A promising but bumpy road ahead for blockchain

Published on Friday, 01 December 2017

Published by Cyn-Young Park on Friday, 01 December 2017

For economists, blockchain technology promises frictionless markets and perfect information.
For economists, blockchain technology promises frictionless markets and perfect information.

Do you remember the world before the internet? Can you imagine your life without it? Prepare yourself, because another revolutionary technology is about to become just as indispensable.

I’m talking about blockchain technology. Blockchain is a digital, distributed ledger that keeps a record of all transactions across participating peer-to-peer networks. It can also be understood as a decentralized database that continuously updates digital records of who owns what, which is then shared within a group or distributed publicly.

It is clear that blockchain is the next generation of the internet. Starting out as interconnected networks for information sharing, the internet grew to connect people for greater collaboration and knowledge sharing by providing access to endless data and information.

Blockchain adds another layer by allowing exchange and storage of “value”. By enabling authentication and nearly instant reconciliation of digital transactions, it provides a platform for creating a market (rather than just for exchange of information) between two or more complete strangers without mediators or central authorities.

  Blockchain efficiency gains from eliminating middlemen would be huge

From an economist’s point of view, the main attraction of this technology is its promise for frictionless markets and perfect information. The efficiency gains from getting rid of middlemen in all economic transactions would be huge.

Virtually all worldly transactions and contracts also have information asymmetry. What we can accomplish from removing all market frictions and information asymmetry in economic transactions would be beyond imagination.

Financial transactions are obvious sources of economic and efficiency gains for this technology. Domestic credit created by the financial sector worldwide reached $140.7 trillion or 186.4% of global GDP in 2016.

Using the 3% net interest margin for all US banks, the cost of global financial intermediation can be roughly estimated at $4.2 trillion. Even if blockchain technology helps reduce only 1% of this amount, the efficiency gains will be $42 billion. Additional cost savings can come from cutting the financial costs associated with global cross-border capital flows.

For example, globally the average cost of sending remittances is over 7% of the amount sent. Last year, remittances sent globally reached $375 billion, which makes about $26 billion spent on sending the remittances. Likewise, blockchain applications can improve business processes, with dramatic increases in economic efficiency in some areas and at least modest increases in most others.

Obstacles ahead

Blockchain-based solutions to development challenges also have vast potential, precisely because developing countries face more market friction and their contracts are subject to greater information asymmetry. Some obvious examples are:

  • Narrowing the credit gap for small and medium-sized enterprises.
  • Reducing the time and cost of cross-border payments like remittances.
  • Providing a platform for secure identity and data storage, for instance in identity management and land title registration.
  • Making aid distribution and disbursement processes more efficient and transparent.

However, there are several important challenges to tackle before blockchain-based solutions can be practically considered. These involve infrastructure, the legal and institutional environment, and regulation. There are also concerns about data privacy, cybersecurity, and governance.

Interestingly, key constraints to address these challenges are often beyond the scope of technology. For example, there is a perennial dilemma and tradeoff between data transparency and privacy, while data transparency through public distribution is at the core of this technology.

Even if technology can protect privacy (or personal data), for example by using encryption and cryptographic keys, we must determine what constitutes personal data, who controls it, and how laws and regulations support the development of technology and innovation – all while personal data is protected. Another considerable challenge will be finding an appropriate governance structure for this very decentralized system.

  3 ways to address challenges to mainstream blockchain technology

Governments, the private sector, international organizations, and intergovernmental agencies must take steps together to address these challenges.

  1. Develop a set of principles and standards for using blockchain-technology, whether it’s for business or for development.
  2. Create legal and regulatory environments that support the adoption of blockchain technology.
  3. Build infrastructure such as high-speed internet, mobile connectivity, and reliable and affordable energy. Multilateral development banks can play an important role on the last point.

Finally, social acceptance and uptake are also important. Like the dotcom bubble in the 1990s, there is much hype over blockchain’s potential. But just like any new technology, blockchain applications need to stand the test of time, and will experience numerous failures doing so.

We need to understand the technology better, recognizing its limitations as much as its potential. In the meantime, proper regulations and a balanced approach to the regulations are both key to managing the risks.