[This is a subpost of Bitcoin, Cryptocurrencies and Blockchains]

Many commercial applications of the blockchain are private (a.k.a. centralized) blockchains. Centralized here refers to the control. Private blockchains involve distributed copies of the blockchain, but the decision of who gets to make edits recording new transactions is made centrally. In this way blockchains are just an improved database technology.

Databases are tremendously useful in all sorts of areas, from processing the payment of financial transactions, to processing global shipping, to buy and selling shares. So the potential of improved database technology may involve substantial upheaval and improved efficiency in many industries. It hardly seems revolutionary, but for some industries like Music a mere better database may be all that revolutionary requires.

Some blockchains, like that of Ethereum, but not that of Bitcoin, also allow for writing smart contracts. Smart contracts are contracts that will automatically trigger when certain events or conditions are met. For example, consider the case of an Importer buying something from a foreign seller. The importer could write a contract containing four stages: one quarter of the money would be payed when the seller says they have sent the good, another quarter when the Port in the foreign country says they have processed the goods, another quarter when the Port in the importing country says they have processed the goods, and the final quarter when the importer confirms they have received the goods. In principle such contracts could be written without a blockchain, but are difficult to implement. Using a blockchain makes it easier to confirm each stage, especially if the Customs authority in each country is using the blockchain as they are then publicly announced, and blockchains like that underlying Ethereum mean that the contract can be signed before any of the transactions are actually made and set up to make the payments automatically as conditions are met, meaning the seller does not need to place as much trust in the Importer to follow through on the agreed payments. This example also illustrates the limits of the blockchain. What is to stop the foreign seller simply lying about sending the good, and then bribing the foreign Port worker to lie about processing it. The smart contract would pay out half of the money before the buyer realized anything was wrong. While blockchains can guarantee the events in the sense of the data being recorded, they provide no guarantee that the data itself is a true reflection of reality. So blockchains reduce the difficulty of establishing trust but certainly do not eliminate it.

This means more trades can take place where previously it was just too difficult to reach the level of trust required. And complex smart contracts can be written that condition on any action that is recorded on the blockchain, this might even include things like an internet-enabled thermometer or any other sensors. Again, such smarts contracts could in theory already be written, but blockchains make them much easier to implement and execute, with less required. The nature of blockchains meaning everything on them can be observed by everyone makes it easier to form consensus through much wider and faster distribution of information. This is the key to smart contracts. One major catch is that many firms may not want to share so much information about all of their transactions. Many emerging commercial blockchain technologies are based on not letting everyone see everything all the time.

So private blockchains and smart contracts are likely to have major implications for industrial organization and the structure of markets and transactions. Although this should probably been seen in the context of better database technologies in general, rather than blockchains as a magic bullet.

One interesting side-effect of blockchains making all transactions publicly observable is that it is expected to make Cartels easier to run. This Cartel aspect is thought to be part of the appeal to the Banking consortia set up by UBS and others. Many Cartels involve firms joining together to fix the price by restricting supply. But it is in the interests of any single Cartel member to betray the cartel by selling more than it is supposed in secret behind the other members; as long as the rest of the Cartel holds, prices stay high and you get to sell lots more at this high price. The incentive of each member to betray is limited by the risk that if other Cartel members find out then the Cartel will collapse and everyone will return to competing at lower prices, meaning lower profits. So if all trade in a given market gets recorded on a blockchain, then because the blockchain is visible by everyone all the time, any Cartel member who tried to betray the others would be instantly revealed by their actions on the blockchain. This reduces the incentive to betray the Cartel, making Cartels more stable and easier to maintain. So wider use of blockchains may lead to more Cartels.

Next post in this series on Cryptocurrencies: Monetary Theory of Cryptocurrencies

References:

Cong & He (2018) – Blockchain Disruption and Smart Contracts