Bob Poekert's Web-Log

Jan 29, 2016

A Sketch of a Fully Distributed Payments System

Problem:

  • I want to buy something from someone, which requires sending them money
  • I don't know them, and they don't know me
  • They're too far away for me to walk over and hand them cash (or rice or a goat or whatever)
  • Neither they nor I have a credit card or a bank account
  • I can't rely on having access to a central broker or ledger. Even if I had access to such a thing I wouldn't trust it. For example, I might live in a place where all the central banking systems are controlled by the government and have problems with graft and rent-seeking.

In other words, I need an actually distributed payment system. Bitcoin won't work for the obvious reason that it relies on a single ledger that every participant in the system can read.

So, can we solve this? Well, first let's see if we can solve an easier sub-problem and then build up from there.

Easy Problem:

  • I want to buy something from someone, which requires sending them money
  • I know the person I want to send money to
  • Because I know them they have a pretty good idea of how creditworthy I am
  • We're phiscally close enough that I can hand them cash
  • I can't go over to their house and hand them cash right now, because I'm busy

I think the solution to this is pretty obvious. If they trust me enough they can accept an IOU where I agree to pay them in cash the next time I'm in the neighborhood, as long as I promise that this'll be within a certain time window (eg: a month). In other words, we're separating payment and settlement. I'm paying them for the thing now, that payment is taking the form of a debt on my balance sheet and an asset on theirs, and that debt will get settled at a specified time (unless I default). This is how a lot of the grown-up banking system works.

What if the person I'm paying is a computer?

They're not a computer, but this blog-post is building towards an automated payment system that people don't have to think too much about, so we'd like for things like creditworthiness to be determined automatically. One way to automatically determine my creditworthiness is to use Bayesian updating. Let's define creditworthiness mathematically as the inverse of the probability of default. We start with a prior probability of how likely people we know nothing about are to default. Then, when we extend credit to someone, we update that probability for them based on whether they paid or not. The more of the time they pay, the more confident we are that they will pay if we lend money to them again. If the probability of default is above some threshold, we ask them to pay extra (a risk premium) so that, in a pool of risky people, the extra money we get from the ones who pay makes up for the money we lose from the ones who don't. If the probability of default is above some higher threshold we refuse to lend them money.

What if the person I'm paying doesn't know me?

If the person I'm paying doesn't know anything about me, then they don't know whether I'm going to give them the money or not. However, if they know someone who knows me, that person can "vouch for" me by passing along their estimate of my probability of default. The person I'm paying can get probability estimates about me from everyone they know who has them, take an average of those estimates weighted by how reliable the person that gave the estimate is, and use that as the probability I will default. And if someone they know doesn't know me, they can ask the people they know about me in turn. This will get information about me if it exists in the network even if it's far away. This is similar to the web of trust concept in cryptography, and to this paper in p2p file-sharing networks.

This system has a bootstrapping problem: what do you do if no one in the network knows you? I don't have a good general solution to this, but since anyone can generate probabilities of default any way they want, you could have participants in the network that acted like rating agencies. If you want to join the network you can pay them, and they'll use outside information to provide a probability of default. Since you're paying them they have an incentive to give you a good rating, but that incentive is balanced by the reliability rating the rest of the network places on them. If a rating agency consistently gives good ratings to people who end up defaulting the rest of the network won't count their ratings for very much.

What if the person I'm paying is too far away to deliver cash to them?

It's likely that if I don't know someone, someone I know knows someone who knows someone who knows them. By "knows" I mean both knows and is physically close enough to hand-deliver cash to. Another way of saying this is that it's likely that there's a path in the network between me and the person I'm transacting with. If that's the case, then all we have to do is find one of those paths, have each party along the path pass the debt on to the next step in the path, and pay each of them something to make it worth the default risk. This works as follows:

  1. I ask everyone I know to transfer a certain amount of money to a certain recipient
  2. If any of them knows the recipient, they send back a bid for what fee they want to charge to make the transfer.
  3. The ones that don't know the recipient send the same transfer request to everyone they know, and send back a bid which is the lowest bid they got plus some premium for themselves. Because steps 2 and 3 are recursive they amount to doing a search across the whole network.
  4. I get back bids from the people I know and pick the lowest one.
  5. The information that I accepted that bid travels along the path in the network it represents and reaches the person I want to pay.

What about systemic risk?

Remember the 2008 financial crisis? That was partly caused by banks borrowing money with the intention of paying the loans back with money that they were owed. Enough banks were doing this that when a few big banks defaulted, the banks they owed money to couldn't pay their debts, and this created a chain reaction of defaults. The standard solution to this in a traditional banking system is for a state regulator to require that banks only borrow a certain percentage of the money they have in cash, so even if a large percentage of the loans they made go bad they'll still be solvent. Doing this requires being able to verify the amount of money that people have. I don't know how you'd do that in the sort of system I'm proposing, especially because the system doesn't say how settlements should happen; anything that's acceptable to both parties is acceptable to the system. So I don't have a good solution to this. Suggestions welcome.

Conclusion

With the pieces I described above we have a sketch of a system that solves the problem posed at the beginning. This system is completely peer-to-peer; every participant in the system has the same status as every other participant. It works over large distances while still being based on physical currency. It doesn't require everyone in the network to have information about everyone else. It doesn't have a central ledger.

I'm really interested to hear what people think of this, especially if they've done research on similar systems, and especially if they're an academic economist. Comment below, or send me an email at <my first name> @ <my last name> .com