Remember Satoshi: Blockchain Economics And Law

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Includes: BK, GS, JPM, UBS
by: Kurt Dew

Summary

The most significant idea in blockchain technology belongs to Satoshi Nakamura.

He co-opted the hackers that attack “secure” websites around the globe.

In bitcoin, hackers make more money protecting the network than hacking it.

No successful blockchain will ignore this principle, although many ignore it now.

Principles of economics and law are not paid enough attention within blockchain startups.

Mystery man with your mystery smile.

I've been chasing these channels of the information age

And I'm sick of this show.

So Mr. won't you tell me what's going on?

-- John Butler Trio

Where's Satoshi in blockchain space? Economics and law are a couple of important factors in the success of any venture. Thus the mystery. The single economic fact that resulted in the economic feasibility and ultimate significance of blockchain technology -- the founder's contribution -- seems to be misunderstood. Nobody in the land of bank-oriented permissioned blockchain-land seems to get Satoshi Nakamura's fundamental message.

Blockchain technology has been the focus of investment expenditures in the billions by large banks such as UBS (NYSE:UBS), Goldman Sachs (NYSE:GS), Bank of New York Mellon (NYSE:BK), JP Morgan Chase (NYSE:JPM) and many others. The fruits of this substantial interest have mostly been hype. As yet no important product.

There are a few simple important issues that few startup financial firms, including the blockchain mavens, often don't address upon beginning their life, oddly. First, there is the nascent firm's economic relative advantage in meeting a proven demand for financial services; second is the new firm's place in the structure of law and regulation. These two, important, considerations are particularly absent in the blockchain space.

With blockchain startups, there's the inevitable white paper -- a pro forma, but lacking analysis linking the firm's costs to customer-generated revenues and competition.

Startup blockchain firms grab the nearest shiny thing and run with it. "Smart contracts," to cite a particularly dubious blockchain function, seem to focus upon the incredibly overused adjective "smart" as essentially desirable, regardless of any explicit consideration of costs and value, or compatibility with legal practice.

The shape of the blockchain space. There are two basic kinds of blockchain -- each identifiable in part by the major success factor that they ignore most. Blockchains generally may be described as transactions verification systems that differ from the ones we know and love -- due to the existence of more than one clearer. Multiple entities serve the function reserved for one transactions clearer in the familiar transactions spaces. Why more than one clearer? Good question.

Public blockchains focus on economics at the expense of law. Bitcoin, for example, is economically viable, but hobbled by its inability to govern itself, or to initiate a dialogue with governments or their agencies. This, at least in part because, by design, no one speaks for bitcoin. Whether you are a fan of Ayn Rand or not, it is simply apparent that such an approach to governance can only limit the significance of this venture in the greater world of transactions and record-keeping. Blockchain can thrive this way, but it will never become a fundamental part of the financial system this way.

Public blockchains are characterized by a blockchain-native cryptocurrency, that establishes its supply-side value through payment to the entities, called miners, that verify transactions -- or otherwise put, perform the clearing function. The demand-side value, in the case of bitcoin, is apparently primarily based in China, where investors have a preference for risky assets. There is also the possibility that some Chinese use bitcoin to transfer assets out of the country, avoiding China's currency controls.

The well-known public blockchains, bitcoin and ethereum, are characterized by open participation. Anyone can own or trade the cryptocurrency, or mine it.

The "permissioned" blockchains -- at least initially -- are mostly the spawn of financial institutions wondering how to seize the initiative in addressing a technology that threatens to gut their operations in coming years. Permissioned blockchains "get" the need for law and regulation. They must, to coexist with bankers. But the examples with which I am familiar fail to consider the economics. Of the two, ignoring the economics is the more egregious error. Ignoring the economics will doom the permissioned blockchains to a relatively short future of failed science projects.

The banks are hip-deep in issues of the profitability of their current existing operations. Adding a new bell or whistle that has not proved itself cost-effective is a non-starter in this environment. The banks must invest initially in blockchain technology, since it's such an obvious threat to their survival. But if it proves no threat, or worse yet, shows no evidence of value in conducting the business of finance, they will toss out blockchain like a pair of old shoes. It would be a shame if that ignominious end came as a result of a failure to consider some important possibility that would have been a success.

Permissioned blockchains differ from public blockchains primarily in that entry into the club of nodes (that perform the function in permissioned blockchains that miners perform in public blockchains) is limited. Nodes must be trusted by the permissioned blockchain's governance. This simple fact itself will become a future problem in one of two ways. The club might turn out to be costly, in which case nodes will chronically depart or malfunction, weakening the performance of their blockchain. Alternatively, the club will be attractive economically, in which case, preferably, standards of the blockchain's governance, or alternatively standards of a government regulator, will limit membership. If government, regulators will be in a position not unlike its current one of limiting membership to the banking system. These nodes, if government determined, will ultimately be viewed by the public in the same warm affectionate way they see commercial banks today.

Getting Satoshi. There is one economic factor the permissioned blockchains ignore that stands above the rest. They don't consider Satoshi. Satoshi Nakamura, the putative inventor of bitcoin, is a novel being -- in many ways emblematic of bitcoin -- in that he can't be found on the planet. Nobody has met the man, or identified him on the public record. That is a fun fact, but it does not diminish his important contribution.

Satoshi, or whoever, turned the world of hackable spaces on its head. He internalized the cost of hacking, recognizing the effort of hackers as an economic resource that, in our current system of firewall-based transaction citadels, is never exploited, almost unexamined. Instead it is seen as a cost to be reduced by incurring other costs such as firewalls.

Satoshi designed the elegant bitcoin blockchain to harness the hackers. Hackers are incentivized to protect the integrity of the blockchain. Once converted, they are known by the evocative term, miners. This conversion of costly hackers into valuable assets minimizes an enormous cost borne by the firewall transactions citadels, such as SWIFT, turning this cost into a resource to be utilized.

Those already immersed in the world of finance are hopefully considering their blockchain endeavors from Satoshi's point of view. Why take the expense of hacking as a given? Is there no way to permission the resources expended by hackers, a la Satoshi, converting them into a resource instead of a cost?

Don't huff and puff to me about moral bankers and immoral hackers. Few readers were born yesterday. I understand that the world will never see the end of hackers -- and likewise bankers with questionable character. The objective is to design a system that maximizes the incentives of hackers to protect transactions and information, and of bankers to behave ethically. The issue Satoshi raised when bitcoin was born was this: How are the nodes best designed to minimize verification cost and maximize value?

The flaw in naïve nodes that are assigned no cost and expected to operate without monetary gain is that this expectation is counter to reality. These nodes all bear a cost, the cost of transaction verification. Without being given economic incentives to minimize that cost and maximize their value to the blockchain network, the system is destined to fail.

It is simply silly to ignore Satoshi's major coup: converting potential hackers of blockchains into protectors. I hasten to add, looking at the rules governing bitcoin's miners -- the specific set of miner incentives in bitcoin -- there is no doubt these rules can be bettered. I believe a skilled financial analyst could design a permissioned blockchain where protectors of the system are identified, managed, and monitored, while giving them incentives sufficient to make protecting more valuable than hacking. I see no reason not to open the doors to potential new permissioned nodes and encourage competition among existing nodes in permissioned systems.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.