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The New Fintech Revolution

(San Francisco, California, U.S.A. - Jeffrey M. Wang)


The New Financial Technology (FinTech) Revolution:

Challenges, Opportunities and Future Directions






"We’ve entered the most profound era of change for financial services companies since the 1970s brought us index mutual funds, discount brokers and ATMs. No firm is immune from the coming disruption and every company must have a strategy to harness the powerful advantages of the new financial technology (FinTech) revolution" -- Business Insider. FinTech, the future of transactions and commerce, is a portmanteau of financial technology that describes an emerging financial services sector in the 21st century. 

FinTech is an area that is radically changing how we live as society and how we do business professionally. It is dramatically reshaping human economic life. It is opening access to markets, investment and credit.  FinTech is inventing new ways to solve age-old financial problems. It has reduced fees, disintermediated banks and brought financial services to emerging economies. The rise of FinTech has opened up a world of possibilities. Businesses can offer more services than ever and for a fraction of the price of what it would have cost before.

FinTech and Financial Inclusion

In emerging markets, billions of people around the world without access to traditional financial services, FinTech could lead to a revolution in financial inclusion and membership in the global digital economy. Individuals and businesses have access to useful and affordable financial products and services that meet their needs – transactions, payments, savings, credit and insurance – delivered in a responsible and sustainable way. Financial inclusion is a key enabler to reducing poverty and boosting prosperity.

FinTech and Disruptive Technology

Financial technology (FinTech), an economic industry composed of companies that use technology to make financial services more efficient, is usually applied to the segment of the technology startup scene that is disrupting sectors such as retail banking, lending and financing, payments and transfers, wealth and asset management, markets and exchanges, insurance, blockchain transactions, etc.. It refers to new applications, processes, products or business models in the financial services industry. However, the FinTech term has started to be used for broader applications of technology in the space – to front-end consumer products, to new entrants competing with existing players, and even to new paradigms such as Bitcoin. The financial services industry is one of the last frontiers new technology has yet to fully conquer. FinTech companies are trying to disintermediate incumbent financial systems and challenge traditional corporations that are less reliant on software. 

Internet-based technology has made it cheap to collect information and to network. This has empowered the sharing economy and allows FinTech companies to seize intermediation business from banks. But both FinTech and "sharing economy" businesses manage information centrally – they serve as middle-men – exactly as traditional financial institutions do. The FinTech revolution is forcing the financial services industry and everything it touches to evolve quickly. 

Digital Lending

Banks have historically handled most consumer and small business lending because they have the resources to assess a borrower's creditworthiness, and the regulatory approval to fund loans. However, this model has some key inefficiencies – interest rates are not individualized, the costs of underwriting loans are high, loan decisions can take months, and small businesses in particular have been shut out of the process. This has left room for the growth of online lending marketplaces – dubbed peer-to-peer (P2P) lenders – that leverage the Internet to give both borrowers and investors a better deal. 

Digital lending is characterized by a focus on making cheaper loans available through completely digital means. It also focuses on automating the entire processing of this low cost asset. Alternative lending is a collective term used to describe the broad range of loan options available to both consumers and business owners outside of a traditional bank loan. Alternative lending models such as Peer-to-Peer (P2P) lending and Business-to-Business (B2B) lending make cheap loans available to an audience that is either cash strapped or traditionally deemed credit-invisible. The FinTechs may have uncovered a new segment and created a new ecosystem but banks are still key for the entire lending cycle to thrive and grow.

- P2P Lending

P2P lending is a new method of debt financing that allows people to borrow and lend money without a financial institution. Harnessing technology and big data, P2P platforms connect borrowers to investors faster and cheaper than any bank. P2P lenders solve the banking model's inefficiencies by developing online marketplaces that use complex algorithms to match borrowers with investors according to each party's specifications.

As consumers and businesses have moved more activities online, they have created an unprecedented amount of data. Online lenders have leveraged this data to make underwriting decisions, creating computer programs that can automate loan originations without the need for a customer to ever set foot in branch. These programs can use traditional underwriting criteria—such as debt to income or cash flow analysis—or less traditional metrics such as the number of visitors to a company’s website. 

Peer-to-peer (P2P) lending platforms offer loan opportunities outside of traditional lending institutions. P2P platforms leverage metrics such as credit scores and social media activity to link borrowers and lenders at favorable interest rates. Platforms have lower regulatory burdens because they are merely acting as intermediaries between borrower, lender, and partner bank, and thus can keep fees and rates low. 

P2P borrowers are often individuals seeking to refinance debt at reasonable rates or small businesses that have trouble getting low-value loans from traditional institutions. Lenders are typically individuals seeking a higher rate of return than can be garnered from other interest-bearing accounts.

- B2B Lending

B2B lending is similar to P2P lending but aimed for businesses. It enables SMEs (Small and Medium-sized Enterprises) to receive the necessary funding for growth directly from a set of online investors (both individual and institutional). The advantage of this model is that it allows businesses to cut the intermediaries like banks with complex and time-consuming paperwork time. In addition, just like P2P lending for individuals, B2B lending offers competitive rates and terms of financing along with transparency and ease of use.

The main advantage with B2B lending is flexibility. Businesses can pick a term, maturity date, and prepayment requirements. You’re able to shop around and compare your options against the market rate, providing more value than the banks.

FinTech Automation

As automation technologies such as machine learning and robotics play an increasingly great role in everyday life, their potential effect on the workplace has, unsurprisingly, become a major focus of research and public concern. Companies are using automation to create efficiency and accuracy in business processes. Automation is about replacing mostly repetitive tasks, with machines. It will continue to progress from simple rules-based systems to complex augmented and autonomous decision-making systems. 

Automation seeks to replace more managerial functions with Artificial Intelligence (AI). AI is about replacing human decision making with more sophisticated technologies. These are not repetitive tasks, but rather judgment-based work which requires a more complex set of algorithms and machine learning which can use a variety of inputs to recognize patterns, predict future outcomes and make decisions. For enterprises, AI is expected to continue serving functions such as business intelligence and predictive analytics. Merchant services such as payments and fraud detection are also relying on AI to seek out patterns in customer behavior in order to weed out bad transactions. AI may help banks in their anti-money laundering or employee misconduct detection efforts by replacing costly functions that are currently done manually by humans.

The Future of FinTech is AI and Big Data

Artificial Intelligence (AI) will have a significant impact on financial services, proving to be its most disruptive force, the result of which is already evident with global banks closing branches and terminating thousands of financial services personnel. Machine learning is a type of AI that provides computers with the ability to learn (or to grow and change) without being explicitly programmed when exposed to new data. Emerging FinTech companies are using machine learning to adapt the changes in real time. 

With the stiff competition in FinTech, ventures have to deliver a truly valuable products and services in order to stand out. The venture that provides the best user experience often wins. The developments in AI may provide that something extra especially if it could promise to eliminate the guess work and human error out of finance. 

In a digital era, data is one of the most valuable resources for a company. Banks house a tremendous amount of customer data that has the potential to drive real value for customers, by allowing banks to better understand their needs. In addition, data is the life-blood of AI. "Access to data" plays a central role in the scope and impact of AI systems. Data, and the various rules and processes which both enable and regulate access to and use of that data, stand at the heart of disruptive FinTech businesses. Even the most advanced and intelligent algorithms and models are useless without efficient, secure and legal access to detailed, accurate and up-to-date data sets. 

Big data. machine learning allows software programs to analyze large sets of unstructured data. One way this could help bankers is by improving fraud detection. Traditional fraud monitoring systems rely on specific non-personal rules (like geography) to detect fraudulent transactions. Machine learning could be applied to analyze the transactions of each customer, flagging transactions that are out of their normal habits. This improved analytical capability has the potential to give banks insights that could allow them to develop better credit models and more accurately identify risks. The power of big data is, however, highly dependent on the quality of the data, which is not always easily accessible.

Today, customer data at banks is often unstructured—housed in systems that are inconsistent and may not talk to each other. A single customer may have multiple accounts with a bank that are all housed in different systems, with inconsistent identifiers. A number of banks, as well as core processors, are working to reconcile these systems. Some are working to build additional data warehouses that aggregate disparate customer data to create a unified view of customers. As these customers continue to interact with their banks digitally, a complete digital view of a customer can help a bank better understand and serve that customer. Banks are beginning to offer value-added services to customers that give them more information about those users. 

Rose_Garden_Hyde Park_London_UK_081217A
(Rose Garden, Hyde Park, London, UK - Hsi-Pin Ma)

Internet of Things (IoT) and Financial Services

Internet of Things (IoT) is a network or ecosystem of Internet-enabled objects with the ability to share and exchange information among them in real time. It is nothing but machine-to-machine communication among machines connected to Internet. What brings IoT into limelight is the surge of smartphones, wearable tech devices, automobiles and smart homes with built-in sensors and the growing ability of financial institutions to anticipate customer needs by leveraging big data predictive analytics and artificial intelligence. While still in its infancy, IoT has a full head of steam and shows no sign of slowing any time soon. 

IoT, a suite of technologies and applications that use embedded sensors in physical items to generate customer, operational, and other data that can be aggregated and analyzed for valuable insights, could have an enormous impact on the financial services industry, generating a range of future opportunities emerging from better data about clients and their physical assets. IoT may transform financial services. Many financial services institutions are using sensor data to improve operational performance, customer experience, and product pricing. Banks can use sensors and analytics to gather more information about customers and offer more personalized services. Insurers and commercial banks can also use sensors attached to assets to track shipments. For example, banks may be able to use internet-connected devices to make better loans and monitor collateral. Inventory or livestock for a small business can be monitored in real time. This would allow a bank to monitor a customer’s balance sheet on an ongoing basis, giving it the tools to make better decisions about lending or adjusting credit lines in real time.

The RegTech Revolution

Regulatory technology, also known as "RegTech", a subclass of FinTech, is using technology, particularly information technology, in the context of regulatory monitoring, reporting and compliance benefiting the finance industry. Just as FinTech is being used to digitize customer-facing financial services, RegTech promises to digitize back-office regulatory compliance, simplify regulatory reporting and empower staff to better assess risk and monitor regulatory compliance. RegTech is another example of an industry that is being changed rapidly by software.

In the wake of the financial crisis of 2008, financial regulators wanted to ensure the industry would not face the same problems again. New regulations were put in place to improve risk controls, maintain capital and create a more transparent financial sector. With financial regulation constantly changing, banks and financial institutions are under constant pressure to keep up to speed with the latest rules. Now, a new wave of technology is emerging to help these organisations make sure they understand the rules and can manage their risks. 

RegTech companies were born out of this combination of regulatory change and more efficient technology. There is a range of companies offering these kinds of services. Some offer solutions for financial institutions to help them comply, while others are aimed at helping policymakers monitor those they are regulating. RegTech companies work in collaboration with financial institutions and regulatory bodies, and utilize cloud computing, big data and data visualization techniques, and blockchain for sharing of information. RegTech is an exciting development that contains the following characteristics: Agility, Speed, Integration, and Analytics. Ultimately, RegTech will be use those characteristics and information to enable more efficient and effective regulation and compliance.

There are a wide variety of technologies being used in RegTech solutions. They all need to be cloud-based. This will ensure that they are responsive and flexible enough. This includes big data and data visualization techniques as well as blockchain technologies used as immutable ledgers of shared information. Other applicable technologies include machine learning, biometrics, the interpretation of unstructured data such as e-mails and Facebook posts, and the use of application programming interfaces (APIs). These tools will be used for aggregating big data, modeling risk for bank stress-testing, monitoring of capital-requirement compliance, updating compliance manuals, improving anti-money laundering and know-your-customer (KYC) programs and preventing fraud and in-house violations. In fact, blockchain and biometrics could be the driving forces that really expand the RegTech industry. Biometric technology could serve as a more efficient way to verify identity and work in collaboration with other technologies. 

Adoption of RegTech will provide operational efficiencies and cost benefits when applied to current compliance and risk management practices. It is anticipated that regulation will only continue to increase with more demand to oversee data, reporting, and operational processes. Fund managers and banks are looking at supporting and partnering with RegTech startups to address the growing regulatory and compliance demand as well as assist in spreading adoption of RegTech solutions for payments and governance.

For a RegTech solution to be successful, collaboration among the following players: "Regulators, RegTech Firms, Professional Service Firms, and Financial Institutions" will be essential so that barriers like forming "a common solution, establishing a set of standards, understanding complex regulations, and help firms and regulators build more efficient, automated, compliance processes" can be overcome. When these parties work together, they will be able to drive innovation within the RegTech industry, develop advanced data analytics capabilities, and reduce the cost of compliance in financial services.

The application of RegTech is still in its infancy. Some ideas require the buy-in of regulators and the maturation of technology, while others are as simple as providing better information to compliance officers—and are available today.

Embracing the FinTech Revolution

If you are in the banking sector, you should be keeping a close eye to the FinTech industry. Besides providing innovative new technology and ideas for the banking industry, these exciting FinTech startups also provide innovative solutions for the small business owner. If you are looking for low-cost solutions to your business accounting and finance needs, from invoicing to payroll to investing, the FinTech sector is an exciting space.

There are four broad categories of FinTech users: (1) B2B for banks and (2) their business clients; and (3) B2C for small businesses and (4) consumers. Trends toward mobile banking, increased information, data and more accurate analytics and decentralization of access will create opportunities for all four groups to interact in heretofore unprecedented ways. Connectivity, simplification and personalization are three fundamental trends about FinTech. Connectivity is about anyone or anything being able to interact, trade or exchange information anywhere and anytime. Technologies such as APIs and the Internet of Things are enablers. Simplification is about reducing complexity. There are many processes and technologies that can result in simplification, of which blockchain is only one. Personalization is about making services easier or more relevant for the user through technologies such as big data, machine learning. 

It is clear that the digital revolution in financial services is under way. Digital disruption has the potential to shrink the role and relevance of today’s banks, and simultaneously help them create better, faster, cheaper services that make them an even more essential part of everyday life for institutions and individuals. To make the impact positive, banks need to shake themselves out of institutional complacency and recognize that merely navigating waves of regulation and waiting for interest rates to rise won’t protect them from obsolescence. Embracing openness and collaboration, and making smart investments is a good place to start. The FinTech industry has orchestrated in just a few short years a sweeping change in customer preferences and expectations for the modern “bank” experience. The next decade will demonstrate the impact of this disruption as customers choose financial services based on the product experience, not on the breadth of offerings.

Blockchain: Disrupting the FinTech

While FinTech disrupts banks, the blockchain disrupts FinTech. A blockchain is a public ledger of all bitcoin transactions that have ever been executed. Blockchain, the technology underpinning the bitcoin digital currency and the technology to power open finance, is a decentralized public ledger (or distributed ledger) of transactions that is revolutionizing the way people around the world exchange value.

Blockchain is a comprehensive, always up-to-date accounting record of who holds what or who transferred what to whom. It is emerging as a way to let people make and verify transactions on a network instantaneously without a central authority. A block is the “current” part of a blockchain which records some or all of the recent transactions, and once completed, goes into the blockchain as permanent database. Each time a block gets completed, a new block is generated. Blocks are linked to each other (like a chain) in proper linear, chronological order with every block containing a hash of the previous block.

To use conventional banking as an analogy, the blockchain is like a full history of banking transactions. Bitcoin transactions are entered chronologically in a blockchain just the way bank transactions are. Meanwhile, blocks, are like individual bank statements. The full copy of the blockchain has records of every bitcoin transaction ever executed. It can thus provide insight about facts like how much value belonged to a particular address at any point in the past. 

Blockchains are a very powerful technology, capable of performing complex operations. The distributed ledger technology that underpins blockchain systems is designed for near real-time transfer of data. It can deliver instant resolution to customers' transactions and interactions with their banks. Three main types of blockchains exist: public (a platform where anyone on the platform would be able to read or write to the platform), private (it allows only the owner to have the rights on any changes that have to be done), and consortium (a mix of both the public and private, wherein the ability to read and write could be extended to a certain number of people/nodes). Ethereum is a public blockchain-based distributed computing platform. It provides a way to create online markets and programmable transactions known as smart contracts. Ethereum is the biggest innovation after bitcoin.

Smart Contracts, Blockchain and Distributed Ledger Technologies

Smart contracts, a central component to next-generation blockchain platforms, are computer protocols intended to facilitate, verify, or enforce the negotiation or performance of a contract. Proponents of smart contracts claim that many kinds of contractual clauses may be made partially or fully self-executing, self-enforcing, or both. The aim with smart contracts is to provide security that is superior to traditional contract law and to reduce other transaction costs associated with contracting. Smart contracts use autonomously executed software programs running on a distributed ledger to automate business processes. Blockchain is the database and smart contracts is the application layer that makes much of the benefits of blockchain technology a reality. Smart contracts cause a convergence of smart devices, analytics, artificial intelligence, cloud, and blockchain technologies.

Smart Contracts, often created by computer programmers through the help of smart contract development tools. They are simply computer program code (such as C++, Python, Java) that is capable of facilitating, executing, and enforcing the negotiation or performance of an agreement (i.e. contract) using blockchain technology. This code defines the rules and consequences in the same way that a traditional legal document would, stating the obligations, benefits and penalties which may be due to either party in various different circumstances. This code can then be automatically executed by a distributed ledger system. The entire process is automated can act as a complement, or substitute, for legal contracts, where the terms of the smart contract are recorded in a computer language as a set of instructions. 

To accelerate the adoption of smart contracts and realize higher benefits, enterprises need to develop a smart contract pool that can connect legal text to business logic and eventually convert to smart contracts on a distributed ledger. Industry standards need to emerge for enterprise adoption. Security of smart contracts is an arena of concern.

Smart contracts have been used primarily in association with cryptocurrencies. The most prominent smart contract implementation is the Ethereum blockchain platform, which also calls them decentralized applications or dapps. In addition, Trade finance, post-trade services, and event-driven insurance are the leading use cases being piloted/experimented by financial services institutions.  Loyalty and rewards, smart power grids, and digital rights management are the top use cases being piloted in other sector.

(United Nations, Geneva, Switzerland - Alvin Wei-Cheng Wong)

Anatomy of a Smart Contract

The main goal of a smart contract is to enable two anonymous parties to trade and do business with each other, usually over the Internet, without the need for a middleman. Smart contracts are becoming a cornerstone for enterprise blockchain applications and will likely become one of the pillars of blockchain technology. For example, A wants to send money to B. The transaction is represented online as a block. The block is broadcast to every party in the network. Those in the network approve the transaction is valid. The block then can be added to the chain, which provides an indelible and transparent record of transactions. The money moves from A to B. Blockchain technology undermines the "middle-man" business model. It makes it harder to cheat in transactions, and so reduces the value of credibility lent by trusted intermediaries.

Distributed ledgers are often viewed as most attractive to industries with businesses that lack a central institution they can trust to keep their records. The implications of decentralized ledger technology (DLT) are astounding: Digital trust is now an ever reasonable possibility; meaning online and offline assets can now be assigned ownership and the transference between those parties can be proven both linearly and cryptographically. Now, people everywhere can trust each other and transact peer to peer. And trust is established, not by some big institutions, but by collaboration, by cryptography and by some clever code. It could offer a new way to move money and track transactions across borders and other networks in a more secure, transparent and effective way than the current system. 

Blockchain will do for transactions what the Internet did for information. In the case of the Internet of Things, we’re going to need a blockchain-settlement system underneath. Banks won’t be able to settle trillions of real-time transactions between things. So this is an extraordinary thing. An immutable, unhackable distributed database of digital assets. All of the advantages derived from basic blockchain technology can be boiled down to only two benefits; corruption resistance and redundancy. This is a platform for truth and it’s a platform for trust. It is fast becoming a symbol of the fourth industrial revolution.

Blockchain is the technology that creates a ledger of transactions on the Internet. It is a data structure that makes it possible to create a digital ledger of transactions and share it among a distributed network of computers. Blockchain uses cryptography to allow each participant on the network to manipulate the ledger in a secure way. It quickens the ownership validation process, executes transactions in just minutes or even seconds. Like the Internet, the blockchain is an open, global infrastructure upon which other technologies and applications can be built. And like the Internet, it allows people to bypass traditional intermediaries in their dealings with each other, thereby lowering or even eliminating transaction costs. 

Emerging Applications For Blockchain

Blockchain shows great promise across a wide range of business applications. An increasing number of enterprises across all industry sectors are now exploring how they can use blockchain technology to remove friction from business processes and build systems of trust for value exchange. Blockchain databases, powered by enterprise-grade, scalable and secure core databases are core to unlocking the potential. 

By using the blockchain, individuals can exchange money or purchase insurance securely without a bank account. Financial institutions can settle securities in minutes instead of days. Blockchain technology lets strangers record simple, enforceable contracts without a lawyer. It makes it possible to sell real estate, event tickets, stocks, and almost any other kind of property or right without a broker. Blockchain also keeps tracks and makes sure all the payments are done properly. Businesses of all types (government, banking, insurance, finance, accounting, healthcare, legal, supply chain and logistics, manufacturing, retail, etc.) can more closely manage the flow of goods and related payments with greater speed and less risk. Unlike existing financial ledgers or databases used by banks and other institutions, the blockchain is updated and maintained not by a single company or government. Instead it is run by a network of users.

The Challenges To Blockchain Technology 

But, the fame of blockchain has also given rise to several new challenges, including interoperability, flexibility, scaling, and management. There are now many blockchain-based currencies, each optimized for different purposes. And none of these currencies are compatible with others, making it hard for users to transfer money between them. Also, there is a growing tendency to use blockchain in other fields. These fields include IoT, the supply chain, stock exchange and other domains where secure data transactions are important. However, the original blockchain used in bitcoin was not designed to scale to all possible use cases, making it difficult to use it in these domains. Since blockchain is a decentralized system, once it goes wrong, there will be no one to sue and be responsible for, and there is the challenge of management. It will take some time for such problems to be worked out. The industry will have to work with governments to create standard rules and laws to govern transactions. Further, nodes holding copies of the blockchain receive constant updates. These nodes are distributed around the world. Because of this, blockchains have high latency. 

Blockchain needs to undergo changes if it is to meet the requirements of every possible industry. The Hyperledger Project, an effort overseen by the Linux Foundation, is a collaborative effort created to advance blockchain technology by identifying and addressing important features for a cross-industry open standard for distributed ledgers that can transform the way business transactions are conducted globally.

Bitcoin and Cryptocurrency Technologies

Bitcoin is a digital asset and a payment system. It is an innovative payment network and a new kind of money. It is designed to enable users to send money over the Internet in a very simple and efficient way. Bitcoin made digital transactions possible without a trusted intermediary. The technology allowed this to happen at scale, globally, with cryptography doing what institutions like commercial banks, financial regulators, and central banks used to do: verify the legitimacy of transactions and safeguard the integrity of the underlying asset.

Like paper money and gold before it, bitcoin is a paperless, bank-less, state-less currency that allows people to exchange value, to pay directly for goods and services. It is a system which allows you to do anonymous currency transactions and no one will come to know about the payment or about all other info related to the payment, including who sent it, who received it, etc. Unlike its predecessors, bitcoin is digital and decentralized. The bitcoin generation algorithm defines, in advance, how currency will be created and at what rate. Any currency that is generated by a malicious user that does not follow the rules will be rejected by the network and thus is worthless. Since the system works without a central repository or single administrator, the U.S. Treasury categorizes bitcoin as a decentralized virtual currency. Bitcoin is often called the first cryptocurrency. 

The success of bitcoin has led to the development of many alternative cryptocurrencies (or altcoins). Most of these altcoins offer their own take on the bitcoin protocol, and are interesting in their own right. Currently, there are hundreds of alcoins out in the wild being traded every single day. But, most altcoins don’t last very long. In addition, just like the unfounded fear of many governments in the world that bitcoin and other virtual currencies are a conduit for money laundering, smuggling, terrorism and tax evasion, they believe that the only means of curbing these harmful elements is through acceptance and regulation.

Bitcoin Network and Bitcoin Clients

Bitcoin is not a fiat currency controlled by a nation-state. It uses peer-to-peer technology to operate with no central authority or banks; managing transactions and the issuing of bitcoins is carried out collectively by the network where each terminal or node is equal in terms of hierarchy. The bitcoin network is a peer-to-peer payment network that operates on a cryptographic protocol. Users send and receive bitcoins, the units of currency, by broadcasting digitally signed messages to the network using bitcoin cryptocurrency wallet software. Transactions are recorded into a distributed, replicated public database known as the blockchain, with consensus achieved by a proof-of-work system called "mining". 

Bitcoin is open-source; its design is public, nobody owns or controls bitcoin and everyone can take part. Bitcoin is run collectively by the users who uses the bitcoin client, and any changes to the bitcoin system have to be approved by the majority of users before they are implemented. Bitcoin clients are the base level of technology for conducting bitcoin transactions. 

Bitcoin is a peer-to-peer network. Any computer that connects to the bitcoin network is called a node. Each node runs a specialized piece of software called a bitcoin client. This client downloads the entire network (i.e history of all transaction blocks) at once on the node and takes care of all the communication with the bitcoin network. The client connects with the user’s ‘wallet’ and updates it with incoming and outgoing funds and uses the keys generated by the ‘wallet’ to sign the transactions. The protocol is designed in such a way that a bitcoin client cannot enforce its own rules and all other nodes running the bitcoin client ensure that every other node is following the rules (in short not trying to hack or corrupt the network). Bitcoin client has to continuously synchronize itself with the entire network. 

The different types of bitcoin client are: full clients, thin clients, web clients, and mobile clients.

Bitcoin Transactions

Bitcoin uses public-key cryptography, peer-to-peer networking, and proof-of-work to process and verify payments. Transactions take place between users directly, without an intermediary. Assets - digital assets like money to music and everything in between - are not stored in a central place, but they're distributed across a global ledger, using the highest level of cryptography. There is no trusted third party controlling the ledger. When transactions are conducted, they are posted globally, across millions and millions of computers. These transactions are verified by the network nodes and recorded in a public distributed ledger called the blockchain, which uses bitcoin as its unit of account. 

Bitcoin transactions are not reversible! Any transaction issued with bitcoin cannot be reversed, they can only be refunded by the person receiving the funds. Bitcoins are sent (or signed over) from one address to another with each user potentially having many, many addresses. Addresses are identifiers which you use to send bitcoins to another person. Transactions sent and received from bitcoin address. Every bitcoin address has a matching private key, which is saved in the wallet file of the person who owns the balance. Please keep your private keys safe, and make periodic backups to prevent the loss of bitcoins. Anyone with your private keys can spend your bitcoins. 

With PayPal you send funds to an email address, and similarly with bitcoin you send funds to a bitcoin address. You can send bitcoins to anyone once you know their bitcoin address. Each payment transaction is broadcast to the network and included in the blockchain so that the included bitcoins cannot be spent twice. This way, no one can copy the currency and use it for more than one time. It’s a simple but effective idea to stop double spending of the same bitcoin. After an hour or two, each transaction is locked in time by the massive amount of processing power that continues to extend the blockchain. Using these techniques, bitcoin provides a fast and extremely reliable payment network that anyone can use.

Helsinki Cathedral_Helsinki_Finland_090515A.jpg
(Helsinki Cathedral, Helsinki, Finland - Hsi-Pin Ma)

Bitcoin Wallet, Mining, and Miner

A bitcoin wallet, a piece of software used to store the private keys, is the first step to use bitcoin. Without a wallet, you can’t receive, store, or spend bitcoins. You can think of a wallet as your personal interface to the bitcoin network, similar to how your online bank account is an interface to the regular monetary system. Primary purposes of wallets are: (1)  generation and management of bitcoin addresses. The bitcoin address, like e-mail addresses, is public and broadcast to the entire network. The user just has to give the public address (which is a string of 27–34 alphanumeric characters starting with 1 or 3) for transfer of funds. (b) generation and management of the public and private keys associated with each address.

Bitcoin wallets contain private keys; secret codes that allow you to spend your bitcoins. In reality, it’s not bitcoins that need to be stored and secured, but the private keys that give you access to them. A bitcoin wallet is simply an app, website, or device that manages bitcoin private keys for you. However, there is no "one size fits all" bitcoin wallet. Wallets come on different platforms with different features.

Bitcoin’s blockchain is replicated on networked computers around the globe and is accessible to anyone with a computer and an Internet connection. A class of participants on this network, called miners, is responsible for detecting transaction requests from users, aggregating them, validating them, and adding them to the blockchain as new blocks. Bitcoins are created as a reward for payment processing work in which users offer their computing power to verify and record payments into a public ledger. This activity is called mining, and miners are rewarded with transaction fees and newly created bitcoins. With a single bitcoin's price continues to rise, this is a very strong incentive. The main role of miners is to ensure the irreversibility of new transactions, making them final and tamperproof. However, when miners devote computational power, they also use a tremendous amount of electricity.

Bitcoins are kept in a digital wallet which you can keep in your computer, or on a website online, which will manage and secure your wallet for you. You can have as many wallets and bitcoin addresses (where you receive money from others) as you like. When a transaction is conducted, it's posted globally. And they compete: the first miner to find out the truth and to validate the block, is rewarded in digital currency, in the case of the bitcoin blockchain, with bitcoin. And then, that block is linked to the previous block and the previous block to create a chain of blocks. And every one is time-stamped. So if I wanted to go and hack a block and, say, pay you and you with the same money, I'd have to hack that block, plus all the preceding blocks, the entire history of commerce on that blockchain, not just on one computer but across millions of computers, simultaneously, all using the highest levels of encryption, in the light of the most powerful computing resource in the world that's watching me. Tough to do. This would scare away hackers because hacking bitcoin to get everyone’s coins would cost a tremendous amount of computing power, electricity, and money. Further, if the bitcoin community became aware of the hack, it would likely cause the price of bitcoin to drop steeply. This makes such an attack economically self-defeating.  This is infinitely more secure than the computer systems that we have today.

Besides being obtained by mining, bitcoins can be exchanged for other currencies, products, and services. When sending bitcoins, users can pay an optional transaction fee to the miners. In many places, bitcoin is less volatile than the local currency so some use it to store value while others use it to consume at hundreds of thousands of vendors across the globe and online.

Bitcoin's Proof of Work (PoW)

But in bitcoin, there is no central authority to enforce the rules. Miners are operating anonymously all over the world driven by a diversity of cultures and bound by different legal systems and regulatory obligations. Therefore, there is no way of holding them accountable. The bitcoin code alone must suffice. To ensure proper behavior, bitcoin uses a scheme called Proof of Work (PoW). A PoW is a piece of data which is difficult (costly, time-consuming) to produce but easy for others to verify and which satisfies certain requirements. Producing a PoW can be a random process with low probability so that a lot of trial and error is required on average before a valid PoW is generated. 

One application of this idea is using Hashcash as a method to preventing email spam, requiring a PoW on the email's contents (including the To address), on every email. Legitimate emails will be able to do the work to generate the proof easily (not much work is required for a single email), but mass spam emailers will have difficulty generating the required proofs (which would require huge computational resources).

Hashcash PoWs are used in Bitcoin for block generation. In order for a block to be accepted by network participants, miners must complete a PoW which covers all of the data in the block. The difficulty of this work is adjusted so as to limit the rate at which new blocks can be generated by the network to one every 10 minutes. Due to the very low probability of successful generation, this makes it unpredictable which worker computer in the network will be able to generate the next block.

For a block to be valid it must hash to a value less than the current target; this means that each block indicates that work has been done generating it. Each block contains the hash of the preceding block, thus each block has a chain of blocks that together contain a large amount of work. Changing a block (which can only be done by making a new block containing the same predecessor) requires regenerating all successors and redoing the work they contain. This protects the block chain from tampering. 

The most widely used proof-of-work scheme is based on SHA-256 (SHA stands for Secure Hash Algorithm) and was introduced as a part of Bitcoin. Some other hashing algorithms that are used for PoW include Scrypt, Blake-256, CryptoNight, HEFTY1, Quark, SHA-3, scrypt-jane, scrypt-n, and combinations thereof.

Therefore, it is crucial that all miners on the bitcoin network have the same copy of the blockchain, and that all changes and transactions are irreversible. 

Bitcoin's Golden Future?

Bitcoin, Ethereum and other blockchain assets are a new way for investors to gain exposure to a high-growth industry. Bitcoin and blockchain technology is a disruptive force in financial services and will likely be the foundation of the next-generation Internet also called Web 3.0. The current market price for a bitcoin is always changing due to the supply and demand for it. It goes up and down. Bitcoins are traded at bitcoin exchanges. A historical bitcoin price chart can be found at: How can we buy some bitcoin? If you are an individual investor and want to buy bitcoin the easiest way is through a digital asset exchange like Coinbase. Coinbase is one of the largest U.S.-based bitcoin companies that facilitates not only buying bitcoin, but also the storage of bitcoin. Open an account with Coinbase, and once you link your bank account you can buy and sell bitcoin. In addition, Coinbase also offers a "vault" that can be used to store your bitcoin. Since bitcoin is a new financial system that can operate without traditional banks, you control your finances. However, this financial freedom means that you are responsible for the safekeeping of bitcoin.

What does the future hold for bitcoin? As outlined previously, it has many advantages and for this reason it will remain relevant as a currency. We see the biggest risk to bitcoin being its substitution and/or parallel use by other cryptocurrencies. One of bitcoin's primary uses is being a store of value and for this reason other cryptocurrencies can always step in and enjoy similar status if aggregate demand requires it. Is bitcoin simply a 21st century version of gold, only without the storage issues? Or is it just a short-lived popular fad that may soon evolve into something quite different? Only time will tell. The only certainty is that its price will remain very volatile in the future.


<updated by hhw: 10/25/17>



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