Blockchains - What Are They? What Can We Expect?

by Elliott Morss

Introduction

I know very little about blockchains (BC), distributed ledger systems, and crypto-currencies such as Bitcoin. But I am a bit dumbfounded by the claims of what "the BC era" will bring. In what follows, I comment on some of these claims appearing in a paper written by Don and Alex Tapscott in the MIT Sloan Management Review. Quotes from the article start with BC. The lead-in to my comments is EM. Click on graphic below for larger image.

A Little Background

BC: For the last century, academics and business leaders have been shaping the practice of modern management. The main theories, tenets, and behaviors have enabled managers to build corporations, which have largely been hierarchical, insular, and vertically integrated. However, we believe that the technology underlying digital currencies such as Bitcoin - technology commonly known as blockchain - will have profound effects on the nature of companies: how they are funded and managed, how they create value, and how they perform basic functions such as marketing, accounting, and incentivizing people....

EM: It sounds interesting. Here is another piece on the same topic. For those who learn from images, this picture might help.

BC: In some cases, software will eliminate the need for many management functions...."

EM: Yes. And indeed, I have written (and worry) about the labor saving automation occurring in most goods and services industries. The macro effect has been to reduce the demand for laborers and wages globally. But automation is running apace and I am not sure how BC will affect what is already happening.

BC: The internet vastly improved the flow of data within and between organizations, but the effect on how we do business has been more limited. That's because the internet was designed to move information - not value - from person to person. When you email a document, photograph, or audio file, for example, you aren't sending the original - you're sending a copy. Anyone can copy and change it. In many cases, it's legal and advantageous to share copies.

By contrast, if you want to expedite a business transaction, emailing money directly to someone is not an option - not only because copying money is illegal but also because you can't be 100% certain the recipient is the person he says he is. As a result, we use intermediaries to establish trust and maintain integrity. Banks, governments, and in some cases big technology companies have the ability to confirm identities so that we can transfer assets; the intermediaries settle transactions and keep records. For the most part, intermediaries do an adequate job, with some notable exceptions. One concern is that they use servers that are vulnerable to crashes, fraud, and hacks. Another is that they often charge fees - for example, to wire money overseas. They also monitor customer behavior and collect data, and they exclude the hundreds of millions of people who can't qualify for a bank account. And sometimes, they make terrible mistakes, as the 2008 financial crisis made evident."

EM: All true. And yes, there are currently transactions fees associated with moving any asset. And yes, more digitalization will probably lead to these fees being reduced. But just how BC will make us safer beyond what is already happening is not clear.

I have real problems with the BC's inference that somehow BC will save us from the "mistakes" that caused the 2008 bank collapse. I have written at some length on the causes of that global collapse. The "mistakes were the result of the incentive structures of banks, greed, and ignorance. And sadly, there is nothing I can see being offered by BC to remedy these problems.

BC: What would happen if there were an internet of value where parties to a transaction could store and exchange value without the need for traditional intermediaries? In a nutshell, that's what blockchain technology offers. Value isn't saved in a file somewhere; it's represented by transactions recorded in a global spreadsheet or ledger, which leverages the resources of a large peer-to-peer network to verify and approve transactions. A blockchain has several advantages. First, it is distributed: It runs on computers provided by volunteers around the world, so there is no central database to hack. Second, it is public: Anyone can view it at any time because it resides on the network. And third, it is encrypted: It uses heavy-duty encryption to maintain security."

EM: Okay. This "internet of value" runs on "computers provided by volunteers around the world." I would prefer to have a paid professional managing my transactions, someone who gets fired if s/he screws up. And let me show my innocence/ignorance: How can data be "public" and at the same time "encrypted?"

BC: We believe that blockchain will transform how businesses are organized and managed. It allows companies to eliminate transaction costs and use resources on the outside as easily as resources on the inside.

EM: I need some convincing on the repeated claim that BC will allow firms to eliminate transaction costs. Advancing technologies will reduce them certainly, but to remove them entirely? I don't see it.

BC: With a prospective employee's consent, an employer will have access to a cache of information that's known to be correct because it has been uploaded, stored, and managed on a highly secure, distributable database. For example, job prospects wouldn't be able to lie about their training or degrees because an authority, such as the university they graduated from, has entered the data on the blockchain. Tampering with data after the fact wouldn't be possible: It would involve taking over the entire blockchain, a nearly impossible task. Individuals would control their own personal data (including birth date, citizenship, financials, and educational records) in a virtual black box. They alone would be able to decide what to do with the information.

EM: No tampering? No hacking? My sense is that for the indefinite future, hackers will continue to successfully hack. Indeed, just has been the case in the past, the arm of the law will continue to fight hackers. Sometimes the hackers will win and sometime they will lose.

BC: Information about a business's financial well-being changes all the time. When you search the web for a company's financial data, you search in two dimensions: horizontal (across the web) and vertical (within particular websites). What you find can be out-of-date or inaccurate in other ways. On a blockchain, though, there's a third dimension: sequence. In addition to being able to obtain a historical picture of the company since it was incorporated, you can see what has occurred in the last few minutes. The opportunity to search a company's complete record of value will have profound implications for transparency as it brings to light off-book transactions and hidden accounts. People responsible for records and reports will be able to create filters that allow stakeholders to find what they are searching for at the press of a button. Companies will be able to create transaction ticker tapes and dashboards, some for internal use and some for the public. As extreme as this may sound, it's really not.

EM: As an investor, I find the SEC reports quite complete. The reports allow me to look back in time since earlier reports remain on the SEC web site. As to seeing "what has occurred in the last few minutes," I don't need it. And in any case, someone will always find a way to get this information before me.

BC: ...we use intermediaries to establish trust and maintain integrity. With the new platform, sellers won't have to incur the cost of establishing trust - thus they can facilitate transactions that would have been risky or might not have been possible otherwise. Furthermore, blockchains will eliminate the cost of warehousing data and protecting other people's data from security breaches. It should also be easier to target customers who make their interests known.

EM: BC says "With the new platform, sellers won't have to incur the cost of establishing trust" .... Exactly how is this going to work? Exactly how will BC eliminate security breaches?

BC: Through smart contracts - software that, in effect, mimics the logic of contracts with guaranteed execution, enforcement, and payments - companies will be able to automate the terms of agreement. A contract can refer to data fields elsewhere on the blockchain (for example, a party's account balance, a change in a commodity price, or an additional sale of a copyrighted work). It can trigger alerts and ensure payments.

EM: A lot of the boilerplate work that lawyers do has already been automated. I am not clear what BC will add.

BC: We believe blockchains will also transform the process of raising money. In our view, the blockchain has the potential to disrupt the way the global financial system works and change the nature of investment. Mindful of this prospect, the New York Stock Exchange has invested in Coinbase Inc., a digital currency wallet and platform company headquartered in San Francisco, California. For its part, the Nasdaq Stock Market is also experimenting with blockchain technology.

Shareholders will be able to enforce the commitments executives make. Companies can specify relationships and state specific outcomes and goals so that everyone understands what the respective parties have signed up to do.

EM: On enforcing commitments, I think all of this can be done through legal agreements as currently written. It is not clear what BC will add. On raising money, I think US venture capital firms and other organizations do a very good job of raising money to commercialize new technologies.

BC: In recent years, we have been reminded all too often that managers don't always act with the highest degree of integrity. (Think of the scandals at Enron, AIG, and Volkswagen, for instance.) What if we could codify ethics and integrity into the circuitry of the enterprise, or reduce the moral hazard that too often sees management gambling with shareholder capital? Through smart contracts under blockchain, shareholders will be able to enforce the commitments executives make. Companies can specify relationships and state specific outcomes and goals so that everyone understands what the respective parties have signed up to do and whether those things are actually getting done."

EM: BC said "BC will...codify ethics and integrity into the circuitry of the enterprise, or reduce the moral hazard that too often sees management gambling with shareholder capital...." I hate to be cynical but consider banks: as I recently noted in a piece, the laws, backed by the financial lobbyists in DC continue to allow banks to gamble with our deposits and I do not see this changing soon. And sure, "smart contracts" make sense. But when parties are willing, are they not being written without BC?

Crypto-currencies/Bitcoin

EM: Centuries ago, currencies came into being so that all trade did not have to be done by barter - goods and/or services in return for other goods and/or services. But to be effective, the currency had to be trusted by the parties to the transaction. And an important element in being trusted was that its value in trade had to remain fairly steady. The world has many currencies with the US dollar currently the ultimate low-risk currency. Certainly, the dollar gains and looses value relative to other currencies/goods/services. But the changes are fairly predictable and one can get insurance for fixed values.

So along comes Bitcoin. At least so far, it has not had the features one wants in a medium of exchange, namely a price that remains quite steady relative to other currencies/goods/services. The values of Bitcoin swing wildly, more like the stock values of IPOs where the underlying values of companies are "sketchy."

Conclusions

The world is in the midst of technological changes made possible largely by the digital revolution. The US is at the forefront of what is happening. Venture capital firms (US VC has invested more than $250 billion in the last five years) along with government research from the Defense Advanced Research Projects Agency (DARPA) and others have spurred the new technologies explosions now occurring.

It is great that intelligent people are working to develop BC. Something beneficial will probably result. However, this approach has yet to prove itself.

Every so often, it is worth pondering whether technological change should be tethered. Bad and good will come out of it. Keep in mind that man's ability to adapt has limits.