"To understand why the blockchain is important, look beyond the wild speculation about what is built underneath.
The Internet bubble of the 1990s is generally considered to be a period of wild excess that ended in the destruction of hundreds of billions of dollars of wealth. What is less often discussed is how all the cheap capital of the boom years was used to finance the infrastructure on which the most important Internet innovations would be built after the bubble burst. It financed the roll-out of fibre optic cable, R&D on 3G networks and the construction of giant server farms. All this would make possible the technologies that are now the foundation of the world's most powerful societies: algorithmic research, social media, mobile computing, cloud services, analysis of large data sets, artificial intelligence and so on.
We believe that something similar is happening behind the wild volatility and hype in the stratosphere of the crypto-money and blockbuster boom. Blockchain skeptics have grumbled with joy as cryptographic prices have fallen from last year's dizzying highs, but they are making the same mistake as the crypto fanatics they mock: they associate price with intrinsic value. We cannot yet predict what cutting-edge industries based on blockchain technology will be like, but we are confident that they will exist, because technology itself is about creating a priceless asset: trust.
To understand why, we have to go back to the 14th century.
It was then that Italian merchants and bankers began to use the double-entry method of accounting. This method, made possible by the adoption of Arabic numerals, provided merchants with a more reliable record-keeping tool and allowed bankers to assume a new and powerful role as an intermediary in the international payment system. Yet it is not only the tool itself that has paved the way for modern finance. It was how it was inserted into the culture of the day.
In 1494, Luca Pacioli, a Franciscan and mathematician, codified his practices by publishing a textbook on mathematics and accounting that presented double-entry accounting not only as a means of keeping track of accounts, but also as a moral obligation. In the manner of Pacioli, for everything that merchants or bankers had of value, they had to give something back. Hence the use of offsetting entries to record separate balancing values: a debit coupled with a credit, an asset with a liability.
Pacioli's morally honest accounting gave a form of religious blessing to these previously decried professions. Over the following centuries, clean books were seen as a sign of honesty and piety, enabling bankers to become payment intermediaries and speed up the flow of money. This financed the Renaissance and paved the way for the capitalist explosion that was to change the world.
Yet the system was not immune to fraud. Bankers and other financial players often failed in their moral duty to keep honest accounts, and they still do: just ask Bernie Madoff's clients or Enron's shareholders. Moreover, even honesty comes at a price. We have allowed centralized trust managers, such as banks, stock exchanges and other financial intermediaries, to become indispensable, turning them from intermediaries into gatekeepers. They charge fees and restrict access, create friction, limit innovation and reinforce their market dominance.
So the real promise of blockchain technology is not to make you a billionaire overnight or to give you the means to protect your financial activities from inquisitive governments. It could significantly reduce the cost of trust through a radical, decentralized accounting approach - and, by extension, create a new way of structuring economic organizations.
The need for trust and intermediaries allows giants such as Google, Facebook and Amazon to turn economies of scale and network effects into de facto monopolies.
A new form of accounting might seem like a boring accomplishment. Yet for thousands of years, since Hammurabi's Babylon, ledgers have been the foundation of civilization. Indeed, the exchange of values on which society is based forces us to trust each other's claims to what we own, what we have and what we owe. To build that trust, we need a common system for monitoring our transactions, a system that gives definition and order to society itself. How else would we know that Jeff Bezos is the richest human being in the world, that Argentina's GDP is USD 620 billion, that 71% of the world's population lives on less than USD 10 a day, or that Apple shares trade at a multiple of the company's earnings per share?
A blockchain (although the term is vaguely used and often misapplied to things that are not really blockchains) is an electronic ledger, a list of transactions. These transactions can in principle represent almost anything. They could be real exchanges of money, as is the case with the block chains underlying crypto-currencies such as Bitcoin. They could mark exchanges of other assets, such as digital stock certificates. They may represent instructions, such as orders to buy or sell shares. They could include smart contracts, which are computerized instructions to do something (for example, buy a stock) if something is true (the price of the stock has fallen below $10).
A blockchain is a special type of ledger, in that instead of being managed by a single centralized institution, such as a bank or a government agency, it is stored in multiple copies on several independent computers within a decentralized network. No single entity controls the general ledger. All computers on the network can make changes to the general ledger, but only by following the rules dictated by a "consensus protocol," a mathematical algorithm that requires the majority of the other computers on the network to agree to the change.
Once the consensus generated by this algorithm has been reached, all computers on the network update their copies of the ledger simultaneously. If one of them attempts to add an entry to the ledger without this consensus or to modify an entry retroactively, the rest of the network automatically rejects the entry as invalid.
Typically, transactions are grouped into blocks of a certain size that are chained (hence "blockchained") by cryptographic locks, themselves a product of the consensus algorithm. This produces an immutable and shared record of the "truth", a record which, if properly prepared, cannot be altered.
Within this general framework, there are many variations. There are different types of consensus protocols, for example, and often disagreement about which type is the safest. There are public registries "without permission", to which anyone can in principle attach a computer and be part of the network; this is what Bitcoin and most other crypto-currencies belong to. There are also "authorized" private ledger systems that do not include any digital currency. These can be used by a group of organizations that need a common record-keeping system, but are independent of each other and may not have complete confidence in themselves - a manufacturer and its suppliers, for example.
The common denominator is that it is mathematical rules and impenetrable cryptography, rather than trust in fallible humans or institutions, that guarantee the integrity of the registry. It is a version of what cryptographer Ian Grigg has described as "a three-entry bookkeeping system": one entry on the debit side, another on the credit side, and a third in an unchanging, uncontested shared ledger.
The advantages of this decentralized model become apparent when comparing the cost of trust in the current economic system. Consider this: In 2007, Lehman Brothers posted record profits and revenues, all approved by its auditor, Ernst & Young. Nine months later, a fall in these same assets led the 158-year-old company to bankruptcy and triggered the biggest financial crisis in the last 80 years. Clearly, the valuations quoted in the books of previous years were very bad. And we later learned that Lehman's ledger was not the only one with questionable data. American and European banks have paid hundreds of billions of dollars in fines and settlements to cover losses caused by inflated balance sheets. This was a stark reminder of the high price we often pay for trusting numbers designed in-house by centralized entities.
The crisis was an extreme example of the cost of trust. But we also see that this cost is rooted in most other sectors of the economy. Think of all the accountants whose firms fill the world's skyscrapers. Their work, which reconciles their firm's books with those of their professional counterparts, exists because neither party trusts the other's track record. It's a long, expensive, but necessary process.
The other manifestations of the cost of trust are not in what we do, but in what we cannot do. Two billion people are being denied bank accounts, taking them away from the global economy because banks do not trust records of their assets and identities. In the meantime, the Internet of Things, which it is hoped will contain billions of autonomous, efficiency-enhancing interacting devices, will not be possible if gadget-to-gadget microtransactions require the prohibitively expensive intermediation of centrally controlled ledgers. There are many other examples of how this problem limits innovation.
Economists rarely recognize or analyze these costs, perhaps because practices such as account reconciliation are assumed to be an integral and unavoidable feature of firms (much as pre-Internet firms assumed that they had no choice but to pay large postage expenses at the post office. monthly bills). Could this blind spot explain why some influential economists have no hesitation in rejecting blockchain technology? Many say they cannot see the justification for its costs. Yet their analyses generally do not compare these costs with the social cost of trust that the new models seek to overcome.
However, more and more people understand this. Since Bitcoin's quiet release in January 2009, its supporters have expanded considerably to include former Wall Street professionals, former Wall Street professionals, technology specialists from Silicon Valley, and development and aid experts from organizations such as the World Bank. Many see the rise of technology as a vital new phase in the Internet economy, one that is even more transformative than the first. While the first wave of online disruption saw brick and mortar companies being displaced by leaner digital intermediaries, this movement is challenging the very idea of for-profit intermediaries.
The need for trust, its cost and dependence on intermediaries is one of the reasons why giants such as Google, Facebook and Amazon are turning economies of scale and the benefits of network effects into de facto monopolies. These giants are, in fact, centralized ledger keepers, building vast registers of "transactions" in what is arguably the world's most important "currency": our digital data. By controlling these records, they control us.
The potential promise of overturning this entrenched, centralized system is an important factor behind the gold rush scene in the crypto-token market, with its rising but also volatile prices. There is no doubt that many investors, perhaps most of them, simply hope to get rich quickly and have little concern about the importance of the technology. But quirks like this one, however irrational they may be, don't come out of nowhere. As with the advent of the transformative platform technologies of the past - railways, for example, or electricity - unbridled speculation is almost inevitable. Indeed, when a great new idea comes along, investors have no framework for estimating the value it will create or destroy, or for deciding which companies will win or lose.
Although major obstacles remain to be overcome before block chains can fulfill the promise of a more robust system for recording and storing objective truth, these concepts have already been field-tested.
Open and freely accessible source code is the foundation of the future decentralized economy.
Companies such as IBM and Foxconn are exploiting the idea of immutability in projects that seek to unlock commercial financing and make supply chains more transparent. Such transparency could also give consumers better information about the sources of what they are buying - if a t-shirt was made with workshop labour, for example.
Another important new idea is that of a digital asset. Before Bitcoin, no one could own a digital asset. Because copying digital content is easy to do and hard to stop, suppliers of digital products such as MP3 audio files or e-books never give customers ownership of the content, but rather rent it out and define what users can do with it in a license. This is a very difficult task, with heavy legal penalties if the licence is broken. That's why you can lend your Amazon Kindle book to a friend for 14 days, but you can't sell or give it away as a gift, like a paper book.
Bitcoin has shown that something of value can be both digital and unique. Since no one can change the registry and "double the spending", nor duplicate a Bitcoin, it can be conceived as a "thing" or a unique asset. This means that we can now represent any form of value, such as a title deed or a music track, as an entry in a blockchain transaction. And by digitizing different forms of value in this way, we can introduce software to manage the economy around them.
As software elements, these new digital assets can be assigned certain "If X, then Y" properties. In other words, money can become programmable. For example, you can pay to rent an electric vehicle with digital tokens that are also used to activate or deactivate its engine, thus fulfilling the coded conditions of an intelligent contract . This is quite different from analog tokens such as banknotes or metal coins, which are agnostic as to their use.
What makes these programmable money contracts "smart" is not that they are automated; we already have that when our bank follows our programmed instructions to automatically pay our credit card bill each month. It's that the computers running the contract are monitored by a decentralized blockchain network. This ensures that all signatories to a smart contract are guaranteed that it will be executed fairly.
With this technology, the computers of a shipper and an exporter, for example, could automate a transfer of ownership of goods once the decentralized software they both use sends a signal that a digital currency payment - or a cryptographically unbreakable payment undertaking - has been made. Neither party necessarily trusts the other, but they can nevertheless make this automatic transfer without the need for a third party. In this way, intelligent contracts take automation to a new level, enabling a much more open and comprehensive set of relationships.
Programmable money and smart contracts are a powerful way for communities to govern themselves in pursuit of common goals. They even offer a potential breakthrough in the "tragedy of communes", the longstanding idea that people cannot simultaneously serve their personal interest and the common good. This was evident in many of the blockbuster proposals of the 100 software engineers who took part in Hack4Climate at last year's UN climate change conference in Bonn. The winning team, with a project called GainForest, is developing a blockchain-based system that allows donors to reward vulnerable tropical forest communities for demonstrable actions to restore the environment.
Yet this utopian, frictionless "symbolic economy" is far from reality. Regulators in China, South Korea and the United States have severely cracked down on token issuers and traders, viewing them as speculative schemes to make quick bucks that avoid securities laws rather than changing new business models. They are not entirely wrong: some developers pre-sold tokens in "initial coin offerings" or ICOs, but did not use the money to build and market products. Public or "no-permission" blockchains such as Bitcoin and Ethereum, which offer the best promise of absolute openness and immutability, are facing growth difficulties. Bitcoin still cannot process more than seven transactions per second and transaction fees can sometimes increase, making it expensive to u
se.
Meanwhile, centralized institutions that should be vulnerable to disruption, such as banks, are getting involved. They are protected by existing regulations, which are ostensibly imposed to keep them honest, but inadvertently constitute a compliance cost for startups. These regulations, such as the burdensome reporting and capital requirements imposed by the New York State Department of Financial Services' "BitLicense" on crypto-money transfer start-ups, become barriers to entry that protect incumbents.
But here's the thing: the open-source nature of the blockchain technology, its enthusiasm and the increasing value of the underlying tokens have encouraged a global pool of intelligent, passionate and financially motivated computer scientists to work to overcome these limitations. It is reasonable to assume that they will constantly improve the technology. As we have seen with Internet software, such open and extensible protocols can become powerful platforms for innovation. Block chain technology is evolving far too rapidly for us to assume that later versions will not be improved on the present, whether in Bitcoin's crypto-money-based protocol, Ethereum's smart contract-oriented block chain, or a yet undiscovered platform.
The cryptographic bubble, like the Internet bubble, creates the infrastructure to build the technologies of the future. But there is also a key difference. This time, the funds raised are not used to underwrite a physical infrastructure, but a social infrastructure. It creates incentives to form global networks of collaborating developers, beehive minds whose supply of interactive, iterative ideas is codified in lines of open-source software. This freely accessible code will enable the execution of countless ideas that are still unimaginable. It is the foundation on which the decentralized economy of the future will be built.
While few people in the mid-1990s were able to predict the emergence of Google, Facebook and Uber, we cannot predict which blockchain-based applications will emerge from the wreckage of this bubble to dominate the decentralized future. But that's what you get with scalable platforms. Whether it's the open protocols of the Internet or the essential components of algorithmic consensus and distributed preservation of blockchain records, their power lies in creating an entirely new paradigm for innovators ready to imagine and deploy world-changing applications. In this case, these applications - in whatever form they take - will be aimed squarely at disrupting many of the control institutions that currently dominate our centralized economy.'.
