Rock, Paper, Blockchain

Twelve years after the publication of the Bitcoin white-paper, a general confusion persists among creators eager to make use of the inventions introduced by its mysterious publisher. Therefore investors cannot be blamed for a general skepticism toward solutions labeled with the term “blockchain”. To understand the paradigm shift these networks introduce, scientific principles demand that its relevance for any commercial activity must be established from first principles.

Before the introduction of electronic computing, physical bearer instruments, such as cash or checks, and dominated in-person businesses’ undertakings. Financial data was recorded on paper and stored in folders and filing cabinets — usually kept by the owner at their place of business. Shortly after the invention of database technologies in the early 1960s, commercial activity and financial data began to be recorded in digital form.

Aside from the conveniences such software provided, data was still siloed, and access was only available to authorized personnel. Databases also introduced a new spectrum of error types, such as data duplication, human entry errors, and hardware malfunction. The thread vector to the information stored in databases increased exponentially with the exposure to networks, which ultimately for most systems included the internet at large.

Blockchain-based solutions enable record-keeping functions resembling those of physical paper; however, like the internet, public blockchains may generally be used by anybody and are permissionless; entries cannot be manipulated without the alteration being observed. And, like transactions with physical bearer instruments such as banknotes, blockchain transactions cannot be undone by the party initiating a transfer and are considered immutable.

While blockchain-based solutions will affect many areas of commercial activity, they will likely have the greatest impact on businesses and governments that maintain siloed data through legacy technologies and layers of middlemen controlling access to assets and information.

As many early blockchain-based innovations are centered around the evolution of money, investors must understand the state of money as a product, its functions, and its use cases. Financial professionals and technologists frequently default to a textbook definition of money that cites its functions as a medium of exchange, a unit of account, and a store of value. However, when the author published these requirements for money in 1875, he could not have known of 21st-century digital technologies (more here).

If William Jevons were alive today, he would observe that the vast majority of current money exists only as database entries. As such, the default medium of exchange has become bytes.

Unlike the commodity money of Jevons’ days, digital money can in principle move at the speed of light. However, banks and financial services providers today are employing database technologies and legacy networks to facilitate the two use cases of money: spending and lending.

Spending most often involves demand accounts, commonly referred to as checking accounts. If Bob wants to send Alice $100 from his checking account, he may instruct his bank to wire the funds to her account. His bank will update his ledger, and through correspondence with Alice’s bank, her ledger will be credited for the amount. Depending on the time and day the wire was initiated, the process might take hours or, in some cases, days. Blockchain-based solutions can accomplish the same in seconds, without fees or intermediaries.

Already more than 150 digital wallets currently support the use of cryptocurrencies. Many of these projects also allow the use of fiat money. However, fees to buy and sell digital assets make the use of these instruments for payment cost-prohibitive and largely impractical.

Furthermore, many startups in the realm of digital wallets are aspiring to comply with regulations aimed at financial services providers of the past. Aside from the costs for licenses borne by these companies, procedures such as know-your-customer questionnaires introduce friction to the onboarding of new users, increasing user acquisition costs. And, while a small number of merchants are willing to accept cryptocurrencies for payment of goods and services, investors should not expect the widespread adoption of new units of account.

This assessment is supported by using any digital wallets available today: The common feature of these solutions is a user interface that converts the value of cryptocurrencies to a fiat currency. Users in the U.S. will see the value of bitcoin in U.S. dollars, while users in Europe will see its value in euro, and Japanese users will see the translation of digital assets to their value in yen. This observation points to an important distinction. While the use cases of money are lending and spending, its function is that of “unit of account” or put simply: the language of value. As such, the widespread adoption of digital wallets for the purpose of payments is likely dependent on the issuance of compatible legal tender by central banks (more on the viability of Central Bank Digital Currencies here).

In developed countries, money’s use case of lending usually exceeds that of payments by a large margin. Today, lending functions are achieved via various forms of deposit accounts. Switching costs — in the form of bank-imposed fees — do not allow for instant and/or incremental exchanges between account types and their various custodians.

This has limited most lending opportunities to licensed institutions, such as banks. However, decentralized finance solutions — referred to as “DeFi” — do not require the involvement of a middleman, such as a financial service provider. The general open-source nature of DeFi systems and voluntary participation has led to an explosion of experiments, creating new blockchain-based lending systems on a weekly basis. Since the beginning of 2020, direct investments into DeFi systems have thus increased from less than $700 million to over $27.68 billion as of this writing, according to DeFi Pulse.

While decentralized finance technologies are still limited to digitally native assets and the early adopters of these systems, compatible government-issued blockchain-based currencies could open the space to a general audience, or even mass adoption. The United States, Europe, and China are all officially exploring the implementation of a blockchain-based currency (more here). With dozens of countries researching or planning their own central bank digital currencies, it is no longer a question of if fiat currencies will make use of blockchains but when.

Previously (shorter version) published on Forbes here.

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