April 03, 2018

Cryptocurrency for Direct Benefit Transfer

The astonishing rise, and fall, in the price of Bitcoin has suddenly made everyone -- other than geeks who have been at it since 2009 -- sit up and take notice of an extraordinary new phenomenon called cryptocurrency. We call it a phenomenon because while it certainly carries value, it is not linked to any traditional investment product like equity, debt, commodity or real estate. What is even more mysterious is that the value is recorded in a database called the blockchain, a shared ledger that resides simultaneously across multiple computers that are operated by unknown, unregulated entities.

image from techbullion.com
Bitcoin is to the transfer of value what the internet is to the transfer of information - made it possible to effect transfers easily, anonymously and most importantly without the intermediation of any central authority. This makes both technologies a favourite with libertarians and an anathema to despotic and autocratic governments. But while most governments, barring a few, have reluctantly reconciled themselves to the free flow of information, the transfer of value is, in general, being opposed tooth and nail by central bankers who see themselves becoming as irrelevant as the telegraph and postal service. Hence a barrage of FUD -- fear, uncertainty and doubt -- has been unleashed stating that Bitcoin is being used by criminals, terrorists and tax-dodgers to undermine social order and so must be stamped out ruthlessly! Adding to this general hostility is of course the unstated jealousy of all those who are rueing the fact that they did not acquire Bitcoins when the price was only a few dollars!

The Government is on record, through the Finance Minister’s budget speech, with its view that crypto-assets must be ruthlessly blocked. This is grossly erroneous. All technology -- from nuclear power through genetic engineering to artificial intelligence -- is inherently double-edged and can be used for good or evil. Just as the commercial benefits of the internet far outweigh the nuisance of its misuse by criminals and terrorist, cryptocurrency can be used very beneficially in social and governmental work and in this article we show how it can be used for direct benefit transfer (DBT).

The public distribution system in India is riddled with inefficiency that results in a massive leakage of both money and goods. Government spends money but the poor people do not benefit. A DBT mechanism is perhaps the only way to control the problem but implementing this is not easy. The current mechanism of using bank accounts linked to biometric based Aadhaar cards is of course one way but tokens based on cryptocurrency technology could be an alternative that is a cheaper, simpler and more transparent.

But first, what is Bitcoin?

A Bitcoin is a unit of value, like an equity share of a company, that can be owned and transferred. It resides in an account in a ledger, like a dematerialised share in a demat account with NSDL. The account number, the public key of the account, is known to all and so anyone can send or deposit demat shares into this account. However to sell or transfer shares out of this account, the anonymous account holder must use a password, a private key that only he knows, to create and publish an outbound transaction pointing to another account identified by its public key. In cryptocurrency jargon, an account is called a wallet and the ledger is called the blockchain. A wallet is defined by a {public-key : private-key} pair consisting of two very large numbers that have special cryptographic properties. But what is really novel is that the blockchain ledger, the record of all transactions, is not maintained by or at any one institution, like the NSDL for equity shares, but jointly by all participants in the network. Everyone has a copy of the blockchain-ledger that has a record of all coin transfers and so everyone can both verify and confirm each transaction before they accept it in their own copy. An invalid transaction can pass into the blockchain-ledger if and only if, it is accepted by more than 50% of the network and this has never happened since 2009.

Verification means that a payment transaction is valid -- the total value of all inbound or credit transactions to a wallet less value of all outbound or debit transactions is more than or equal to the current outbound debit transaction. Confirmation means that there is no double spend and the same set of unspent, inbound, credit transactions (“UTXO” or unspent transactions outputs) are not being used to create more than one outbound payment transactions. Since everyone has access to all transactions, anyone can perform the verification and confirmation. This leads to a problem of sequencing. If A has Rs 1000 in his account but writes two cheques of Rs 800 and Rs 900 to B and C, either -- but not both -- cheques will be honoured by the bank, depending on which is presented first. However when there are multiple agencies that are verifying and confirming transactions, there is distinct possibility of an inconsistency in the shared ledger depending upon the transaction that each agency sees first. To overcome this, all cryptocurrencies implement a consensus process. In a zero-trust environment, the consensus is achieved through a proof-of-work algorithm that is based on brute computing power -- it is as if the first banker who completes a 10 km run will be allowed to update the shared ledger! But since this consensus is essential for the success of the process there is a reward for demonstrating that power. “Miners”, that is those who verify and confirm transaction  by running full node blockchain software on a powerful computer, are rewarded with newly created coins that are added to their wallet when they have verified and confirmed a new block of transactions -- that is then added to the blockchain. However the reward is not given to any miner who performs the verification and confirmation but to the one specific miner who, in addition to the verification and confirmation, also solves a difficult mathematical puzzle first, like the first banker who runs 10 km!

The payment, or output  transaction that deposits a newly created coin into a successful miner’s wallet is called a coinbase transaction. It is different from all other transactions because it is not backed by any previous input transaction. Hence the analogy of mining, as if a coin was dug out of the ground and not received from anyone else, whereas all other coins would have to be received from someone before they can be sent to someone else. However a better analogy would be to view Bitcoin, as sweat equity that is given, in lieu of salary, to the accountants in a bank for checking and approving all transactions. The brilliance of “Satoshi Nakamoto”, who designed bitcoin, was in equating the sweat equity of the bank to the assets that are managed by the bank and initiating a self-sustaining network that is working flawlessly since 2009. The magic mathematics of cryptography ensures that this decentralised autonomous organisation (DAO) runs without any formal management and yet has achieved a market capitalisation of over US$ 70 billion.

But why should these “sweat equity” shares of a non-existent bank, the actual Bitcoins, be each worth thousands of dollars today? Many people, who are not miners, buy these coins from the miners for investment or payment purposes and this demand is pushing up the market price.  Bitcoin can be purchased at many cryptocurrency exchanges with fiat currency like US$ or INR ₹. After KYC compliance, these exchanges will convert fiat currency into cryptocurrency and vice versa at market driven prices. Hence, Bitcoin is both a currency that is extremely useful as a payment mechanism because transfers are simple, fast and anonymous and is also a commodity that has appreciated in value and hence worth investing in.

For DBT let us define a new blockchain based cryptocurrency token ( lets call it the cowrie) and peg it to the Indian rupee. So anyone can use a cowrie in lieu of a rupee to pay for goods and services provided the seller is willing to accept the same. This is neither illegal, nor anything new because we already have loyalty points from retailers, credit cards and even meal-companies like Sodexho, that are freely tradeable in lieu of cash at selected stores. Moreover, since the value of the cowrie is pegged to the rupee, there is no question of trading, capital gains and taxation.

Cowries, like any other cryptocurrencies, can easily be stored in mobile wallets and freely transmitted from one wallet to another without the fear of double-spend. They can also be freely exchanged for fiat currency like rupee through cryptocurrency exchanges that follow normal KYC guidelines applicable to banks or at banks themselves.

As an example, let us focus on the public distribution of rice at ₹ 2/kg. Assuming that the government gives 2 kg per week per person when the prevailing market price for similar quality of rice is ₹ 25, the subsidy works out to ₹ (25-2) x 2 x 4 = ₹ 184 per person per month. Let us assume that the government selects 1 crore people who will get this ₹ 2/kg subsidised rice. This means that the government intends to spend ₹184 crores every month for this subsidy. A government agency, say the NPCI,  builds a cowrie wallet and floats an Initial Coin Offering (ICO) that is subscribed to by the government. Government pays ₹184 crores to NCPI and NPCI “pre-mines” ( or creates) 184 crore cowries and transfers them to the Government’s cowrie wallet.

The cowrie wallet is available as a free and open-source software that anyone can download and install on their mobile phones. However those who are entitled to receive the subsidy will have to register their cowrie wallet public addresses with the government disbursement agency with proper identification as would be the case if they were to apply for a ration card. Any shopkeeper who wants to sell rice must also install a cowrie wallet on their phones or computers.

At the beginning of the month, government will transmit 184 cowries to each registered wallet. Recipients, who are entitled to the subsidy, can now go to any rice shop and buy rice by transferring cowries to the shopkeepers wallet and paying the rest in cash at ₹ 2/kg. The shopkeeper can either keep the cowries for future use or exchange them for rupees at a cryptocurrency exchange. The exchange operator can also either keep the cowries for future use or trade them with NPCI in exchange for rupees and NPCI will extinguish them by dumping them into a one-way, black-hole wallet from where they cannot be spent any more.

The cowries are freely transferable. Recipients who are not interested in buying rice can use the same cowries to buy wheat, or daal or school exercise books from the same store using the cowries. Or they might transfer it to the wallets of their friends and relatives and even perfect strangers as gifts or in lieu of other goods and services. Transfer of cowries is governed by the same verification / confirmation mechanism common to all cryptocurrencies and those who validate transactions could be rewarded with newly “mined” cowries as an incentive. However if miners are registered and hence trustworthy, then the computationally expensive proof of work processes can be replaced with simpler consensus mechanisms.

All this can be done using standard cryptocurrency software except that instead of using anonymous public addresses, we can ensure that all public addresses are tagged to a government identity document so that there is perfect transparency on the blockchain about who is getting how many cowries and how these are flowing through the system. However, private addresses are secret to the wallet owner so that only he can spend from the wallet. In principle, even a liquor store can accept cowries, but the blockchain database can be used to track this if it happens too regularly and we wish to question the spender!

One of the attractive benefits of this mechanism is that multiple subsidies can be routed through this mechanism. For example, subsidies on diverse goods and services, like kerosene oil and school tuition, that are delivered through different channels, can be routed through the same wallet. Family wallets can hold cowries for all members. Multi-signature wallets can be coded so that the male member cannot spend the cowries without the consent of the female member and vice versa. Smart contracts can be developed so that not all the cowries can be spent immediately and there will be “timed release”. Smart contracts can also be created to make sure that cowries are spent only at specified points or on specified goods and services. All this is technically possible but initially it may be prudent to keep matters simple so that people first understand how cryptocurrency works.

To continue with the subsidy, Government must continue pay ₹184 crore to NPCI every month to buy 184 crore cowries that NPCI must “mine” and push them into the respective wallets. The exact amount will of course change depending on the kind and level of subsidy that government wants to disburse in each specific month.

Cryptocurrency is an amazing technology that could revolutionise payment systems. Instead of trying to throttle it, it is better that government finds creative ways to use it to discharge its obligations towards its citizens. DBT could be the first of many applications. Who ever has advised the Government that “blockchain is good but cryptocurrency is bad” fails to understand that cryptocurrency is the most natural and popular use of blockchain technology. It is as if we are saying that TCP/IP technology that runs the Internet is good but we should not use it for http applications like websites because websites can peddle pornography. Instead we must use TCP/IP only for FTP, SMTP, NNTP, ICMP, SIP and other “useful” things … Without websites, the benefit of the internet will be restricted to laboratories and not be accessible on our laptops, phones and in our lives. So is the case of cryptocurrency and the blockchain.

This article originally published in Swarajya, the magazine that reads India right.


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