Blockchain not suitable for payments

Why are crypto currencies no alternative to cash, so far? The main reasons include scalability, volatility, speed and price.

▽Oct. 29, 2019|Bernhard Kauer

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The blockchain is regarded as the crucial technology to change the world of finance. Using the latter shall facilitate asset transfers, the implementation of smallest transactions, the autonomous payment of IoT devices, accelerated settlements between banks and much more.

The initial idea of Satoshi Nakamoto, the bitcoin inventor, was to develop an electronic payment system for the Internet that does without any ‘Trusted Third Party’. Thus, trust should not be created by a central bank anymore, but by the majority of thousands of miners. They provide processing power to include transactions in the blockchain and in return earn transaction charges.

As with Puzzle we are working on a payment solution that shall substitute cash digitally, we certainly also had a look at Bitcoin and other blockchain-based crypto tokens such as Ethereum.

Using this technology would have several advantages for us. Above all, as a startup we could enter the market faster, if we would build on an existing blockchain. Moreover, it would also have financial benefits. There are respective Crypto VCs that especially invest in blockchain startups. With an Initial Coin Offering you can also obtain venture capital relatively easily. Finally, you can enthuse employees with ‘hip technology’.

However, our analysis unveiled four decisive disadvantages of blockchains that are still a bar to the use as a cash alternative:

• The performance does not scale with the users
• The volatility is too high
• The blockchain is too slow
• The transactions are more expensive

The performance does not scale with the users

As every other system, blockchains have their limits. To date they cannot deliver the performance that is necessary for a general payment system. In Germany alone, 80 million payments are settled every day. All cryptocurrencies together only conduct about one million transactions per day, so far.

The general problem consists in the fact that blockchains do not scale with the users, as both the space in the blockchain and the amount of money is limited. The limited space leads to the congestion paradox: when it comes to blockchains, it’s not that more demand does reduce the costs per user (network effect), but the overload even brings along rising prices.

More recent approaches such as the Lightening Network or µRaiden thus send transactions off-chain through previously established channels. Although this may prevent some scalability issues, at least one-time payments are still bound to the blockchain. As the money has to be reserved throughout the entire transaction period via this channel, theses shortcuts are also still relatively expensive.

The volatility is too high

As soon as money is available in foreign currencies, there is a currency risk. However, cryptocurrencies are especially volatile, as no central instance stabilizes the price here, as for example central banks usually do. Fluctuations of 10% per day and 25% per week are relatively normal. However, for merchants with low margins, the risk of loosing money is way too high. Consequently they do not readily accept blockchain currencies.

Similarly, only few customers will accept this volatility in everyday life. At the latest when the weekly shopping or the fuel is 25 % more expensive than the last time, most of them will be out of sympathy.

Thus, a cash alternative will not work out in every day life without being bound to a stable currency. However, if the so-called stable-coins are used instead, as for instance Facebook plans to do with Libra, the advantage of a decentral currency being independent is suddenly gone. With interests in double figures per year, decentral stable coins such as DAI are rather expensive.

The blockchain is too slow

Inherently, blockchains that are implemented as global systems struggle to cope with respectively high latencies. Above all, this is the case since transactions must have obtained a majority of the participants before they can be considered as accepted. This is why for the most currencies, several minutes are required per block.

An especially fast cryptocurrency such as Ethereum takes between 10 and 20 seconds to complete a single block and in extreme cases once in a while even more than a minute. Both ranges are not sufficient for interactive applications, as it is the case at the point of sales.

As there might be a race condition anytime, in which the blockchain splits into several parts for a short time period, in practice several blocks must be awaited to make sure that the transaction is permanently part of the chain. When it comes to bitcoin, this means that you have to wait about 10 minutes per block. However, transactions are not generally accepted before having completed 6 blocks or 60 minutes are gone. With such high latencies, purchases at retail cannot be made.

The transactions are more expensive

In the last three months a bitcoin transaction cost between $0.07 and $1.50. For comparison: the ECB charges 0.002 for SEPA instant payments, which is between 30 and 750 times less.

Most blockchains are based on a lottery method. In order to decide which miner may add the next block to the chain, respective cryptographic conundrums must be resolved. However, this proof-of-work procedure wastes plenty of energy, which leads to unnecessarily high transaction costs.

Recent approaches such as proof-of-stake, which shall reduce these costs, cannot be implemented trivially and though having been discussed for years, are still not widely accepted.

In general, distributed systems are always more expensive than a centralized approach, though. Running thousands of computers leads to higher costs in any case, as compared to involve only a handful of machines in a transaction. Thus, every (public) blockchain will have to have a price disadvantage.

Summary

We examined the suitability of blockchains for payments in everyday life. Compared to centralized approaches, they are inferior in terms of volatility, scalability, speed and price.

The crypto community will have to implement new solutions to achieve less volatility and better scalability. However, the lower speed and the higher costs of the blockchain as compared to central solutions are principally unavoidable. This is the price one has to pay for decentralization.

For Puzzle, this means that we cannot rely on blockchains, since we want to become a fast and economic alternative to cash.