or benefit to the DAO and its members."

Traditional business entities exist as a result of legislation permitting groups of actors to shift risk and obtain legal protection by incorporating. In exchange for these privileges, groups of individuals operating as entities must comply with financial and operational restraints imposed by the State. Unlike conventional business entities, DAOs exist only within their own blockchains, and are generally unable to interact with the outside financial and/or regulatory actors. As a result, DAOs are reliant upon outside information in order to act.
The DAO is structured to include four types of actors: the creators of the platform, the curators, the contractors, and the DAO token holders (i.e. investors). The creators of the platform wrote open-source code that allows The DAO to function and that anyone can freely use. Investors (also called DAO token holders) in The DAO obtain stakes in The DAO by exchanging  ETH for DAO tokens. Along with these tokens investors are granted voting rights.
Contractors then offer proposals which are potential investments for The DAO’s accumulated ETH assets, along with clear payment terms in the form of a return on The DAO’s investment. Curators in-turn verify and "whitelist" proposals without providing opinions as to the merits of any proposal. The DAO thus requires external inputs in the form of investor capital, investor voting participation, the supply of project information from contractors, and the approval of projects by curators.

Will the law recognize The DAO?

DAOs are not currently recognized legal actors in the US. This creates uncertainty for legal actions brought against a DAO, and the legal rights of a DAO. It is unclear whether the actions of a DAO would be attributed to the creators of that DAO, those who maintain that DAO, those who suggest projects, or those who have invested in a DAO. Although it may be helpful for a DAO to designate a human representative, DAO token holders may choose not to disclose an owner or primary actor.
If a lawsuit were filed against a DAO, it would stall immediately because of the difficulty of identifying a party who represents the DAO to serve with process. A plaintiff would need to verify that the person is appropriate to represent the DAO, and prove that the person falls within the jurisdiction of the court. Any party served with legal process on behalf of a DAO would likely seek to quash service on the basis that they are not an authorized representative of the DAO. The court would then need to determine what is a DAO in a legal context.
As litigation lawyer Steven Palley suggests, DAOs would likely be considered general partnership or joint ventures, resulting in any participant being a representative of the DAO’s interests. Palley’s article earlier this year suggests that DAOs would be considered general partnerships, which would allow a plaintiff to reach individual participants for service and or liability.
Under Palley's theory, anyone suing The DAO could attempt to obtain jurisdiction over the organization by serving any human participant in The DAO. If considered a general partnership, each partner would then be held jointly and severally responsible for all liabilities of the business, and all personal assets of each partner are subject to seizure or lien by creditors. Thus, the parties to a DAO may have unlimited potential liability for the entity’s actions. The lack of regulatory recognition will thus limit the utility of DAOs for risk-mitigation.
Palley’s conclusion is problematic. It suggests that a lawsuit against bitcoin itself might be viable, provided that the digital currency’s creator, a bitcoin core developer, node operator, and/or miner may be served with process, be deemed a representative of the network, and potentially have liability.
If considered a general partnership, a plaintiff could thus serve any participant who benefits from the DAO who is within the geographic scope of the Court’s power. Using pseudo-anonymous blockchains to obtain funding makes identifying and locating investors extremely difficult. Contractors who suggest projects may be easier to identify than any other actors because disclosure of the nature of the project is necessary. If the DAO’s creators, or those who benefit from the DAO, are not located in United States, obtaining judicial redress may be functionally impossible.

Why voting might be The DAO’s Achilles Heel?

Investors in The DAO have voting rights that permit them to collectively determine whether projects are funded. Each investor has a voting share that is proportional to the amount of tokens the investor DAO held. The voting investor has the ability to irrevocably vote once per proposal, and a vote freezes that investor’s DAO tokens. However, for The DAO to engage in any investment activity, at least 20% of its DaoToken holders must vote for the project. This may be a critical vulnerability in The DAO.
"Accepting a Proposal requires a majority decision after a debating period of two weeks minimum, and a participation rate of 20% or higher calculated proportionally to the value of ETH requested in the Proposal." As noted by chief technical officer of SteemitDan Larimer, once a party has voted, their ETH is committed to that project until the project is accepted or rejected, which seems to dis-incentivize voting.
Agreeing to fund projects may actually cause a drop in the value of ETH and DaoTokens because a project will require The DAO to transfer ETH to a contractor, who would then likely convert it to fiat currency, which may depress the value of the ETH on open trade markets, which would then reduce the value of The DAO’s ETH holdings. As Larimer suggests "Every time a project is funded, the amount of ETH backing the DAO tokens falls and is replaced with speculative IOU from a contractor." Thus, The DAO funding a project may actually cause a reduction in the value of ETH and reduce the value of its own investment base.
Finally, the voting system may be subject to manipulation by disproportionate actors. If a small group of investors hold an aggregate 20.1% share of existing DaoTokens, they could collaborate to force the acceptance of the proposal, irrespective of any other investors’ votes. If less than 20% of the investment value of The DAO actually votes, The DAO will never fund a project.

Why the investment in The DAO is probably a security

The SEC regulates securities or investment contracts, which are defined as an investment in a common venture premised on a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others. In this case, it is likely that investors who purchase or "create" DAO tokens with ETH are purchasing securities or investment contracts.
Investors in The DAO pay ETH to "create" DAO tokens. Although ETH is not "money," the law suggests that money equivalents qualify as "money" for this analysis as long as the investor is subject to financial loss. A court will also examine what was represented to the investor. Thus, if the representations suggest that the investor was promised a return on the investment, and has a risk of loss, then it is likely considered a payment to an investment contract or security.
The DAO clearly promotes the expectation of investors of ETH obtaining returns. "The goal of The DAO is to diligently use the ETH it controls to support projects that will: …[p]rovide a return on investment or benefit to the DAO and its members;" "The DAO then has the option to accumulate this ETH to support its growth, or redistribute it to the [DAO token] Holders as a reward.” The DAO discloses the risk of loss of invested ETH: "The use of The DAO’s smart contract code and the Creation of [DAO tokens] carries significant financial risk." But The DAO also clearly represents that investors should expect a return on investment or to receive benefit through the increase of value of the [DAO tokens].
The next prong is commonality of enterprise. Although different courts apply different tests to determine commonality of enterprise, under the tests applied by most courts, the structure of The DAO would be deemed sufficiently common to satisfy this prong of the test.
Finally, The DAO appears to satisfy the requirement that profits derive solely from the efforts of others. The DAO functions to fund projects approved by the investors. Without projects, The DAO does nothing but hold invested ETH pending approval of a project. To determine whether the profits derive from the efforts of others, the court will determine whether the significant, managerial efforts that affect the failure or success of the enterprise are made by those other than the investor. Because The DAO relies upon contractors and their projects to present investment opportunities from which returns or profits may be obtained, this prong is likely also satisfied.
The sale of DAO tokens by The DAO in exchange for ETH carries all of the hallmarks of an investment contract or security, and under this analysis, the SEC could assume jurisdiction over The DAO. The DAO presents novel legal issues, both with respect to its ability to interact with the legal system, and as to the potential regulatory ramifications of investing in a new novel structure.
Disclaimer: The views expressed in this article are those of the author and do not necessarily represent the views of, and should not be attributed to, CoinDesk.

Sydney Stock Exchange Developing Blockchain Trading System

A stock exchange in Australia is developing a private equity market solution using blockchain technology.
As reported by the Sydney Morning Herald, the Sydney Stock Exchange (SSX) will initially look to facilitate the trade of private stocks, but will eventually open the system up to publicly traded stocks as well. The project brings to mind Linq, the blockchain project developed by securities exchange operator Nasdaq in partnership with blockchain startup Chain.

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Loretta Joseph, the lead SSX consultant working on the project, told the Morning Herald:

"We will start with a private secondary equity market for venture capital and crowdfunded startups to register on our exchange. We will then move to a public secondary market. VC and crowdfunding are private little markets. It will give them another market that they can come to."

According to the report, the project has been in development for year, but recent moves by the government encouraged SSX to push ahead on the initiative. Statements from the exchange’s leadership indicate that it intends to both use the solution internally as well as market it to other exchanges.
By planning to integrate blockchain tech into its systems, SSX becomes the second notable securities exchange in Australia to seek to adopt the technology.
The Australian Securities Exchange (ASX) has been working on its own solution in partnership with New York-based startup Digital Asset Holdings. The exchange was also an investor in Digital Asset’s recent $60m funding round.
The move comes during a formative time for the technology in Australia. Earlier this year, the government gave its effective stamp of approval through public statements on such projects, stating the intention to develop new legal frameworks for blockchains.
Image via Shutterstock

Digital Currency Exchange Gatecoin Offline After Loss of Funds

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Hong Kong-based digital currency exchange Gatecoin has reportedly experienced a hack, resulting in losses from its connected wallets.
CEO Aurélien Menant took to the Slack channel for the DigixDAO project yesterdayand indicated that the exchange lost control of bitcoins and ethers, the native token of the Ethereum network, during the incident.
Menant said that tokens tied to the DigixDAO project as well as the Augur and TheDAO projects were unaffected.
The CEO indicated via Slack that he was not entirely clear on the amount of funds taken, but noted “[the numbers] are big” and that the exchange will seek to refund customers following the loss. Though unconfirmed by any official source, rumors have begun circulating that the losses could be as much as $2m.
In a statement provided to CoinDesk, Gatecoin said:

"Last night Asia time, we suspected a potential leak on our hot wallets. Therefore, we decided to shut down the exchange and ports in order to minimise further potential losses, and we are conducting a full forensic investigation to identify the root of the issue. This is why Gatecoin's user interface and API are currently offline."

The hack comes amid the ongoing crowdsale for TheDAO, an initiative aimed at providing a funding mechanism for Ethereum projects.
Gatecoin has been facilitating the sale of tokens used to hold votes in the decentralized autonomous organization (DAO) through the use of IOUs, which according to materials on the exchange’s site would be swapped for tokens following the completion of the crowdsale.
Earlier today, the exchange took to Twitter to report that it had taken its website offline “due to a high risk” that funds would “leak” from some of the connected wallets. The warning read:

Alert: our website is down due to a high risk of leak in some of our hotwallets.

— Gatecoin (@Gatecoin) May 13, 2016

On Twitter, Gatecoin later said it was investigating the issue, and other posts suggest that the exchange had been taken offline prior to the announcement, a move attributed on the main Gatecoin page to “maintenance”.
Gatecoin did not immediately respond to a request for comment.
Image via Gatecoin

Why Out-of-Hospital Blockchains Matter

Cyrus Maaghul is a blockchain innovation advisor and the head of product at healthcare platform startup PointNurse.
In this opinion piece, Maaghul discusses what he sees as the potential applications for blockchain in the field of healthcare, an area increasingly of interest to industry firms.

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I bought my first bitcoin in May 2013 while on a vegan retreat in Asheville, North Carolina. Going through the purchase process reminded me of when I first downloaded Mosaic and surfed the net. I thought to myself, "this is going to be a game changer". It was.
Bitcoin and blockchain technology will be game changers, too.
Bitcoin, its underlying blockchain and evolving peer-to-peer networks with Turing-complete smart contracts such as Ethereum will have a disruptive impact on many industries for years to come. Financial services, payments, supply chain logistics, insurance, and healthcare are just a few that will be disrupted with these new technologies.

Out-of-hospital blockchains

Healthcare will be a primary beneficiary of these new technologies, especially outside of the walls of hospitals.
As more and more health and preventive care is provisioned in virtual environments, at home, in cars, at work, etc, the need for open and accessible tracking, verifying and provisioning of care will become extremely critical for patients, payors, providers, scientists and regulators.
These new out-of-hospital (OOH) blockchains developed in the non-clinical community will set the pace for how patient behavioral and inter-clinic visit vital data is tracked in the future for provider reimbursement, regulatory compliance, safety monitoring and patient adherence.
The blockchain is a near-perfect technology (not necessarily the current implementations) to securely and safely make OOH data easily accessible with relatively minimal privacy and hack risk to all patient stakeholders, including the patient themselves, family, caregivers, clinics, providers, insurance companies and all those with a stake in their patients’ health.
Each and every one of these stakeholders or network peers approved by the patient can easily join OOH blockchains as either nodes or buyer or seller of tokens or payments to gain access to patient data, utilizing a variety of open access methods and smart contracts that store and monitor real-time contractual conditions agreed to by and between various stakeholders.
There will be many OOH blockchains developed to address the myriad of use cases in healthcare, including tracking the development of drugs, doctor and nurses credentialing, real-time population health data analysis and alerts, insurance peer-to-peer risk pooling, telemedicine and home health visit data sharing, decentralized autonomous organizations, verification and audits, and remote device monitoring commonly addressed today under the Internet of Things category.
These open and viable peer-to-peer healthcare blockchains will open the door to new business models in healthcare, including analytics-for-healthcare products and services, flash malpractice insurance and friction-less claims processing hence shorter revenue cycles.

Healthcare insurance claims processing

It is no secret that healthcare claims processing is a nightmare for all parties involved. Reimbursement is opaque, fraud is prevalent, and transactions frequently difficult to reconcile.
For example, home health, a great OOH blockchain example, is possibly one of the greatest sources of fraud in the US healthcare industry today. Smart contracts powered by a blockchain could provide consumers and payors with the means to manage claims in a transparent, immutable and responsive fashion.
Insurance contracts, premium payments and their respective claims could be recorded onto a blockchain and validated by node consensus, preventing fraudulent claims from being processed. Smart contracts could enforce claims triggering payments when due or dispatching specialists, nurses or doctors to follow up with patients when anticipated claims are not recorded by presumptive dates.

Managing "super-utilizers"

The term super-utilizer describes individuals whose complex physical, behavioral and social needs are not well met through the current fragmented health care system.
These individuals go from emergency room to emergency room, to admission and re-admission, in a chaotic and costly manner. Mental health, substance abuse, poverty and education are frequently cited as common characteristics of many but not all in this group. Many researchers and experts postulate how more "community support" and "real-time engagement" is needed to manage this socially isolated population of healthcare super-utilizing consumers.
Smart contracts powered by an OOH blockchain utilizing the bitcoin payment system could be used to create a rewards and incentive system to manage super utilizer behavior.
Behavioral contracts could be developed between payor and patient to trigger rewards denominated in BTC for attending support groups, regularly engaging a telehealth professional, reporting health conditions (possibly at kiosks with bitcoin point-of-care devices), and meeting agreed upon health goals.
Payors would fund reward payouts via efficient BTC accounts established at commercial digital currency exchanges. A smart contract would trigger a reward payment (or loss) when goals are met near real-time to the patient’s public bitcoin address which in turn could be tendered at local participating outlets equipped with BTC point-of-contact devices including community centers, supermarkets and apartment complexes to pay bills, purchase healthy foods and meet rent obligations.

Medical malpractice insurance DAOs

In theory, decentralized autonomous organizations (DAOs) are entities that are self-governing. DAOs on a OOH blockchain could enable trust and provide an immutable record and audit trail of an agreement without a single controlling body.
Doctors and nurse practitioners could collaborate to establish a peer-to-peer malpractice DAO and record each peer's premium payments and claims on the blockchain. All premiums paid in would create a pool of capital to pay claims.
By combining the blockchain with the peer-to-peer business model, this creates the potential for a near-autonomous self-regulated insurance business model for managing policy and claims. No single entity would control the network. Policyholders could "equally" control the network on a pro-rata basis.
But, these are just a few examples of how bitcoin and blockchain technology will change the face of healthcare in the future.
The blockchain is a new and exciting technology, and we are now just beginning to see both small and large players dip their toes into the water. I personally would discourage any entrepreneur from pursuing the use of blockchain technology inside the walls of clinics and hospitals today, as the those lanes are laden with painful obstacles – the OOH blockchain is your winning lane today.
This article originally appeared on LinkedIn and has been republished with the author's permission.
Future doctor image via Shutterstock
Disclaimer: The views expressed in this article are those of the author and do not necessarily represent the views of, and should not be attributed to, CoinDesk.

Building a Better Bitcoin Fee Market

Over the past year, we have seen the fee market for bitcoin transactions evolve at a rapid pace. As transaction volume continues to increase, so does the demand for block space, which remains in limited supply of 1 megabyte (MB) approximately every 10 minutes.
As we have debated the issue of increasing the supply of block space ad nauseum, this article will focus on the history and current state of bitcoin transaction fees.
The fact is that the pressures resulting from high contention for block space have degraded user experience and thus incentivized bitcoin wallets to make adjustments in order to keep their users happy by ensuring timely confirmation of transactions.
However, we're a long way from operating an optimal fee market.

The History of Transaction Fees

For the first several years of bitcoin’s existence, transaction fees were optional – they were considered a donation to miners.

Wallets paid the same fee on every transaction – defaulting to whatever fee the wallet developer thought was appropriate.
Bitcoin Core's default fee changed several times over the years as the bitcoin exchange rate increased, from 0.01 BTC to 0.0005 BTC to 0.0001 BTC. There were also rules around "priority transactions" that enabled users to send transactions with no fee if the inputs were old and high value enough, though miners have mostly phased those out at this point.
We learned over the years that hard-coded static transaction fees are terrible for several reasons:

• It's not the absolute fee that matters to miners, but rather the fee rate per bytes of transaction data. From the miner’s perspective, they only have 1 MB of space into which they want to insert as many transactions as possible in order to collect more fees. As such, a 200 byte transaction with a fee of 0.0001 BTC is preferable to a 1,000 byte transaction with a fee of 0.0001 BTC, because they can insert five of the former and collect five times as much in fees.
• From the user’s perspective, if you always set a static fee, you’ll likely eventually create a large data size transaction (due to spending many low value inputs) with a very low fee rate that may never get confirmed.
• Wallets with static fees can't adapt to quickly changing market conditions, resulting in users broadcasting transactions that are either overpaying or underpaying. The former won't get transactions confirmed much faster, while the latter will result in long confirmation times because miners pass them over in favor of more profitable transactions to confirm.

The release of Bitcoin 0.3.15 in November 2010 included a change to start calculating fees relative to the transaction’s data size, but not every wallet software followed suit and many users continued blindly setting the same static fee on every transaction. This was generally not a problem until we started bumping up against the max block size, because miners would confirm pretty much any valid transaction that was successfully relayed to them.
As blocks began to fill up in 2015, it became clear that the best practice is to use a dynamic fee algorithm because it can respond to changing conditions on the network.
Bitcoin Core started calculating dynamic fee estimates as of the 0.10 release in February 2015, and Alex Morcos has been steadily improving them since then. Core's fee estimate algorithm is rather complex; you can view its code here and the english explanation here.

A Fee Market Emerges

Antoine Le Calvez, developer of p2sh.info, provides a historical analysis of dynamic and static fees.
Here are the past two years:

Historic Dynamic Fee Usage, via P2SH.info

We can see significant jumps in dynamic fee usage during the network stress tests and attacks last fall.
However, I suspect that this was not due to normal users switching to dynamic fee wallets, but rather the attackers themselves paying fees that they intentionally set to be higher than the static fees being used by most wallets at the time.
Some of the more sophisticated users adjusted their hard-coded fees during the attacks, but these were likely a small minority of the total transactions. We can also see a jump at the beginning of March 2016 – this is likely partially a result of Blockchain's new wallet deploying dynamic fees about a month earlier.
Rusty Russell performed an excellent analysis of the emerging fee market in December 2015, which showed that more transactions are using dynamically calculated fees, and that the average value of a transaction is increasing as tiny payments are getting priced out of the blockchain.

AJ Towns followed up on Rusty’s post with more in-depth analysis. He identified eight distinct fee market phases over the course of bitcoin’s history:

Towns continued his investigation in a second post and came to several conclusions about the effects that the emerging fee market has had upon users.

These were:

• A significant number of wallets are dynamically calculating fees, at a per-byte granularity.
• Many wallets still don’t calculate fees dynamically, or even calculate fees at a per-byte level.
• Market-driven fees will only be able to rise further with increased adoption of wallets that support dynamic fee estimates.
• Significantly overpaying the market rate will not get your transaction confirmed any quicker.
• There have been two fee events that have impacted wallets with static fees, and a third fee event is coming soon.
• Wallets that dynamically calculate fees pay substantially lower fees on average than those that don’t.

I've been tracking Bitcoin Core's fee estimates with Statoshi; here you can see that they have tripled over the past six months as contention for block space continues to increase.

Bitcoin Core Fee Estimates, via Statoshi.info

Calvez also provides a dashboard with all of the publicly available fee estimate APIs and their historical estimate data:

Various services' fee estimates, via P2SH.info

Interestingly, it appears that 21, BitGo, and Blocktrail’s fee estimates appear to be the most responsive to changing market conditions while BitPay, Blockchain, and BlockCypher have less volatile estimates.
However, it would be negligent for me to broadly recommend everyone switch to using dynamically calculated transaction fees without first noting the dangers involved.
As the saying goes, every solution leads to new problems. Dynamic transaction fees are no exception.

Dynamic Difficulties

Dynamic fee estimates will never be perfect because they are an attempt to predict the (near) future.
As Danish physicist Niels Bohr once quipped: "prediction is very difficult, especially about the future". If a fee estimate algorithm fails to correctly predict the future state of the fee market then users get stuck in a "fee trap" as noted by Dr Washington Sanchez of OpenBazaar.
This can occur if you broadcast a transaction with a perfectly reasonable fee for the current market conditions, but immediately after doing so, many other higher fee transactions get broadcasted by other users, which essentially push your transaction to the back of miners’ priority queue. The problem is that you can't, without Replace By Fee (RBF), update your "bid" in order to compensate for the new market conditions.
Bugs in fee estimate algorithms also have potential to wreak havoc on the fee market. Take, for example, a recent user error that resulted in someone creating a transaction with a whopping 300 BTC fee. This was bad enough for the unfortunate user who likely fat-fingered the "fee" and "value" amounts into some poorly coded software, but it also had ripple effects:
This is an educated guess, but it appears that BlockCypher’s "1 to 2 block target" is using a fee estimate algorithm based upon a weighted moving average of fees from the past two days of blocks. As a result, when the 300 BTC fee transaction was mined, the recent fee average and thus their estimate spiked by 800%.
But this is not meant to pick on BlockCypher, as we have seen many wallets have issues with transaction fees. Not even Bitcoin Core is exempt, as I recently observed an unexpected spike in the fee estimates from Bitcoin Core 0.12.0:

Bitcoin Core Fee Estimate Anomaly, via Statoshi.info

I noticed that Statoshi.info’s "two block target" fee estimate surged from 44 to 112 satoshis per byte on 27th February for no apparent reason. My other bitcoin nodes did not report the same spike.
This could perhaps be explained by differences in mempool transactions since Core’s fee estimate algorithm only uses fees from transactions that were first received as unconfirmed.
It is concerning and is a demonstration of a downside to extrapolating the future based upon your node’s view of the network, which is not guaranteed to be the same as everyone else's.

Macro meltdown

While there are plenty of challenges presented to bitcoin developers on a per-transaction basis, we should also be cognizant of the effects upon the fee market as a whole.
I'm concerned by a couple potential scenarios that could drive fee rates up faster than necessary:

1. Poorly coded dynamic fee algorithms could create a feedback loop that drives the fee rate up with no ceiling as transactions continue to flood the network with no regard for the mempool backlog. This is not a huge concern if most transactions are being initiated by humans who are then seeing a fee displayed and deciding whether or not it is too high for their tastes. However, if many transactions are being created automatically without any human decision making and the algorithms creating them don’t have any sanity checks on the maximum fee paid, the market could run away until the engineers who wrote those algorithms notice and make changes to them.
2. Frustrated users (or lazy developers) who are still relying upon hard-coded fees may keep manually updating their wallet settings until their transactions start getting confirmed, likely overpaying significantly, but eventually forcing other static fee users to do the same in order to remain competitive. Dynamic fee users will be pulled upwards as a result. I've already observed the former happening, though not yet to the extent that it has affected dynamic fees significantly.

One recent development that hasn’t received much attention despite the fact that it has the potential to affect the fee market is the development of secondary miner fee markets.
This can take the form of special customer incentive programs such as BTCC’s BlockPriority service or it can take the form of private prepaid block space purchases. This spells trouble for any developers who are writing fee estimate algorithms because now there are opaque fee markets that are invisible to the rest of the world.
To quote BTCC’s press release:

"BlockPriority prioritizes all BTCC’s customers’ transactions, including those who pay zero transaction fees."

This should not be a problem for Bitcoin Core’s fee estimate algorithm because it requires 95% of mempool transactions with a given fee rate to be confirmed in X blocks after being seen, but it could affect more naive algorithms. The lesson for developers is that just because you are seeing transactions at a low fee rate of X being confirmed no longer means that it’s safe for your service to broadcast transactions at that fee rate.
It may make economic sense for mining pools to sell prepaid block space contracts because it gives them a new predictable revenue stream.
However, my warning to pools is this: you won’t be able to hide this activity if it becomes a significant portion of your mined transactions. There are plenty of wallet engineers such as myself who are monitoring for this type of behavior, and if it becomes a problem, we will go public. I suspect that any public mining pools found to be participating in this behavior will not fare so well if the individual hashers discover that the pool has been mining lower fee transactions and not sharing the profits from the private block space contracts.
This could result in hashers moving to a pool that they think will be more profitable.
Segregated Witness will also likely have an effect upon the fee market. It will offer a 75% fee discount in an attempt to rebalance the costs of creating versus consuming unspent transaction outputs.
This is expected to encourage users to favor the use of transactions that minimize impact on the UTXO set in order to minimize fees and to encourage developers to design smart contracts and new features in a way that will also minimize the impact on the UTXO set.
David Harding wrote up a helpful breakdown of the data savings provided by SegWit.
I think this is the right path to take, though I’m not sure that 75% is the optimal number. It seems to me that the most fair discount would be dynamic and based upon the ratio of the output’s data size to the corresponding data size of the same output when it is spent as an input.
Though this would certainly be much more difficult to implement, if it’s even possible at all.

Moving forward

There are still many wallets and bitcoin services that have not implemented dynamic fees. You know who you are, and your inaction is likely resulting in a poor experience for some of your users. If you haven’t implemented dynamic fees, then every transaction you broadcast fits into one of two categories:

1. You're overpaying the market rate and not getting confirmed significantly faster.
2. You're underpaying and transactions are getting stuck, resulting in a poor user experience.

It's highly unlikely that a transaction broadcast with a hard-coded fee is hitting the sweet spot and paying the optimal rate to match current market conditions.
Wallet developers should add safety mechanisms such as sanity check thresholds at the micro level and circuit breakers at the macro level to prevent users from shooting themselves in the foot.
Wallets should set a minimum threshold that is higher than just the minimum relay fee. By observing the minimum fee transactions that make it into blocks, we can clearly see that as of today if you’re paying under five satoshis per byte, you’re going to have a bad time.

Bitcoin Mining Fee Distribution, via BitcoinFees

Wallet developers should think adversarially about their fee estimate algorithms and write them to be robust against edge cases that could occur due to mistakes in other wallet software or malicious attacks by entities trying to manipulate the fee market. They should also monitor their fee estimate data and set alerts to notify them if the estimates become more volatile than expected.
But, we should recognize that there is no "one-size-fits-all" fee estimate algorithm – it really depends upon the use case your bitcoin transactions fall under.
Bitcoin Core's algorithm aims to be as generic and conservative as possible so that it's incredibly reliable, but for some use cases it may result in overpaying. Each wallet and service will need to decide what trade off they are willing to make to balance the risk of delayed confirmations against the reward of saving money on fees.
As such, I encourage all bitcoin wallets to make their fee estimates accessible via public APIs. I suspect that the fee estimate algorithms themselves will become a point of competition and often remain closed source, but it the estimates are public then we can more easily watch for abnormal activity. Perhaps someone will even build a "Bitcoin Average" aggregator for fee estimates!
We should recognize that the "fee market" isn’t exactly a market in the traditional sense of the word.
Users can place a "bid" by broadcasting a transaction, but miners don’t publicize their "asks" – wallets have to guess based upon the transactions miners have recently confirmed and by what transactions are currently waiting to be confirmed.
Konrad S Graf stated his thoughts on the "fee market" recently:

"Fees are paid; products and services are bought. So, this term already obscures the real product. Users submit transactions with a fee as an open bid in hopes of confirmation. I describe this as a market for transaction-inclusion services. Users bid to have miners include transactions in candidate blocks. Inclusion in more candidate blocks—especially in relation to the total hashrate mining for those candidates – raises odds of quicker confirmation. Users prefer quicker confirmation to slower, other things equal, so the time element of scarcity is key. It is a market for confirmation priority, a time market."

Perhaps if mining pools published public APIs with their mining policies and "going rates", then it could help wallet services make more informed decisions when calculating dynamic fees rather than forcing developers to rely upon guesswork. This could also help alleviate problems caused by miners who create opaque secondary fee markets via private block space contracts.
Bitcoin users should not need to keep track of the current state of block contention.
Wallets should be handling the complexities of the fee market under the covers, giving the user several simple options when sending a transaction. One potential route would be for the user to authorize a max fee depending upon the transaction urgency and have the wallet use RBF to ramp up the fee paid after each block that passes without it being confirmed.
Transaction fee values should be displayed to the user in terms of their preferred unit of account, such as dollars. It would probably also make sense to display the fee in terms of a percentage of the transaction's value if it exceeds a certain threshold, such as 1%. This will make it easier for users to decide if the current state of the fee market is too contentious and that they would prefer to delay making the transaction until they can safely do so at a lower fee rate.
When we are discussing transaction fees, bitcoin users should stop saying that they paid "X cents" or "Y bits" in transaction fees because this type of statement is nonsensical without knowing the size of the transaction. We should standardize using fee rates in discussions, preferably denominated in terms of satoshis per byte. It’s simpler for humans to write and keep track of "20 satoshis per byte" in comparison to "20,000 satoshis per kilobyte".
The evolution of bitcoin's transaction fee market has been a rocky road up to this point.
At first fees were set manually by developers, then manually by users, and now we're at a more chaotic and potentially dangerous point where developers are playing a more active role in steering the economics of this emerging market.
Kristov Atlas eloquently noted the risks we take by centrally planning economic changes to bitcoin without fully studying them; developers should keep this in mind when writing fee estimate algorithms. We should strive to ensure that the fee market remains driven by humans with the aid of machines, not the other way around. Wallet developers must be careful when building their fee logic so that we can provide a smooth user experience without taking away users' freedom of choice, which is necessary for maintaining a functioning fee market.
Image via Dan Nott for CoinDesk