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Blockchain: The Future, or an Economic Catastrophe?

Blockchain: The Future, or an Economic Catastrophe?

Image Source: Getty Images

Image Source: Getty Images

By: Tejas Kashyap

Since the dawn of mankind, humans have engaged in transactions to obtain what they could not produce or scavenge.  In a direct payment system (under the same tent), the system was fairly simple: give an item of similar value in exchange for what one needs.  However, there are several issues with the trade of non-commutable objects; i.e., goods that are not implicitly equal to one another.  Both parties engaging in trade must value these objects equally.  The market determines the price of a good relative to a certain object, but what is the true, intrinsic value of the object?  Currency may allow for an object to be valued relative to the amount of output it is likely to produce over the coming years, discounted to the present, but who values the currency?  Additionally, how can we trust this valuation?

This trust relationship is the crux of our financial transactions.  In the case of U.S. dollars, the currency is backed by the full faith and credit of the U.S. government. These dollars, a type of fiat currency, are worth something because the government says that they are, and because government is derived from a social contract with the constituents it represents, dollars are effectively given value by the people that use them.  People worldwide use US dollars because the US government is a trustworthy backer.  However, in our rapidly globalizing world, where transactions can and should take place between countries and continents, electronic payments and processing based on electronic representations of fiat currency have increasingly supplemented existing cash systems.  As of today, these systems have required trusted third parties to manage personal electronic currency supplies, oversee the transactions and maintain a record in the event that a transaction is disputed.   

There is a tangible agency problem with “trusted” financial third parties who hold the keys to our escrow transactions.  These groups do not always act with the interest of ensuring a stable transaction, as they reap profits from the margins of the transactions that they oversee alongside interest from leverage financing for other transactions.  These third parties are also subject to fraud, and the cost of mediating disputes increases the average cost of each transaction.  This risk of fraud is the predicament of a trust-based financial model including third-parties.  Transaction costs will increase as long as there are actors that dispute the trust relationship involved in holding information and running transactions through a third-party financial institution, which increases the cost of doing business overall.  

The answer to this issue lies in blockchain, “an electronic payment system based on cryptographic proof instead of trust” where transactions are not escrowed by trusted third parties.  The competitive advantage to blockchain is in its mechanization of trust. Computers do not suffer an agency problem. They are inherently rational, and therefore perfectly trustworthy.  The currency is backed by the faith and full credit in the system itself, which ensures that transactions are listed and grow at a rate that is virtually un-hackable.  

Blockchain runs via a timestamp server, where a chain (hash) of transactions is stored.  The principal is that, by allowing each coin to contain a list of transactions that are updated as new transactions are made, there is no need for a trusted third party. Each new transaction is appended to the chain, and once a link is added, it cannot be altered in any way. This makes it very difficult to corrupt a transaction.  

For the block validation to occur, blockchain currencies must be mined.  In some circumstances, where perfectly trustworthy actors are trusted, the currency does not have to be mined, but this is not the case for a currency like Bitcoin.  Bitcoin operates like an e-currency, but it is mined like gold.  The rationale for this is that there must be an incentive for a participant who has amassed a large CPU (Computer Processing Unit) power to follow the rules and use his CPU to mine more coin rather than steal back his previous transactions from the chain.  

Blockchain also advantages third-party actors by providing privacy.  While investment and commercial banks maintain privacy by limiting information to all parties and acting as stanchions of trust, blockchain uses public keys that are kept anonymous.  The public can see within the chain that a transaction occurred between two keys, but if these keys are kept anonymous and unlinked to the transaction actors within the chain, there is no need for a third party to withhold the information.  

Just because blockchain is secure and trustworthy does not indicate that it is stable.  In the past month, Bitcoin’s price has jumped 48.5 percent, a financial windfall for early adopters. In the past year, it has jolted upwards 775 percent, resulting in unprecedented ROI (return on investment).  However, in early November, Bitcoin’s price crashed completely, falling from $7,700 to around $5,600.  Other currencies exist as well.  Ethereum and Litecoin are a few popular ones, but with the constant price fluctuations, how can an institutional or private investor consider converting assets to these coins?  

The price of Bitcoin is determined by supply and demand. Because the number of coins is finite, limited and growing at an estimable and decreasing rate, demand must grow at the level of inflation to maintain a price.  Because demand for the coin has grown exponentially this year, the price of the coin has grown and can only fall with increasing supply via mining or a drop in demand.

While Bitcoin operates on economic principles, these economic principles will be its downfall if there is no widespread adoption.  Because there is a small number of users using each of the various cryptocurrencies, the market cannot price-in an equilibrium price on a small spread.  The currency value will fluctuate, rise and crash frequently because its demand is determined by the whims of a few with large concentrations of coin, rather than billions who demand more regularly.  Bitcoin apparently solves an agency problem, but the features of a good currency lie not only in a trust relationship between user and issuer but also in the storage of value.

Of course, the U.S. dollar is subject to fluctuations in storage of value via inflation or appreciation/depreciation in value as compared to other global currencies.  However, this inflation is steady, and the fluctuations in value occur on a spread that is significantly tighter than Bitcoin’s wide daily spread.  Additionally, there are constant opposition movements to Bitcoin’s adoption, primarily spearheaded by our current “trusted” third-parties.  For example, in March 2017, the Securities and Exchange Commission shot down a pitch by the Winklevoss twins (yes, of The Social Network fame) to create a Bitcoin ETF, citing primarily that Bitcoin did not satisfy a regulated markets requirement.  Ironically, the entire point of Bitcoin is that it is unregulated; any regulation would negate the trust benefits and add an agency problem to an agency-free cryptocurrency.  

Deregulation, a tenant of cryptocurrency, is also a factor in its price volatility.  Imagine the market for marijuana in a state or country where it is illegal to vend or use.  As compared to the total population, there are relatively few buyers and significantly less sellers, primarily due to the high punishment if one is caught engaging in such actions.  This market is, by definition, deregulated.  Additionally, it is understood that prices will be high per unit due to low supply.  However, the price is irrelevant here--it is the volatility that we are concerned with.  Volatility, in this case, is driven by a lack of information.  Johnny, looking to buy marijuana, potentially has one to two sellers he can contact, if he has any at all.  Johnny can take the lowest price he finds between the one to two sellers, or alternatively he may not buy at all until he can gain information that will enable him to buy at a better rate.   The market is not priced-in because there is not significant numbers of buyers and sellers, causing a liquidity problem, and there is an information premium, where those who have access to more buyers (more information) can obtain better rates.

Bitcoin suffers from this information problem.  Because there are so few buyers and sellers, all masked in anonymity, information about the stability of the currency on any given day is skewed towards those with access.  With scalability, this cryptocurrency volatility will decrease, but it is questionable if the currency will ever be able to scale.  It is in the interest of our trusted third party financial advisors and vendors to oppose the growth of Bitcoin, as it reduces the premium that they are paid for the trust relationship.  For now, blockchain currencies remain trustworthy in name, but not in reality, due to the inability of their small market to price-in a stable rate with low spreads.

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