MIT Technol

T logy Re
eview

Connectivity

In blo
ockcchaiin w
we ttrusst
To undderstand why
w block kchain matters, loook past thhe wild sppeculationn at
what iss being bu
uilt underrneath, arrgue the aauthors off The Agee of
Crypto
ocurrencyy and its newly
n pub blished foollow-up, The Trutth Machinne:
The Bllockchain and the Future
F off Everythiing.
 by Michael
M J. Casey and
d Paul Viggna
 Apriil 9, 2018

The dott-com bubble of the 1990s is

popularrly viewed d as a perio
od of crazy y
excess that
t ended d with hund dreds of
billionss of dollarss of wealth
h being
destroyyed. What’s less often discusseed
is how all the cheeap capitall of the
boom years
y helpeed fund thee
infrastruucture upoon which the
t most
importaant interneet innovatio ons would d
be builtt after the bubble
b burrst. It paid
d
for the rollout
r of fiber-opticc cable,
R&D in n 3G networks, and the t buildo out
of giantt server farrms. All of this wou uld
make possible thee technolo ogies that
are noww the bedro ock of the world’s
most po owerful co ompanies: algorithmic search, social meddia, mobille computiing,
cloud seervices, biig-data anaalytics, AII, and moree.
We think something similar is happening behind the wild volatility and
stratospheric hype of the cryptocurrency and blockchain boom. The blockchain
skeptics have crowed gleefully as crypto-token prices have tumbled from last
year’s dizzying highs, but they make the same mistake as the crypto fanboys
they mock: they conflate price with inherent value. We can’t yet predict what
the blue-chip industries built on blockchain technology will be, but we are
confident that they will exist, because the technology itself is all about creating
one priceless asset: trust.

To understand why, we need to go back to the 14th century.

That was when Italian merchants and bankers began using the double-entry
bookkeeping method. This method, made possible by the adoption of Arabic
numerals, gave merchants a more reliable record-keeping tool, and it let bankers
assume a powerful new role as middlemen in the international payments system.
Yet it wasn’t just the tool itself that made way for modern finance. It was how it
was inserted into the culture of the day.

In 1494 Luca Pacioli, a Franciscan friar and mathematician, codified their

practices by publishing a manual on math and accounting that presented double-
entry bookkeeping not only as a way to track accounts but as a moral obligation.
The way Pacioli described it, for everything of value that merchants or bankers
took in, they had to give something back. Hence the use of offsetting entries to
record separate, balancing values—a debit matched with a credit, an asset with a
liability.
SELMAN DESIGN
Pacioli’’s morally upright acccounting bestowed a form off religious benedictioon
on thesee previoussly disparaaged professions. Ovver the nexxt several ccenturies,
clean boooks camee to be reggarded as a sign of hoonesty andd piety, cleearing bannkers
to become paymeent intermeediaries an nd speedinng up the ccirculation of moneyy.
That funded the Renaissanc
R ce and pav
ved the waay for the ccapitalist eexplosion tthat
would change
c thee world.

Yet the system was

w not imp pervious too fraud. Baankers andd other financial actoors
often brreached th
heir moral duty to keeep honest books, annd they stilll do—justt ask
Bernie Madoff’s clients or Enron’s shareholders. Moreover, even when they are
honest, their honesty comes at a price. We’ve allowed centralized trust
managers such as banks, stock exchanges, and other financial middlemen to
become indispensable, and this has turned them from intermediaries into
gatekeepers. They charge fees and restrict access, creating friction, curtailing
innovation, and strengthening their market dominance.

The real promise of blockchain technology, then, is not that it could make you a
billionaire overnight or give you a way to shield your financial activities from
nosy governments. It’s that it could drastically reduce the cost of trust by means
of a radical, decentralized approach to accounting—and, by extension, create a
new way to structure economic organizations.

The need for trust and middlemen allows

behemoths such as Google, Facebook, and
Amazon to turn economies of scale and
network effects into de facto monopolies.

A new form of bookkeeping might seem like a dull accomplishment. Yet for
thousands of years, going back to Hammurabi’s Babylon, ledgers have been the
bedrock of civilization. That’s because the exchanges of value on which society
is founded require us to trust each other’s claims about what we own, what
we’re owed, and what we owe. To achieve that trust, we need a common system
for keeping track of our transactions, a system that gives definition and order to
society itself. How else would we know that Jeff Bezos is the world’s richest
human being, that the GDP of Argentina is $620 billion, that 71 percent of the
world’s population lives on less than $10 a day, or that Apple’s shares are
trading at a particular multiple of the company’s earnings per share?

A blockchain (though the term is bandied about loosely, and often misapplied to
things that are not really blockchains) is an electronic ledger—a list of
transactions. Those transactions can in principle represent almost anything.
They could be actual exchanges of money, as they are on the blockchains that
underlie cryptocurrencies like Bitcoin. They could mark exchanges of other
assets, such as digital stock certificates. They could represent instructions, such
as orders to buy or sell a stock. They could include so-called smart contracts,
which are computerized instructions to do something (e.g., buy a stock) if
something else is true (the price of the stock has dropped below $10).

What makes a blockchain a special kind of ledger is that instead of being

managed by a single centralized institution, such as a bank or government
agency, it is stored in multiple copies on multiple independent computers within
a decentralized network. No single entity controls the ledger. Any of the
computers on the network can make a change to the ledger, but only by
following rules dictated by a “consensus protocol,” a mathematical algorithm
that requires a majority of the other computers on the network to agree with the
change.

Once a consensus generated by that algorithm has been achieved, all the
computers on the network update their copies of the ledger simultaneously. If
any of them tries to add an entry to the ledger without this consensus, or to
change an entry retroactively, the rest of the network automatically rejects the
entry as invalid.

Typically, transactions are bundled together into blocks of a certain size that are
chained together (hence “blockchain”) by cryptographic locks, themselves a
product of the consensus algorithm. This produces an immutable, shared record
of the “truth,” one that—if things have been set up right—cannot be tampered
with.

Within this general framework are many variations. There are different kinds of
consensus protocols, for example, and often disagreements over which kind is
most secure. There are public, “permissionless” blockchain ledgers, to which in
principle anyone can hitch a computer and become part of the network; these
are what Bitcoin and most other cryptocurrencies belong to. There are also
private, “permissioned” ledger systems that incorporate no digital currency.
These might be used by a group of organizations that need a common record-
keeping system but are independent of one another and perhaps don’t entirely
trust one another—a manufacturer and its suppliers, for example.

The common thread between all of them is that mathematical rules and
impregnable cryptography, rather than trust in fallible humans or institutions,
are what guarantee the integrity of the ledger. It’s a version of what the
cryptographer Ian Grigg described as “triple-entry bookkeeping”: one entry on
the debit side, another for the credit, and a third into an immutable, undisputed,
shared ledger.

The benefits of this decentralized model emerge when weighed against the
current economic system’s cost of trust. Consider this: In 2007, Lehman
Brothers reported record profits and revenue, all endorsed by its auditor, Ernst
& Young. Nine months later, a nosedive in those same assets rendered the 158-
year-old business bankrupt, triggering the biggest financial crisis in 80 years.
Clearly, the valuations cited in the preceding years’ books were way off. And
we later learned that Lehman’s ledger wasn’t the only one with dubious data.
Banks in the US and Europe paid out hundreds of billions of dollars in fines and
settlements to cover losses caused by inflated balance sheets. It was a powerful
reminder of the high price we often pay for trusting centralized entities’
internally devised numbers.
 SELMA
AN DESIGN
The crissis was ann extreme example
e of the cost of trust. B
But we alsoo find that cost
ingraineed in mostt other areaas of the economy.
e T
Think of aall the accoountants
whose cubicles
c fiill the skysscrapers off the worldd. Their joobs, reconcciling theirr
compan ny’s ledgerrs with tho ose of its business
b coounterpartts, exist beecause neitther
party trrusts the otther’s recoord. It is a time-conssuming, exxpensive, yyet necessaary
processs.

Other manifestati
m ions of thee cost of tru
ust are feltt not in whhat we do but in whaat
we can’’t do. Two o billion peeople are denied
d bannk accountts, which llocks themm out
of the global
g econ
nomy becaause bankss don’t truust the recoords of theeir assets annd
identitiees. Meanwwhile, the internet
i off things, whhich it’s hhoped will have billioons
of interracting autonomous devices
d fo
orging new w efficiencies, won’t be possibble if
gadget--to-gadget microtran nsactions reequire the prohibitivvely expennsive
intermediation of centrally controlled ledgers. There are many other examples
of how this problem limits innovation.

These costs are rarely acknowledged or analyzed by the economics profession,

perhaps because practices such as account reconciliation are assumed to be an
integral, unavoidable feature of business (much as pre-internet businesses
assumed they had no option but to pay large postal expenses to mail out
monthly bills). Might this blind spot explain why some prominent economists
are quick to dismiss blockchain technology? Many say they can’t see the
justification for its costs. Yet their analyses typically don’t weigh those costs
against the far-reaching societal cost of trust that the new models seek to
overcome.

More and more people get it, however. Since Bitcoin’s low-key release in
January 2009, the ranks of its advocates have swelled from libertarian-minded
radicals to include former Wall Street professionals, Silicon Valley tech
mavens, and development and aid experts from bodies such as the World Bank.
Many see the technology’s rise as a vital new phase in the internet economy—
one that is, arguably, even more transformative than the first. Whereas the first
wave of online disruption saw brick-and-mortar businesses displaced by leaner
digital intermediaries, this movement challenges the whole idea of for-profit
middlemen altogether.

The need for trust, the cost of it, and the dependence on middlemen to provide it
is one reason why behemoths such as Google, Facebook, and Amazon turn
economies of scale and network-effect advantages into de facto monopolies.
These giants are, in effect, centralized ledger keepers, building vast records of
“transactions” in what is, arguably, the most important “currency” in the world:
our digital data. In controlling those records, they control us.

The potential promise of overturning this entrenched, centralized system is an

important factor behind the gold-rush-like scene in the crypto-token market,
with its soaring yet volatile prices. No doubt many—perhaps most—investors
are merely hoping to get rich quick and give little thought to why the technology
matters. But manias like this, as irrational as they become, don’t spring out of
nowhere. As with the arrival of past transformative platform technologies—
railroads, for example, or electricity—rampant speculation is almost inevitable.
That’s because when a big new idea comes along, investors have no framework
for estimating how much value it will create or destroy, or for deciding which
enterprises will win or lose.

Although there are still major obstacles to overcome before blockchains can
fulfill the promise of a more robust system for recording and storing objective
truth, these concepts are already being tested in the field.

Freely accessible open-source code is the

foundation upon which the decentralized
economy of the future will be built.

Companies such as IBM and Foxconn are exploiting the idea of immutability in
projects that seek to unlock trade finance and make supply chains more
transparent. Such transparency could also give consumers better information on
the sources of what they buy—whether a T-shirt was made with sweatshop
labor, for example.

Another important new idea is that of a digital asset. Before Bitcoin, nobody
could own an asset in the digital realm. Since copying digital content is easy to
do and difficult to stop, providers of digital products such as MP3 audio files or
e-books never give customers outright ownership of the content, but instead
lease it and define what users can do with it in a license, with stiff legal
penalties if the license is broken. This is why you can make a 14-day loan of
your Amazon Kindle book to a friend, but you can’t sell it or give it as a gift, as
you might a paper book.
Bitcoin showed that an item of value could be both digital and verifiably unique.
Since nobody can alter the ledger and “double-spend,” or duplicate, a bitcoin, it
can be conceived of as a unique “thing” or asset. That means we can now
represent any form of value—a property title or a music track, for example—as
an entry in a blockchain transaction. And by digitizing different forms of value
in this way, we can introduce software for managing the economy that operates
around them.

As software-based items, these new digital assets can be given certain “If X,
then Y” properties. In other words, money can become programmable. For
example, you could pay to hire an electric vehicle using digital tokens that also
serve to activate or disable its engine, thus fulfilling the encoded terms of a
smart contract. It’s quite different from analog tokens such as banknotes or
metal coins, which are agnostic about what they’re used for.

What makes these programmable money contracts “smart” is not that they’re
automated; we already have that when our bank follows our programmed
instructions to autopay our credit card bill every month. It’s that the computers
executing the contract are monitored by a decentralized blockchain network.
That assures all signatories to a smart contract that it will be carried out fairly.

With this technology, the computers of a shipper and an exporter, for example,
could automate a transfer of ownership of goods once the decentralized software
they both use sends a signal that a digital-currency payment—or a
cryptographically unbreakable commitment to pay—has been made. Neither
party necessarily trusts the other, but they can nonetheless carry out that
automatic transfer without relying on a third party. In this way, smart contracts
take automation to a new level—enabling a much more open, global set of
relationships.
SELMAN DESIGN

Programmmable money
m and smart conttracts consstitute a poowerful way for
commu unities to govern
g them
mselves inn pursuit oof commonn objectivees. They evven
offer a potential
p breakthrou
b ugh in the “Tragedy
“ of the Com mmons,” tthe long-heeld
notion that
t peoplee can’t sim multaneoussly serve thheir self-innterest andd the comm
mon
good. That
T was ev vident in many
m of th
he blockchhain proposals from the 100
softwarre engineerrs who too ok part in Hack4Clim
H mate at lasst year’s U
UN climatee-
change conferencce in Bonn n. The winn ning team, with a prroject calleed GainFoorest,
is now developing g a blockcchain-based system bby which ddonors cann reward
communities living in vulnerable rain forests for provable actions they take to
restore the environment.

Still, this utopian, frictionless “token economy” is far from reality. Regulators in
China, South Korea, and the US have cracked down on issuers and traders of
tokens, viewing such currencies more as speculative get-rich-quick schemes that
avoid securities laws than as world--changing new economic models. They’re
not entirely wrong: some developers have pre-sold tokens in “initial coin
offerings,” or ICOs, but haven’t used the money to build and market products.
Public or “permissionless” blockchains like Bitcoin and Ethereum, which hold
the greatest promise of absolute openness and immutability, are facing growing
pains. Bitcoin still can’t process more than seven transactions a second, and
transaction fees can sometimes spike, making it costly to use.

Meanwhile, the centralized institutions that should be vulnerable to disruption,

such as banks, are digging in. They are protected by existing regulations, which
are ostensibly imposed to keep them honest but inadvertently constitute a
compliance cost for startups. Those regulations, such as the burdensome
reporting and capital requirements that the New York State Department of
Financial Services’ “BitLicense” imposed on cryptocurrency remittance
startups, become barriers to entry that protect incumbents.

But here’s the thing: the open-source nature of blockchain technology, the
excitement it has generated, and the rising value of the underlying tokens have
encouraged a global pool of intelligent, impassioned, and financially motivated
computer scientists to work on overcoming these limitations. It’s reasonable to
assume they will constantly improve the tech. Just as we’ve seen with internet
software, open, extensible protocols such as these can become powerful
platforms for innovation. Blockchain technology is moving way too fast for us
to think later versions won’t improve upon the present, whether it’s in Bitcoin’s
cryptocurrency-based protocol, Ethereum’s smart-contract-focused blockchain,
or some as-yet-undiscovered platform.
The crypto bubble, like the dot-com bubble, is creating the infrastructure that
will enable the technologies of the future to be built. But there’s also a key
difference. This time, the money being raised isn’t underwriting physical
infrastructure but social infrastructure. It’s creating incentives to form global
networks of collaborating developers, hive minds whose supply of interacting,
iterative ideas is codified into lines of open-source software. That freely
accessible code will enable the execution of countless as-yet-unimagined ideas.
It is the foundation upon which the decentralized economy of the future will be
built.

Just as few people in the mid-1990s could predict the later emergence of
Google, Facebook, and Uber, we can’t predict what blockchain-based
applications will emerge from the wreckage of this bubble to dominate the
decentralized future. But that’s what you get with extensible platforms. Whether
it’s the open protocols of the internet or the blockchain’s core components of
algorithmic consensus and distributed record-keeping, their power lies in
providing an entirely new paradigm for innovators ready to dream up and
deploy world-changing applications. In this case, those applications—whatever
shape they take—will be aimed squarely at disrupting many of the gatekeeping
institutions that currently dominate our centralized economy.