Despite the technological innovations brought about by the Internet, most economic transactions require the presence of at least one central intermediary who often controls the terms of trade.
Intermediaries are banks, insurance companies and other economic operators who benefit from interfacing between service providers and end users to facilitate transactions. However, they do so at great cost, sometimes raising some fundamental concerns.
First, the presence of an intermediary can lead to potentially abused market power. Secondly, there is the possibility of a fleeting engagement and the potential conflict of interest. Finally, almost all existing intermediaries use opaque proprietary platforms which impede interoperability and, therefore, create “walled gardens”. For example, Apple strictly controls which mobile phone applications can be installed on its operating system.
Blockchain technology, a relatively recent development, promises to address some of these structural problems. In simple terms, a blockchain is a ledger on which transactions are organized and recorded, in much the same way they would be in an accounting ledger (Chart 1). Blockchain applications are being developed for a multitude of activities including finance, supply chain management, game, digital identity, land title and the Arts.
While the number of blockchain initiatives has steadily increased over the past decade, most of the activity, as measured by the number of transactions, is concentrated in the largest chains, such as Bitcoin and Ethereum. They have contracted moderately in recent months (Chart 2).
Eliminate the intermediary
In a traditional, centralized intermediate ledger, a single entity is responsible for approving, viewing, verifying, and clearing transactions. For example, if you don’t pay with cash, only your bank or credit card company can “change” your account by approving every transaction you make. In a blockchain, governance is decentralized. Users interact with each other through a protocol available to anyone.
Because many people can modify the ledger, a cost-effective mechanism is needed to ensure that no one illegally alters its contents. Thus, a transaction is only recorded if enough agents, called validators, agree that the transaction actually took place. In order to align the interests of validators with the interests of users, the network rewards validators in the form of a token (commonly referred to as a cryptocurrency) which loses value if the integrity of the ledger is breached.
Initially, blockchain technology was conceived primarily for digital payments: “a peer-to-peer electronic payment system” in the words of Satoshi Nakamoto , the inventor of the Bitcoin protocol. To support the digital payment system, a digital token (bitcoin) was created in place of traditional currency, assuming that its value depended on people’s willingness to accept it as a medium of exchange. Since then, many more tokens have been created that serve as currency for other blockchains.
An important feature is that, similar to a physical coin, a digital token can be controlled directly by the owner without centralized intermediation. This is possible because a digital currency has an unforgivable unique identifier, a public key, that only the rightful owner of the currency can transfer.
This type of peer-to-peer system differs from traditional electronic payment systems, which rely on traditional fiat currencies (dollars, euros and pounds, for example) which are, ultimately, a liability of the central bank that issues them. A traditional electronic payment system simply connects financial institutions and merchants, but still ultimately requires net settlement at the central bank level.
“Smart Contracts” carry out transactions automatically
Most blockchains work seamlessly with smart contracts, programs that run automatically when specified conditions are met. This is because they process digital native transactions with digital native currency.
Smart contracts are central to the application of decentralization through blockchain because they automatically follow predetermined rules. Imagine a bank that doesn’t make a subjective judgment about whether or not someone should get a loan, but only lends money if the borrower has sufficient collateral.
Within a few years, blockchain technology has evolved from Bitcoin to a new economic system, web 3.0, where decentralized applications use smart contracts to allow users to interact with each other and exchange value securely and anonymously without relying on a centralized brokerage platform.
A unique feature of the blockchain is the high level of transparency and decentralization of its infrastructure. All protocols are built through open source collaborations between a decentralized network of developers.
No one owns or controls the protocols, which are managed and updated by all interested parties through a consensus system. The code used by the protocols is public and available for anyone to see, check and copy. Transactions are visible for anyone to monitor and verify.
Legolike pack of financial transactions
Another important feature is the concept of modularity: “Lego money”, as is metaphorically known. Due to the open source nature of the protocols and their interoperability, multiple transactions can be stacked on top of each other, like Lego pieces, to create faster, cheaper and more convenient products.
For example, this composability could soon allow you to take out a home loan, exchange dollars for euros, buy an apartment in Paris, hedge your currency risk with futures, and donate any unused funds to charity. The entire collection sequence will require just a few lines of code executed by smart contracts in a decentralized ledger that is owned by no one and is managed collectively by anonymous individuals to each other.
Navigate new challenges
Numerous challenges remain with the blockchain. Finding consensus across a large network of users in a decentralized environment can be slow and costly. The bigger the network, the more expensive it becomes to operate.
Therefore, the main feature that makes blockchain attractive, its decentralized structure, could become the main obstacle to its wider adoption. Not surprisingly, most of the recent innovations have been geared towards creating faster and more efficient protocols, increasing their ability to scale applications.
The global reach of blockchains presents another challenge. By design, anyone in the world can access and participate in these peer-to-peer networks. At the same time, laws, regulations and practices differ greatly from country to country. To thrive, blockchain initiatives will need to find ways to create regulatory compliance mechanisms that differ from the traditional, established approach taken by centralized enterprises.
For example, there is no identity on the blockchain and each user is identified by public/private key pairs. This is a key feature of blockchain technology and does not fit well with existing anti-money laundering practices. At the same time, blockchain technology is completely transparent and transactions are traceable. Malicious actors can be identified and prevented from operating under most protocols and transitioning into the traditional financial system.
While the resources dedicated to the development of blockchain technology have increased dramatically in recent years, the ultimate success of the technology depends on whether blockchain protocols can interact with the current economic landscape and how this is done.
About the author
Saretto is a senior research economist and consultant in the research department at the Federal Reserve Bank of Dallas.
The views expressed are those of the authors and should not be attributed to the Federal Reserve Bank of Dallas or the Federal Reserve System.