Economic principles of blockchain applications

Blockchain technology is widely believed to have a profound impact on human society due to its characteristics such as openness and immutability. This article further defines basic concepts such as transactions and trust to explain the economic principles of blockchain applications and provide theoretical support for the application of this cutting-edge technology in practice.

Transactions and transaction fees

The purpose of a transaction is to achieve a Pareto improvement in the utility of both parties by exchanging materials or rights under given constraints.

A complete transaction contains three basic elements: the entities involved in the transaction, the materials or rights used for exchange, and the time sequence of the transaction process.

Transaction costs refer to the sum of costs incurred by all participants in the entire transaction process, including the cost of finding and identifying the counterparty before the transaction, the cost of executing the transaction terms during the transaction, the taxes paid, and the possible costs of disputes arising from the counterparty's failure to perform its obligations normally.

In transaction costs, except for the two fixed components of execution costs and taxes, all other items are caused by the uncertainty of abnormal performance of the counterparty, and transaction costs are positively correlated with uncertainty. Williamson: Uncertainty in transactions is the main cause of transaction costs.

The main reasons why the counterparty fails to perform its obligations normally are:

1. At a certain point in the transaction, the two parties will enter a non-equivalent state (a time series characteristic of the transaction), which will give one party the motivation to perform abnormally;

2. Differences in subjective understanding of transaction terms, and in some cases, subjective judgment that the other party has not performed its obligations normally.

Trust and Credit

Credit refers to the possibility of a trading subject being subjectively determined by the counterparty to perform its obligations normally in a transaction. The better the credit, the lower the possibility of abnormal performance.

Trust refers to the behavior of one party willing to bear the uncertainty of the other party's abnormal performance in order to reach a transaction. Using pure market means (such as executing additional terms or some form of pre-emptive measures) to deal with the abnormal performance of the counterparty will incur transaction costs, and trust behavior can significantly reduce transaction costs in this situation.

A trust relationship refers to an event in which one party is willing to bear the uncertainty of the other party's abnormal performance of the contract for a certain uncertain event. Each trust relationship includes the trusted party (generally with good credit), the party that trusts the other party (willing to bear uncertainty in order to reach a transaction), and a specific uncertain event. The better the credit of the counterparty, the lower the uncertainty borne by the other party, and the lower the corresponding transaction costs.

Credit is cumulative. Credit is generally accumulated over many past transactions. The following figure shows the relationship between the degree of trust and the number of transactions (positive correlation), which is widely recognized in disciplines such as behavioral science and organizational science.

Transferability of credit. People judge the credit level of their counterparties based on past transaction experiences. When the information is nearly equal, people will also judge the credit level of their counterparties based on external information (the transaction experience of the counterparty with others) (transferability of credit). When using the Internet to engage in standardized business, transactions occur quickly and transaction information is efficiently transmitted, so it is very easy for transaction entities to accumulate credit.

Economic principles of blockchain applications

Trust relationships are widely present in business activities, especially in the financial system. Behind each set of trust relationships in a transaction, there is the existence of corresponding uncertainty and the saving of corresponding transaction costs.

Blockchain technology makes an absolutely trustworthy transaction information flow a reality. This enables the trust relationship between people in many transaction links to be transformed into trust between people and technology, reducing uncertainty to zero, and reorganizing the trust relationship in the entire transaction process, making it possible to reduce transaction costs overall.

In addition to improving efficiency overall, the application of blockchain technology in practice also needs to not bring significant negative impacts. At present, the application of blockchain has some unsatisfactory aspects in terms of transaction speed (7 transactions per second for Bitcoin), privacy, asset recoverability (Mt.Gox hacked), etc., and the stable operation of a business in a commercial organization, its related business forms will be matched accordingly, and the profit distribution mechanism will be determined accordingly. When applying blockchain, it is necessary not to bring significant negative impacts on the interests of decision makers who adopt or not the technology (for example, blockchain technology can solve the problem of vehicle management officials deleting violation records, but the operating space of the existing technology system is regarded by the decision-makers as implicit income for subordinates to improve the enthusiasm of the team, so blockchain technology is temporarily difficult to be adopted by them).

Generalization

In the transaction activities of traditional commercial organizations, all transaction information is subject to human manipulation when it is disseminated to the public (modification, addition, or deletion of certain transaction information), and no transaction information is absolutely credible to the public.

One of the revolutionary advances of blockchain technology is that it makes an absolutely reliable transaction information flow a reality, which has led to an absolutely reliable transaction information database, absolutely reliable asset ownership, absolutely reliable transaction executors (smart contracts), and so on.

There are common trust issues in general transactions, and blockchain has potential application space. Visible applications include fraud (resume fraud, bill fraud, financial fraud), notarization (property notarization, will notarization), seals (electronic signatures), administrators illegally modifying information (deleting credit blacklists, deleting vehicle violations, mutual insurance platform fraud), etc., and the blockchain's absolutely reliable transaction information flow can assist high-quality transaction entities to prove their credit level, such as stock traders' follow-up investment platforms and smart investment advisors' follow-up investment platforms.

As blockchain continues to produce absolutely reliable transaction information flows and other absolutely reliable information or behaviors derived from them, driven by rational behavior to reduce transaction costs, more and more trust relationships between people in transactions will shift to trust between people and technology, uncertainty will be greatly reduced, and business activities can be achieved at a lower cost. Since trust relationships are prevalent in business activities, the application space of blockchain may be very broad.

The author is Shu Guozhu, CEO of New Financial Frontier (a new financial voice live broadcast platform) and one of the first options traders in China.