Blockchain: When Does Decentralization Make Sense?

This may well be the billion-dollar question of today’s crypto-craze. In my last blog post, I wrote that people should “use common sense” to evaluate “whether decentralization makes sense” when choosing to invest in ICOs. A few months on and many an unsolicited white paper in my inbox later, I recognise that this was a somewhat disingenuous statement! Deciding whether or not decentralization will create value is not common sense; it’s the great challenge of the blockchain revolution, for both entrepreneurs and investors.

The notion that the revolution will be decentralized has become almost sacrosanct among the crypto-elite. But it’s important to critically examine the hype. Rarely is anything gained without some else being lost. So, in this post, I lay out the beginnings of a framework to the big question: When does decentralization actually make sense?

To decentralize, or not to decentralize — that is the question.

Coase’s Theory of the Firm:

Naval Ravikant, founder of Angellist, wrote in his infamous tweet storm that, “Blockchains will replace networks with markets.” The argument goes that, in the future blockchains and crypto-economics will enable strangers to collaborate, exchange, and share in profits without intermediaries. As a result, the networks that organize our society today — religion, money, corporations, banks, universities, social networks — and enable us, as social animals, to cooperate will be blown wide open by the blockchain. The gatekeepers will be removed. Gradually, and then all of sudden, networks will be replaced by open and merit-based markets.

I love this notion and, perhaps in time, it will come true. I’m skeptical though. It feels like an engineer’s dream — to remove all human contact and let the math do the work. Humans are rarely cold-headed, rational actors as Richard Thaler (the winner of this year’s Nobel Prize for Economics) has ably demonstrated. Our decisions are driven more by emotion and psychology than reason. And Naval is not the first to claim that the market is the best allocator of resources. In fact, classical economic theory from the 1930s made similar claims arguing that the market is perfectly “efficient” and that all trade should transpire in markets. To these economists’ confusion, firms (a form of network and the focus of this post) persisted and continue to flourish to this day. Why?

In his famous essay, “The Nature of the Firm” (1937), Ronald Coase offered an explanation as to why individuals form companies and partnerships rather than trading exclusively through markets. Coase argued that the answer is, transaction costs. Firms persist because there are transaction costs to using the market. The cost of obtaining a good or service via the market is actually more than just the price of the good. Other costs, including search and information costs, bargaining costs, policing and enforcement costs, can all potentially add to the cost of transacting via the market. As a result, people organize into firms to be maximally efficient.

Coase’s theory provides us with an the beginnings of a framework for evaluating the decentralized future. Decentralized markets, where individuals trade peer-to-peer and which are governed by meritocratic voting or participatory work, remain an exciting prospect. But the truth is, firms contribute value. That’s why they exist and why I believe in many cases they will continue to. Let’s dive in and consider the value firms offer.

The Value of Firms:

Firms exist, partly, to manage operational complexity and coordinate actions between individuals. Though it’s far from a perfect correlation, as a general rule, adding people to a process means increasing the costs of coordination. Firms help to minimize these costs by creating structures and contracts that are less transaction focused.

In short, firms minimize the costs of coordination when transactions are operationally complex. My working definition of operational complexity is “a collection of strategies and structures that require human input and are dynamic.” But firms also create value by marshalling a wide range of resources, creating corporate culture, and reinvesting profits, in ways that markets cannot. As one point of reference, Peter Thiel argues, in his seminal book Zero to One, that monopoly — an extreme form of centralization — should be the ultimate goal of any company. My point is that centralization of resources and decision making, embodied in a firm, can create value. Take Amazon, which isn’t a monopoly by the traditional definition, but is a company that dominates online commerce. Through its relentless focus, reinvestment of profits, and strong leadership, Amazon offers consumers choice, affordability, and convenience. In turn, consumers have voted with their wallets and made Amazon one of the most valuable companies in the world. Clearly, for some types of businesses, centralization may be the better choice. We’ll explore this point further through some examples below.

Decentralized vs. Centralized Organizations

Consider a decentralized marketplace, such as OpenBazaar, versus a traditional online marketplace, such as Zappos. Zappos is an online shoe store that became famous for its customer service before Amazon acquired it. Customers loved its rapid delivery, impeccable call centres, and obsession with customer satisfaction. The company succeeded in creating a delightful experience by coordinating action, reinvesting profits, and hiring explicitly. OpenBazaar, by contrast, is a decentralized marketplace where users buy and sell directly without any intermediary. This decentralized marketplace leaves much to be desired in the customer satisfaction department.

Or, consider digital asset exchanges. Decentralized exchanges are being hailed with great excitement. Should Kraken, Coinbase, and Poloniex be concerned? I don’t think so, at least not in the near term. Sure, decentralized exchanges are more censorship-resistant than centralized exchanges. (It’s not clear, yet, that decentralized exchanges will be more secure. Many centralized exchanges already use decentralized architecture for their wallets and have the benefit of a private codebase. Once a codebase is public, as they are with decentralized exchanges, the assets are secure as long as the codebase has no errors and the smartest hackers are on the“good” side.) But on the other hand, Kraken and Coinbase offer customer support, account managers for enterprise clients, and insurance. Could a decentralized exchange offer these elements? It remains to be seen. The benefits of centralized exchanges are enough that many traders are happy to stay put for now.

So, What Kind of Applications Should Be Decentralized?

In my opinion, the applications or services that are currently best suited to decentralization are those where the transactions:

1.) Do not involve significant operational complexity.

a. I would argue that there is an negative correlation between operational complexity (recall my definition) and the potential for decentralization. Indeed, today we are witnessing operational complexity grow within the Bitcoin community as disagreements arise over block size, forks, and more. The project may implode as a result.

2.) Involve the exchange of non-physical assets.
3.) Transact in markets where firms currently offer little value through the coordination and management of human capital.
4.) Have the potential to be broken down into simple incentive structures, which is easier said than done (and requires Game Theoretical testing).
5.) Occur in markets where anti-censorship protection, which is a core feature of distributed systems, is important to the users. (Optional).

Bitcoin is an example that satisfies the above constraints 1.) Bitcoin transactions are not that operationally complex. Miners provide the blockchain network with computational power and are rewarded for doing so while a core set of coders maintain the codebase. Users transact peer-to-peer. 2.) Bitcoin is a digital asset. 3.) Banks, the dominant firms in the money markets, offer little value during basic payment transactions. They are intermediaries that confirm identities and prevent “double spend.” 4.) The incentive structures were clearly defined for market participants of Bitcoin by Satoshi Nakomoto. 5.) Bitcoin provides anti-censorship protection to its users because the transactions are pseudo-anonymous and the powers-that-be cannot shut down Bitcoin due to its distributed nature. This was an important feature for early adopters of both the libertarian and criminal bent.

A visual approximation of the above tenets is displayed below in a venn diagram:

The Next Bitcoin?

I believe that the next decentralized applications to catch hold will bear some combination of the characteristics, listed above. Within the flurry of activity in the blockchain space, I’ve identified two types of applications that I believe embody some of these characteristics. The first stratum are developer tools and infrastructure projects, which serve as the building blocks of decentralized applications. The second are simple peer-to-peer applications that involve the exchange of a digital mediums or non-physical assets. Below are a few examples:

Developer Tools & Infrastructure Projects:

a. Zeppelin

An open-source, distributed platform of tools and services on top of Ethereum to develop and manage smart contracts applications securely.

b. Mattereum

Mattereum is an infrastructure project for legally-enforceable smart contracts, enabling the sale and lease of physical property and transfer of rights in assets. By embedding legal code into smart contracts, Mattereum is ensuring that they are enforceable in the offline world.

c. BigChain DB

BigchainDB allows developers and enterprise to deploy blockchain proof-of-concepts, platforms and applications with a scalable blockchain database, supporting a wide range of industries and use cases.

Peer-to-Peer Applications:

c. Filecoin

A decentralized storage network that enables people to rent the spare storage on their computers on the FileCoin network. It leverages decentralization of architecture to provide novel financial incentives and theoretically should provide more privacy and security than DropBox.

d. Orchid

An anonymous internet browser built on top of the blockhain.

e. Gaming

Imagine a global chess tournament with people competing (remotely) from around the world. There are significant bounties at each stage for the winners. Smart contracts could be built into the tournament so that as people win and progress, the winnings are automatically transferred to the winner’s accounts. Unikrn, a decentralized token for Esports and gaming, is an exciting project in this vein.

These examples all leverage architectural decentralization and offer users and participants novel financial incentives with clear incentives. They involve the exchange of digital assets. They transactions are not operationally complex. Therefore, these markets are largely self-policing and there is little scope for dispute. And anti-censorship is an important feature for a few of the applications.

In the case of developer tools and protocols, they function similarly to traditional internet protocols and can be easily deployed in other applications. The key difference, as discussed in my last post, is that as other applications use these “fat protocols”, their tokens will rise in value. In the case of peer-to-peer applications, such as bitcoin, well it’s in the name. They’re peer-to-peer. The transaction costs of exchanging digital assets peer-to-peer, whether it’s music or a digital currency, is very low. With both types of applications, the transactions and incentives are simple and there is little operational complexity involved.

Conclusion:

When you peel it back, decentralizing decision making and governance is hard. It remains difficult to accurately measure and manage someone’s contribution remotely and to manage large distributed teams. Ethereum, the most successful application since Bitcoin, is often held up as the paragon of a decentralized platform application. It may have a decentralized architecture but it has, let’s be honest, a fairly centralized governance. Ethereum does have a cohort of contributors and stakeholders around the world but like most successful startups, it has a clear leader. And that leader is the genius maverick, Vitalik. Decentralization of architecture can enable powerful incentive structures but nothing about managing human beings is easy, as the recent battle in the Tezos’ “boardroom” makes abundantly clear. I don’t think crypto-economics change that reality.

Nevertheless, technology has historically enabled humans to coordinate in greater and greater numbers and the blockchain will likely accelerate this trend. The apps that succeed on the blockchain will evolve over time as the UI, performance, technology stack, and public understanding improves. I do believe there will be blockchain creations, in the future, that sound fantastical to us today.

But for now, I remain most excited by decentralized developer tools and peer-to-peer applications that involve the exchange of non-physical assets, often in markets where anti-censorship is important for users. I predict that operationally complex transactions will remain centralized, at least from a governance standpoint. History suggests that successful economies need both the benign dictatorship of the firm and the invisible hand of the market. The market networks of the blockchain may prove no different.

p.s Many smart people disagree with me and I’ve included some of their viewpoints in the bibliography.

p.p.s I enjoy receiving the white-papers so keep sending them and please do get in touch if you’re building a startup within these parameters and would like to chat.

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BIBLIOGRAPHY:

The Nature of the Firm by Ronald Coase

The Meaning of Decentralization by Vitalik Buterin

The Slow Death of the Firm by Nick Tomaino

How Blockchains Will Change Organizations by Don Tapscott

Blockchain Project Ecosytem by Josh Nussbaum

Blockchain will kill the traditional firm by Dr Catherine Mulligan

Thank you to Barend Vanden Brande, Fırat İleri, Dominik Vacikar, Lola Wajskop, and Genevieve Fish for helping me with the piece.