'In God We Trust' In blockchain we trust

'In God We Trust' In blockchain we trust

To understand why blockchain matters, look past the wild speculation at what is being built underneath, argue the authors of The Age of Cryptocurrency and its newly published follow-up, The Truth Machine: The Blockchain and the Future of Everything.

The dot-com bubble of the 1990s is popularly viewed as a period of crazy excess that ended with hundreds of billions of dollars of wealth being squandered and/ or destroyed. What’s less often discussed is how all the cheap capital of the boom years helped fund the infrastructure upon which the most important internet innovations would be built after the bubble burst. It paid for the rollout of fiber-optic cable, R&D in 3G - 5G networks, and the buildout of giant server farms, client/ server a precursor to 'cloud computing.' All of this would make possible the technologies that are now the bedrock of the world’s most powerful companies: algorithmic search, social media, mobile computing, cloud services, big-data analytics, Ai, inet of things and more.

We think something similar is happening eversince there was value to bit ones and zeroes, behind the wild volatility and stratospheric hype of the cryptocurrency and blockchain boom. The blockchain skeptics have crowed gleefully as crypto-token prices have tumbled from last year’s dizzying highs, but they make the same mistake as the crypto fanboys they mock: they conflate price with inherent value. We can’t yet predict what the blue-chip industries built on blockchain technology will be, but we are confident that they will exist, because the technology itself is all about creating one priceless asset: trust.

To understand why, we need to go back to the 14th century.

That was when Italian merchants and bankers began using the double-entry bookkeeping method. This method, made possible by the adoption of Arabic numerals, gave merchants a more reliable record-keeping tool, and it let bankers assume a powerful new role as middlemen in the international monetary and payments system. Yet it wasn’t just the tool itself that made way for modern finance. It was how it was inserted into the culture of the day.

In 1494 Luca Pacioli, a Franciscan friar and mathematician, codified their practices by publishing a manual on math and accounting that presented double-entry bookkeeping not only as a way to track accounts but as a moral obligation. The way Pacioli described it, for everything of value that merchants or bankers took in, they had to give something back. Hence the use of offsetting entries to record separate, balancing values—a debit matched with a credit, an asset with a liability.
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Pacioli’s morally upright accounting bestowed a form of religious benediction on these previously disparaged professions. Over the next several centuries, clean books came to be regarded as a sign of honesty and piety, clearing bankers to become payment intermediaries and speeding up the circulation of money. That funded the Renaissance and paved the way for the capitalist explosion that would change the world.

Yet the system was not impervious to fraud. Bankers and other financial actors often breached their moral duty to keep honest books, and they still do—just ask Bernie Madoff’s clients or Enron’s shareholders. Moreover, even when they are honest, their honesty comes at a price. We’ve allowed centralized trust managers such as banks, stock exchanges, and other financial middlemen to become indispensable, and this has turned them from intermediaries into gatekeepers. They charge fees and restrict access, creating friction, curtailing innovation, and strengthening their market dominance.

The real promise of blockchain technology, then, is not that it could make you a billionaire overnight or give you a way to shield your financial activities from nosy governments. It’s that it could drastically reduce the cost of trust by means of a radical, decentralized approach to accounting—and, by extension, create a new way to structure economic organizations and activity in the ether.

The need for trust and middlemen allows behemoths such as Google, Facebook, and Amazon etc. to turn economies of scale, the collective intelligence and intellect of the inet and network effects into de facto monopolies and thereby creat their own economies.

A new form of bookkeeping might seem like a dull accomplishment. Yet for thousands of years, going back to Hammurabi’s Babylon, ledgers have been the bedrock of civilization. That’s because the exchanges of value on which society is founded require us to trust each other’s claims about what we own, what we’re owed, and what we owe. To achieve that trust, we need a common system for keeping track of our transactions, a system that gives definition and order to society itself. How else would we know that Jeff Bezos is the world’s richest human being, that the GDP of Argentina is $620 billion, that 71 percent of the world’s population lives on less than $10 a day, or that Apple’s shares are trading at a particular multiple of the company’s earnings per share?

A blockchain (though the term is bandied about loosely, and often misapplied to things that are not really blockchains) is an electronic ledger—a list of transactions. Those transactions can in principle represent almost anything. They could be actual exchanges of money, as they are on the blockchains that underlie cryptocurrencies like Bitcoin and Ripple. They could mark exchanges of other assets, such as digital options, stock & bond 'certificates.' They could represent instructions, such as orders to buy or sell a stock, bond or commodity. They could include so-called smart contracts, which are computerized instructions to do something (e.g., buy a stock, bond or commodity) if something else is true (the price of the stock has dropped below $10).

What makes a blockchain a special kind of ledger is that instead of being managed by a single centralized institution, such as a bank or government agency, it is stored in multiple copies on multiple independent computers within a decentralized network. No single entity controls the ledger. Any of the computers on the network can make a change to the ledger, but only by following rules dictated by a “consensus protocol,” a mathematical algorithm that requires a majority of the other computers on the network to agree with the change.

Once a consensus generated by that algorithm has been achieved, all the computers on the network update their copies of the ledger simultaneously. If any of them tries to add an entry to the ledger without this consensus, or to change an entry retroactively, the rest of the network automatically rejects the entry as invalid.

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Typically, transactions are bundled together into blocks of a certain size that are chained together (hence “blockchain”) by cryptographic locks, themselves a product of the consensus algorithm. This produces an immutable, shared record of the “truth,” one that—if things have been set up right—cannot be tampered with.

Within this general framework are many variations. There are different kinds of consensus protocols, for example, and often disagreements over which kind is most secure. There are public, “permissionless” blockchain ledgers, to which in principle anyone can hitch a computer and become part of the network; these are what Bitcoin and most other cryptocurrencies belong to. There are also private, “permissioned” ledger systems that incorporate no digital currency. These might be used by a group of organizations that need a common record-keeping system but are independent of one another and perhaps don’t entirely trust one another—a manufacturer and its suppliers, for example.

The common thread between all of them is that mathematical rules and impregnable cryptography, rather than trust in fallible humans or institutions, are what guarantee the integrity of the ledger. It’s a version of what the cryptographer Ian Grigg described as “triple-entry bookkeeping”: one entry on the debit side, another for the credit, and a third into an immutable, undisputed, shared ledger.

The benefits of this decentralized model emerge when weighed against the current economic system’s cost of trust. Consider this: In 2007, Lehman Brothers reported record profits and revenue, all endorsed by its auditor, Ernst & Young. Nine months later, a nosedive in those same assets rendered the 158-year-old business bankrupt, triggering the biggest financial crisis in 80 years. Clearly, the valuations cited in the preceding years’ books were way off. And we later learned that Lehman’s ledger wasn’t the only one with dubious data. Banks in the US and Europe paid out hundreds of billions of dollars in fines and settlements to cover losses caused by inflated balance sheets. It was a powerful reminder of the high price we often pay for trusting centralized entities’ internally devised numbers.
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The crisis was an extreme example of the cost and benefits of trust, namely the cost. But we also find that cost ingrained in most other areas of the economy. Think of all the accountants whose cubicles fill the skyscrapers of the world. Their jobs, reconciling their company’s ledgers with those of its business counterparts, exist because neither party trusts the other’s record. It is a time-consuming, expensive, yet necessary business process.

Other manifestations of the cost of trust are felt not in what we do but in what we can’t do. Over two billion people are denied bank accounts, which locks them out of the global economy because banks don’t trust the records of their assets and identities. Meanwhile, the internet of things, which it’s hoped will have billions of interacting autonomous devices forging new effectiveness and efficiencies, won’t 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.

These costs are rarely acknowledged or analyzed by the economics profession, perhaps because practices such as account reconciliation are assumed to be an integral, unavoidable feature of business ( much as pre-internet businesses assumed they had no option but to pay large postal expenses to mail out monthly bills and yearly financial reports - Annual Report (3 reports)). Might this blind spot explain why some prominent economists are quick to dismiss blockchain technology? Many say they can’t see the justification for its costs. Yet their analyses typically don’t weigh those costs against the far-reaching societal cost of trust that the new models seek to overcome.