Just a little over 10 years ago, on January 3rd 2009 Satoshi Nakamoto created the genesis block of Bitcoin. This was the beginning of a story which promised to uproot the world, create the new economy and relegate existing banks to the sidelines.
The 10 year anniversary is a good milestone to reflect on the promise. Mosaic, the first Internet browser, was created in 1993 and signified the beginning of the consumer Internet. 10 years later we had giants like Yahoo, Google, Amazon, eBay. Yahoo’s capitalization was $20B in 2003, Google was a big deal and just a year away from the $23B IPO. Where are all the yahoos and googles of blockchain today?
Technically, blockchain is a distributed ledger — a distributed database of cryptographically signed transactions. In more common terms it’s like a ledger or an accounting book which is maintained by multiple independent accountants instead of a single one. Multiple independent agents agree on common terms of record keeping: each one makes records independently then they compare the books and decide which sequence of records is the correct one.
Today we’re still in the centralized world of a single agent keeping track of all the transactions. The reason why blockchain has failed to change it is the higher cost of doing business the new way.
In the centralized world there is just one agent and one book. The agent adds the record to the book and that’s it. Let’s say the cost of this operation is $1. In the decentralized world there are many agents each with a personal book. If there are 1000 agents, then each one adds the record to the book paying $1. Collectively they pay $1000. But that’s not all. The records are now made but they may differ between the agents. The agents collectively have to reconcile them. The problem gets complicated because some of the agents may cheat by failing to add records or by adding wrong ones. Blockchain makes finding the agreement possible when less than half of the agents cheat. The extra cost or reconciliation is hard to quantify but in our example it’s expected to be greater than $1000. Thus the total cost of a distributed transaction is some thousands of dollars vs just $1 for a centralized one.
More formally, if the cost of a single transaction is equal to one, then the same transaction will cost N + X(N) if carried out by N agents: every agent does the transaction once 1 * N = N, then all the agents have to reconcile the records = some non-negative function X() dependent on N.
Consequently, a distributed transaction — always and with no exceptions — is more expensive than a centralized one:
N + X(N) > 1
This is the fundamental reason why blockchain has found no mainstream applications.
Why Blockchain?
There are three broad categories of blockchain applications today:
I. Illegal transactions.
Illegal trades by definition are not protected by the law. It’s reasonable to expect that the law will also try to prosecute participants of an illegal transaction. Consequently illegal transactions with a trusted third party are dangerous and expensive. The trusted third party takes hard to calculate risks and demands exorbitant premium for it. Cryptocurrencies solve this problem by eliminating the single point of excessive risk. All parties share the risk more or less equally. Even though the distributed transaction is still technically more expensive than a centralized one, the business cost of risk offsets the difference.
This category contains the likes of the Silk Road, money laundering, tax evasion, circumvention of currency controls.
The largest case of illegal cryptocurrency use today is moving capital out of China. PRC instituted stringent currency controls. It’s exceedingly difficult to move money out of China. Cryptocurrencies solve the problem: 1) first people buy electricity and crypto-mining equipment domestically paying in local currency (Yuan); 2) then they use the equipment to create the cryptocoins (called “mining”); 3) finally they sell the coins in the States or EU, effectively converting Yuans to Dollars and Euros. Interestingly, this use case makes sense even if mining costs exceed the value of produced cryptocurrency. The difference is just the price of moving the capital.
II. Legal transactions — ineffective or illegal business.
Blockchain is invariably more expensive than a centralized transaction with a trusted third party. Nonetheless it’s frequently used despite the ineffectiveness. In this case the ineffectiveness is compensated in other ways.
Initial Coin Offerings (ICOs) are in this category — these are the crypto-currency version of the stock market Initial Public Offerings (IPOs). The business models of ICO companies are usually bogus. In those rare cases when the model is workable, it’s still less efficient than it could have been without the blockchain. On the other hand, if the company were to choose a traditional IPO instead of an ICO, the inefficient or outright fraudulent business model would likely become obvious. The IPO would cost a lot more (because of regulatory requirements aimed at protecting the investors), would bring a lot less money or even fail, and the owners would have to release some control of the company because they were to sell the company shares.
To summarize, an ICO costs a lot less than an IPO, brings more money, has no regulatory oversight, and does not dilute ownership — wins for the company owners on all counts. Why does it bring more money? First and foremost it’s speculative frenzy, desire to make money fast, to gamble and win. It’s HODL! It’s the same reason Ponzi schemes are so popular. Some people just want a shortcut to riches. Blockchain is hyped beyond belief, people want to catch the train to wealth or so they see it. As a perfect example, a British company did nothing but added the word ‘blockchain’ to its name and saw its shares surge 394%!
The second reason is the lack or regulatory oversight which enables investments from people who have no business of making such risky bets. There are known cases of people taking home equity loans and maxing out credit cards to buy Bitcoin. The third reason is money laundering.
And yes, this category contains your favorite ICO, if you have one. The distinction between an ICO and a Ponzi scheme is often weak to none.
This category also contains all the attempts by companies like IBM, Maersk, ING to build blockchain solutions. “Blockchain is the future! We are the thought leaders. We must be on the forefront of blockchain revolution”. IBM lists over 300 blockchain solutions on their website! Their only problem is that all of them are less efficient than the centralized alternatives. Can one use an iPad to hammer nails? Sure. It’s just cheaper and more convenient with a hammer.
This is FOMO: Fear of Missing Out. Nothing useful will come out of these projects. Anything they can do with the blockchain others can do easier/cheaper without it. Blockchain is a handicap, not an advantage.
“You must be wrong — you could say — these are large respectable companies. I’m sure they know where to invest.” Not necessarily. A large company often has a large gap between the people making the investment decision and the people understanding the problem. The former don’t always listen to the latter. The people doing the work may be happy to just take the money and shut up even if they know that the project they work on will fail. The executive leadership may realize that the blockchain is useless and still have a team assigned to it because the shareholders expect them to or due to an off-chance that there is something there (Pascal’s Wager).
III. Selling Picks and Shovels
During the California Gold Rush of the 1840s and 1850s the most money was made by selling shovels and other mining tools rather than by mining gold. This history is repeating. Money is made by crypto exchanges including the cases of “we are so sorry, we got hacked and lost all your money, suckers”, Nvidia, makers of mining equipment, etc. This business is reasonable (except for the mentioned cases of outright fraud) but derivative from Categories I and II above.
What about Smart Contracts?
When parties enter an agreement they codify their rights and responsibilities in the contract. If one party refuses to honor the terms, the other party may use some enforcement mechanism to compel the execution. The enforcement could be in the form of legal system for lawful contracts or it could be the thugs in case of illegal dealing. In other words if one refuses to honor the contract his property, freedom, and ultimately life could be threatened by men with guns (be that the police or the mob).
Smart contracts are expected to offer some form of enforcement too, otherwise they have no value. In reality they offer protection only if the entire transaction happens on the blockchain, and even then the protection is very weak. Smart contract loses enforcement power as soon as the value is moved off blockchain. Even worse, enforcement is mostly impossible even when the value is retained on the blockchain.
Let’s say Alice entered a smart contract with Bob. Under the contract Alice made a loan to Bob in the amount of 1 ETH with the interest rate of 10% per month. In the end of the month the smart contract automatically deducts 1.1 ETH from Bob’s wallet and deposits it to Alice’s wallet. The trouble starts when the contract fails to execute because Bob’s wallet has no money in it. What are Alice’s options?
- Alice may go to court, but then what’s the use of the smart contract? A dumb contract on a napkin would work better.
- Alice may have asked Bob to deposit the money in an escrow account, but why would Bob take the loan if he can’t use the the money?
- Alice may try to roll back all Bob’s transactions to return the 1 ETH. Unfortunately Bob spent all the money on a space station in Adam Online. Why would Adam Online return the money if it fulfilled the obligations? OK, let’s assume that Bob spent the money on an ICO and all the tokens and cryptocurrency are still on the blockchain. Shall Alice try to roll back the 1 million transactions in which Bob’s coins have participated?
And we are not even discussing the interest in the amount of 0.1 ETH.
Money is expected to be fungible, meaning $100 is $100 regardless of its history. Cryptocurrency stops being fungible if smart contracts are allowed to roll back subsequent transactions: one has to consider all the contracts which the particular coin has participated in, potentially considering the entire history of smart contracts on the blockchain for every transaction. Given that the smart contract becomes unenforceable if the value is moved off of blockchain (someone somewhere used a coin to buy a pizza) the whole thing becomes unusable.
In practice, smart contracts are used only for token sales during and post-ICO. It’s useful in the ICO because one side of the transaction takes no risk at all: the tokens sold in the ICO have zero incremental value to the seller. The contract is fulfilled once this zero-value goods is exchanged for the non-zero value goods. Consequently, the risk of non-delivery of tokens or the risk of tokens having less value than expected is negligible. After all, if you are selling grains of sand for $1 each, you are unlikely to fail at delivering the sand to the buyer, right?
But Fiat Money Is Just Paper!
Not really. Government-issued fiat money has a distinct feature which no cryptocurrency possesses: government money has the final consumer. States usually collect taxes. Taxes are almost always nominated in local currency. That means local currency must be purchased at least for tax payments. Taxes create demand for the currency, and as long as the state collects taxes, the currency value cannot go to absolute zero.
Talking about US dollars, USA collects roughly 25% of the GDP in taxes. All US workers spend 25% of their workday supporting the dollar. Nothing comparable exists in the cryptocurrency world.
The number of currencies is limited by the number of sovereign states on Earth give or take a few. The number of cryptocurrencies is unlimited. Each human on Earth may have a personal cryptocurrency. Each bacteria living in the gut of each person on Earth may have a personal cryptocurrency. Each atom comprising each bacteria living in the gut of each person on Earth may have a personal cryptocurrency. The supply of cryptocurrencies is literally unlimited while the demand is limited by the economic activity. In the long term the demand is constrained to Category I — illegal transactions. Unlimited supply, limited demand…
Miscellania
Did you forget your password to online banking? No biggie, call the bank and have it restored. In the worst case you have to go to the bank and show your ID. Did you forget the password to your crypto wallet? No biggie, call the … Actually no, it’s kind of a biggie. Your cryptomoney is gone forever, no recourse.
You gave your buddy John $1000 writing a few words on a napkin as a contract. If John does not return the money you go to court, win, and impound John’s 1998 Chevy Impala. See above what happens if you give John 10 ETH with a smart contract. Did you remember to kiss your money goodbye?
“How much is it going to cost you to send $100K to Uganda? If you send 30 BTC it’s going to cost you just $10!”. Well, not really. Indeed if you just send 30 BTC from one wallet to another you will pay ~$10 for the transaction. But if you want to spend the money you have to convert BTC to Ugandan shilling first and that’s going to cost you a lot more than transferring the money by non-blockchain means.
“Lightning network will solve all problems”. It may solve some but you won’t like the solution. Remember the formula N + X(N) > 1? Lightning network solves the inefficiency by reducing the N. In other words it makes the transaction cheaper by making the system less distributed. Then wouldn’t it make sense to take the next logical step and reduce the inefficiency to the maximum extent possible by leaving just one agent? The centralized system wins.
What to Expect from the Blockchain in the Future?
The most common use case of blockchain — cryptocurrencies — is not likely to disappear, but is going to be used almost exclusively for conducting illegal transactions, i.e. Category I. Bitcoin value won’t go to zero but the number of transactions will be lower than today and the BTC will be less valuable, particularly if demand for capital transfer out of China diminishes due to changes in economy there.
The cost of mining will consistently exceed the value of produced coins. Nonetheless, the mining will continue because the users will see the excessive cost of mining just as a cost of doing business.
The frequency of 51% attacks will grow. They won’t succeed in actually stealing the money because converting crypto to fiat will become more difficult, but they will create enough of a nuisance to erode the value of cryptocurrencies further.
It cannot be ruled out that someone will find a truly distributed use case for blockchain, something outside of the three categories described here. For instance, TRON Foundation recently bought BitTorrent Inc (actually called Rainberry, Inc.). There are lots of parallels between blockchain and torrents, both being inherently distributed. There is a small chance that TRON will find some non-trivial cross-product of blockchain with torrents. On the other hand, it’s more likely that they will just add crypto payments to torrents, essentially enabling paid downloads of pirated content. Which is Category I again.
No hope in sight for blockchain. Only pain and darkness.
