Despite the technological innovations brought by the Internet, most economic transactions require at least one central intermediary who often controls the terms of trade.
Intermediaries are banks, insurance companies, and other economic agents who take advantage of the interaction between service providers and end users to facilitate transactions. However, they do so at a cost while sometimes raising some basic concerns.
First, the presence of a middleman can lead to market power that can be abused. Secondly, there is the possibility of transient commitment and potential conflicts of interest. Finally, almost all existing brokers use opaque proprietary platforms that prevent interoperability, thus creating “walled gardens”. For example, Apple strictly controls what mobile applications can be installed on its operating system.
Blockchain technology, a relatively recent development, promises to address some of these structural issues. In simple terms, a blockchain is a ledger on which transactions are organized and recorded, in the same way they are in an accounting ledger (Chart 1). Blockchain applications are being developed for many endeavors, among them finance, supply chain management, gaming, digital identity, land titling, and the arts.
Although the number of blockchain initiatives has increased steadily over the past decade, most of the activity, measured by the number of transactions, is concentrated on the largest chains, such as Bitcoin and Ethereum. They have contracted moderately in recent months (Chart 2).
Eliminate the middleman
In a traditional centralized and intermediary ledger, a single entity is responsible for approving, viewing, reviewing, and deleting transactions. For example, if you don’t pay with cash, only your bank or credit card company can “modify” your account by approving every transaction you make. In the blockchain, governance is decentralized. Users interact with each other through a protocol that is available for anyone to use.
Since many people can edit the ledger, an economic mechanism is required to ensure that no one illegally changes its content. Thus, a transaction is only recorded if enough agents—called validators—agree that the transaction actually took place. In order to align the interests of validators with those of users, the network rewards validators in the form of a token (commonly referred to as cryptocurrency) that loses value if the integrity of the ledger is violated.
Initially, blockchain technology was mainly envisioned for digital payments – “a peer-to-peer electronic cash system” in the words of Satoshi Nakamoto, the inventor of the Bitcoin protocol. To support a digital payment system, a digital token (bitcoin) was created in place of a traditional currency, with the assumption that its value would depend on people’s willingness to accept it as a medium of exchange. Since then, many tokens have been created that act as currency for other blockchains.
An important advantage is that, similar to a physical coin, the owner can control a digital token directly without central mediation. This is possible because the digital currency has a unique, non-forgeable identifier, which is a public key, which can only be transferred to the rightful owner of the currency.
This type of peer-to-peer system differs from traditional electronic payment systems, which rely on traditional fiat currencies (dollars, euros and pounds, for example) that are ultimately the responsibility of the central bank issuing them. The traditional electronic payment system simply connects financial institutions and merchants but still ultimately requires net settlement at the central bank level.
Smart contracts automatically execute transactions
Most blockchains work seamlessly with smart contracts — programs that automatically execute when specific conditions are met. This is because they digitally process local transactions with the original currency.
Smart contracts are the key to decentralization through the blockchain because they automatically follow predefined rules. Imagine a bank that does not make a self-judgment about whether someone should take out a loan or not, but only lends money if the borrower has sufficient collateral.
Within a few years, blockchain technology has evolved from Bitcoin into 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 a central intermediary program.
The unique feature of the blockchain is the high level of transparency and decentralization of its infrastructure. All protocols are created through an open source collaboration between a decentralized network of developers.
Nobody owns or controls the protocols, which are managed and updated by all stakeholders through a consensus system. The code used by the protocols is public and available for anyone to see, audit, and copy. Transactions are visible for anyone to monitor and verify.
Legacy packaging for financial transactions
Another important feature is the concept of compoundability – “Money Legos” as it is known figuratively. Due to the open source and interoperable nature of the protocols, multiple transactions can be stacked on top of each other – like Lego pieces – to create faster, cheaper and more convenient products.
For example, this alignment may soon allow you to get a home loan, convert dollars into euros, buy an apartment in Paris, hedge currency risk with futures, and donate any unused money to charity. The entire assembly sequence would require only a few lines of code executed by smart contracts in a decentralized ledger that is owned by no one and is run collectively by individuals who are anonymous to each other.
Navigating new challenges
There are still a number of challenges with blockchain. Achieving consensus across a large network of users in a decentralized environment can be slow and expensive. The larger the network, the more expensive it is to operate.
Thus, the main feature that makes blockchain attractive – its decentralized structure – could become the main obstacle to its wider adoption. It is no coincidence that most of the recent innovations have been directed towards creating faster and more efficient protocols, increasing their potential to scale applications.
The global scope of the blockchain is another challenge. By design, anyone in the world can access and participate in peer-to-peer networks. At the same time, laws, regulations, and practices vary widely from state to state. To thrive, blockchain initiatives will have to find ways to create regulatory compliance mechanisms that differ from the traditional standardized approach taken by centralized companies.
For example, there is no identity on the blockchain, and each user is identified by public/private key pairs. This is a core feature of blockchain technology, and it doesn’t fit well with current anti-money laundering practices. At the same time, blockchain technology is completely transparent and transactions can be traced. Bad actors can be identified and prevented from operating under most protocols and from descending into the traditional financial system.
While the resources dedicated to the development of blockchain technology have increased dramatically in 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
Sareto Senior research economist and advisor in the Research Division of the Federal Reserve Bank of Dallas.
The opinions expressed are those of the authors and should not be attributed to the Federal Reserve Bank of Dallas or the Federal Reserve System.