Blockchain technology aims to expand the role of digital transactions on the Internet
Alessio Saretto
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 exchange.
Intermediaries are banks, insurance companies and other financial actors that profit from interfaces between providers of services and end users to facilitate transactions. However, they do so at a cost, while sometimes raising some fundamental concerns.
First, the presence of an intermediary can lead to market power that can potentially be abused. Second, there is the possibility of volatile engagement and the potential for conflicts of interest. Finally, almost all existing intermediaries use opaque proprietary platforms that prevent interoperability and thus create “walled gardens.” For example, Apple strictly controls which mobile phone applications can be installed on the operating system.
Blockchain technology, a relatively new development, promises to solve some of these structural problems. Simply put, a blockchain is a ledger where transactions are organized and recorded, much like they would be in a ledger (Diagram 1). Blockchain applications are being developed for a multitude of endeavors, including finance, supply chain management, gaming, digital identity, land title, and art.
Although the number of blockchain initiatives has steadily increased over the past decade, most of the activity, measured by the number of transactions, is concentrated in the largest chains, such as Bitcoin and Ethereum. They have gone moderately together in recent months (Diagram 2).
Eliminate the middleman
In a traditional intermediate and centralized ledger, a single entity is responsible for approving, viewing, auditing and deleting transactions. For example, if you don’t pay with cash, only your bank or credit card company can “edit” your account by approving every transaction you make. In a blockchain, governance is decentralized. Users interact with each other through a protocol that is available for everyone to use.
Because many people can edit the ledger, an economic mechanism is required to guarantee that no one illegally changes its contents. Thus, a transaction is only registered if enough agents – called validators – agree that the transaction actually took place. To align the interests of the validators with the interests of the users, the network rewards validators in the form of a token (often referred to as cryptocurrency) that loses value if the integrity of the ledger is violated.
Originally, blockchain technology was primarily envisioned 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 in place of traditional currency, under the assumption that its value would depend on people’s willingness to accept it as a medium of exchange. Since then, many more tokens have been created that serve as currency for other blockchains.
An important feature is that, like a physical coin, a digital token can be controlled directly by its owner without centralized mediation. This is possible because a digital currency has a unique, unforgettable identifier, a public key, which only the legitimate owner of the currency can transfer.
This type of peer-to-peer system differs from traditional electronic payment systems, which rely on traditional fiat currencies (such as dollars, euros and pounds) that are ultimately a liability to the central bank that issues them. A traditional electronic payment system simply connects financial institutions and merchants, but still ultimately requires a net settlement at the central bank level.
“Smart Contracts” Perform transactions automatically
Most blockchains work seamlessly with smart contracts – programs that run automatically when specified conditions are met. This is because they process digitally native transactions with digitally native currency.
Smart contracts are key to the application of decentralization through blockchains because they automatically follow predetermined rules. Imagine a bank that does not make a subjective assessment of whether someone should or should not get a loan, but only lends money if the borrower has enough security.
In just a few years, blockchain technology has evolved from Bitcoin to a new economic system, Web 3.0, where decentralized applications use smart contracts to allow users to interact with each other and exchange value securely and anonymously without relying on a centralized intermediary. platform.
A unique feature of blockchain is the high level of transparency and decentralization of the infrastructure. All protocols are built through open source collaboration between a decentralized network of developers.
No one owns or controls the protocols, which are managed and updated by all stakeholders through a consensus system. The code used by the protocols is public and available for anyone to see, revise and copy. Transactions are visible for anyone to monitor and verify.
Lego-like packaging of financial transactions
Another important characteristic is the concept of composability – “money Legos”, as it is metaphorically known. Due to the open source nature of the protocols and their interoperability, multiple transactions can be stacked on top of each other – like Lego pieces – to create faster, cheaper and more convenient products.
For example, this composition may soon allow you to get a mortgage, exchange dollars for euros, buy an apartment in Paris, hedge the currency risk with futures and donate any unused funds to charity. The entire fundraising sequence will require just a few lines of code executed by smart contracts in a decentralized ledger owned by no one and run collectively by individuals who are anonymous to each other.
Navigating new challenges
A number of challenges remain with blockchain. Finding consensus across a large network of users in a decentralized environment can be slow and costly. The larger the network, the more expensive it will be to run.
Thus, the main feature that makes blockchain appealing – its decentralized structure – may become the main obstacle to wider adoption. Not coincidentally, most of the recent innovations have been aimed at creating faster and more efficient protocols, increasing their ability to scale applications.
The global scale 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 practice differ considerably between countries. To thrive, blockchain initiatives must find ways to create regulatory mechanisms that differ from the traditional consolidated approach used by centralized businesses.
For example, there is no identity on the blockchain, and each user is identified by public/private key pairs. This is a core feature of blockchain technology and sits poorly with existing anti-money laundering practices. At the same time, the blockchain technology is completely transparent and transactions are traceable. Bad actors can be identified and prevented from operating in most protocols and from exiting the traditional economic system.
While the resources devoted to the development of blockchain technology have increased dramatically in recent years, the ultimate success of the technology depends on whether and how blockchain protocols can interact with the current economic landscape.
About the author
Alessio Saretto
Saretto is a senior research economist and advisor in the research department of 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.
