Trust is the fundamental lubricant of commerce. We accept a cash payment from someone we don’t know because we trust the central bank that issued it and trust that we can, in turn, use it to purchase products and services. Banks lend people money because they trust they’ll repay the loan. Similarly, companies make down payments with suppliers trusting that they’ll deliver. Workers take up employment with firms trusting they’ll be paid at the end of the month. We have this trust despite our inner knowledge that our counterparties are hardwired to put their interests ahead of ours. In ancient times our levels of trust would have been very low outside of people in the tribe. Within the tribe we could learn through experience which individuals were trustworthy and which weren’t. We could also more easily hold people to account. Outside of the tribe neither of these things were true. In the modern economy we have massively scaled the amount of people and institutions we can trust via two mechanisms.
The first of these is reputation. In the situations above, the bank, the company and the worker trust their counterparties will do their utmost to make good on their promises because if they don’t, they’ll damage their precious reputational capital. Reputation is heavily monitored in our modern networked world as it’s in the collective interest to have as much information as possible on it. Banks share information about our performance in repaying credit. Information about which companies are reliable in both supplying goods and in treating their staff well is also well-documented. Ledgers full of data about people’s past behaviour that once-upon-a-time existed only in the minds of members of tribes, now take up petabytes of server space in the cloud. On account of information sharing, people that fail to meet their contractual obligations risk being frozen out of credit markets and losing business to competitors. As a consequence, most people are incentivised to make good on their promises.
The second mechanism in establishing trust is the “men with guns” mechanism, otherwise known as law enforcement. Some centuries ago, we expanded our tribes into nation states and formalised expected behaviours under the rule of law. Nowadays modern economies are heavily regulated with the expected behaviour of people and institutions well established in various areas of the law. The courts treat everyone the same (or at least are supposed to). Consequently, even people/institutions from outside the jurisdiction (the tribe) can seek remedy if wronged. We’ve also scaled laws beyond national courts through trade agreements and third-party arbitrators. If a party reneges on contractual obligations, they can expect that they may be taken to court. If they lose the case they will incur great cost and possibly even a loss of liberty if the actions are deemed criminal. Again, the incentives usually favour good behaviour.
As a result of these mechanisms, commerce has scaled to enormous levels globally and despite well-documented externalities that we are now setting about remedying, this has been hugely beneficial for humanity. We’re well on the way to eliminating poverty and health and lifespans continue to increase exponentially. These mechanisms are far from perfect however. Sometimes the reward from bad behaviour can outweigh the loss from torching one’s reputational capital. Furthermore, in many cases a guilty counterparty can fudge an issue and apportion blame, creating a variant of a prisoner’s dilemma situation where either neither party comes out of the dispute with reputational damage or both do.
Law is also far from perfect in guaranteeing trust. Seeking legal remedy is increasingly costly and, in many cases, not worth it. Further, much of the law is local and thus subject to local interests and politics. The legal system doesn’t always treat everyone the same, generally favouring those with more money, and laws are often written to suit local interests. We see examples of this all the time these days. China heavily restricts foreign companies from operating in its market. As it has grown in global stature, other powers have become less willing to allow her companies to also operate freely within their jurisdictions. Huawei recently lost a number of 5g infrastructure development contracts across the western world subsequent to US diplomatic pressure. The US also ordered Tik Tok’s US operations to be sold to a US buyer or to be halted. The EU has said it will forbid Facebook’s Diem payments system from competing with its payments infrastructure and currency dominance. Post Brexit there is still uncertainty over which access UK financial services providers will gain on account of passporting rules. Often these rules are brought in under the guise of national security or anti-trust concerns. Sometimes these concerns are warranted but in many cases it’s just good old-fashioned protectionism that hurts global consumers to the benefit of local producers.
So what have blockchains like Ethereum got to do with any of this? Blockchains are a special type of database technology that can scale trust much like traditional databases have scaled it by broadening our reservoir of knowledge of reputation. They scale it in a very different manner, however. Whereas reputational damage or legal censure are probable consequences of bad behaviour, blockchains are ledgers that are secured by a mechanism that minimises the opportunity for bad behaviour in the first place. They employ non-cooperative economic games that reward honest behaviour and punish bad behaviour. These incentives ensure content written to the ledger on a day-to-day basis cannot be amended without going to great expense. Any other changes to the ledger are implemented via decentralised governance mechanisms. Without going into the game theory, the incentives create a coordination problem that makes them extremely difficult (practically impossible) to change by any single party. Therefore, when one creates a financial application and uploads it to the blockchain, the creator of the application ceases to have any control over it. It simply exists in the form of an autonomous robot on a distributed global network of computers.
The significance of this is huge. The history of finance is littered with service providers abusing their position, making false promises, gambling with their customers’ money or outright stealing from them. Understandably, finance is now one of the most heavily regulated industries in the world as a result. With onerous regulation comes a huge compliance burden, the costs of which are passed on to consumers. Since the financial system is global but laws are local, anyone wishing to serve global markets must become regulated in each jurisdiction. This creates enormous barriers to entry for competition which not only stifles innovation but concentrates risk. The financial system is now even more concentrated than it was when governments vowed to end “too big to fail” finance in 2008.
In largely removing the principal-agent problem in finance, blockchains almost entirely eliminate the need for users to trust an application that lives on them. What follows from this is that a decentralised application (dApp) need not be regulated to anywhere near the extent a traditional financial services provider must be. What in turn follows from this is the possibility of a Cambrian explosion in financial innovation since anyone on the planet is now empowered to become a financial services provider to anyone else on the planet with access to the internet.
Since the financial applications are secured by a global non-cooperative bargaining game, the trust users have is the same no matter which country they or their transacting counterparty resides in or if their counterparty has a good reputation or not. Transactions are settled globally in seconds without intermediaries. The blockchain is a completely neutral entity that no country can command to suit its interests. Consequently, geopolitical manoeuvring that stifles competition to further the interests of national champions is removed from the equation. Finally, since the system is completely open, any application can seamlessly interoperate with another. A user’s wallet can be their savings account, their brokerage account, their Transferwise account or whatever else all in one. In sum blockchains have the potential to vastly expand financial access by reducing the cost of trust, reducing opportunity cost by reducing friction for users, enhancing competition and in doing so reducing system risk. That’s a very powerful proposition.
I am certain in the future there will be a requirement for code governing financial apps to be audited by a globally certified body, something the industry currently self-regulates on, but such a compliance system would pale in size to the compliance teams that occupy thousands of skyscrapers around the world today. Naturally there will continue to be a need for rules governing market structure to mitigate systemic risk as well as rules aimed at mitigating the costs money laundering imposes on society but due to these ledgers being unamendable and publicly viewable, it’s likely a lot of the human labour involved in these areas will also be automated and improved.
So that’s essentially what blockchains do. They automate a certain type trust. Since trust is a fairly abstract concept, many have struggled to see the value proposition of blockchains. It’s easy to visualise automation as robots replacing humans in manufacturing assembly lines in the 80s or the digitalisation of many physical human processes with the advent of personal computers and the internet in the 90s or as things like self-driving cars today. We imagine these things as it’s easy to visualise both the human that was replaced by a robot and the product that is delivered. Visualising compliance teams that deliver an abstract entity called trust being replaced by code on a distributed network of computers doesn’t come as easily to people. Consequently, there has scarcely been a more debated technology in history. $2.5tn of capital (and counting) invested suggests that debate is ending, however. The next ten years will herald a revolution in finance and beyond.
