Institutional Cryptoeconomics & the Future of the Blockchain Economy

What is blockchain and distributed ledger technology (DLT)?

When most people think of blockchain, the majority would probably think of Bitcoin. Bitcoin is a decentralised, peer-to-peer online cash system which was the first to utilise blockchain technology, invented and released in 2008 by an unknown alias, Satoshi Nakamoto (Nakamoto, 2008). Despite being the first network using blockchain technology, blockchain as a whole is not strictly limited to peer-to-peer, cross-border payments such as Bitcoin and other cryptocurrencies. It far exceeds the realm of just simple, global payment systems (Anascavage & Davis, 2018).

At its fundamental core, blockchain is a digital distributed ledger recording different types of data like transactions, documents, and property rights (D’Aliessi, 2016). It can also have different levels of decentralisation and openness depending on its use case. Users can choose between a private, permissioned — or open, public blockchain. Blockchain is a revolutionary technology as it entirely disrupts the current institutional economic model as we know it. It does this by reducing the cost of trust and industrialising it, allowing promises between two individuals to work without involving an intermediary and overcoming opportunism (IBM, 2017).

Ledgers, and why they are so important

Ledgers are a type of ancient accounting technology developed to record and maintain agreement about: who owns what, how much they own, and when they purchased it. Ledgers may seem like a mundane and monotonous system correlated to accounting; however, ledgers are essential to the legitimisation of transactions and a crucial technology of modern market capitalism and Government (Davidson, Filippi, & Potts, 2017). In fact, ledgers have been utilised for millennia, with the oldest record of a ledger dating back 7000 years ago, recorded in Ancient Mesopotamian clay tablets (Fabri, 2020). In reality, ledgers are crucial to the economy, as evidently shown through entities such as the Federal Reserve Bank, as whoever controls the financial ledger also controls the whole monetary system and the people connected to it.

Today, modern-day ledgers are massive databases and servers containing all the valuable data of their customers. Of course, these are all controlled by a single centralised company. This problem of centralisation is a road to many problems which may result in the exploitation of consumer data. Two examples of this occurring include the 2011 Sony Playstation Network Outage, where 77 million accounts were compromised (Quinn & Arthur, 2011) and in 2013, where over one billion Yahoo accounts were exploited (Perlroth, 2017). These are only two examples amongst hundreds of others. Centralised databases rely on the trust of their users, having a single-point-of-failure, and are only as secure as the organisation which holds it. This is the exact problem that blockchain solves by being a distributed ledger, as a coordinated central point-of-attack would not compromise the network.

INSTITUTIONAL CRYPTOECONOMICS

What is institutional cryptoeconomics?

Institutional cryptoeconomics is a new phase in economics which studies the use of DLT for the recording of social facts, property rights, personal identity, documents, promises (which are contracts) and the coordination of governance for institutional use. Simply put, institutional cryptoeconomics looks at the institutional economics of blockchain and the cryptoeconomy (Bocetta, 2020). Before 2009, there were three predominant mechanisms where all economic activities took place, being the Government, the firm, and the market. Governments are hierarchical entities containing ledgers that document access rights, ownership, and responsibility. These include digital passports, travel information, citizenship, taxation details and property ownership. Firms are centralised, trusted ledgers of contracts and capital; recording capital ownership, patents and other intellectual property of their customers and contractors.

Why would the Government and firms use blockchain and DLT?

The blockchain is not a brand new broad-purpose technology, it’s a new technology for institutions as it facilitates cooperation between individuals by opening channels of exchange, collaboration and the building of new infrastructure previously closed off because of high information and transaction costs. Governments and firms can utilise blockchain and DLT to make their business more secure, efficient, and transparent; as these institutions rely on constant communication and daily global transactions. Blockchains facilitate this in a cost-effective, secure, and near-instantaneous fashion (McCallum & van der Laan, 2017). Governments and institutional firms could utilise the immutability features of blockchain, ensuring that personal documents are tamper-proof and accurate. A well-implemented system would allow residents of a country more power over their data, and who they shared them with, whilst decreasing the overall cost of trust associated with accounting, auditing, and manual verification (Berg, Davidson, & Potts, 2017).

The cost of trust

A recent study has estimated that the cost of trust is accounted for 35 per cent of employment in the United States (Davidson, Novak, & Potts, 2018). This means that roughly one in every three people’s job in the United States is to check and verify someone else’s work. The cost of trust includes establishing a relationship — as this includes transactional costs (among many others), the constant monitoring and auditing of each other’s work and verifying for truthfulness. In a system or world where everyone spoke the truth, we would not need all these facilities of auditing and verification. Trust is treated as an input — a substantial underlying cost paid for the production of wealth. That is why any technology that can disrupt this cost of trust will cause a global-shaking new technological shift. Blockchain industrialises trust by taking opportunism off the table and lowering the overall costs of contracting between individuals.

A simple example of this is seen in Bitcoin. A miner burns electricity to facilitate a transaction between two individuals allowing them to trade in a trustless manner. In doing so, and by playing by the rules, miners are rewarded with BTC by the network. Therefore, miners are incentivised to stay and participate in securing the network.

Institutional smart contracts — the future of blockchain

The area in which blockchain will revolutionise institutions is through the use of smart contracts. Just as contracts are at the epicentre of every business and economic organisation, which economics Nobel prize winners Ronald Coase and Oliver Williamson made clear, smart contracts are the fundamental driver of institutional cryptoeconomics. They allow for any contractual agreement to be executed autonomously, in a secure and fast manner; eliminating the need for manual auditing by accountants, lawyers or other members of the legal system. Two types of contracts exist — complete and incomplete contracts. A complete contract states what is to happen in every possible scenario, whilst incomplete contracts allow for negotiation to occur under unforeseen circumstances; being one of the primary reasons why exchange occurs in firms. Smart contracts lower both informational and transactional costs coupled with incomplete contracts, further facilitating the expansion of economic activities; allowing the operation of markets and businesses where previously only firms and Governments could operate.

Case Example — Blockchain in Australian Government

Australian Central Bank Digital Currency (AUDC)

An excellent example of the implementation of blockchain and DLT in Government systems is through the implementation of a central bank digital currency (CBDC) such as an Australian digital dollar. The Reserve Bank of Australia (RBA) could issue a digital encrypted currency which would be fully backed 1:1 and redeemable for a single Australian dollar and implemented on a private Ethereum-based blockchain. This distributed monetary system would allow transactions to occur between participating individuals in a near-instantaneous, costless and secure manner. All transactions would be recorded in the ledger, whilst still retaining privacy rights, where only the sender and receiver of the transaction can see how much is being exchanged.

Real-time auditing and blockchain interoperability

Further benefits such as real-time auditing, make a CBDC attractive to governments as all transactional information and metadata are incorporated within the transaction itself, which can be queried and accessed at any point in time. Previously, the transactional layer and data layer were separate. However, blockchain and DLT combine the transactional and data layer onto a single platform. This would allow citizens to manage and pay their taxes with ease, whilst also severely decreasing the amount of tax evasion, monetary fraud and laundering. Furthermore, citizens participating would be able to see where their taxes are being allocated to in real-time. This transparency between Government and citizens can help increase the trust and relationships between the community and their Government.

Furthermore, depending on how interoperable the private blockchain system is, and whether it is Ethereum-based, there may be potential for “plug-in” compatibility with the Ethereum public blockchain. This would allow users to lend their funds and earn interest through decentralised finance (DeFi) protocols and applications such as Aave (Aave, 2020) and Compound (Compound Labs Inc, 2020). Data would then relay back to the private chain, allowing users to report and pay taxes seamlessly on any income securely and efficiently, as all information is on-chain.

Recently the RBA announced it was partnering with the Commonwealth, NAB and a software company named ConsenSys to explore the use of a wholesale central bank digital currency (CBDC) based on the Ethereum network. More information is yet to be announced. However, it is exciting and promising for the future of cryptocurrency and DLT in Australia (Reserve Bank of Australia, 2020).

Blockchain is not a silver bullet

Blockchain is still in its infancy, and the technology is currently being experimented in businesses to determine its effectiveness and capabilities. Blockchain is not a silver bullet — meaning that it doesn’t solve problems for all business models. Blockchain is most effective in businesses that: require consensus between multiple parties; spend large amounts of money hiring manual auditors; are transacting with highly sensitive information, requiring tamper-proof, cryptographically secure and distributed data. Currently, problems such as scalability, transaction speeds and interoperability are the biggest concerns for blockchain adoption, especially in the context of the Ethereum network, as it can often get congested with highly variable gas prices (Jagati, 2020). These are considerations that must be made when deciding on whether to implement a private or public blockchain, as security is often sacrificed for efficiency and vice-versa. Nonetheless, blockchain will continue to revolutionise the industry, and it will be exciting to see how the new technological paradigm shift will unfold, what new systems will be built and how will they be integrated into the economic sector in years to come.

REFERENCES

Aave. (2020). The Liquidity Market Protocol. Retrieved from https://aave.com/

Anascavage, R., & Davis, N. (2018). Blockchain Technology: A Literature Review. doi:http://dx.doi.org/10.2139/ssrn.3173406

Berg, C., Davidson, S., & Potts, J. (2017). Institutional Cryptoeconomics: A New Model for a New Century. Retrieved from https://www.coindesk.com/institutional-cryptoeconomics

Bocetta, S. (2020). Institutional Cryptoeconomics: Everything You Need to Know about This Blockchain Concept. Retrieved from https://fee.org/articles/institutional-cryptoeconomics-everything-you-need-to-know-about-this-blockchain-concept/

Compound Labs Inc. (2020). The Compound Protocol. Retrieved from https://compound.finance/

D’Aliessi, M. (2016). How does the blockchain work? Retrieved from https://onezero.medium.com/how-does-the-blockchain-work-98c8cd01d2ae

Davidson, S., Filippi, P. D., & Potts, J. (2017). Blockchains and the economic institutions of capitalism. Journal of Institutional Economics, 14(4), 23.

Davidson, S., Novak, M., & Potts, J. (2018). The Cost of Trust: A Pilot Study. 1–28.

Fabri, J. (2020). Ledger-nomics. Retrieved from https://bitemycoin.com/opinion/ledger-nomics/#:~:text=The%20first%20recorded%20ledgers%20were,the%20banks%20of%20the%20time.

IBM. (2017). The difference between public and private blockchain. Blockchain Pulse: IBM Blockchain Blog.

Jagati, S. (2020). Ethereum scalability issues exposed as high gas fees stall DeFi boom. Retrieved from https://cointelegraph.com/news/ethereum-scalability-issues-exposed-as-high-gas-fees-stall-defi-boom

McCallum, T., & van der Laan, L. (2017). The blockchain could have better security than the banks. Retrieved from https://theconversation.com/the-blockchain-could-have-better-security-than-the-banks-80748

Nakamoto, S. (2008). Bitcoin: A peer-to-peer electronic cash system. In.

Perlroth, N. (2017). All 3 Billion Yahoo Accounts Were Affected by 2013 Attack. Retrieved from https://www.nytimes.com/2017/10/03/technology/yahoo-hack-3-billion-users.html

Quinn, B., & Arthur, C. (2011). PlayStation Network hackers access data of 77 million users. Retrieved from https://www.theguardian.com/technology/2011/apr/26/playstation-network-hackers-data

Reserve Bank of Australia. (2020). Reserve Bank partners with Commonwealth Bank, National Australia Bank, Perpetual and ConsenSys Software on Wholesale Central Bank Digital Currency Research Project. Retrieved from https://www.rba.gov.au/media-releases/2020/mr-20-27.html