Journal of Financial Market Infrastructures

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Proof-of-work blockchains and settlement finality: a functional interpretation

Ruth Wandhöfer and Ron Berndsen

  • One of the claims of Bitcoin (Nakamoto, 2008) is that settlement takes place without a central authority. The authors, Ruth Wandhöfer and Ron Berndsen, investigate this claim by comparing Bitcoin’s proof-of-work consensus algorithm to the legal concept of settlement finality used in financial market infrastructures worldwide.
  • The existing analytical framework (Berndsen, 2013 in JFMI vol 2(2)) had to be extended to arrive at an encompassing definition called degree of settlement finality (DSF). The idea is that in the Bitcoin blockchain the degree of settlement finality of the transactions in an existing block is increasing with every newly added and verified block. In practice when a block reaches DSF >= 6, the transactions in that block are deemed settled with finality as per the current ‘market’ convention for bitcoin transactions.
  • The authors conclude that in terms of settlement finality , subject to certain conditions, proof-of-work settlement is preferable to legal settlement finality. However, those conditions are not likely to be met as they pertain to the well-known drawbacks such as lack of scalability, excessive energy use and the 51% attack vulnerability. Future designs of new types of blockchains will need to consider these shortcomings in order to enable the regulated industry to benefit from this technology innovation.           

In this paper, we aim to provide an interpretation of the legal issue of settlement finality in the context of proof-of-work distributed ledger technology, such as the Bitcoin network. Bitcoin intends to achieve certainty of settlement of its cryptocurrency in a trustless environment, without the need for intermediaries and without recourse to any legal provision. We extend earlier work on functional modeling of the theoretical settlement problem to include blockchains, and we provide a functional interpretation of settlement finality by introducing the notion of degree of settlement finality. In principle, we conclude that functional settlement finality in Bitcoin is preferred to legal enforceability. However, in practice, the Bitcoin blockchain is not suitable for the trusted environment of the regulated financial industry unless well-known issues – such as high energy consumption, low settlement speed, problems with scalability and the 51% attack risk – are resolved.

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