Will UBS’s Settlement Coin Steal Bitcoin’s Thunder?

Over the weekend, UBS followed Barclay’s bitcoin news with news of their own, announcing through media outlets, that they are developing their own blockchain that, if all goes according to plan, could be held by various interests in the financial industry. The ultimate goal, is to greatly reduce settlement times and costs. The coin that will flow through this centralized blockchain has the appropriate but completely unimaginative unofficial name of “utility settlement coin” [USC]. But could USC actually steal Bitcoin’s thunder and turn what could have been the most disruptive technology of the past decade into nothing more than a new toy for the old guard?

The short answer is no, Bitcoin has more uses than the limited scope USC appears to be focusing on, but the answer is a bit more muddy if we are talking specifically as a settlement method between large financial institutions.

Bitcoin has five major advantages over traditional methods of exchanging money: It’s cheaper, it’s faster, it’s private, it’s more secure when used properly and it doesn’t rely on any central authority. Utility settlement coin has the potential to address three, possibly four of those issues. If it is a success, it could potentially be cheaper and faster than traditional methods. Depending on how UBS wants to build it, USC could be more private as well. It is unlikely that it will be as private as a true cryptocurrency, but it seems possible that it could mask identifying information from merchants in a manner similar to Apple Pay or Google Wallet (though, judging by the language used by USB, USC won’t be used by average consumers and privacy may not be as important to the market they are targeting). The same applies to security. It is unlikely that USC will reach the near infallibility provided by the incredible amount of hashing power put towards the bitcoin network, but there is no doubt that traditional methods of payment are pathetically insecure and it won’t be a tough task for USC to top that.

Utility settlement coin won’t be used by the unbanked of the third world, or underground online markets (both illegal and legal but embarrassing) or online casinos or techies looking to tinker. We know it won’t erase bitcoin’s existence entirely. What it has the potential to do, is circumvent bitcoin in what has been called a huge potential area of growth for cryptocurrencies: the settlement of large transactions of currencies, securities and commodities between large financial institutions.

In the average bitcoin advocate’s ideal world, a significant portion of the world’s trade involving those traditional stores of value are transacted using some sort of Bitcoin 2.0 technology, ideally one that ultimately utilizes bitcoin itself.

UBS’s USC has a chance to spoil that. If banks, clearing houses and other members of the traditional finance elite can greatly reduce their own costs without giving a hand to the disruptive, upstart “we are going to destroy the old financial system” cypherpunk 2.0 “crazy folk” (from their perspective) that make up the bitcoin community, it isn’t unreasonable to think they would do that.

Why would UBS move to a decentralized system that takes the power out of their hands, when they ccould create a new system that has the potential to lower their costs, while allowing them to keep the keys to the kingdom?

The project by UBS is still in its infancy, so it is hard to predict how it will work and what exactly its function will end up being, but if it is meant to head off bitcoin replacing the banks and clearing houses as the primary method of transfering value overseas and between large organizations, then it could be seen as a threat to bitcoin’s value rather than news investors should be buying off of.

There is the possibility, since they have partnered with Clearmatics, whose core team includes the founder of Ethereum — Vitalik Buterin — that USC could be put on the Ethereum blockchain and would therefore find itself squarely within the confines of the Cryptocurrency market. That would likely be a boon to cryptocurrencies in general, including Bitcoin. For the purposes of this article and judging by the tone of the majority of the articles that have so far talked about USC, we are going to assume that USC will be something more than an Ethereum smart contract and will have its own blockchain.

There are a lot of potential flaws in a centralized blockchain powered coin like USC and we will get to those. Let us say, for the sake of argument, that everything goes according to plan and USC is secure, fast and inexpensive. It gets distributed among the financial gatekeepers, who happily get on board and work to secure the system. In such a case, it isn’t unreasonable to think that USC could be as inexpensive to use as Bitcoin, or at least inexpensive enough that any difference is negligible. Money transmitters and banks could charge the same ridiculous fees they charge now with lower costs to themselves, or they could lower that fee to something approaching Bitcoin’s miner fees whenever they felt insecure about a growth in bitcoin’s use.

This would be the worst case scenario for anyone hoping bitcoin to disrupt the settlement market in any fashion other than price. Getting from the traditional finance system into the Bitcoin system – and back again – is the most difficult part of using cryptocurrencies. If the traditional finance industry can accomplish the same ultimate goal (moving gold or cash or bonds or anything else) for a comparable price, then there is little incentive for the average investor to deal with the hassle of using bitcoin and all the high-minded idealism about decentralized systems in the world, won’t convince them otherwise.

But the story isn’t over yet, there are still significant hurdles before USC can challenge bitcoin on even the issues it was made to address. The first significant hurdle is getting the other major players in the financial world to get on board. Being accepted by one or even a few banks is not enough for a digital currency to succeed. David Chaum’s DigiCash had a partnership with Citibank, but that didn’t slow its quick decent into irrelevancy.

For utility settlement coin to succeed, it needs the support of enough financial players that not supporting it would cause the remaining players to be at a disadvantage. That means developing partnerships with organizations across the globe and dealing with the financial regulations in each of them. UBS has said, via the Wall Street Journal, that they are in the process of developing relationships now, but they didn’t elaborate on how far along the talks are or what caliber of partnerships are in the works. Competing organizations may wonder, especially if UBS builds in some advantages for itself over other participants, why they don’t simply create their own settlement coin/quasi-digital currency.

Getting partners on board for the acceptance and acknowledgment of USC will prove difficult enough, but for the coin to be really successful, they will need partners that do much more than that. Clearing and settlement houses have made an entire industry out of simply verifying transactions. For USC coin to be successful in lowering that cost, it will need some sort of distributed (if not decentralized) system that confirms the transactions for them. In the bitcoin industry, this is called mining or minting, depending on the method used. USC will undoubtedly have to use some sort of system that works in a similar way, computers across the network will have to confirm transactions as valid.

Unless UBS plans to turn USC into a true cryptocurrency by decentralizing its blockchain, it will have to depend on itself and its partners to do that confirming themselves. Big financial institutions may be able to trust each other enough to make centralization less of a concern than in bitcoin, but with only a few select players allowed to mine, only a few centralized points will have to be compromised in order for the whole system to come tumbling down. The more the system runs autonomously the quicker and cheaper it can become, but for an autonomous system to be secure, it has to depend heavily on the hashing power of its network.

There is virtually no point to switching to a digital cash-like system, if each transaction has to be manually checked by a central authority, it would require the same slow and expensive transaction times as the systems that are used today. The only way the system works is if it can be trusted, but what happens if one of the few entities allowed to mine the coin is compromised? Would a hacker then be able to turn that hashing power into fiat before anyone realized what happened? In that scenario, who would be to blame, UBS for creating the system? The mining partner whose key was insecure? Surely it won’t be the individual customers, which means someone, somewhere will be on the hook for any breaches of the USC system, which likely means insurance and a corresponding increase in transaction fees.

There is also the reward problem. If trusted partners are going to secure the network, what reward incentive will there be for them? Transaction fees perhaps, but will the small transaction fees typically seen in cryptocurrencies be enough for them?

This, I believe, is what Jon Matonis is talking about when he says that centralized blockchains may not benefit from the network effect that keeps bitcoin growing. With only a handful of powerful players, will there be a temptation to increase fees and what will that do to its competitiveness with bitcoin?

These hurdles will be huge if UBS wants to overcome Bitcoin, even if it limits itself to this one specific (albeit large) niche. Their advantage is that they have the contacts, capital and will to make it happen, but there is a lot of work to be done if they want to steal bitcoin’s thunder.

Ultimately, UBS’s interest in blockchain technology is good news for the cryptocurrency community in general. The price of Bitcoin reflected that. Despite this being the strongest indication that Bitcoin will see something resembling a competitor from the traditional finance giants, the price went up. It seems investors are more encouraged by UBS’s interest than threatened by the potential competition.

“First they ignore you, then they laugh at you, then they fight you, then you win.”

That quote is often attributed to Mahatma Gandhi, but somewhere between “fight” and “win” there can be another step, then they imitate you. UBS might be imitating, or they might be joining, but either way, it doesn’t seem like victory is far off.