Blockchain — The New Economic Institution
Introduction
The year is 2009, and the world is in the grip of the Global Financial Crisis (GFC). Governments across the globe are in the process of bailing out their central banks.
At the same time, Satoshi Nakamoto included the following news headline within the Bitcoin blockchain, which was immutably time-stamped;
“The Times 03/Jan/2009 Chancellor on brink of second bailout for banks.”
Satoshi goes on to comment;
“The root problem with conventional currency is all the trust that’s required to make it work. The central bank must be trusted not to debase the currency, but the history of fiat currencies is full of breaches of that trust.”
Bitcoin has been revealed to the world, albeit a small community to begin with. One of its goals was to re-establish trust in currencies via mathematical cryptography embedded in a blockchain architecture, no longer controlled by a central government.
Trust Defined
Without trust, transactions and exchanges of value would be almost impossible.
James Coleman defines trust as “a willingness to commit to a collaborative effort before you know how the other person will behave.”
Kevin Werbach summarizes its definition succinctly as “confident vulnerability.”
Why is Trust Required?
Traditionally, economists have made the assumption that rational individuals are self-interested. Oliver Williamson describes them as follows: “individuals are opportunistic — individuals are self-interest seeking with guile.”
Nash Equilibrium and the Prisoner’s Dilemma are examples of participants who, by seeking to defect through self-interest, create sub-optimal consequences.
Knowing this information, how is this opportunistic behaviour managed? Let’s consider this through the traditional centralised third-party intermediary lens first.
Traditional Trust
Traditionally, third-party intermediaries have earnt economic rent from providing trust-based services. They have been the traditional “keepers of the ledger,” limiting who can access, who can view, add to or edit the ledger.
“Historically, trust has been provided by market mechanisms such a reputation or hierarchy — those organizations, such as firms and governments, that have suppressed opportunistic behaviour through ranked authority.”
Costs of Traditional Trust
Organisations, institutions, markets and government structures have traditionally played the role of upholding and ensuring trustworthy behaviour between participants.
Trust plays a crucial role in conceivably every economic transaction. Much of the institutional economics literature has been focused on the ways economic agents enforce trust amongst each other.
When participating in forms of economic and market exchange, enforcing trust comes at a price. Hodgson describes this in terms of transaction costs by describing it as “policing and enforcing contracts.”
Put simply, this is a cost (transaction cost) of maintaining and policing trust. So how much is this overhead?
In their paper entitled “The Cost of Trust: A Pilot Study” (2018), Sinclair Davidson et al provide some answers.
“Overall, it is estimated that about 35 percent of employment in the United States relates to activity aimed at upholding trustful economic relationships.” This is a very hefty price tag for maintaining trust.
Some of the tools and mechanisms that have been employed to maintain an environment of trust between transacting parties include:
· developing a sound reputation as being a trustworthy counter-party — this may be event and experience-based
· developing corporate and institutional cultures of honesty and transparency
· compliance monitoring and analysis
· state-based regulation
· setting industry and market ethical standards
· legal and court-based remedies and their associated legal costs for non-compliance
· ledgers in their many and various forms
This leads to our next topic for consideration — Ledgers.
Ledgers
So why are ledgers so important? Put simply, a ledger is a tool for creating trust.
“Ledgers record and verify the information jointly known about ownership, identity, relations and exchange that is necessary for economic activity to occur”.
When there is agreement between all parties to the transaction as to a state of being, then something has happened — “an economic fact” — there can be agreement between the parties that the transaction is valid and trustworthy.
“Agreement about the facts and when they change — that is, a consensus about what is in the ledger, and a trust that the ledger is accurate — is one of the fundamental bases of market capitalism.”
Before moving onto the discussion regarding blockchains and the roles that they can potentially play with regarding to establishing industrialised trust, we will first consider the importance and role of Institutional Economics and Institutional Cryptoeconomics.
Institutional Economics
Institutional Economics is a transaction centered view of the economy, and transactions are the basic unit of analysis.
Ronald Coase describes the existence of the firm through the lens of transaction costs. Transaction costs are associated with price discovery in a market and include “negotiations to be undertaken, contracts have to be drawn up, inspections have to be made, arrangements have to be made to settle disputes, and so on.”
In effect, Coase argues that the existence of transaction costs gives rise to the need for the firm.
Oliver Williamson built upon the concept of transaction costs and established that firms exist to minimise transaction costs. In addition, company managers need to take into account transaction costs when deciding what to produce within the firm and when to outsource this process to other firms.
“Institutions are mechanisms that reduce uncertainty, simplify decision-making and promote cooperation among individuals so that the costs of coordinating economic activity can be lowered.” In other words, lowering transaction costs. (RMIT 2022)
Geoffrey Hodgson takes things a step further and introduces the concept of property rights in a market setting:
“Exchange … involves contractual agreement and the exchange of property rights, and the market consists in part of mechanisms to structure, organise, and legitimise these activities. Markets, in short, are organised and institutionalised exchange.”
“The rights which individuals’ possess are determined largely by the legal system. Therefore, the legal system will have a profound effect on the working of the economic system.”
It is apparent that property rights are closely linked with the ability to establish and enforce them via the legal system and forms part of the model for Institutional Economics.
Institutional Cryptoeconomics
“Institutional cryptoeconomics is an extension of institutional economics — it is based on a transactions costs approach — but it specifically focuses on ledgers as a foundational institutional technology.” Institutional cryptoeconomics also studies how changes in ledger technology affect economic activity along with their subsequent impact on institutions, organisation, governance and transactions costs.”
One key reason for understanding the significant impact of ledgers within the economy is;
“A well-trusted ledger creates a low transaction cost economy, a pre-condition for economic efficiency and prosperity.”
Blockchain Defined
In order to more fully understand blockchains, we will start with two (2) definitions:
“Blockchain Technology is a distributed (peer-to-peer), digital, database or ledger with two critical properties: decentralisation and immutability.”
Alternatively, from a ledger-based definition, “a blockchain is way of creating a robust, transparent, distributed ledger.”
As a result of their decentralised structure, blockchains are a major step forward with regard to the industrialisation of trust.
Blockchain-based Trust
Blockchains incorporate the use of mathematical cryptography and consensus algorithms to preserve their immutability and network security. By assigning and delegating security of the blockchain network to mathematics, the need for a centralised third-party intermediary to establish this trust is eliminated.
By eliminating centralised third-party intermediaries who had provided trust in the past, there is an opportunity to:
· reduce economic rents
· establish mutual consensus and a single version of the truth
· clearly define property rights
· reduce transaction costs
· reduce opportunism (with the application of smart contracts)
Blockchain Ledger Economies
With the arrival of blockchain ledgers, they provide a completely new evolution in the ways of organising economic activities, for example, V-form organisations. [1] Blockchains have the ability to support a new form of economic institution that is discrete from firms, markets, and governments.
Hayek alluded to decentralised economies and distributed information processing in his paper entitled “The Use of Knowledge in Society.”
Sinclair Davidson describes blockchains “as a new type of economy: a spontaneous organisation, which is a self-governing organisation with the coordination properties of a market.”
Benefits of Blockchain
Blockchains provide many of the following improvements and benefits over existing economic structures including transaction transparency, network security, simplicity & streamlining with the application of smart contracts, auditability, distributed network, dis-intermediation, and industrialisation of trust, consensus-driven mechanisms, availability of permissioned and permissionless blockchains.
Blockchains can also reduce decisional noise with the ability to standardise and codify complex processes via smart contracts[2].
In the article entitled “The Blockchain and Increasing Cooperative Efficacy,” Malavika Nair et al (2018) establish that blockchains have the ability to increase “cooperative efficiency”[3] and significantly reduce the size and scope of government, overcome many free-rider problems and reduce transaction costs.
Blockchain: Institutional technology versus general purpose technology
Blockchains are capable of exhibiting both characteristics of a general-purpose technology and an institutional technology depending upon their specific application.
In the article entitled “Blockchains and the economic institutions of capitalism,” Sinclair Davidson et al (2018)(a) assert that blockchains are an institutional technology.
In contrast, general-purpose technologies are described as providing production or efficiency gains offering margins of improvement to existing economic institutions.
Sinclair Davidson et al assert that “blockchain is actually a new way of coordinating economic activity”. That is, this technology is a new type of economic institution.” and that they now compete against firms, markets and economies as institutional alternatives.
Traditional Market Failures
Traditional markets, firms, and economic institutions are subject to market failures. These include monopolies, monopsonies, asymmetric information (averse selection and moral hazards), and externalities.
Taking this down to a ledger-based discussion, centralised ledgers are subject to single points of failure, manipulation, fraud, and collusion.
Blockchain Market Failures
Blockchain-based mechanisms and institutions are also subject to market failures. Some of these include:
· centralisation of asset ownership and control
· poor blockchain governance structures
· smart contract failures and/or errors
Regulation
One way of dealing with and managing market failures is via regulation.
“According to the institutional theory of regulation, the case for public intervention relies crucially on the presumptive failure of market discipline to control disorder. In the event of failure of market discipline, litigation becomes an efficient means of minimising costs of social disorder (Coase theorem at work).” (RMIT 2022)
Conclusion
Trust sits at the core of all economic exchanges and transactions. Centralised institutions such as firms, markets, and governments have evolved to provide rent-based trust services. More recently, blockchains have evolved to provide industralised trust. This will lead to new forms of economic coordination and organisations of economy activity.
For multiple parties to agree and trust that something has happened or more precisely, that a trusted or valid transaction has taken place, this occurs against a backdrop of:
· mutual agreement between the transacting parties
· established trust (be it in the form of a government, firm, market or blockchain)
· a trusted and accurate ledger
· property rights within the legal context
· associated transaction costs
Blockchains can assist with validating a transaction by providing:
· industrialised trust supported by mathematical cryptography
· an immutable ledger establishing trustless trust
· a consensus mechanism yielding one version of the truth
However, blockchains do not operate in isolation and are subject to market failures of their own kind, which may require government intervention and possibly regulation via state-based institutions. Also, blockchains and their participants operate against the backdrop of the legal system, which provides additional forms of recourse to any potentially aggrieved parties to a perceived untrustworthy or “invalid” transaction[4].
Finally, with the arrival of blockchain ledgers, they provide a completely new infrastructure and evolution for organising economic activities in unique ways. Blockchains have the ability to support a new form of economic institution that is discrete from firms, markets and governments by way of the fact that they can industrialise trust and can pave the way for significant improvements in economic efficiency and prosperity.
[1] “A V-Form organisation is an outsourced, vertically integrated organisation, tied together by a blockchain.”
[2] “Human decision making is often prone to biases and irrationality. Group decisions add dynamic interactions that further complicate the choice process and frequently result in outcomes that are sub-optimal for both the individual and the collective. We show that an implementation of a Blockchain protocol improves individuals’ decision strategies and increases the alignment between desires and outcomes.”
[3] “Cooperative efficacy involves a communities or group’s ability to engage in collective action.”
[4] “After the vote passed on Friday, Asano explained to CoinDesk that he might consider pursuing legal action, depending on what the community decides to do next.”
Nathan van den Bosch is a Behavioural Economist, Tokenomics Specialist and Blockchain Strategist, with more than 30 years of experience in emerging and disruptive technologies. Nathan has degrees in Economics, Commerce, Behavioural Economics and Applied Blockchain.
Nathan specialises in designing the reward and incentive schemas for gamified metaverses, digital ecosystems and digital economies. His focus is based upon understanding the behavioural drivers that spur adoption and sustained usage in blockchain-based network environments.
