Why Blockchain Matters

"Cryptocurrencies. Everything you don’t understand about money combined with everything you don’t understand about computers.” - John Oliver, Comedian (1977 to Present)

Bitcoin, and the underlying technology of blockchain, is a journalist’s dream. There are stories of down-on-their-luck people becoming millionaires overnight, former child actors talking of “tokenizing every asset in the world” and investors losing millions of dollars in cases of clear fraud. Throw in a dash of boxer Floyd Mayweather – apparently, he prefers to be called Floyd Crypto Mayweather now – and you have a never-ending pipeline of clickable stories to write.

Lost in this circus, however, is something much more important: Blockchain has the potential to fundamentally change how markets work, including energy, advertising, and finance. The implications for business, governments, individuals and investors are immense. That is the real story.

What is Blockchain?

Listening to people explain blockchain can be like overhearing a drunken conversation between Sphinxes in Ancient Greece: Each riddle posed seems to be answered by another riddle. This can make for good comedy (links: Seth Myers, John Oliver and Conan O’Brien) but a basic understanding of the technology is needed in order to ascertain its potential impact on markets.

There are three attributes of blockchain technology, working in tandem, that give it great potential:

1.    Ownership of many assets can be put into a secure, non-replicable, digital format

2.    Transactions can be done on a peer-to-peer basis, with no middleman needed

3.    Transactions are recorded in a secure, immutable public record

This might seem simple, but the implications are quite extraordinary as explained below. It begs two questions: How does it work? Why is it important?

For the first time, you can trust in owning and transacting assets digitally with no company or government sitting in the middle. Assets can be tangible, like money, but also intangible such as environmental attributes, contractual rights or even your attention (e.g., agreeing to see an advertisement). And, given the transaction is digital, these assets can also be programmed to automatically transfer once certain pre-agreed conditions are met.

The implication? All sorts of previously impossible transactions are now possible. This holds the potential to create different forms of market collaboration, incentives and cause-and-effect relationships. As explained later, this has the potential to change how many markets work.[1]

Digitizing the ownership of an asset such as money always faced the so-called double-spend problem: How do you prevent someone from reproducing this asset over and over?[2] Most of us, after all, would be tempted to simply copy-and-paste $100 bills all day long if it were possible.

Blockchain solves this conundrum in a very creative way. At its core, it is a “ledger of provable signed, sequentially linked, and cryptographically secured transactions that’s replicated across a network of computer nodes, with ongoing updates determined by a software-driven consensus”.[3]

Huh? Another way to think about it: What you own is a unique, private, digital key (think of a series of random numbers and letters known only to you) that a universally accepted, online, ledger (imagine a big spreadsheet online that anyone can see) recognizes as the true owner of an asset. This key also allows you to send the right to the asset securely to another person, who the ledger then recognizes as the owner, if you so choose. Importantly, this online ledger is not maintained by one company or government entity but rather by a host of independent computers in real-time. The ultimate ledger recognized as true is the one that most of these computer nodes have agreed upon given the rules of the blockchain computer code. You are putting your faith in the mathematics and incentives of the blockchain code to consistently maintain one version of the truth that is accurate and secure.

So, just how good is blockchain technology at getting independent computer nodes to confirm one version of the truth in a secure manner? Here’s one way to look at it. Bitcoin, whose system is based on blockchain technology, has not been hacked even though doing so would present someone with a multi-billion-dollar prize. It is important to note that most of what is read in the press are hacks of Bitcoin-related services, such as exchanges, and not hacks of the bitcoin blockchain itself.[4] This highlights the structural benefit of decentralizing the data versus keeping it centralized with groups like Uber or Equifax, both of which had their (our!) private data stolen.

Given the different lingo and concepts of owning an asset, it can be easy to feel lost. Just imagine a giant online database that thousands of independent computers have confirmed as true. Based on experience, the best way to really understand it is to buy some cryptocurrency on your own. When you see recognition of ownership on the blockchain, it can begin to become more real.

Remember that Bitcoin is simply one application of blockchain technology out of many. While a more detailed discussion is beyond the scope of this newsletter, here are some helpful sources for those that want to learn more:

•  Bitcoin (cash using blockchain) and Ethereum (smart contracts using blockchain) white papers
• Good visual illustration on Blockchain – click on link
• View the blockchain: Such as Block Explorer for Bitcoin or Etherscan for Ethereum
• Beyond the Bitcoin Bubble, The New York Times, January 2018
• The Truth Machine: The Blockchain and the Future of Everything, by Casey and Vigna (2018)

Six Main Areas of Criticism – And Why Most Do Not Pose a Long-term Risk

Blockchain is not without its critics. For example, the stratospheric rise in the price of various cryptocurrencies in 2017 have led some to call it an over-hyped bubble. Others cite limited real business cases of scale, technical problems, fraud, legal issues and unintended consequences. Many of these are real short-term risks that are, quite frankly, to be expected with big technological changes. However, they are unlikely to impede blockchain’s impact on markets long-term. Why? The core innovation is sound and, given the critical mass of developers, governments and business people working on it, many of these issues will be resolved. For example, see Vitalik Buterin (founder of the smart contract blockchain, Ethereum) discuss advances on some of the technical issues (link here).

Blockchain’s Real Potential Lies in Changing How Markets Work

Markets are a complex weave of interdependent forces: companies seeking profits, individuals buying goods and services, government policy incenting certain behaviors and restricting others, fluctuating commodity prices and changing technologies to name just a few. The resulting incentives and cause-and-effect dynamics drive the financial and non-financial outcomes many of us care about, such as economic growth and pollution levels.

Unfortunately, when outcomes are not as good as desired, responses tend to myopically focus on single-point solutions aimed at directly influencing the outcome. If we want less pollution, let’s generate more clean energy. If we want more job creation, let’s cut taxes on domestic businesses. These are not necessarily bad but if the underlying market drivers do not change, or new problems are created, outcomes are unlikely to change. They may even get worse.

Consider climate change. There have been huge gains in solar, wind and energy efficiency in the past two decades. And dirty fossil fuels, such as coal, have lost share to cleaner natural gas. With so many positive things going on, it might be surprising to see carbon dioxide levels rising unabated. Something about the structure of global markets is pushing in another direction. Importantly, if that something does not change, why will future outcomes be better than today?[5] Mother Nature cares only about one outcome, the amount of carbon dioxide (CO2) in the atmosphere. That data, as shown below, is going in the wrong direction. 

Another way to think about it: If a patient is consistently sick, a bad doctor will focus on the symptom (i.e., the outcome), perhaps giving the patient a tissue. A good doctor will focus on the driver of the symptom, maybe recommending changes to diet or lifestyle. Many markets are sick – or at a minimum have a nagging runny nose – which is limiting their true potential to generate better financial and social outcomes. Handing out tissues is not getting the job done.

To be clear, changing the market drivers related to economic growth, pollution, income inequality or healthcare is hard. For example, you can advocate for changed policy or regulation, attempt to influence public perception, pressure shareholders or invest in new technology. While these efforts can be helpful, they often create too little, too late. Blockchain presents a new tool that can fundamentally change how transactions – the lifeblood of markets – work. In doing so, it has the potential to change the underlying drivers of market outcomes.

Examples of Some Possible Market-Changing Blockchain Applications

Creative minds have just begun to think through how blockchain might be applied to certain markets, changing incentives, behavior and, potentially, market outcomes. Some examples:

* Electricity Microgrids: The electricity industry has operated on a centralized business model for over 100 years. For example, many utilities receive coal from hundreds of miles away, burn it all in one spot to produce electricity and then transmit it many miles to the final user. The result is a costly and inefficient system where only a small percentage of the power produced gets used by the end user. The rest is inefficiently lost.

The TransActive Grid is a Brooklyn-based project that is using blockchain technology to create electricity microgrids, a different business model that generates power right where it is used. Homes put solar on their roofs and connect with each other in a local grid. Each day certain homes will be faced with an over- or undersupply of electricity depending on what they produce and use. The TransActive Grid uses blockchain technology to sit in the middle of the homeowners, helping to handle these transfers of power from one home to another with limited human interaction. This is a different, potentially much more efficient, decentralized business model versus the centralized utility model that currently exists.

* Ride Sharing: Uber and Lyft are the dominant ride-sharing companies in many parts of the world. The model is simple: they play a middleman role between drivers and passengers. For their efforts, they take a large fee of 20% to 25% (on every ride in Uber’s case). Given the fees and network effects, it is a tremendous business.

However, blockchain presents the potential for drivers and passengers to interact directly, with no middleman. The reduction in fees could be a win/win for the passenger and the driver with an added benefit that one company will not control our personal data and knowledge of our whereabouts. Companies are pushing forward: Arcade City, Rentberry and Stayawhile are focused on Uber and Airbnb-like applications using blockchain.

* Online Advertising: Most of us give away our personal data and attention for free to companies like Google and Facebook. They sell this freely acquired asset to advertisers and, by doing so, have become some of the most valuable companies in the world. These data monopolies, in addition to monetizing our data, also present risks when they are hacked or used for nefarious purposes. Why do we give this data away for free?

Brave, a company started by the creator of Javascript and the web browser Mozilla, is aiming to change this market dynamic. Participants use a special browser that blocks all advertising. If desired, people can opt-in to see advertising and then get to earn BAT tokens (Basic Attention Token). Advertisers can spend money to buy BAT tokens and then deliver their ads to the group that opted-in. The result is a very different type of market than exists today, where people earn something of value in return for giving advertisers their attention.

The ultimate success of any of these ideas is far from clear. They all might fail, but that is not the point. Each is using blockchain to change the way an industry currently works. As people with specific industry expertise collaborate with technical blockchain experts, more ideas will take hold in the future.

Thoughts on the Future

My positive view on the potential for blockchain to drive disruptive change is based on the following. First, blockchain technology allows for all sorts of creative transactions to take place in ways previously not possible. This simple concept holds incredible potential. Second, the many valid near-term critiques of the technology are likely to be less concerning as the industry matures. Finally, while there are countless nonsensical applications, or even outright fraud, there are many others that hold transformative promise. More importantly, imaginative minds are likely to find new, more innovative, applications in the future.

While blockchain has the potential to be pervasive in many areas of society over the long-term, the business and investment community should be on the lookout for change in the following, by no means all-inclusive, areas:

• Industry Dynamics: Many industries may face new risks or opportunities. For example, companies that play a middleman role may find new competitive threats. Others might find that certain blockchain-based applications can help in managing their core business better (e.g., prediction market blockchain applications might help the insurance industry).
• Financing Methods: New methods of financing, beyond issuing debt or equity, are now possible. Existing companies may realize benefits of financing certain assets in a different way or monetizing different assets not before considered. Other companies that have potential but struggle to get financed through traditional means may find unique structures that work better.
• Investment Allocations: Nearly all investors seek a quality, risk-adjusted financial return that is ideally not correlated to other asset classes. Over time, some cryptocurrencies have potential to provide such benefits. For so-called impact investors (those that desire to have their capital provide both a financial and social return) there will likely be investments in the future that present a unique opportunity to meet both goals.

No one knows with certainty just how pervasive, or not, blockchain may become. We do know, however, that countless applications are being developed right now by people all over the world. The most impactful may be those yet-to-be-developed ones focused on the biggest issues of our day, including climate change, income inequality and better healthcare. These systemic issues have stumped traditional efforts at improvement for a long time. However, now there is a new tool – blockchain – coming to the fore. Creative minds may develop applications that fundamentally change how markets work, improving future outcomes in ways we have yet to envision today.

Now, that would be quite a story for a journalist to write. 

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[1] These are benefits to permission-less blockchain systems; there are other variations not discussed here

[2] See Satoshi Nakamoto’s original white paper, Bitcoin: A Peer-to-Peer Electronic Cash System.

[3] The Truth Machine: The Blockchain and the Future of Everything, Michael Casey and Paul Vigna, March 2018.

[4] See link here for Coinbase’s commentary.

[5] Problematic market drivers include a lack of global governance and the general mispricing of energy. See my book, Decoding the Energy Enigma: Improved Decision Making on This Generation’s Most Pressing Issue, as well as the newsletter entitled, “An Unfortunate Reality: We will Not Stop Global Warming,” January 2017