Crossing the Rubicon: Why Blockchain Will Fundamentally Change Finance for the Better
This article aims to serve as a primer on the newly emerging world of decentralized finance that is enabled through blockchain technology. I hope that readers of this article will feel armed with the requisite background information to better understand the promise of this space. I believe that distributed ledger technology, the core feature of “blockchain”, will help to usher in a new era of open, democratized, and efficient finance — let me attempt to show you why.
Old School Cool — The Finance of Yesterday
The transfer of value, management of wealth, and study of money all live under the umbrella we call “finance” today. The origins and evolution of finance coincide with the development of civilization throughout human history. From the early use of coins to represent value to paper money and the concept of inflation to the first loans and banking institutions: the way humans share, trade, and borrow their wealth and value has seen several evolutions since the emergence of finance. With that said, I will spare the reader too much of a history lesson, instead, I would like to touch on a few key ideas that have underpinned finance throughout history.
The first crucial concept to finance is the concept of the ledger. In the context of finance, a ledger is simply a system that allows a bookkeeper (someone that manages ledgers) to keep track of economic transactions. Although this may seem like a simple notion, it is a crucial underpinning of the financial system. This is because the ledger is the backbone of Accounting.
Empowered by the ledger, Accounting is thought of as the “language of business”. It is widely considered to be one of the most important subjects for an individual to know to understand finance and business. Quite simply, Accounting allows a bookkeeper to communicate crucial information about all of the activities, investments, and profits of a business entity. Furthermore, although the field has evolved tremendously since Luca Pacioli first codified the double-entry accounting system, Accounting is still done today with simple ledger technology at its core.
Here is a simple Accounting example to illustrate the concept of double-entry accounting and the use of ledgers: if a farmer spends cash on a new field plow, two entries will be made in the farmer’s Accounting ledgers to show the trade of cash for a field plow. Imagine that one day, this farmer has a bountiful harvest and sells grain for a large profit that year — all of this is accounted for in the farmer’s ledgers. Importantly, if the farmer manages orderly ledgers for all of her transactions then anyone could pick up her books and immediately understand the past dealings of the farmer’s business and easily trace the legitimate flow of funds throughout the farm’s history. It is this system that helped to build trust and clarity in early financial markets.
With the emergence and development of Accounting over time, financial markets were able to sprout and grow as well. One development of note is the banking system. Early banks were simply a collection of deposits, loans, and, wait for it… ledgers! The farmer would deposit her hard-earned money into the bank, the bank would then lend out that money to other farmers with interest to make a profit, and the bank would keep a careful eye on its ledgers to make sure they had enough cash on hand should the farmer want her money back. Importantly, accounting and financial discipline helped to build trust in these institutions.
As finance developed from paper money to the emergence of lending institutions like banks, trust became increasingly important in the system as civilizations scaled and economies grew. To help instill trust, many nation-states stepped into the system and chartered, backed, and supported financial institutions like banks. These institutions quickly became the central means through which people were able to store, borrow, lend, invest, grow, and transfer their money. It was these systems of manufactured trust and tidy ledgers that helped usher civilization into the modern era of finance.
Wall Street and Central Banks — The Finance of Today
The modern era of finance represents a highly-efficient, massive, and powerful evolution from the finance of old. A massive quantity of people today is aware of the immense power of Wall Street, the importance of this space, and the ebbs and flows of recession and expansion. Entire generations of young students grow up today aspiring to throw themselves into the world of fund flows, trades, and transactional advisory as financiers.
Interestingly enough, the complex financial markets of today are not a far cry from the simple financial building blocks that were developed hundreds of years ago. For example, take the New York Stock Exchange (NYSE) which processes billions of dollars and millions of trades in a given day. At its core, the NYSE simply hosts what is known as an order book: a collection of buy and sell orders for any given company and stock whose shares are listed on the exchange. Thousands of participants from market makers to traders to hedge funds to speculators all take bets on whether or not a company will be worth more or less than they are at any give moment. These companies that are the target of the market’s research and gambling report their actual performance to other market participants by sharing their audited ledgers or “financials” publicly a few times each year.
To achieve massive throughput, scale, and access to these markets the financial systems of today rely on trusted institutions and third parties much like the farmer relied on banks of old for her financial needs. In addition to banks, venues like the NYSE rely on entities like brokerage firms, clearinghouses, transfer agents, regulatory bodies, accounting firms, and financial services companies to provide the trust these markets need. For billions of dollars to be thrown into something like a stock exchange, a fund manager must know that governing law, rules of the exchange, FDIC insurance, and specialized brokers are all doing their jobs so the manager can have faith that their funds are safe and the rules of the game will be adhered to.
Despite the beauty of many of these markets, it is crucial to understand that systems that rely on trusted third parties and intermediaries are suboptimal, costly, and a playground for bad actors hoping to exploit the rules. In modern finance, many of these cons and costs are accepted due to the massive benefits that come with huge financial markets that most actors can trust. There is no shortage as to the litany of examples that illustrate how imperfect the present system is: regular cases of fraud, access for only the elite few, victimization of retail traders, prohibitive costs, and rampant greed are all things that stem from the nature of humans while enabled by an inefficient system. The world has needed middlemen and intermediaries to make sure that everyone played by the rules and market participants could trust the game, but the financial markets of the future have much to improve on — it is time to take finance to the next level.
New Kids on the Block — The Finance of Tomorrow
The emergence of blockchain technology represents the first step towards a more efficient, democratized, and open financial system. This started with the deployment of the Bitcoin blockchain in the wake of the 2008 financial crisis. To understand why blockchain represents the underpinning of future financial markets, first, take a step back and examine what the actual technology does.
The key idea that is present in all blockchains is the notion of the distributed ledger. A blockchain at its core is a record of transactions and interactions between network participants. Transactions and activity are recorded in sequential “blocks”. What is key is the fact that all market participants agree on the past order of all transactions and interactions as stored in their respective blocks. This chain of blocks in a specific order is where the name blockchain comes from. Moreover, due to everyone in the network agreeing on the order of all past transactions, everyone in the network must also agree on “who has what” and the present state of the blockchain at any given moment. This is done by those running the network sharing an identical copy of all past transactions and network states — the distributed ledger.
How everyone in the network agrees on what the shared ledger should look like and, in turn, who has what is called a consensus mechanism. This is a system that uses code and economics to ensure that good actors running the network are correctly identifying, ordering, and recording all present and past transactions in a network. The consensus mechanism is key because it ensures, based on mathematics, game theoretics, and unfailing code, that all network participants can trust the system and all actors within it. It is these systems that have led many to think of blockchain networks as “trust machines” — systems where fidelity is baked into the DNA and nature of the network itself.
Another crucial piece of blockchain networks is the concept of the smart contract. This is most clearly seen in the emergence of the Ethereum network — Bitcoin’s most notable successor to date. Ethereum is a blockchain-based on the foundational work of Bitcoin with an added dimension: a Turing complete computation layer and programming language baked into its blockchain. This is important because it expands the use of blockchains from simply being a way to move around ledger entries or digital currencies as Bitcoin introduced. The smart contract enables a developer to encode any arbitrary logic into a contract that would live on the blockchain. Once there, it is completely transparent (most blockchains are entirely public) and due to its computer science building blocks, it is unfailing. This means that any two actors can participate in any arbitrarily complex interaction in accordance with the rules of the smart contract. Moreover, due to the context of the interaction, the network will block any transactions that go against the rules of a smart contract and do not adhere to its code.
The elegance of blockchain stems from its ability to allow global networks of unregulated and uncoordinated actors to interact, trade, and develop all in the same network. Moreover, these interactions can occur on a peer-to-peer basis due to the network’s ability to ensure trust, security, and transparency. This means that no middlemen are required for two actors to transact, exchange, lend, borrow, etc. There is no need for middlemen when cryptographically guaranteed trust is the foundation of the network. Instead of requiring a third party to play referee in an interaction, a smart contract can unfailingly ensure good behavior instantly. A network where everyone within can trust that their funds are safe, transactions are legitimate and secure, the rules of the game must be followed, and no middlemen are required is where the financial markets of the future will be built.
The nascent space that is starting to build the financial markets of the future on the blockchain is known as decentralized finance or “DeFi”. This space is comprised of projects that replace the costly intermediaries and trusted third parties of today with code. These markets are also more efficient in the long-run than the financial markets that are characteristic of Wall Street: not needing middlemen to ensure trust and fair play means that DeFi wins massively on cost (most interactions with smart contracts cost pennies in network transaction fees). Decentralized finance markets are also easily accessible by anyone in the world with an internet connection on a permissionless basis: in a world where only a select proportion of people can participate in financial markets, DeFi beats legacy systems on access. Moreover, markets in DeFi are also democratic and fair. Most protocols that govern rules of peer-to-peer exchange utilize a governance token to ensure that the rules of interaction are voted on democratically by a protocol’s users. In short, the removal of middlemen and trusted third parties that decentralized finance permit allows these markets to be more efficient, easy to access, free to use, and democratic.
The future of finance on the blockchain is in its early innings. I believe that this technology will be the backbone of global finance especially as these systems scale, iterate, and grow in adoption. By understanding where we came from in finance, I feel that it becomes clear to see where we are going. I hope this information helps to highlight the promise of the emerging financial markets on the blockchain and I would challenge everyone to explore these young systems and help build a better future for all on the blockchain.
Thank you for reading this article. If you would like to share your thoughts, criticisms, or ideas, please ping me on Twitter or shoot me an email. I am working on leveraging the blockchain to usher in a new era of equity finance.
