Civilization is founded on trust. A welter of research over the past two decades has shown that high trust societies grow more rapidly than low trust societies. There is an immutable logic for this relationship: Growth is generated by the development of better, less expensive products and processes, which in turn is driven by opportunities made possible by trade, and trade is facilitated by institutions that enable counterparties to trust one another.
Historically, trust-enhancing institutions have relied on trusted third parties. Among the earliest of these, dating back 7,000 years, were ledgers documenting exchanges of goods received and traded in Mesopotamia. These ledgers were kept in temples, the primary trusted third party of the day. By the First Century AD, the Romans had developed ledgers into sophisticated means of accounting for credit and debt. These ledgers enabled large sums to be transferred without moving physical currency. Such transactions could even take place internationally through a trusted authority called the publicani – private companies responsible for tax collection in the provinces.
A significant advance in the functional effectiveness of ledgers occurred in 1458, when Benedikt Kotruljevic, a merchant from Dubrovnic, invented double entry bookkeeping. By maintaining a consistent record of all debits and credits, double entry bookkeeping enables investors and potential investors in a company better to identify the company’s assets, liabilities, profits and losses. But for double entry book-keeping to be trusted requires the entries to be verified. Traditionally, this has been the job of auditors — a trusted third party.
Unfortunately, as the various accounting scandals of the past two decades show, auditors can be misled. Moreover, valuations made by auditors typically only reflect a snapshot of the actual value of assets and liabilities at the time of the audit, often based on arbitrary valuation rules. When assets depreciate rapidly, companies that look solid on the basis of “book” value can in fact be insolvent, causing major disruptions to counterparties.
These problems may soon be overcome by a new type of ledger. In The Truth Machine, Michael Casey and Paul Vigna argue that the blockchain, the technology underpinning Bitcoin, is potentially the most significant advance in accounting since the invention of double entry bookkeeping. Instead of a centralized ledger verified by trusted third parties, the blockchain is an immutable, distributed, append-only ledger secured through public key encryption and validated by untrusted third parties through the application of a cryptographic algorithm.
These features make the blockchain incredibly secure and almost impossible to hack. As Casey and Vigna point out, to work through every possible number that could be generated by Bitcoin’s hashing algorithm, for example, would take over 4,500 trillion trillion trillion years using all the computers on its network. Meanwhile, taking over 51 percent of Bitcoin’s miners and thereby forcing the network to accept a false change to the ledger would cost over $2 billion. (One caveat: quantum computing might pose a threat in the future but solutions to such threats are already being investigated.)
Among the many blockchain applications Casey and Vigna discuss is one developed by Factom, “an Austin, Texas, company that created an audit trail of financial documents’ changes, creating a model that if it is widely applied, will eventually replace the whole industry of quarterly and annual accounting and auditing with something that happens in real time.”
While blockchain has significant advantages as a means of securing and validating transaction data without the need for verification by a trusted third party, it has faced challenges due to the small number of transactions that can be processed at any one time and the at-times high cost of such transactions. Bitcoin can only process seven transactions per second, takes about 10 minutes on average for validation, and, depending on the extent of congestion in the system can cost anywhere from 20c to over $100 per transaction. (Transaction costs rose dramatically at the end of 2017 and in early 2018, as bitcoin mania erupted around the world. They have since fallen down to earth.)
By contrast, payment networks such as Visa and MasterCard can process 65,000 transactions per second, provide near-instantaneous verification, and typically charge between 0.1 percent and 1 percent of the transaction amount, depending on the type of transaction and the location and type of merchant. Casey and Vegna incorrectly assert that payment networks charge interchange fees of 3 percent — confusing that fee with the bundled processing fee charged by some merchant acquirers.
Various innovations may dramatically increase the speed and reduce the cost of transacting using blockchains. For example, the Lightning Network is a payment network based on a set of smart contracts that operates in concert with blockchains (primarily but not exclusively Bitcoin). Basically, funds are transferred from a blockchain address to the Lightning Network according to rules in a smart contract. Those funds can then be allocated between participants in the Lightning Network according to agreements embedded in other smart contracts. The blockchain is used for validation of the initial smart contract and as enforcement in the case of a breach of transfer contracts. In principle, Lightning Network has the potential to process 65 billion transactions per second.
As Casey and Vegna illustrate with numerous examples, these and other innovations are likely to bring blockchains into the mainstream within the next few years. Use cases are still being developed but in principle any activity that relies on trusted third parties, from accounting to notarization, and from fund management to property registries, could be dramatically affected.
However, Casey and Vegna sound a note of caution regarding the development of private or “permissioned” blockchains, which are being developed by various banks and consortia. While in principle, these have many of the benefits of public blockchains, such as Bitcoin, Etherium and Eos, they are not truly decentralized and thus retain some of the inherently problematic features of trusted third parties. But it may be that these permissioned blockchains offer sufficient improvements in scale and reductions in cost relative to existing transaction processing systems that they undermine the case for switching to public blockchain based applications.
Alternatively, it is possible that both permissioned and permissionless blockchains will operate in parallel, with some being more-or-less dominant in certain applications and others continuing to compete for market share, just as Apple’s iOS-based products compete with those offered by the many companies offering products operating over Google’s Android OS.
Another note of caution is worth raising: Governments are waking up to the potential for blockchains to be used to circumvent regulations, ranging from capital controls to securities regulation. As others have noted in these pages, China’s government has clamped down on cryptocurrency exchanges, realizing that these offer a means for people to convert currency into private crypto-assets (such as Zcash and Monero) that are almost impossible to trace.
Meanwhile, the U.S. Securities and Exchange Commission has launched investigations into numerous initial coin offerings (ICOs) on the grounds that these are effectively unregulated securities offerings. In response to the latter, most new ICOs are now launched in jurisdictions that are not subject to SEC purview, including Switzerland, Lichtenstein, Gibraltar and Cayman, and U.S. residents are prohibited from participating.
It is probably too early to tell whether blockchain will change the world. The cryptocurrency bubble and associated profusion of ICOs recall the Internet bubble of 1999. There are likely some world changing platforms and apps out there (and Bitcoin may well be among them). But there are also likely many poorly conceived, poorly implemented applications that will fail. And of course there are some outright frauds.
“The Truth Machine” offers a valuable history of the development of blockchain, its potential role as an alternative to trusted third parties, and a discussion of some of the platforms and apps that have thus far been developed. The authors have tried to remain impartial, though they evince a bias in favor of permissionless blockchains that may or may not be justified.