Agency Problems and Economic Efficiency of Blockchain Systems

The invention of Bitcoin in 2008 marked the beginning of a new era in finance and economics. Bitcoin eliminated the need for trusted human institutions to operate the financial system. In this article, we will try to understand the nature and significance of this transition. We therefore strive to identify and illuminate the impact that blockchain technology may have on the future of society.

At the heart of the concept of money are those conflicting properties. In some ways, money must be easy and comfortable for everyone to use for many things—transferring, trading, converting to smaller units, storing, transporting, and keeping safe. In other ways, there must be some restrictions to prevent others from issuing money, or taking money away from others.

The contradiction between these two types of activities - one that is easy to perform, while the other is severely restricted - has resulted in the creation and maintenance of monetary systems being firmly in the hands of large entities with sufficient resources. Furthermore, efforts to ensure the security and validity of individual transactions are similarly performed only by specialized institutions (such as banks), to which we are all forced to place our trust, for lack of better options.

“The cost of operating a system that has humans executing it is inefficient and hinders the operation of the entire system.”

In the modern financial system, most tasks underlying monetary transactions must rely on the credibility of the people who perform them. People are notoriously unreliable when it comes to digital and mechanical tasks. Furthermore, when individuals find themselves in control of the flow of money, they tend to become corrupt. Morality aside, this is human nature and we must deal with these matters in the best possible way. Historically, this has meant adding additional layers of control structures, aimed at verifying the correctness of transactions and detecting corrupt behavior.

We hope that, in aggregate, the costs of these extra layers plus the costs of errors and residual corruption are manageable. Opinions diverge on this, and adding extra layers works differently in different places. However, one thing is clear: no matter what you do, these costs are significant. These costs create inefficiencies that hinder the functioning of the entire system.

Therefore, today's financial system can only function when it reaches a certain scale. There are two reasons for this. On the one hand, the costs of these inefficiencies can only be absorbed by a sufficiently large economy of scale. On the other hand, the resources required to run certain systems are only available to sovereign governments (such as law enforcement agencies and the military).

“This is a qualitative shift that rivals the most important innovations in human history.”

Blockchain offers an alternative to this scenario. In crypto finance, at least some tasks that have traditionally been performed by humans can now be delegated to a distributed network of computers that is highly reliable and largely independent of human reputation.

To understand this, let’s take a closer look at the difference between blockchain technology and traditional digital finance over the past three decades. Electronic banking is a major advancement in the financial industry, and it has also eliminated many of the tasks that were previously done by people. However, while electronic banking makes processes more efficient, it does not solve the agency problem, which is the key to the overall inefficiency of modern finance. Electronic banking relies on human credibility as much as paper finance does. It involves trusted actors at every level.

The trust we lend to those who perform modern financial transactions is twofold. On the one hand, we must trust these people to do the right thing. For example, programmers are trusted to develop software that functions correctly, back-office personnel are trusted to perform reconciliations, and traders and bank tellers are trusted to correctly input numbers into their systems. Of course, correctness is ensured through expensive additional layers of control and verification.

But we also have to trust that those involved won’t do the wrong thing. So once a particular system is in place, we have to trust that it won’t change in a material way without our knowledge. We trust those who move our money around for us not to take it for themselves. This requires layers of control, but more importantly, history shows that trust is broken far more often than we’d like.

“Blockchain completely solves the agency problem.”

This is the qualitative shift that blockchain systems bring. Unlike modern digital finance, if a blockchain functions correctly, it can ensure some well-understood parameters (for example, assuming that most nodes are honest), and no one can bypass the rules it is encoded in. Not network participants, not network developers, not users, not anyone.

In this sense, blockchain completely solves the agency problem. It simply does not require the control and verification layers that the previous financial system required. The resulting efficiency gains are huge and unbounded. Blockchain leaps forward orders of magnitude.

This shift has enabled innovation in two areas: accessible, customized finance and mini-economies.

The problem in custom finance is that traditionally, creating financial instruments with new properties has been the exclusive prerogative of large, deep-pocketed organizations that have the legal expertise and qualified operational talent. This is not due to over-regulation. The high cost of creating custom financial instruments is primarily due to the way these contracts and transactions are conducted - through people. Building a layer of human control to transact custom financial instruments is expensive and complex. As a result, most of us are limited to well-understood models and a small set of instrument types.

The mini-economy refers to the newfound ability to create tokens of value with very small market caps, as small as a few thousand dollars. The properties of such tools can be tailored to meet the needs of small businesses that do not need to reach the scale they previously needed to perform their functions. This is also made possible by the incredible efficiency improvements provided by blockchain. In addition, decentralized exchanges and other infrastructure components of the blockchain ecosystem make these tools secure and accessible to large communities of participants.

“This is a new wave of innovation on an unimaginable scale.”

Do you remember what happened when people invented the transistor and people were able to build small custom electronic devices, remember when people invented the microchip and people were able to build small custom personal computers, remember when people invented compilers and people were able to build small custom software systems? History tells us that when efficiency increases beyond a certain point, the potential for innovation becomes truly incredible.

What I’m describing here is the ability to create small, accessible, and customizable economic systems. This is a recipe for a new wave of innovation at an unimaginable scale. Economic transactions facilitate every aspect of our lives, every aspect of every business organization, including governance structures, supply chains, transportation networks, payments, and more. The key point of this article is not that bad actors will no longer have the ability to control our finances, as some people claim. It is that individuals and small organizations can experiment and innovate in this space through blockchain technology, which they could not do before.

I can’t predict how blockchain will change individuals and small organizations at this point. However, some cutting-edge business models are being explored as we speak. Social network Steemit rewards users with cryptocurrency for posting content as a means of attracting users to their social network. Data storage network Sia allows users to rent disk space from each other using a blockchain-based asset, for a fraction of the price DropBox charges for a similar service, but with absolute privacy. Public blockchains are entering every industry, from movies and digital content distribution to real estate and transportation networks.

“The huge efficiency gains that blockchain brings will free up resources, both financial and cognitive, that are needed to mitigate the risks it poses.”

In conclusion, I want to use the vantage point of efficiency to address a question that many people are asking about blockchain. The question is whether blockchain can be used for illegal purposes (classic examples are drug sales, assassination markets, and child pornography) and whether it poses a real danger to society. Although a complete answer to this question requires another article, readers can focus on the early days of the Internet, when the Internet also faced these problems. Today the answer is simple. We are always adapting to innovations and looking for ways to reduce risks. But the most important thing is that today the Internet is a law enforcement tool, not just a criminal tool.

The same is true for blockchain technology. The huge efficiency gains that blockchain brings will free up resources, both financial and cognitive, that are needed to mitigate the risks it brings. It is only a matter of time before the benefits of blockchain arrive, and we need to remain aware and realistic about the nature of the changes that are taking place.

Welcome to the future.