In 2008, during the turbulence of a global financial crisis, a person (or group) called Satoshi Nakamoto released a white-paper called Bitcoin: A Peer-to-Peer Electronic Cash System. The principle was simple but revolutionary- a technique to record digital transactions in a way that was public, permanent and verifiable without requiring a third party for trust. It is this principle that became more commonly known as Blockchain (or distributed ledger). Today, just 13 years later, the cryptocurrency market is valued at a staggering $1.6 trillion (around 2% of the entire global economy) and blockchain based companies are raising some of the largest rounds of funding in technology.
Q: Why is blockchain economically useful?
[Prof. Eric Maskin]: There are two key features of blockchain that make it, potentially, a very useful technology from an economic perspective. First, the data about transactions are posted on many public sites thus giving these data an immutability that makes disputes easy to avoid. What happens in transactions will be recorded and so there will be less need for third parties to adjudicate those transactions. Second, although the data are in some sense public, they can be encrypted so that a particular party learns only those aspects that she needs to know. For example, if I am buying a widget from you, I may not want you to know that I would have been willing to pay more, and you might not want me to know that you would have accepted less. Blockchain enables us to set up the transaction without disclosing such sensitive information. Thus, it ensures both the integrity of the database (so parties can transact without trusting one another) and also privacy—- two features that I think are very valuable, economically speaking.
Over the centuries, social institutions have evolved to allow us to trade with more and more people. Long ago, we were limited to family members and other close associates, but then courts made it possible to transact with people we knew less about, because there was a pathway to resolution if they turned out not to be trustworthy. With blockchain, you may not even need to bring someone to court, because the evidence is already there- on the blockchain! Producers can sell their products and services to people they don’t know and need not trust—- so that expands their market. Buyers can buy from a wider range of sellers, and that expands their choices. The anonymity and privacy aspects of blockchain improve everyone’s possibilities.
Q: What is the opportunity presented by blockchain for finance?
[Michel Rauchs]: First we must define what we mean by blockchain. Even now, more than 11 years since Bitcoin emerged in 2009, we still have no established definition of either cryptocurrency or blockchain.
There are many systems that market themselves as being blockchain or blockchain-like to attract funding and attention, but many of those systems have nothing to do with what we consider to be the actual key characteristics of blockchain systems. True blockchain systems are modelled from the original Bitcoin design whereby you have separate parties who want to reach some agreement over something. Blockchain meme projects piggyback the hype.
The potential for blockchain is to accelerate the digitization of financial markets. In financial markets you have a large, opaque web of intricately linked financial institutions, people and companies who maintain their own ledgers. There are naturally coordination problems, exacerbated by a lack of common data standards (something which could have been fixed 50 years ago). Blockchain gets everyone excited as it has the potential to convene these different parties together to reach the necessary agreements, in that sense it is a unique enabler, a coordination mechanism. That has massive implications on the structure of our financial markets.There are also aspects of blockchain which we simply can’t achieve with other technologies. That’s where we end up with systems like Bitcoin or Ethereum which are open, public, commission-less and without significant barriers to entry.
Q: What are the layers of blockchain?
[Michel Rauchs]: There are 4 layers in blockchain’s vertical stack.
Firstly, protocols. These are essentially rules that govern how the system work. There are established open-source frameworks that anyone can use, tweaking a few parameters to launch their own network.
Networks are the entire systems; you can think about them in the same way you might perceive a living organism. It’s the initiation of the protocol into practice, its’ the nodes and people who are connected to each other to exchange information.
You can add platforms in-between, but that’s more of a technical distinction in terms of how systems are being run.
Finally, you have applications that sit on top of the networks. Applications are what you build and deploy with those networks once they’re in place and they are where end users interface with the networks.
Q: What are your views on cryptocurrencies?
[Prof. Eric Maskin]: I should say right away that I am very much a cryptocurrency sceptic. My judgement is that the dangers of cryptocurrencies do not outweigh the benefits.
When cryptocurrencies first arose, one benefit was enabling people to transfer money to others without going through banks. Normally, if I want to send you $10, our banks will have to get involved. But if I live in a remote part of the world where I might not already have a bank, that could be a headache.Through cryptocurrency, we can do the transfer directly and avoid the intermediary. Unfortunately, there is a substantial downside too.
First, circumventing banks makes it easier to carry out illegal transactions (e.g., money laundering). So, we might be better off with a transfer system that legal authorities can monitor on at least an occasional basis.
Even more seriously, cryptocurrency can interfere with governments’ ability to fight recessions with monetary policy. Suppose that the economy is faring poorly: unemployment is high and output is low. The government (i.e., the central bank) can counteract this recession by expanding the money supply, which will stimulate demand and supply and get the economy back on track. Conversely, if the economy is booming, the government can contract the money supply to reduce inflationary pressure. Thus, monetary policy is a valuable tool to reduce macroeconomic volatility. But when people are using privately created money (cryptocurrency) rather than ordinary money, the money supply is beyond the government’s control, and monetary policy can no longer be conducted. That’s a bad thing.
Thanks to monetary policy, business cycles are far less volatile today than they were in the 19th century, when we had huge swings. But if cryptocurrency takes over the way its proponents would like, we could return to the ups and downs of the pre-monetary policy era.
I also worry about the effect that cryptocurrency could have on banking. If we are not saving and transacting through banks, then they will be crippled Yet, banks perform an essential economic function: they evaluate entrepreneurs’ projects and decide which ones to invest in. Crowdfunding is not an adequate substitute for the expertise in evaluation that banks provide. If that expertise is lost, then entrepreneurship will be under threat.
Despite these drawbacks, cryptocurrencies are attracting a lot of attention. They seem new and different to people, and their volatile prices appeal to speculators, who love volatility. For people suspicious of authority, cryptocurrencies are a great way to snub their noses at government and banks. Indeed, there is a view—-which I believe is misguided—that cryptocurrency is useful because its supply (like the gold supply) is not affected by economic conditions and thus protects us from inflation. But that view misses the point that responsible central banks have done vastly more good than harm precisely by making the supply depend on how the economy is faring.
As for ease of transferring money, we don’t need private cryptocurrency for that. Suppose the US created a crypto-dollar and Europe created a crypto-euro. They would be as easy to transfer as Bitcoin—- and I anticipate that governments around the world will move in that direction. Indeed, once we have the crypto-dollar, the social value of private cryptocurrencies will be gone. I can see no good reason for Bitcoin once that happens.
[Michel Rauchs]: Cryptocurrencies follow a 3–4-year cycle that seems to repeat. We have ‘crypto winter’ which is when media interest is generally low, the price of the cryptocurrencies are lower and it tends to be the time where developers and builders create the most interesting stuff that makes cryptocurrencies useful. You then have sudden price rises that bring attention to the crypto-ecosystem and you see cascading hype that forms what can be perceived as a bubble. People rush-in, new projects that don’t make any sense are able to raise 7-8 figure sums against nothing but a whitepaper…. You see these cycles returning time and time again, and it feels as if we are in one right now.
Is it truly a bubble? If you look at the ecosystem as a whole, there are certain elements that definitely exhibit some tendencies of bubbles, but if you look at systems like Bitcoin – even after the corrections, the price still remains way above the previous cycle highs. As an investor, as long as you don’t get caught up in day-trading you could plug your money in and watch it grow. That is not the traditional trajectory of a bubble- they tend to have an upward trajectory, then a massive crash and no recovery. We have had a succession of mini bubbles in crypto for the last decade, yet it’s always a new top that comes and that top is always higher than previous. I don’t therefore think of cryptocurrencies on the whole as being a bubble, but rather that they are bubbly-terrain depending on where we are in the cycle.
Q: Could we see ‘government backed’ crypto currency?
[Michel Rauchs]: People often talk about government backed crypto currencies, but they are somewhat of an oxymoron. One of the defining aspects of cryptocurrencies is that there is no central-bank or issuer. They are more like virtual, digital commodities rather than financial assets. There is no ‘liability’ in the same way as financial assets like money.
You can compare crypto to gold which also has no issuer. You have a predetermined supply which can be verified without having to trust someone. Cryptocurrencies function quite similarly- they have a utility function in their own network which often becomes an incentive. It is then through a complex interplay of game theory and economic incentive design that the system pulls together. Every cryptocurrency has its’ own network and ecosystem, essentially they are each like their own monetary system. You have a base asset, a unit of account and a pricing mechanism. You have Bitcoin (with its native unit, BTC) and Ethereum (with its native unit ETH) and can imagine them as international monetary systems that bring-together local ecosystems. We used to have gold as a key reserve asset, and now it’s the US dollar. In the cryptocurrency world, it used to be Bitcoin that everything was priced and measured against, but in the past 2-3 years we’ve seen a move towards Ethereum, a platform on which many of the new tokens, assets and applications are being built.
We are seeing the emergence, development and evolution of entire monetary systems live, unfolding before our eyes.
While it is true conceptually that each cryptocurrency can be its’ own ecosystem or monetary system that doesn’t necessarily mean that the system will become dominant or useful in the future. Bitcoin may be the exception given its size and scale – but pretty much all other cryptocurrencies (of which there are tens of thousands) have no relevance at all. I wouldn’t even want to elevate them to competing with our USD based monetary system.
Q: What are the energy implications of cryptocurrencies and blockchain?
[Michel Rauchs]: When people talk about the energy implications of blockchain networks and cryptocurrencies they’re mostly talking about Bitcoin and to a lesser extent Ethereum. Not every blockchain network needs to have that level of energy to function.
There is a very specific design primitive that was introduced with Bitcoin called proof of work. In recent years, researchers have come up with alternative mechanisms and theories to arrive at the proof without the insane levels of energy use but the consensus has not yet been reached about whether they offer the same level of guarantee and proof as the traditional method. Bitcoin proof of work is responsible for 95% of the energy consumed by blockchain networks. Until Bitcoiners are convinced by alternate mechanisms, this will not change.
Q: Will we need to regulate cryptocurrency?
[Michel Rauchs]: There is an impression that cryptocurrencies are like the wild-west, that they are completely unregulated. This may be true in some cases, but at the network level – that is absolutely not the case. The actual industry that has formed around cryptocurrencies with employees, partners and so-forth are bound by the traditional regulations that apply to financial services of a similar nature. What regulators have done in the past (and continue to do) is to regulate the endpoints rather than the network – this gives much tighter control over the entire system as it enables the tracking of inflows and outflows.
Q: Do cryptocurrencies facilitate crime?
[Michel Rauchs]: I would disagree that cryptocurrencies are a perfect instrument for criminals. While it’s true that there are features of cryptocurrencies that preserve anonymity or privacy- you have to understand that the ledgers are completely public and transparent so that everyone can verify everything. Every single transaction by every single participant is stored forever. This is a super-inefficient way to run any payment system or financial market, but it gives a level of trust that makes the system valuable to start with. Each transaction is a string of numbers but those numbers tie to real-world identities.
So, even if 50 years if there is some new crypto-breakthrough, you will still be able to check every transaction that happened today. From a privacy perspective, unless you are really good at breaking the link between your identity and your blockchain identity, it’s actually a privacy nightmare. That’s one of the reasons law-enforcement and regulators actually like blockchain – it makes it relatively easy to track every movement of a criminal or organisation once they have been identified.
Our traditional banking system by comparison is made-up of opaque and closed ledgers in different jurisdictions often making it practically impossible to get data.
Consumers need to be very aware that if you transact on a blockchain, it will be stored there forever. So be careful what you do. It’s definitely not an anonymous system.
Q: What excites you about the future of blockchain?
[Prof. Eric Maskin]: Blockchain was created for Bitcoin, which is a terrible application. There are so many great applications for blockchain that it’s too bad Bitcoin was first.
For example, blockchain could be used very effectively in auctions. Suppose that you have a valuable asset that you would like to put into the hands of the potential buyer who values it the most (e.g., imagine that you’re the government, the asset is a band of radio frequencies, and the potential buyers are telecom companies that can use the band for their mobile services). How do you make sure the right buyer gets it when you don’t know the buyers’ values? You might think of running an auction: have each buyer make a bid, award the asset the high bidder, and have the winner pay his bid. However, that won’t work—-buyers will always bid less than the asset is worth to them (if they bid their true values, their net profit would be zero), but with all buyers underbidding there’s no guarantee that the right one will win. However, there is a clever way around this problem: award the asset to the high bidder, but have him pay the second highest bid. In this second-price auction, buyers will have the incentive to bid exactly their values—so the right buyer wins. The trouble is that the winning buyer has to know what the second-highest bid is—and the second highest bidder may not want the winner to know what she bid (the two buyers might be rivals). That’s where blockchain comes in. It is easy to arrange for the winner to learn what the second highest bid was without him finding out who made that bid. In other words, blockchain, once again, is a great tool for preserving privacy. And that’s just one example from a huge array of potential applications.