Maybe the most poorly understood feature of blockchain technology is the role of the cryptocurrencies that power them — and as a result, how to fit cryptocurrencies into existing regulatory goals. The most challenging thing about this is that each blockchain protocol is different, meaning that regulators may regulate with one blockchain in mind, not recognizing the consequences for innovation outside of that paradigm. The goal of this post is very simple: to explain why cryptocurrencies are an essential part of how blockchains work — and hence why we should care about fostering a policy and business environment that allows this kind of innovation to flourish.
The basic function of a blockchain is to keep accurate and reliable records without having a single, trusted intermediary manage the recordkeeping. The simplest example of the traditional model is a bank. A bank is a centralized party that, among other things, keeps track of how much money people who use that bank have. A blockchain replaces the bank with an algorithm and a network of participants who provide the resources necessary to power the algorithm. It thus replaces one party, a bank, with an entire network of participants, hence the jargon-y term, “distributed ledger.” Even putting aside how exactly this works, we have to concede: it’s a little bit odd to think that “everyone” doing the recordkeeping is more efficient than one reasonably reliable party doing the recordkeeping. But for a surprising and growing number of use cases, it can not only be more efficient, but much more secure.
To understand why, we have to understand the cost structure and the incentive structure of the traditional model— and then contrast that with the cost and incentive structure of blockchains.
The Traditional Model
In the traditional model, much of economic activity relies on the concept of a “firm” — e.g., a partnership, LLC, or corporation. These firms often have overhead. They need to hire people to build products, market them, ensure compliance, provide HR services, and to manage the firm’s work. As a result, the success of these firms often depend on people. This can all be costly but the idea is that the sum of their work will produce enough revenue to pay for itself, and will ideally produce a reasonable return for whoever is providing the capital.
The “mechanism” for ensuring these people do good work, whether it’s marketing or accurate recordkeeping, is the principal-agent relationship (i.e., management). The firm hires agents (employees) and uses management tools to achieve its goals — e.g., structuring compensation to provide good incentives, creating good processes and oversight, etc. These are inherently “closed” environments, meaning that only the people on the “inside’’ fully appreciate how everything works. Thus generally only people on the inside can study and fix any issues. In a firm, enormously consequential decisions can come down to the judgment of a few managers, or even the ability of an IT person to spot and troubleshoot problems. Any failures can lead to outsized, almost unbelievable costs, like the time Citibank lost $900 million because of human error in inputting data into back office software.
We take the structure of these firms and their existence for granted now, but it wasn’t always so obvious. Ronald Coase won a Nobel Prize in Economics in part for his 1937 article, “The Nature of the Firm,” where he explained that these firms were increasingly emerging because they have certain efficiencies and are better equipped to deal with the transaction costs of doing business (vs. individuals contracting at will). That idea, once Nobel-worthy, has become intuitive and obvious, as much of our economic activity is now conducted through firms of one sort or another.
Enter Blockchains
Some have suggested that blockchains and cryptocurrencies merely benefit from regulatory arbitrage — i.e., their advantage is they avoid “overhead” that relates to regulatory compliance. The implication of this is that there is no novelty other than avoiding regulations. The regulatory status of cryptocurrencies can and should be debated, but it’s important to understand — as part of that debate — that the primary benefits of cryptocurrencies have nothing to do with regulatory designation. This is like thinking about the benefits of driverless cars in terms of what automobile regulations they may or may not be subject to. It’s a factor, and something that needs to be figured out, but it’s not the point. Like driverless cars, the benefits of blockchain come from automation, and in the case of blockchain, it’s worthwhile to delve into how and what they automate.
Blockchains automate at least parts of what firms do, and promise to automate much more. But they don’t just automate; otherwise the role of blockchains would be a lot like how firms use software for other things like billing or HR or UI/UX. Blockchains — wherever they are used — import a totally different cost and incentive structure.
To understand this, you have to understand that generally speaking a blockchain has three component parts: (1) an algorithm that uses resources like processing power to verify certain facts; (2) a network, generally one that is “open” to anyone; (3) incentives that are built into the algorithm’s code, and that encourage people to join that network and provide the algorithm with the resources it needs. Thus, whereas firms rely on their own internal managers and employees, blockchains rely on code — both to execute functions and to drive network effects.
This is not to say that blockchains don’t rely on people. They do. The blockchain’s code depends on its network — i.e., the people who use it — to actually provide the resources that are necessary to power that blockchain, like computing or processing power. They also need people for the human capital necessary to update and maintain the blockchain’s protocol (e.g., catch security issues). These all require resources — time, computing power, and so on. So the question is, why would anyone volunteer these resources? Like a firm, the only way a blockchain can incentivize people to do this is to “pay” them. But a protocol doesn’t have a balance sheet, much less money, so how can it pay anyone? From what resources?
Enter Cryptocurrencies
The answer, as you may know by now, is that the protocols are programmed to reward participants with their own native currency, called a cryptocurrency because the underlying code uses cryptography. In other words, if the protocol requires people to provide processing power, it pays anyone willing to do so with its own native “coin.”
The first and most obvious follow-up question is, why would anyone want some newly generated “cryptocurrency”? It sounds like Monopoly money. But it’s not — or at least, not necessarily. Here’s why. First of all, the algorithm that produces the coins and allows them to be transferred is designed to prevent counterfeit money. This goal — preventing counterfeit money or double-spend as it’s sometimes called — had long eluded computer scientists who were trying to create “digital cash,” until, of course, it was solved by Bitcoin’s algorithm. Now, any blockchain can use Bitcoin’s algorithm (or similar principles) to also prevent counterfeit money. But even if the money can’t be counterfeited, a basic question still remains: why does it have any value?
The answer is simple. The algorithm behind something like Bitcoin (and many of the blockchains you hear about) was designed so that in the future, if you want to transact (buy/sell/transfer or otherwise participate), you have to pay a small transaction cost using that very same cryptocurrency. This is important because generally speaking, the price or value of anything is at the intersection of supply and demand, so this tiny little feature — using the native currency for transaction costs — means the demand for this cryptocurrency is greater than zero, so long as people want to use the underlying protocol. By extension, the actual price of the cryptocurrency is a function of how many people will need to use its functionality and will thus need to pay the appropriate transaction cost. The most obvious implication of this is that blockchains have enormous network effects — i.e., they become more valuable as more people use them, because the demand for the coin goes up as more people need the coin in order to pay the necessary transaction fees. In a way, it resembles how a government might create demand for its local currency by requiring tourists to use that currency to transact locally, or by requiring that all taxes be paid in the local currency.
Thus, the “cryptocurrency” itself is a crucial part of how a blockchain can replace the principal-agent relationship of a firm with an “open network,” in which participants in the network are properly incentivized to power the blockchain’s protocol. In Bitcoin, this means providing computing power to make sure transactions are valid and thus creating a viable digital alternative to gold. But in other blockchains, this could mean providing computational power to accomplish other tasks — e.g., execute smart contracts or confirm certain needed verifications (e.g., verifying ID, credit scores, title to real estate, etc).
It’s worth emphasizing the implications of changing the incentive structure from a firm model to a blockchain model. For example, in the firm model, the firm will seek to acquire customers insofar as doing so generates profits. It accomplishes this through direct or indirect marketing and through things like offering referral bonuses. Blockchains like Bitcoin are not built to hire marketing teams in that sense, but they have their own mechanism for acquiring new customers. Every single person who owns a Bitcoin (or whatever cryptocurrency they happen to have) has an incentive to explain to others why that protocol and thus its native cryptocurrency are valuable.
On the plus side, this is the ultimate referral bonus, and it creates an incentive for people to share information about products. On the con side, this incentive turns a lot of cryptocurrency holders into marketers — and certain levels or kinds of marketing can be annoying (“shilling” has become the term of art), and not particularly helpful, like when the only thing people are sharing is predictions and hopes about price movements. By its nature this injects into the price of the cryptocurrency an element of speculation about how many people will use it in the future, just as one may buy barrels of oil not to use the oil, but on the theory that more people will need oil down the road. This is why much of the engineering and design brilliance of blockchains — which solved Nobel-Prize level problems that had been vexing computer scientists for decades — have been both promulgated by members of the Bitcoin community (rather than a marketing team), and obscured by the loud noises of self-promoters and get-rich-quick hopes.
More importantly, this same mechanism, the self-interest of all holders, makes it more likely that holders of the cryptocurrency will form a community that tends to the needs of the protocol — not just marketing but also things like catching bugs or discussing how and when to improve the protocol’s performance or its security. These actors don’t need altruistic motivations; they are often involved because of self-interest (and perhaps just interest). A bug can kill the value of an asset they hold or a functionality they find important; by extension, improvements can improve the value of something they own or care about. This is extremely powerful, particularly in a world where protocols can have hundreds of thousands if not millions of users, putting together their brain and processing and marketing power.
As a side note, once we see cryptocurrencies this way, it becomes obvious why there is also a political valence — or at least the temptation to draw political analogies — when it comes to blockchain technology. It is substituting “one” or a few trusted — but not always trustworthy — intermediaries with the broader, messier democracy of having a community rule itself. And because it is also a way of organizing human effort to achieve things without necessarily using incentives of the typical “firm” (i.e., paying managers to get returns on capital), it is a competitor to the modern corporation which has reigned dominant for over 100 years. There are of course limits to any of these comparisons, but my only point here is to note that the surface level appeal is fairly obvious.
In sum: (1) Bitcoin is a breakthrough that will enable incredible amounts of innovation as developers think of more and more ways to use its underlying blockchain technology, and for more varied things than just digital money; (2) an integral, indeed fundamental part of how blockchain technology works is through use of native cryptocurrencies; (3) blockchains leverage open source networks so that community members have incentives through cryptocurrencies to do the work that centralized intermediaries used to do, and to feel invested in the success of the protocols; this harnesses an incredible amount of energy and can for some uses lead to much stronger and more secure protocols and functionality than those offered by centralized intermediaries.
At the same time, regulators have a variety of legitimate and important concerns, ranging from consumer protection to money laundering to deterring ransomware, that are implicated by these cryptocurrencies. It is beyond the purview of this piece to discuss each of those concerns in detail, but I do want to note that they exist and they are important. In some contexts, they have been so frustrating that prominent officials and media outlets have gone as far as suggesting that we ban cryptocurrencies. The main point of this piece is to point out that there is a baby in the bathwater, and it’s not just a potentially transformative technology — it’s a potentially transformative way of organizing human beings. And like the printing press, radio, phone, computer, and internet, it is part of a trend of using technology to connect more and more dots and more and more people.
