Cryptonetworks through the prizm of institutional economics

ESPRYT
ESPRYT
Feb 4 · 11 min read

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LONG INTRO

Cryptonetworks are usually researched through the prism of economics. That makes sense, as their influence on the financial world is obvious — we see the rise of the new asset class and new economic relations.

Traditional economic schools are dominant in analysing crypto. Especially researchers here love macroeconomics and its laws. Monetary ideas align with cryptonetworks, and analogies with the national economies work pretty well.

Let’s try something different — institutional economics.

Have you heard about it? If not — it’s the discipline in economics, that is even far from the economics. It’s rather a stream in social philosophy that tries to find explanations for some economic relations. We see its methods beautiful because it avoids many formulas, math abstractions and discusses just people, their behaviour and cooperation patterns.

INTRO: Participants

Cryptonetworks are a kind of digital networks. They consist of its participants with different interests and functions. Participants are, in fact, machines running the code and exchanging the information. However, it is still people behind.

In this definition, we see no difference with other digital networks. Cryptonetworks just represent the relations between people and move this relations to the digital environment. Like other digital networks do.

Let’s focus on people a bit longer.
What does institutional economics think about people?
Two things:

We will use this profile above. For now, let’s just capture the vision of institutional economics on people.

We must add one more thing to the analysis — a protocol. And here we see the first difference from the other digital networks.

INTRO: Protocols

Protocols are rules for machines. Machines follow these rules to communicate. If a machine does not follow these “rules” — one is not a part of the network. So, it is beneficial for machines (and people behind them) to follow the rules.

Most of the protocols lay on the technical level, and their functions are often linguistic. Protocols form the networks of machines around them. These networks exchange information and provide us (people) with services (like communication).

For example, your computer is running lots of protocols to be a part of the global Web.

Some of the protocols build up networks with more tangible services. Consider the torrent-protocol. When running these protocols, you are joining the network of the file sharing. And here you are equal with other participants. You and other participants have a mutually beneficial interest in running the same protocol and maintain rules to be followed.

INTRO: Cryptoprotocols

You may find lots of parallels with cryptonetworks. And yes, they have mutual grounds — they still are decentralised protocols, like Torrent, but with new services and new technologies applied.

What technologies?

Cryptography? It may be a shock for some crypto enthusiasts, but cryptonetworks, that we see hyped now (Bitcoin, Ethereum, etc.) — are
far from being the first protocols using cryptography.

Maybe blockchain? Seems to be closer to the truth. Blockchain granted unique features to networks. Joining these networks helps to get services, that are not available in other networks.

But some of these cryptonetworks usually discussed… do not use blockchain. Like IOTA.

That is why we face the problem of the right naming. As it is not a focus of this paper, we will use the term “Cryptonetworks”.

INTRO: What do we have

Cryptonetworks turn self-governing organisms. Technologies behind these networks and their design defend the networks’ security and provide users with unique services.

Also, in the majority of cases, we see economic incentives implemented in protocols.

So users see beneficial to join a network: some want to receive services, some just want to earn money by supporting a network. But both motivations are designed initially and strengthen networks.

A cryptonetwork is a perfect subject for institutional economics. We will view the cryptonetworks from the points of institutional economics:

• Trust
• Transaction costs (note: not those cost in the networks! Not fees! Institutional economics see it wider)
• Institutions (note: not institutes! Not universities!)
• Maybe something else

CRYPTONETWORKS AS COMMUNITIES WITH NO TRUST

Trust is the key measure in institutional economics. It changes relations dramatically. People create formal and informal rules to achieve different levels of trust and make new goods/services available. Rules help to make others’ behaviour more predictable (if people follow them) — so some uncertainty fades away.

As we mentioned before, institutional economic believes, that people tend to behave “opportunistically”. Is it the same as “egoistically” or “selfishly”? Not at all.

Egoism is about self-interest. Opportunism is about breaking rules to reach something — to solve a problem, to reach a goal, to help someone, to gain power or, of course, to earn money.

Protocols in the cryptonetworks make a wonder possible — they use people’s egoism to prevent opportunism. They assume all participants to be selfish, and opportunism is either technically impossible or economically inefficient. This egoism is a basis for new services to emerge.

Thus, everyone should follow rules.

Protocol in a cryptonetwork is a new kind of law — the formal agreement in the digital environment of how participants should cooperate.

Protocols exclude opportunism.

The crucial thing is that participants understand that! They see egoists in other participants but believe that The Protocol will set the justice. And it does.

Moreover, protocols are usually open-sourced — everyone can check its code, sometimes even modify it. Thus, there is no need to believe others — the only thing one needs is to believe the protocol. To trust only the protocol.

Cryptonetworks are usually considered as a network with no trust. In fact, the trust puzzle for every single participant is just minimized and simplified.

HOW CRYPTONETWORKS MINIMIZE TRANSACTION COST

Once again — here we observe transaction costs of institutional economics. Not commissions in the networks. Not fees.

Transaction costs — costs of gathering information, processing, making decisions, defending rights or contracts and etc. Every decision in the economic activity requires transaction costs. They are hardly measured in money — usually, it is time, alternative opportunities, etc.

The obvious observation widely mentioned is that digitalisation decrease transaction cost. Examples are usually IT-giants (or startups).

What IT-giants have done? Their services meet supply and demand on markets. Both parties now have lower costs in finding a counterparty for the deal. IT-giants take transaction cost from the supply and demand sides, then optimise these transaction costs (thanks to technologies and information consolidation), and finally eliminate most of these transaction costs. The result — fewer transaction costs in the society at large, so IT-giants take their deserved reward.

Not to mention, that business models may differ, as well as services provided by IT-giants. It may be an engine to meet supply and demand in the traditional way (like Airbnb does, on the hospitality services market) or in not so obvious ways (like Instagram does, consolidating information about users for the marketing purposes).

Also, IT-giants upgrade the trust between people. IT-giants centralise the information and took responsibility for scoring parties. It is a new service for users — an IT-giant has already gathered all the information about a counterparty, rated him/her and did everything so that all the information presented on the IT-service would be enough for making a decision.

Users love it. A headache is mitigated.

The only thing users need…is to believe an IT-giant. Hope you catch parallels with the trust in cryptonetworks. Yes, the mechanism is the same in cryptonetworks with the only-one-trust-line-left.

But what’s the problem? The problem is that the situation is not the same a bit.

As we mentioned a few times, people tend to behave opportunistically. IT-giants are people (surprise-surprise). To make it worse, they are people setting rules in their systems. Obviously, they do not avoid a possibility to set rules, that are beneficial for them. They use this chance and use the trust of their users. They monetise it.

Is it fair? We will not discuss it here. However, this situation looks like a kind of social contact — people “sell” their private information and let IT-giant monetise their weakness points for receiving services and new possibilities.

Why are cryptonetworks a new step? Because IT-giants are replaced by the protocols — coordination process turns transparent and automated.

Here new services/goods arise. These new services may compete with the IT-giants’ services (be an upgraded duplicate of the similar services already available on markets) or be brand-new for users.

We promise to discuss services in more detail in other essays. But, for now, let’s go back to transaction costs.

In cryptonetworks we see no centralised owner, taking all the rent and abusing its monopolistic position. The rent is distributed among nodes, supporting the protocol and firming up a service in a network. These nodes still are people behind the machines — but their authority is so distributed that no one has enough power to “hack the system”. Their possible opportunistic cooperation is also under control and is considered by “the scenario”.

The group of all the users controls the protocol. And that is why the protocol serves all the users.

Transparent rules, followed by the machines, dramatically increase the trust. The code is unprejudiced. It cannot be opportunistic. It has no self-interest. It is just code.

It is much easier to believe and control the code, than people (represented by governments or IT-giants).

This organisational trick together with some technological innovations — decrease transaction costs, increase trust, distribute the rent fairly with no abuse. And all this staff combined together grants the beneficial terms that attract people to be a part of the network.

That is the mechanism, why cryptonetworks make a new step further in trust between people and a new step further in fewer transaction costs for effective cooperation.

CRYPTONETWORKS AS INSTITUTIONS

Institutions — sets of formal and informal rules, that regulate our daily life. They appear as multiple layers around us determining the behaviour of people. They help us to cooperate, manage risk, distribute responsibilities and just live in the world of limited information. They may be stand-alone rules or groups of people joint by these rules.

Some examples: government, family, constitution, religion, insurance, IT-giants, property rights, corruption, payment systems, fashion and so on.

Institutions set rules and shape our incentives. They can decrease transaction cost as well as increase them. They create benefits or eliminate them.

Institutions are everywhere. And they are extremely complex! That is why it appears so difficult to simulate or model the society or a few groups of people. They are complex systems with multi-layer relations.

That is the vision of institutional economics on the world, and that is why it does not love formulas, laws. That is why institutional economics sometimes is criticised by other disciplines with more formalised methods.

If you become a citizen of a country (or just visit one) — you become a member of its “network”, you accept its formal and informal rules (from laws to cultural traditions). And you are expected to do so, and you expect others to follow rules. It is a mutually beneficial agreement between citizens (or residents). It decreases the uncertainty and contributes to the effective and less risky cooperation for everyone.

Cryptonetworks have all the features of institutions. They have formal laws inside (very formal, it is an inhuman and senseless code — protocol). Participants join these network and accept these rules if they see it beneficial.

And, for now, it is beneficial. Cryptonetworks are innovative in terms of trust, new services and transaction costs. In previous pages, we have seen how this evolution happen.

So, we may consider cryptonetworks as highly positive institutions for the society with the great potential behind.

TRANSACTION COSTS OF CONFLICTS BETWEEN INSTITUTIONS

The benefits (or services), that cryptonetworks grant, are a good subject of structuring and analysis — we will dedicate an essay to explore the whole bunch of them.

But for this essay, let’s take an example of anonymous payments (as a service of some cryptonetworks). Before the cryptonetworks…you was able to make payments without disclosing your personality. But. It was costly enough, transaction costs were high. And it is still costly and is going to be more and more costly to hide from the Big Brother. Now, you can use some cryptonetworks not only to transfer value hiding your personality but can also leave no traces and proof of this transfer. And it is very cheap.

The only transaction costs left high are the costs of joining cryptonetworks. Why? Because it requires having some value in these networks. Cryptonetworks have their own flow of value, with their own assets. The institutions, that would help to exchange value equivalents between the crypto world and our “real” world, are weak. These two types of worlds are in conflict (on the institutional level), and institutions overcoming this conflict are only emerging.

However, the conflicts between institutions are the general state of affairs and sometimes are the basis for the evolution.

FORMAL VS INFORMAL

Another exciting field of analysis is the relations between formal and informal institutions. As we can observe, for now, cryptonetworks are regulated strongly by formal rules in protocols. And it is their power and the greatest advantage.

By the way, informal institutions exist on the level of the crypto industry at large — much wider community. Informal rules come from other institutions — from the business around, from people’s beliefs, from ethics, from ideologies.

The first example. The fundraising rules (in ICOs) that took the best practice and experience from the venture industry — quite informal rules.

The second example. Some developers that build up protocols and products just for people, just to support the idea and principles of the crypto industry excluding their egoistic financial interest. It is a beautiful motivation based on personal ethics and ideology.

As we told, the structuring of all the institutes is hard. And the crypto industry is not an exception. It requires non-trivial approaches, and we hope to introduce our vision in the following essays.

WHAT’S NEXT

Every “crypto enthusiast” believes that cryptonetworks grant us the revolution in some fields — usually in finance.

We think it is not the revolution — it is the evolution. The evolution of trust and cooperation. We evidence the penetration of digital innovations into the fabric of complex human relations. Digital innovations help us to upgrade our institutions and create the brand-new ones.

Cryptonetworks are just the one step further. They use our behaviour patterns and egoistic incentives for social benefit. It is a highly effective innovation in the world where the trust between people is fading away. Cryptonetworks prove that mutual trust and confidence are not must — we use innovative technologies to reach win-win relations, overcome our weaknesses and produce social goods believing no one. Cryptonetworks grant us the ability to cooperate transparently and efficiently in the no-trust environment.

“WHERE ARE MY LOVELY COINS?”

And yes, cryptonetworks have cryptoassets. But we see it a bit sad, that their prices are the №1 topic when touching cryptonetworks.

We see it not surprising in the world, where everyone is looking for a chance to make money and gain the peace of the rent.

By the way, we are going to present our vision on them in the following essays.

THE END

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ESPRYT

Written by

ESPRYT

Researchers with focus on social & digital issues.

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