The limits of blockchain technology

The just described (direct) holding pattern does not fairly reflect the current market practice, at least in relation to the circulation of cryptocurrencies. This has progressively moved to more efficient (indirect) holding patterns. The fundamental impetus to that trend has been that the blockchain’s capacity as data management technology is too clunky to operate at scale.[1]

The issue of blockchain’s inability to handle bitcoin transactions in an effective way has always been familiar to developers. However, it has never been identified as particularly concerning until the system, as the crypto-bubble was inflating in 2017, became so clogged that to ensure that transactions would go through, users had to pay miners an extra fee per transaction to prioritise payments. In theory, it takes approximately 10 minutes for a transaction to be validated by the network and recorded in the blockchain. That limits the network to processing about seven transactions per second (Visa, by contrast, can handle tens of thousands per second). More worryingly perhaps, this is not even what frequently happens, and settlement periods arc often longer. Transactions which fail to get the attention of miners sit in a limbo called Mempool until they possibly drop out. The future is also not promising. Settlement problems will be hard to overcome in the short run: with the increase in the number of transactions, the blockchain will grow as will its requirement in terms of storage bandwidth and computational power.

Quite interestingly, this scenario is similar to the one experienced during the ‘paper crunch’ in the 1970s in the United States and in the 1980s in the UK where the traditional process of delivering paper-based securities against payment in order to fulfil contractual obligations arising out of trading could not keep pace with the increase in the number of transactions. Severe delays in the settlement interval became frequent and backlogs of unsettled trades threatened the integrity of the securities market. As will be described in Part III below, the solution to the settlement problem adopted by market practice in the case of investment securities is very similar to the one chosen by investors in cryptocurrencies.

Empirical evidence and (other) rationales

While the ''scalability’ issue has been the fundamental driver to market changes in the holding and transfer of cryptocurrencies, the relevance of other concurring explanations should not be ruled out. These will be examined below, after offering appropriate reference to the developments that can be observed in market practice.

Abundant evidence points out that the vast majority of small-scale cryptocurrency payments are not currently processed on the blockchain. Most of the transactions (up to 99% according to one authoritative source[2]) occur ‘off-chain’ between customers at the same exchange (or wallet-provider of specialist crypto-custodian). The fact that off-chain transactions would have become the norm was first highlighted by bitcoin pioneer Hal Finney in 2010 when he declared:

Bitcoin itself cannot scale to have every single financial transaction in the world be broadcast to everyone and included in the block chain ... Most Bitcoin transactions will occur between banks, to settle net transfers. Bitcoin transactions by private individuals will be as rare as... well, as Bitcoin based purchases are today.

Data assembled by Chainalysis for The New York Times on bitcoin’s use in 2016 suggests that the direct bitcoin holding models have never been widely adopted. This observation is confirmed by other authoritative sources and can be supported by a simple empirical test. Using data from CoinMarketCap, an authoritative website that provides cryptocurrency market capitalisation rankings, 2 4-hour trading volumes were around US$130 billion on 4 March 2020. This figure, even with necessary adjustments to take into account probable fake transactions (often the result of‘wash

Distributed ledgers and custodial services 411 which traders buy and sell to each other to create the illusion of volume[3]), is many times greater than the USS1.3 billion corresponding to the trading volumes on the blockchain at the same date. It is also greater than the one generated by decentralised exchanges that facilitate direct swapping of assets between users using peer-to-peer smart contracts. Using data from DEXWatch, a decentralised exchange explorer that captures on-chain data pertaining to decentralised exchanges in real time, 52,000 Ethers were traded per day across the major decentralised exchanges on 4 March 2020. With Ethereum priced at around US$201, this equates to approximately US$10.5 million in trade per day.

Once accepted that the blockchain is not currently able to deal with a large number of users and that this has likely contributed to the rise in off-chain cryptocurrency transactions, the impact of other concurring explanations should not be underestimated. The most relevant of these relate to the technical concerns in downloading the specialist software to keep a copy of the blockchain, which now exceeds 11 gigabytes in size and continues to grow steadily. Moreover, the costs required in updating the hardware, together with the computing power necessary to participate in the mining process, the risk of losing the private key and the fact of being exposed to hackers’ attacks, also contributed to prevent this original model to achieve widespread diffusion, especially among retail investors. A well-known example of the risks involved in maintaining the ability to generate the right digital signature with which to sign transactions is the case of Mr Howells, a British crypto enthusiast, who bought 7,500 bitcoins in 2009, when they were nearly worthless, before throwing away the hard drive on which they were stored. By 2013 they were worth millions of dollars. Mr Howells’ attempts to recover his hard drive from a

Welsh landfill were not successful.’2 Finally, the relevant transaction costs,[4] and certain technical disadvantages, including the fact that bitcoin’s circulation faces severe capacity constraints compared with other payment systems, should also be factored in as possible concurring explanations.

From a rational investor’s perspective, there might also be additional economic motives to explain the recent trends in market practice. In particular, with the growth in the number of cryptocurrencies available (and, in the light of their fundamental use as a store of value), cryptocurrency exchanges have become the marketplaces for listing and trading cryptocurrencies. As a basic approach to portfolio diversification would suggest, to trade efficiently rational users would buy multiple digital currencies and exchange them according to various cryptographic protocols when their needs evolve. This will be possible only by combining the operations of an exchange with basic custodial services, centralised order booking and efficient order matching, together with a decentralised cross-chain settlement based on cross-chain cryptographic protocols that allow users to settle transactions across heterogeneous blockchain networks without a ‘trusted’ third party and without counterparty risk.

The developers’response

There have recently been a number of (so far not particularly successful) attempts to find alternative technical means to overcome the blockchain inability to net and to allow for trading on credit.

The most promising example has been the use of limitless ‘off-chain’ transactions managed via smart contracts under the ‘Lightning Network’. This is simply a second-layer payment protocol that exists on top of blockchain and allows two people

Distributed ledgers and custodial services 413 to transfer bitcoins directly, rather than via the main bitcoin blockchain.[5] However, while it frees up capacity on the main network, it moves the circulation of cryptocurrencies away from ‘real time gross settlements and push payments and into the world of deferred net settlement and pull payments’, in this way reinstating an clement of intermediation.

The latest addition to market practice has been the introduction of decentralised exchanges. These are non-custodial, peer-to-peer exchanges, with users enjoying total control of their funds, and the ability to trade directly from their own wallets with on-chain settlement without the supervision of any central authority. Trades arc executed by a smart contract (a program executing on a blockchain) visible on the Ethcreum blockchain, providing the appearance of transparency. As custody and transfer mechanisms are processed and guaranteed by the smart contract, funds cannot be stolen by the exchange operator. The combination of the technology of a centralised custodial exchange with a decentralised cross-chain settlement might allow cryptocurrency traders to obtain the efficiency of a centralised exchange when they need quick and liquid trading for exchanging big volumes, and also the ability to settle a transaction without the supervision of a third party. However, it has been suggested that trading in cryptocurrencies is not fair when it takes place on decentralised exchanges because of certain design flaws arising from numerous arbitrage bots and inherent market-exploiting behaviours that threaten the underlying blockchain security.

  • [1] Primavera De Filippi and Aaron Wright, Blockchain and the Law: The Rule of Code (Harvard University Press 2018) 56-57. 2 Kaminska, 'The Currency of the Future’ (n 19). 3 The median time for a transaction to be accepted into a mined block and added to the public ledger is available: ‘Median Confirmation Time’ ( accessed 20 April 2020. 4 The Mempool is effectively a ‘waiting area’ for bitcoin transactions that each full node maintains for itself. 5 The number of unconfirmed transactions building up on the bitcoin network on 15 June 2019 was 20,000: ‘BTC / Unconfirmed Tx’ ( accessed 20 April 2020. 6 Kieren James-Lubin, ‘Blockchain Scalability: A Look at the Stumbling Blocks to Blockchain Scalability and Some High-level Technical Solutions’ (O’Reilly Media, 22 January 2015) accessed 20 April 2020; Yoohwan Kim and Juyeon Jo, ‘Binary Blockchain: Solving the Mining Congestion Problem by Dynamically Adjusting the Mining Capacity’ in Roger Lee (ed), Applied Computing & Information Technology (Springer International Publishing 2018) 29; Raphael Auer ‘Beyond the Doomsday Economics of “Proof-of-work” in Cryptocurrencies’ (2019) BIS Working Papers No 765 accessed 20 April 2020. 7 Richard Smith, ‘A Piece of Paper Revisited’ (1971) 25 The Business Lawyer 1769; David Donald, ‘The Rise and Effects of the Indirect Holding Systems - How Corporate America Ceded its Shareholders to Intermediaries’ (2007) Institute for Law and Finance Working Paper Series No 68. 8 The topic is comprehensively covered in Madeleine Yates and Gerald Montagu, The Law of Global Custody (4th edn, Bloomsbury Professional 2013) Ch 8.
  • [2] According to the recent TABB Group research report: Monica Summerville, ‘Crypto Trading: Platforms Target Institutional Market’ (TABB Group, 5 April 2018) accessed 20 April 2020. 2 Tuur Demeester, 'Bitcoin: Digital Gold or Digital Cash? Both’ (Medium, 15 January 2017) accessed 20 April 2020; and Ross Anderson and others (n 18). 3 Hal Finney, ‘Bitcoin Bank’ (Bitcoin Forum, 30 December 2010) accessed 30 March 2020. 4 Nathaniel Popper, 'How China Took Center Stage in Bitcoin’s Civil War’ (The New York Times, 29 June 2016) accessed 20 April 2020. Chainalysis has a proprietary method of tying specific transactions to particular businesses: (Chainalysis') accessed 20 April 2020. 5 CoinMarketCap, 'Top 100 Cryptocurrencies by Market Capitalization’ (CoinMarketCap) accessed 20 April 2020.
  • [3] See Matthew Hougan, Hong Kim and Micah Lerner, ‘Economic and Non-Economic Trading in Bitcoin: Exploring the Real Spot Market for the World’s First Digital Commodity’ (24 May 2019) Bitwise Asset Management accessed 15 March 2020. Similar conclusions were reached by The Block (the leading research, analysis and news brand in the digital asset space): Larry Cermak, ‘Up to 86% of Total Reported Cryptocurrency Trading Volume Is Likely Fake, According to Analysis of Exchange Website Visits’ {The Block, 28 May 2019) accessed 15 March 2020. See also Paul Vigna, ‘Most Bitcoin Trading Faked by Unregulated Exchanges, Study Finds’ (The Wall Street Journal, 22 March 2019) accessed 20 April 2020. 2 With bitcoin priced at US$4,950: ‘Confirmed Transactions Per Day’ ( accessed 20 April 2020. 3 This is a marketplace for trading Ethereum-based tokens where a certain element of the exchange’s functionality operates according to Ethereum’s decentralised protocol. 4 (DEXWatch) accessed 20 April 2020. 5 The first bitcoin exchange (Mt Gox) was set up when the computing resources required to mine bitcoin became unreasonable and inadequate to meet the demand for bitcoins. See Nathaniel Popper, Digital Gold: Bitcoin and the Inside Story of the Misfits and Millionaires Trying to Reinvent Money (HarperCollins 2015) 51. 6 See Hannah Murphy, ‘Lost Your Bitcoin Password? Call in the Crypto-hunters’ (Financial Times, 18 July 2018) accessed 30 March 2020.
  • [4] See Aatif Sulleyman, 'Man Who “Threw Away” Bitcoin Haul Now Worth over 80M Wants to Dig Up Landfill Site’ (The Independent, 4 December 2017) accessed 20 April 2020. 2 See Izabella Kaminska, ‘But, But ... I thought Bitcoin was Supposed to be Cheap?’ (Financial Times, 17 March 2017) accessed 20 April 2020; and Izabella Kaminska, ‘Bitcoin’s Fake News Problem’ (Financial Times, 21 March 2017) accessed 20 April 2020. 3 The speed and cost of bitcoins’ transaction is not yet competitive with payments in national currency. See Jan Vermeulen, ‘Bitcoin and Ethereum vs Visa and PayPal - Transactions per second’ (Mybroadband, 22 April 2017) accessed 20 April 2020. Contrary to debit or credit card transactions, bitcoin transactions are not completed in seconds, but hours, unless a large transaction fee is introduced to persuade bitcoin miners to complete the transfer rapidly; see the British Retail Consortium’s Payment Survey 2016 (BRC, 2016) accessed 20 April 2020. 4 And, possibly, margin trading, proprietary lending, and peer-to-peer lending. 5 See Joseph Poon and Thaddeus Dryja, ‘The Bitcoin Lightning Network: Scalable Off-Chain Instant Payments’ (Draft Version, 14 January 2016) ; Izabella Kaminska, ‘Blockchain and the Holy Real-time Settlement Grail’ (Financial Times, 27 February 2016) accessed 20 April 2020; and Kaminska, ‘The Currency of the Future’ (n 19).
  • [5] See {Lightning Network) accessed 20 April 2020. See also the commentary provided by Michael J Casey and Paul Vigna, The Truth Machine: The Blockchain and the Future of Everything (St Martin’s Press 2018) 95. 2 Izabella Kaminska, ‘By love! Crypto Has Discovered Netting’ (Financial Times, 5 December 2019) accessed 20 April 2020. 3 See also Frances Coppola, ‘The Fat Controller of the Lightning Network’ (Coppola Comment, 17 January 2018) accessed 20 April 2020. 4 Philip Daian and others, ‘Flash Boys 2.0: Frontrunning, Transaction Reordering, and Consensus Instability in Decentralised Exchanges’ (Cornell University arXiv:1904.05234 [cs.CR/, 10 April 2019) accessed 20 April 2020; and Izabella Kaminska, ‘Don’t Bet on Decentralised Exchanges Becoming the New Crypto Frontier...’ (Financial Times, 11 September 2019) accessed 20 April 2020. 5 Low and Teo (n 22) 264.
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