Blockchain Labs 2021
Working Group Projects
This semester, we decided to focus on two main themes – central bank digital currency (CBDC) and bitcoin. But why these themes? CBDC and Bitcoin are two areas of research where the DCI is focusing its efforts. Having the students concentrate on real-world problems that are active research foci of the DCI allows for an enjoyable and more valuable experience for all those involved.
Please reach out to MITBlockchainLabs@media.mit.edu if you have any questions on the course.
Projects
Please click on the papers front cover to read the full report for each
Adoption of Digital Currencies at Scale in Online Retail Payments
Will consumers adopt digital currencies at scale?
Collaborator: American Express
Executive Summary
This study aims at providing an analytical approach to identify the main drivers of digital currency adoption in the online retail payments market. Through a combination of System Dynamics modelling and scenario planning, we identify four scenarios which will likely represent the future role of cryptocurrencies in online retail payments:
Digital Dollarization – A combination of timely regulation, coordinated government action and distinctive fintech innovation will allow Central Bank Digital Currencies (CBDCs) to be successful and represent the leading means of payment. Selected relevant cryptocurrencies (e.g., Bitcoin) will exist in the market, but mainly as an investment asset class;
Triumph of Tokenization – Cryptocurrencies (e.g., Bitcoin, Ether, Libra) market continues to grow and mature. CBDCs in developed world economies are launched with support from fintech innovators and coexist with “private market solutions”. Incumbent financial institutions are progressively disintermediated as the existing two-tier banking system evolves;
Buying Lattes with Bitcoin – Cryptocurrencies and decentralized solutions represent the leading market option as a consequence of low and slow regulation, failure of established macroeconomic institutions, and breakthrough financial innovation;
Regulated into Irrelevance – Central Banks, scared of losing control of the monetary base, promptly regulate the space. Legacy financial institutions innovate enough to ensure the existing account-based system achieves satisfactory performance. Digital currencies may remain in the market but will play a marginal role.
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Wholesale CBDC: Potential Impacts to Dollar Funding Markets
What is the impact of CBDC on institutional liquidity management?
Collaborator: Fidelity
Executive Summary
As many countries and central banks investigate the viability and utility of Central Bank Digital Currencies (CBDCs) they find far reaching impacts across the entirety of the financial system. In the case of a US wholesale CBDC, there are a few major areas of interest and open questions. This report aims to answer four specific questions:
1. What will a US central bank digital currency (CBDC) look like?
2. How will the introduction of real-time gross settlement change current banking operations?
3. How will a wholesale CBDC change cross-border payments?
4. What is the impact on dollar funding markets?
US CBDC
A US Federal Reserve backed CBDC would focus on delivering value in three key ways: reduce cost, increase speed, and create digital identity. More specifically, this means settlement in real time, at a lower cost per transaction. While many countries around the world are looking to implement CBDCs to improve domestic settlement, the US already has a very robust domestic settlement infrastructure via fluid wholesale markets. Moreover, the US financial system benefits greatly from asynchronous settlement practices like netting. As a result, motivations for a Federal Reserve CBDC vary; however, the most compelling argument for digital currency centers not on domestic transactions but on cross border payment efficiencies. A secondary, less concrete motivation is greater visibility for the Fed into the underlying health of the financial system
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Lightning Network Interest Rate
Develop a method(s) for calculating and measuring a nodes realized interest rate and develop a framework for aggregating and reporting those rates in a reference rate
Collaborator: Fidelity
Executive Summary
As of date, Bitcoin is the largest cryptocurrency measured by market capitalization. The Bitcoin blockchain can support somewhere between 4 and 7 transactions per second, preventing BTC from achieving the status of a truly modern method of payment. The Lightning Network is a secondary layer protocol designed to solve the problem of scalability for Bitcoin. The Lightning Network enables efficient micropayments of BTC between two parties in a network of nodes connected via channels. When two parties wish to transact with each other, they can open a channel between their respective nodes. Each party commits a certain amount of BTC to the channel, which is recorded on-chain. Subsequent transactions between the parties are reflected by updating the balances of each party within the channel; these cryptographically-secured transactions are recorded off-chain. Thus, rather than recording each transaction on the Bitcoin blockchain, only two transactions are ever recorded on-chain — the channel’s opening and closing — and all other transactions take place off-chain, vastly improving Bitcoin’s processing capacity.
A key feature of the Lightning Network is multi-hop payments: the ability to route transactions through a node path. That is, if a channel exists between Alice and Bob and another channel exists between Bob and Claire, then Alice can pay a certain amount of BTC to Claire even if there is no channel between the two of them: Alice can route the payment through Bob, so that Alice first transfers some BTC to Bob and then Bob transfers the same amount to Claire (minus a fee Bob chooses to charge for routing through his node). Thus, the more channels and nodes there are in the Lightning Network, the more potential payment routes exist, thus solving the problem of scalability. Due to the design of multi-hop payments, it is possible for nodes to generate a profit by charging a routing fee on transactions; the interest rate of a node is the proportion of BTC earned for routing transactions divided by the total liquidity committed to the node. Continued…
Mining Pools
Which mining pools are performing best at maximizing the block reward?
Collaborator: Fidelity
Executive Summary
Fidelity Investments, the project client and sponsor, is continuously engaged in a number of cutting edge R&D initiatives within the financial sector. More than five years ago, Fidelity started their cryptocurrency operations with a proof-of-concept into the sector. Since then, their operations have grown in scale both within mining as well as into other cryptocurrency related activities. This project is part of Fidelity’s efforts to improve their bitcoin mining operations as is sponsored by their Bitcoin Mining team.
In our analysis, we examine mining efficiency from 3 lenses:
1. A preliminary outside-in-view that assesses pool mining efficiency quantitatively based on historically achieved total fees and block sizes. The data on each of the 55k historical blocks were sourced from BTC.com, including information on fees, transactions, size, and etc. Note that while substantial public historical data is available and miners or observers can easily source the data to reconstruct this view, it serves as a naive perspective of pool mining efficiency and one that is incomplete for assessing operator behavior. The main drawback of the outside-in-view is that it does not compare the fees from the actual block mined against the fees from the theoretically mempool-optimal block.
2. A simulation and benchmarking analysis that compares the fees and transactions in the actual block mined by pools against a near real-time simulated mempool-optimal block over a 300hr period. To create the mempool-optimal block, we simulate the block formation and fee maximization process that rational miners and operators undertake when creating a block. This piece of analysis was integral to answering the main project question of which pools are performing best in terms of mining efficiency. Note that this framework can be further refined in future works by employing more resources (to enable more efficient data sourcing) and utilizing optimization.
3. A qualitative research approach that focuses on the upcoming trends and expected impact on mining efficiency. At the time of writing, these trends include
Stratum V2, Segwit, Block updates, and Banned Addresses.
Key Design Principles of Better Money: Examining the implications of wholesale Central Bank Digital Currency (wCBDC) on the velocity of money, transaction costs, and counterparty risk.
Partner with Deloitte and the DCI to scope out the CBDC wholesale research work stream
Collaborator: Deloitte
Executive Summary
Background -
Central Bank Digital Currencies (CBDC) are digital currencies issued by central banks. They are a digital form of fiat money issued and regulated by the issuing country's central bank. CBDCs can be wholesale CBDC (wCBDC) meant for wholesale use among financial institutions or retail CBDC (rCBDC) available to the general public. The focus of this paper is on the economic impacts of wCBDC. We aim to discuss its economic benefits and impact on the velocity of money supply.
Research questions and process -
As a part of this study, we aim to research the economic impacts of a wholesale CBDC. Our process consisted of literature reviews and independent research that helped us formulate the hypothesis around the "Core Design Principles of Better Money" and the options for a wCBDC minimum viable business product. We also studied the current state of the system to elaborate on what can be reimagined with wCBDC. Finally, we discussed the most significant benefits and design innovations from wCBDC that make the high velocity of money possible. The focus questions were the Core Design Principles of Better Money. We also examined the impact of these core design principles on mitigating counterparty credit risk and liquidity risk, reduced transaction costs, and increased velocity of money due to the efficiencies of a wCBDC implementation.
Findings -
Velocity of money and inflation - Economic theory links money supply with inflation using the "quantity theory of money." Based on this equation, holding the money supply constant, if the velocity increases faster than the real economic output, the price level must increase to make up the difference, thereby having an inflationary effect. The efficiencies that a wCBDC implementation offers, including real-time settlement and asset transfer, the compression in transaction times alongside the increasedvelocity of money, might create inflationary effects.
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Digital Identity: International Benchmarking
Review and provide recommendations for best practices for the means by which persons and entities are identified by digital platforms
Collaborator: Federal Reserve Bank of Boston
Executive Summary
A digital identity system not only has the potential to improve efficiency and convenience, it may also effectively reduce instances of identity fraud in both online and offline transactions. Moreover, a digital identity system may create economic and social value by increasing financial inclusion.
The US faces a unique set of challenges with respect to the development of large scale digital identity solutions. Although there are federal ID solutions in place in the US, either adoption is low (passports) or use cases are limited (social security numbers). Today’s ID system in the US relies heavily on State/Driver’s Licenses, which is built on a highly fragmented issuance process.
Given the close relationship of the Boston Fed with the administration, we have focused our research in developing an international benchmark of government-led initiatives. We have analyzed China, Estonia, India, Israel and Singapore, as we consider these are the leading countries in terms of digital identity management. We have identified two different archetypes in terms of how to implement the solution and onboard both the citizens and third parties in the development and usage of the identity solution – (1) government-controlled model, (2) user-controlled model. We draw on Singapore and Estonia as case studies for these two archetypes.
In our recommendation for the United States, we recognize that conventional examples of centralized or government-controlled model, which may work well in other countries, are not necessarily feasible in the US. We presented two options – either a top down approach that would entail that the federal government playing a key role managing a centralized digital identity database across the entire country, or a bottom up approach that would entail that states and local government having ownership over the digital identity database. While each of the options have pros and cons around cyber security risks, political acceptability and public trust, the federal government will need to play a key role in settings standards to ensure a scalable digital identity solution. We also identified four key design principles – privacy-by-design, federated infrastructure, interoperable solutions, open innovation – that will be critical for a successful digital identity program in the United States.
Onboarding individuals and organizations onto the Grant Payments Blockchain
As blockchain is a decentralized systems and many of the grantees work with more than one agency, we need to determine onboarding and security processes.
Collaborator: US Treasury: Office of FIT
Executive Summary
The purpose of this report is to outline the key decisions and considerations related to the design of the onboarding procedure for the Blockchain for Grant Payments (hereinafter “the Grant Payments Blockchain” or “the Blockchain”). The primary design criteria are (1) to increase the transparency of the grant process (2) to reduce the burden on individuals and entities engaged in the grant process and (3) to increase the overall efficiency of the grant process. Blockchain technology presents a new and unique avenue to reimagine the grant space and meet these design goals.[1]
This report will divide the onboarding process into two steps: authentication and authorization. Authentication describes the process of reliably ascertaining the identity of an entity that needs to be onboarded on the Grant Payments Blockchain. The authentication process allows a unique identifier to be generated for each entity and, where required, provides a mechanism by which an entity can log into the Grant Payments Blockchain interface. Authorization describes the process of defining what permission an entity has on the Grant Payments Blockchain. The permissions restrict both the actions of an entity (for example, the permission to make a drawdown request) and what information the entity may view (for example, a list of all transactions related to a particular grant).
For the authentication step, we propose leveraging existing infrastructure, in particular SAM.gov and LOGIN.gov, to authenticate organizations and individuals, respectively. While these systems were not designed with a Blockchain application in mind, they provide a time and cost-effective authentication solution. In the relevant sections, this report will touch on some of the potential limitations of these tools and how they may be addressed.
For the authorization step, the set of possible permissions for each user will be determined based on the organization with which the user is affiliated. For example, permissions surrounding the creation of a new subgrant would be restricted to users affiliated with a prime grant recipient. As for the authentication procedure, users would generally self-select the required permissions from this limited set, however, these permissions may need to be approved by another user.
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