Despite the technological innovations brought about by the Internet, most financial transactions require the presence of at least one central intermediary, who often controls the terms of trade.
Intermediaries are banks, insurance companies, and other financial agents who profit from interactions between service providers and end users to facilitate transactions. However, they do so at a cost while raising some fundamental concerns.
First, the presence of an intermediary can lead to market power that can be abused. Second, there is the potential for transient commitment and potential for conflict of interest. Finally, almost all existing intermediaries use opaque proprietary platforms that prevent interoperability, thus, creating “walled gardens”. For example, Apple strictly controls which mobile phone applications can be installed on its operating system.
Blockchain technology, a relatively recent development, promises to solve some of these structural problems. Simply put, a blockchain is a ledger that organizes and records transactions in the same way as an accounting ledger (Chart 1). Blockchain applications are being developed for many endeavors such as finance, supply chain-management, gaming, digital identity, land titling, and the arts.
Although the number of blockchain initiatives has grown steadily over the past decade, most activity measured by number of transactions is concentrated on the largest networks such as Bitcoin and Ethereum. In recent months they have shrunk moderately (Chart 2).
Eliminates the middleman
In a traditional intermediated, centralized ledger, a single entity is responsible for approving, viewing, auditing, and deleting transactions. For example, if you don’t pay in cash, only your bank or credit card company can “edit” your account, approving every transaction you make. In a blockchain, governance is decentralized. Users interact with each other through a protocol that anyone can use.
Since many people can edit the ledger, a financial system is needed to guarantee that no one illegally changes its contents. Therefore, a transaction is recorded only if sufficient agents, called validators, agree that the transaction actually took place. For aligning the interests of validators with those of users, the network rewards validators in the form of a token (commonly called cryptocurrency) that loses value if the integrity of the ledger is violated.
Initially, blockchain technology was conceived mainly for digital payments – “a peer-to-peer electronic cash system” in the words of Satoshi Nakamoto, the inventor of the Bitcoin protocol. To support the digital payment system, a digital token (Bitcoin) was created to replace traditional currency, on 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 serve as the currency of other blockchains.
A key feature is that, like a physical coin, a digital token can be directly controlled by the owner without a centralized intermediary. This is possible because a digital currency has a public key, a unique identifier that can only be exchanged by the legitimate owner of the currency.
This type of peer-to-peer system differs from traditional electronic payment systems that rely on traditional fiat currencies (eg dollars, euros, pounds) that are, in the end, the responsibility of the central bank that issues them. A traditional electronic payment system connects financial institutions and merchants, but ultimately requires net settlement at the central bank level.
‘Smart contracts’ automate transactions
Most blockchains work seamlessly with smart contracts – programs that automatically execute when specific conditions are met. This is because they process digitally native transactions using digitally native currency.
Smart contracts are important in the application of decentralization through blockchains because they automatically follow predetermined rules. Imagine a bank that does not make a subjective decision about whether a person wants a loan or not, but lends money only if the borrower has sufficient collateral.
In just a few years, blockchain technology has evolved from Bitcoin to a new financial system called Web 3.0, in which decentralized applications use smart contracts to allow users to interact with each other and exchange value securely and anonymously. platform.
A unique feature of blockchain is the high level of transparency and decentralization of its infrastructure. All protocols are built through open source collaboration among a decentralized network of developers.
Protocols are managed and updated by all participants through a consensus mechanism, owned and controlled by no one. The code used by the protocols is public and available for anyone to view, audit, and copy. Transactions are visible for anyone to monitor and verify.
Legolike packaging of financial transactions
Another important characteristic is the concept of composability—“money Legos,” as it is metaphorically known. Because of the open source nature of protocols and their interoperability, multiple transactions can be stacked together – like Lego pieces – to create faster, cheaper and more convenient products.
For example, this composability may soon allow you to get a home-equity loan, convert dollars into euros, buy a flat in Paris, hedge currency risk with futures, and donate unused funds to charity. The entire sequence of collection requires only a few lines of code executed using smart contracts on a decentralized ledger owned by no one and run together by individuals unknown to each other.
Navigating new challenges
Many challenges remain with blockchain. Finding consensus across a large network of users in a decentralized environment is slow and expensive. The larger the network, the higher its operating costs.
Thus, the main feature that makes blockchain attractive—its decentralized structure—may become a major barrier to its wider adoption. Not coincidentally, much of the recent innovation has focused on creating faster and more efficient protocols and increasing their ability to scale applications.
The global reach of blockchains 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 significantly across countries. To thrive, blockchain initiatives will need to find ways to create regulatory compliance mechanisms that differ from the traditional, one-size-fits-all approach adopted by centralized businesses.
For example, there is no identity in blockchain, and every user is identified by public/private key pairs. This is a key feature of blockchain technology that does not fit well with existing anti-money laundering operations. At the same time, blockchain technology is completely transparent and transactions are traceable. Bad actors can be identified and prevented from operating in most protocols and off-ramping into the traditional financial system.
Although the resources devoted to blockchain technology development have increased significantly over the past few years, the ultimate success of the technology depends on whether and how blockchain protocols can interact with the current financial landscape.
About the author
Zareto He is a senior research economist and advisor in the Research Department at 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.