Courtesy of Lawrence Baxter, Ryan Clements, and John Lightbourne
The buzz surrounding Blockchain, the distributed ledger infrastructure upon which Bitcoin operates, and how it will transform commerce while reducing transaction costs is at a crescendo. As John Oliver recently hilariously lampooned, many investors assign instant value to any firm with Blockchain in its name, mirroring the kind of “capital euphoria” seen during the Dot-com bubble.
Reflecting however on what is really entailed, the glamor of the Blockchain project, at least for complex financial use cases, is not that clear. Our understanding of the potential of Blockchain has assuredly evolved, thanks to projects like Ethereum, to contemplate a virtual environment executing programs across a peer-to-peer network and beyond the failure of centralized servers or the reach of most hackers. Yet large-scale institutional Blockchain projects for complex financial use cases have been slow to emerge outside a few, mainly closed and permissioned test initiatives and general expressions of interest. This is hardly surprising.
The technological demands of designing a protocol for complex financial uses are high enough in themselves. Coordinating widely disparate parties, adverse interests, and the enormous investment of highly skilled labor involved to create these “hyped up” use cases, is a potentially much larger cost. After all, continuously reducing complex legal transactions and documents to executable code that works across a broad range of commerce requires many “specialists” including lawyers, computer scientists, and business stakeholders.
Blockchain enthusiasts tend to overlook this stark reality by clinging to a fiction that just because certain technological principles can be boiled down to “white papers,” implementation is inevitable. Yet even if we could program all contingencies and discretionary rights into the complex smart contracts inherently necessary to bespoke agreements, which is unclear despite DTCC’s “success” in programming a more standardized CDS, the pre-contractual costs of coding the smart contract, given the current state of technology, would very likely outweigh the marginal benefits. And this doesn’t begin to account for the costs associated with the legal uncertainty of how liability is allocated when (inevitably) self-executing code produces adverse economic consequences that are misaligned to the parties’ intentions. Further, it’s questionable whether it would be desirable from a legal or business perspective to incorporate certain discretionary rights in code. Given the complexity, and scope, of the U.S. market, experimenting with nascent technology is questionable given an uncertain return.
Another frequent refrain from Blockchain enthusiasts is how Blockchains quickly eliminate existing transaction costs by removing “costly” intermediaries. This is often nonsense. Leaving aside enormous new computing costs, existing transaction costs in finance are already relatively low. Where they are not, the costs are due to bespoke engagements that require the kind of specialized, and expensive, expertise that will continue to be necessary to automating and distilling negotiated transactions to code. Additionally, the upfront costs, to be amortized over many years, of Blockchain development and genuine application to actual transactions are also very high. As with the development of e-commerce, proponents also have to be willing and able to sink large sums of capital, and fund its implementation over many years, in the hope that somewhere in the future they will see returns to justify the investments. Given the current short-termism that pervades the financial world, we doubt for the time being that there will be many takers for moving beyond an experimental level. Also, high profile security breaches due to lapses in smart contract coding (like the DAO) likely gives firms pause, despite the assurances of technologists.
Instead, viable use cases will likely come from smaller initiatives where the costs of failure, and technological requirements, are lower. Perhaps as the technology matures, and sequentially complicated financial use cases are proven, we may slowly see smart contracts assume a role in complex financial transactions in a mature market like the U.S. So maybe one day we will have a real Blockchain-based economy—just not any time soon.