Over the years, Blockchain technology has become a buzzword.
However, due to the fact that governments are exploring the technology to develop their own cryptocurrencies, Facebook is creating its own digital currency through its Libra Foundation, and the multitude of ambitious projects that are being developed with blockchain technology in mind, it’s clear that it’s far more than just a passing fad.
Many who follow blockchain, and cryptocurrency overall, are still strong believers in the technology, and the principles behind it are rightfully celebrated for many applications. After all, who doesn’t like the sound of high security, reduced costs, and eliminating middlemen?
In this article, we’ll briefly introduce blockchain technology before exploring its 4 current biggest problems – scalability, privacy, interoperability, and price volatility. We’ll also take a look at which solutions are being implemented to tackle these issues.
Blockchain Technology 101
Nowadays, all economic activities require a trusted third party, such as PayPal for online transactions, or escrows for loans. These third parties lower uncertainties in regards to the likelihood of contractual agreements to be non-performing, and are cornerstones to today’s economic and transaction flows.
However, this increased trust has its drawbacks.
- First and foremost, these parties often have a monopolistic position, and therefore charge high fees for their services (PayPal is another great example of this).
- Secondly, as everyone uses these third parties, they become targets for hackers as their database is centralized and contains all users’ data – leading to data security issues.
- Thirdly, uncertainty issues are not completely removed but are migrated to an entity that may encounter cash flow issues, or go bankrupt leading to contracts being unable to be performed.
In a nutshell, Blockchain technology is a tool which could remove the need for third parties and their drawbacks, while at the same time removing the need for trust between parties.
Blockchain Technology’s Current Problems
Some of the major problems that blockchain technology suffers from are: scalability, privacy, and interoperability.
- Scalability refers to the limited rate at which transactions are being processed.
- Privacy refers to the fact that all transactions are transparent and that its actors can be identified.
- Interoperability refers to the fact that blockchains work in silos and cannot communicate with each other.
Another issue that is more specific to the assets put on the blockchain is price volatility.
Scalability is blockchain technology’s current main issue, as demonstrated by the network congestion the Ethereum blockchain suffered from during the CryptoKitties saga, where transactions took hours (if not days) to be performed, and transaction fees grew abnormally high.
The bitcoin blockchain also suffers from congestion – known as the bitcoin scalability problem. It refers to the limited rate at which the bitcoin network can process transactions due to its size and the frequency at which these blocks are added to the blockchain.
Currently, the Bitcoin blockchain processes between 3 and 4 Transactions Per Second (TPS) due to the limited size of its block (1MB). It also averages a 10 minute confirmation time and requires a certain amount of transactions confirmed by miners before the transaction is fully confirmed.
This issue is the reason why it is impossible to use bitcoin to buy coffee and the reason of the debates around whether bitcoin is a Store of Value (SoV) or at P2P Electronic Cash System as depicted in the bitcoin white paper. This led to the creation of Bitcoin Cash (BCH); while bitcoin blocks are limited to 1 MB, BCH blocks can contain up to 8 MB of transactions.
As we explained in our High-Performance-Blockchain analysis, the key to large-scale commercial application is for networks to have high transaction throughput while maintaining low latency, which neither Ethereum nor bitcoin can currently handle.
To solve these scalability issues, many solutions are currently being researched, such as the implementation of accelerated chips to speed up confirmation and transaction times, the use of sidechains to mitigate data processing from one blockchain to another (such as Bitcoin’s Lightning network), or Ethereum’s sharding, to name just a few.
Typical applications of sidechain include the Lightning Network for Bitcoin, Raiden Network for Ethereum, or Trinity for Neo. The aim of such protocols is to reduce the load on a given blockchain by sending transactions via these connected sidechains and putting the end state of the transaction on the main blockchain – thereby offloading all the processing of transactions from the main blockchain. For instance, by using the AION protocol, people can use the most efficient (or cheapest) blockchain for processing data and send the final state of the transaction to the blockchain of their choice.
A scaling solution being worked on for the Ethereum blockchain is sharding. Sharding technology divides a blockchain network into many separate areas, called shards, with each shard assigned a small group of nodes to maintain. Sharding includes transaction sharding and state sharding. Transaction sharding refers to assigning different transactions to different shards. This way, parallel processing becomes possible, leading to high TPS. In contrast, state sharding allows the data state to be stored in different pieces on different nodes. In essence, it means that a single node is only responsible for saving a portion of the ledger.
Another example is the use of a multi-layered structure, which is the isolation of transaction processing and data storage. Cardano (ADA) is the most well-known project which proposes this layered structure, by dividing the blockchain network into a control layer and settlement Layer. The settlement layer is responsible for transaction confirmation and the flow of the coin, while the control layer runs smart contracts and will be programmed to recognize the ID of the data. Similarly, CPChain separates its blockchain layer from its application layer, so the blockchain only has to store data IDs (which are on a cloud) rather than the data itself – thereby reducing block sizes.
Under a public blockchain environment, the network ledger is open to anyone and all transactions are transparent – so they can be tracked. This lack of privacy might be an issue for certain types of transactions, for instance in the case of confidential corporate deals. Several protocols have developed alternatives to Bitcoin’s pseudo-anonymity, with the three main ones being Ring Signature, Zero-knowledge proof, and CoinJoin.
Given enterprises’ need for privacy, many firms are trying to solve this issue. For instance, in March 2020 EY launched Baseline protocol in cooperation with Microsoft, open-source software with the aim to enable businesses to run processes on the Ethereum blockchain uses Zero-Knowledge proofs, off-chain storage, and distributed identity so that enterprises can set up and synchronize processes and agreements using common standards. This should enable full privacy without storing sensitive business information on the blockchain itself.
Ring Signature is probably one of the most famous privacy protocols as it is used by Monero. With Ring Signature, whenever a transaction is initiated, the sender’s transaction is combined with the transactions of other users in order to form a ring. This process masks the origin of the transaction, and ensure that all inputs are indistinguishable from each other. On top of the Ring Signature, Monero also utilizes Stealth Address technology to automatically generate one-time addresses for every transaction.
Zcash uses Zero-Knowledge Proof in order to allow anonymous transactions. The technology automatically conceals transaction information, such as sender information, receiver information, and the amounts. Only users who own the private keys of the smart contract being performed have full access to the information.
CoinJoin is the technology used by Dash. The protocol mixes multiple payments from multiple spenders into one single transaction, making the transaction more difficult to trace. In the meantime, in order to prevent masternodes from being attacked, Dash introduced Chaining and Blinding, allowing senders to choose multiple masternodes randomly with which to send the transaction. The system enables the mixing of transactions among these master nodes, and transactions appear to be sent by the masternodes and not by the users themselves.
Blockchain networks are divided into private, consortium, and public blockchains, each having their own pros and cons, depending on application requirements. Having one “blockchain” is not feasible as there is no one-size-fits-all solution; specific industries, with specific use-cases, need their own consensus mechanisms, economic models, privacy schemes, and centralization levels. For instance, IoT solutions will require extremely low fees and high TPS throughputs, while supply chain blockchains require less TPS but higher decentralization.
The problem is that blockchains currently can’t communicate with each other. Therefore, various cross-chain technologies that could help different blockchains to interconnect are being explored. Some of the leading projects tackling this issue are AION, ICON, and NEO (with the development of NeoX). Nevertheless, most blockchains enable the creation of sidechains, such as CPChain or ICON. Sidechains are blockchains running in parallel to the main blockchain. Additionally, as we explored in the scalability section above, a sidechain using the same consensus protocol mechanism as the main chain can also validate transactions happening on the main chain.
Another interoperability solution is the one being used by Ripple (RPX), using escrows. Ripple uses its Interledger Protocol to connect different ledgers and lets users transmit currencies freely by using third-party connectors or validators. The Interledger Protocol adopts cryptographic algorithms and uses third-party connectors to create fund custody for two different ledger systems. Additionally, a trusted person or group will hear and respond to incidents on each side of the ledger system. Once all parties reach an agreement on cross-ledger transactions, transactions are confirmed.
Other famous examples of cross-chain communication are the Bitcoin Lightning Network and Raiden Network for Ethereum, which use hash-locking technology to allow for cross-chain payments. The Lightning Network is realized through the establishment of off-chain payment channels between different blockchains, allowing for instant value transfer. Similarly, the Raiden Network will help Ethereum switch from its current model where all transactions are passing through the blockchain, to a model where users transfer tokens by exchanging data off-chain without involving a global consensus protocol, while maintaining the security of the Ethereum network.
Lastly, some projects are teaming up in order to allow their blockchains to communicate with each other. ICON, AION, and WAN formed the BIA in December 2017, in order to solve the blockchain isolation problem. AION aims to become the common protocol for all blockchains to connect to one another through the creation of a networked and federated blockchain. The Aion protocol will enable the transfer of value and data between all Aion-compliant blockchains by utilizing bridges. In essence, Aion allows networks to communicate with each other, allowing any DApp to run on any blockchain within the network. In contrast, WAN is building a system to allow digital assets to be securely transferred and exchanged across any blockchain system. ICON, which we have analyzed, is creating a system of sidechains in order to connect all industry chains to its main network.
Another drawback of blockchain technology is that most assets on the blockchain are volatile – one of the main reasons these assets are so heavily traded.
However, one of the key characteristics of money is that it should be a store of value and medium of exchange – and so by definition stable. Despite all the benefits of using the current iteration of cryptocurrencies as money, the main problem is that they are highly volatile, and are thus a very bad medium of exchange due to this instability. For adoption that is a huge drawback; it is not uncommon for bitcoin’s price to fluctuate 10-15% within a day.
This issue has led to the creation of so-called stablecoins. Stablecoins are blockchain-based payment instruments that aim to achieve price stability. Stablecoins have solved problems that exist strictly within the cryptocurrency ecosystem, and certain implementations have seen billions of dollars’ worth of daily volume.
There are many ways that stablecoins achieve price stability. Some stablecoins rely on a 1:1 fiat backing (such as Tether). Other stablecoins rely on collateral in the form of gold, Bitcoin, or other cryptocurrency assets to back their value (MakerDAO), while others seek to use fundamental economic laws and incentive mechanisms to achieve stability.
Perhaps the simplest to conceptualize, fiat-collateralized stablecoins, such as Tether (USDT) are basically IOU certificates on fiat currency, or any other asset deemed stable, such as gold. In essence, a user deposits $1 in a bank account, the bank thereafter locks the dollar and distributes $1 to the user in the form of a cryptocurrency, which the user can freely trade move between wallets on the blockchain. When the user wants to redeem its true dollar value, the user sends the digital dollar back to the bank, which destroys the token and redeems the true dollar, decreasing the supply available to the market.
There have been many other iterations of stablecoins. However, as shown in the metrics below, USDT still has more than 90% of the market. Additionally, USDT runs on the Omni layer (built on the Bitcoin blockchain), and benefits from Bitcoin’s security, but also suffers from its flaws, such as the low TPS throughputs and high latency. This might not be problematic yet, but it might be a hurdle to overcome if and when the adoption of cryptocurrencies increases.
An interesting project which tackles this in a decentralized fashion is MakerDAO (MKR). MakerDAO is a protocol that issues stablecoins (called DAI) backed by crypto collateral. DAI is algorithmically managed to keep them as close as possible to a $1 peg. It’s worth reading this article if you’d like to know more about this protocol, as it’s a complicated project outside of the scope of this article.
For blockchain technology to become mainstream and implemented at a larger scale, the bottlenecks current blockchain platforms suffer from – scalability, privacy, and interoperability – need to be addressed. Scalability issues are critical for IoT solutions as these could require millions of transactions to be performed in a single moment, and the confirmation time needs to be minimal. Fortunately, many projects, such as High Performance Blockchain or CPChain, which are directly targeting the IoT space, are already working on some of the solutions proposed above.
While blockchain technology has undergone rapid improvement since its creation, it’s a relatively young technology and some of the main problems still remain today. However, with minimal transfer fees on the blockchain, more and more projects working on elements of tokenization, and even major companies like Facebook and even governments starting to discuss the creation of their own cryptocurrencies, these technological barriers will likely be overcome sooner rather than later.