Despite the technological innovations brought about by the Internet, most economic transactions require the presence of at least one central intermediary that usually controls the terms of trade.
Intermediaries are banks, insurance companies, and other economic agents who profit from the interface between service providers and end users to facilitate transactions. However, they do so at a cost and sometimes raises some fundamental concerns.
First, the presence of intermediaries can lead to market power that can be abused. Second, there is the potential for short-lived commitments and potential conflicts of interest. Finally, almost all existing intermediaries use opaque proprietary platforms that impede interoperability, thus creating “walled gardens.” For example, Apple tightly controls which phone apps can be installed on its operating system.
Blockchain technology is a relatively new development that promises to solve some of these structural problems. In a nutshell, a blockchain is a ledger on which transactions are organized and recorded, much like the way they are in an accounting ledger (Figure 1). Blockchain applications are being developed for many fields, including finance, supply chain management, gaming, digital identity, land titles, and art.
While the number of blockchain initiatives has increased steadily over the past decade, most of the activity measured by the number of transactions is concentrated in the largest blockchains such as Bitcoin and Ethereum. They have contracted moderately in recent months (Figure II).
In traditional intermediary and centralized ledgers, a single entity is responsible for approving, viewing, auditing, and deleting transactions. For example, if you don’t pay with cash, only your bank or credit card company can “edit” your account by approving every transaction you make. In blockchain, governance is decentralized. Users interact with each other through a protocol that anyone can use.
Because many people can edit the ledger, an economic mechanism is needed to guarantee that no one illegally changes its contents. Thus, a transaction is only recorded when enough delegates (called validators) agree that the transaction actually happened. To align the interests of validators with those of users, the network rewards validators in the form of tokens (often referred to as cryptocurrencies) that lose value if the integrity of the ledger is violated.
Initially, blockchain technology was primarily envisioned for digital payments — a “peer-to-peer electronic cash system,” in the words of Satoshi Nakamoto, inventor of the Bitcoin protocol. To support a digital payment system, a digital token (bitcoin) replaces traditional currency, assuming its value depends on people’s willingness to accept it as a medium of exchange. Since then, many more tokens have been created to serve as currencies on other blockchains.
An important feature is that, similar to physical coins, digital tokens can be directly controlled by their owners without the need for a centralized intermediary. This is possible because digital currencies have a unique unforgeable identifier, a public key, that can only be transferred by the currency’s rightful owner.
This type of peer-to-peer system differs from traditional electronic payment systems, which rely on traditional fiat currencies (such as the dollar, euro, and pound sterling) that are ultimately liabilities of the central bank that issued them. The traditional electronic payment system only connects financial institutions and merchants, but ultimately still requires net settlement at the central bank level.
“Smart contracts” execute transactions automatically
Most blockchains work seamlessly with smart contracts — programs that execute automatically when specified conditions are met. This is because they process digitally native transactions using digitally native currencies.
Smart contracts are the key to applying decentralization through the blockchain because they automatically follow predetermined rules. Imagine a bank that doesn’t make subjective judgments about whether someone should get a loan, but only lends if the borrower has sufficient collateral.
In the span of a few years, blockchain technology has evolved from Bitcoin to a new economic system, Web 3.0, in which decentralized applications use smart contracts to allow users to interact with each other and exchange value securely and anonymously without relying on centralization Intermediary platform.
A unique feature of blockchain is the high degree of transparency and decentralization of its infrastructure. All protocols are built through open-source collaboration among a decentralized network of developers.
No one owns or controls the protocols, which are governed and updated by all stakeholders through a consensus system. The code used by the protocol is public and can be viewed, audited and copied by anyone. Transactions are visible and can be monitored and verified by anyone.
LEGO packaging for financial transactions
Another important feature is the concept of composability – “Money Legos”, as it is metaphorically known. Thanks to the open-source nature of the protocol and its interoperability, multiple transactions can be stacked on top of each other – like Lego bricks – to create faster, cheaper and more convenient products.
For example, this composability could soon allow you to take out a home equity loan, convert dollars to euros, buy an apartment in Paris, hedge currency risk with futures, and donate any unspent funds to charity. The entire collection sequence will require only a few lines of code executed by a smart contract in a decentralized ledger owned by no one and jointly operated by individuals who are anonymous to each other.
meet new challenges
Blockchain still has many challenges. Finding consensus among a large network of users in a decentralized environment can be slow and expensive. The larger the network, the higher the operating costs.
As such, the main feature that makes blockchain attractive — its decentralized structure — could become a major obstacle to its wider adoption. Not coincidentally, most of the recent innovations are aimed at creating faster and more efficient protocols, improving their ability to scale applications.
The global scope of blockchain presents another challenge. By design, anyone in the world can access and participate in these peer-to-peer networks. At the same time, laws, regulations and practices vary widely across countries. In order to thrive, blockchain initiatives must find ways to create regulatory compliance mechanisms that differ from the traditional integration approaches employed by centralized businesses.
For example, there is no identity on the blockchain, each user is identified by a public/private key pair. This is a core feature of blockchain technology and does not mesh well with existing anti-money laundering practices. At the same time, blockchain technology is completely transparent and transactions can be traced. Bad actors can be identified and blocked from operating in most protocols and preventing their entry into the traditional financial system.
While the resources devoted to blockchain technology development have increased dramatically over the past few years, the ultimate success of the technology depends on whether and how blockchain protocols can interact with the current economic landscape.
about the author
Saleto is a senior research economist and advisor to the Research Department of the Federal Reserve Bank of Dallas.
The views expressed are those of the authors and should not be attributed to the Federal Reserve Bank of Dallas or the Federal Reserve System.