Thursday, September 01, 2016

Defining the Blockchain Economy: What is Decentralized Finance?

The aim of this article is to explore the intersection of blockchain technology and finance from a practical, theoretical, and conceptual standpoint.

1. Practical Blockchain Finance
Financial services is one of the last sectors of the economy to become modernized by the Internet and the possibilities of digitalization. Broadly, the first main phase of the Internet can be seen as enabling the transfer of information. However, additional features are necessary in economics and finance for the secure transfer of value, and to avoid the double-spend problem. Whereas it is possible to make an arbitrary number of copies of a digital file sent in email for example, money should only be spent once. Now in what could be the second major phase of the Internet, blockchains have arisen as a crucial enabling technology to allow the secure transfer of value, and thus for economics and finance to uplift into the modern Internet era. This could be a rapid move given the computational and infrastructural network resources already in place.

Blockchains allow the digital payments layer the Internet never had, and more broadly contemplate an era whereby all forms of secure value transfer could take place via the Internet. This could include all monetary assets (the cash or spot market), and all assets and liabilities over any future time frame (the futures and options market, mortgages, debt and equity securities, treasury issuance, and public debt). The implication is that there could be a digital future of cryptographically-activated assets and actions, where 1) all physical and intellectual property might be registered and transacted via blockchains as smart property, and 2) all agreements, contractual relationships, societal record-keeping, and governance might be enacted through code-based smart contracts. For maximum resiliency and adoption accustomation, the two systems would likely run in parallel until there was gradually enough comfort in the digital system to drop the analog system.

Global financial institutions are rapidly adopting the single-ledger technology of blockchains, which is essentially, having one database of securities transactions instead of many proprietary versions that need to be reconciled. The benefit is that the time to clear securities transactions may be reduced significantly from days to hours, which confers a tremendous decrease in risk and cost from the time savings. These cost savings could be passed on to the customers of securities trades. The need for independent custody functions and other costly aspects of the securities value chain could also be greatly reduced in having a single asset registry of securities, including because ownership can exist in an open and readily-confirmable mode as opposed to having to be researched and verified in every transaction.

A valuable property of blockchains for the digital automation economy is synecdoche (where a part represents a whole). Blockchains simultaneously connect many layers or levels of detail in that in the connected database tree, any one items calls or refers to all other levels, so it is easily possible to drill up and down levels of detail. For example, with a hard-currency dollar bill, there may be twenty levels of aggregation upstream from the actual unit of the bill, all of which could be rolled up at the click of a mouse. Another case of the crypto-synecdoche property in action is in the idea of hospital inventories (including controlled-substance pharmaceuticals) instantiated as blockchain-based smart property, where a hospital, county, state, or nation’s inventory could be viewed at any instant. The crypto-synecdoche property could be used to roll up the whole of an economy for an on-demand real-time assessment (essentially automating NBER). As in all industries, in finance too, blockchains are a next-generation technology that enables the secure, trackable, automated coordination of large-scale projects with arbitrarily-many detailed items.

Blockchains, HFT, and Smartnetwork Automatic Markets
Beyond digitalizing money, payments, economics, and finance, blockchains are a next-generation information technology and a new form of general computational substrate. Blockchains solve a long-standing computing challenge called the Byzantine General’s Problem, which entails how to securely update far-flung nodes in a distributed computing network. The issue is knowing whether Byzantine generals out in the field are defecting and colluding, or remaining loyal and fighting; i.e.; how to determine if network nodes have become befouled. By enforcing integrity and security in distributed computing, blockchains dramatically extend the scale and scope of what might be possible in networks into a whole new tier. HFT (high-frequency trading) is already one of the most automated computational network activities, and could become even more so if instantiated in blockchain-based smart contract DACs (distributed autonomous corporations (i.e.; packages of smart contracts)). A heightened speed-up in concentration, processing power, and returns in HFT might be available in the short-term (until extirpated). The bigger point is that more of our human activity and patterns might be instantiated in smart contract DACs that look like HFT financial instruments (not in the sense of securities requiring regulation, but in the sense of automated pricing and execution behavior). Real-time bidding networks for advertising are already a kind of financial instrument in this sense, and more human-intervened processes could be implemented in the automatic markets format. Energy, logistics, fulfillment, and transportation (autonomous driving Uber-nets) could all be automatically orchestrated by tradenets and smart contract DACs, unobtrusive and backgrounded to the consumer. Pricing as an external heuristic (currently assessed and imposed by human agents) is no longer needed to price the resource in smartnetworks because the most effective pricing is when the resource prices itself. In this fit-ordered model, the underlying resource determines its own real-time minute-to-minute value, prices itself as a smart resource on a smartnetwork, and might enter into future contracts for its availability too.

2. Theoretical Blockchain Finance
As economics has been traditionally conceived with scarcity as its basis (the production and consumption of scarce resources), so too has finance been conceived as the control or prediction of the future value of assets and liabilities. However, the scarcity view of economics no longer holds in an era of digital services, non-rival goods, and complementarity. Likewise, the controlled future value of assets view of finance also no longer holds in an era where all of the variables concerning assets, capital, and investment might be changing. In economics, three crucial mindset shifts are moving from scarcity to abundance, labor to fulfillment, and hierarchy to decentralization. In finance, three similar mindset shifts could be moving from ownership to access, point values to topological ranges, and insufficiency to assurity (cognitive easing). Already there are indications that a significant transformation to autonomous driving might be underway, turning transportation into a fungible on-demand resource with a focus on access as opposed to ownership. Cars could become like air, a resource that one does not generally (on terrestrial Earth) have to think about owning, or expounding cognitive effort towards its ongoing attainment. Other examples in the emergence of the blockchain economy include the centralized version moving to the decentralized alternative: OpenBazaar to eBay, to Reddit, and LaZooz to Uber. Many decentralized versions have been conceptualized, even if they are not yet fully available.

Kickstarter, Crowdfunding, and Ambient Finance
One of the most rooted assumptions in economics is that any large-scale project requires financing, which would necessarily be in the form of debt capital. There is really just one mode of undertaking large-scale projects now, and that is to raise a chunk of capital that is spent down over time. This is a tremendously inefficient process at every step of the value chain, but there has been no viable alternative so far. The inefficiency of capital is highly visible in the case of startups (in the recent failures of Clinkle and Color). Institutional capital in public and corporate projects likely has greater inefficiency, and much less transparency, particularly regarding the degree of corrupt appropriations.

Now available: Configurable Smartmoney 
The immediate benefit of blockchains is that they have the capacity to bring greater transparency, accountability, and monitoring to the effective use of capital. The more profound contribution of blockchains is that they invite a new class of thinking about all financial matters including capital. Currently, there is just one mode of capital-raising for projects and it is narrowband; the “big chunk of capital” method. Other methods such as pledged capital calls have traditionally failed because monies are not escrowed and thus unavailable when needed. Blockchain-based smart contracts can change all of this, and vastly open up the range and type of financing choices that might be available. At minimum, pledges can be confirmed and escrowed. At a higher level of resolution, a whole new mode of finance might be implemented whereby capital is an available on-demand resource disbursed continuously in real-time per the assessed level needed. This more ambient version of capital as a resource can fluctuate with greater correspondence to objectively-determined and objectively-monitored underlying project needs.
Capital budgeting becomes an on-demand resource assignation process like just-in-time inventories or Uber rides. 
As smart resources automatically price themselves on smartnetworks, so too could smart contracts automatically call from escrowed pledges and “drip” capital into projects as needed. Some of the technical modes of effectuating this are Ricardian contracts and Hash Time-Locked Contracts (such as on the Lightning payment network); essentially ways to escrow-pledge capital and secure bi-directional payment channels without cheating.

Long-tail Economics and Ambient Capital
Kickstarter and the legalization of crowdfunding have already been a shift towards alternative more resilient network models of ambient finance. The greater effect of blockchains is that we might now have additional trustable cryptographic methods to administer capital commitment calls in greater correspondence, ambience, and monitoring with the underlying project needs. Most essentially, finance concerns credit, and credit concerns trust. With the creation of algorithmic trust and other blockchain-type mechanisms, the possibility is that the long-tail of economics and finance can meet. Like eBay for investors and projects, any two long-tail parties can meet and transact in a secure blockchain-based environment without having to know each other. The effect could be that many more projects and micro-starter projects might be able to receive the funding needed to advance. In the abundance economy of the future, credit to explore one's project ideas could come to be seen as a basic human right, in a sort of singularity-class financial inclusion operation of blockchains.

3. Conceptual Blockchain Finance
There may be two nodes in the adoption of any new technology. Initially the innovative idea, such as blockchains, might be grasped in its capacity as a “better horse;” as an improved version of something familiar. Most simply, blockchains are merely a modernizing information technology. Blockchains might help to do everything that we are already doing better. Blockchains streamline and modernize the operations of the financial services enterprise. In the second moment, after having implemented a new technology in its “better horse” applications, a new tier of possibilities, perhaps anticipated at the outset, can come into view more strongly, with the new technology now being conceived as a “car;” as a transformative and novel paradigm that completely reconfigures the former operation. At present, “better horse” implementations of blockchain technology are underway, modernizing the existing financial services industry with single-ledger technology, private ledgers (known confirmed identity of transaction-submitting parties) that are still centralized. In the second moment, “car” implementations might be the longer-term future. Digitalizing money, payments, economics, and finance renders all of these factors infinitely more composable, malleable, fungible, distributable, automatable, and configurable in a plurality of ways and novel applications that has not been possible before. With blockchains, the implication is not just that all modes of financial activity could be modernized, but that the very foundations of the concept of finance could be rethought.

Raising a Trust Bond: Using financial structures to expand into the economy of the future
In one potential near-future world of having transitioned to an automation economy, successful economies may be attending to the production and consumption of intangible social goods like autonomy and recognition, in addition to materials goods (where all needs might be met via GBIs (guaranteed basic income initiatives) or other measures). The same financial system could be used to deploy the new intangible social goods economy, for example, for community initiative X, there could be a trust bond. For example, the government might need to raise trust (as an intangible currency) to launch a certain program, such as a digital identity system. The same financial structure can be used, but instead of raising capital, trust is the commodity required to be raised or amassed for this particular initiative. Another example is raising the intangible social good of agency for personal health and fitness care-taking. These were two examples using the familiar financial structure with the alternative currencies of trust and agency. Another example using familiar financial structures for alternative “future finance” purposes could be simply the decentralized version. This would be the same capital-raising supply chain for example, but now populated by Kickstarter-like crowdfunding sources. In another example of similar concepts in a decentralized structure, Medici has been envisioned as a decentralized public capital market for stock and bond offerings.

4. Conclusion: The new finance – Cognitive Easing
Blockchains are a new form of cryptographic information technology that allows the digitalization of money, payments, economics, and finance. The stakes are high – blockchains could be instrumental in orchestrating an orderly transition to the automation economy (the outsourcing of unelected labor to technology). There could be two core objectives to such an orderly transition to the automation economy. One is material easing (less efforting required to attain material sustenance requirements), and the other is cognitive easing (less mental efforting required to attain tangible material goods and intangible social goods such as autonomy, recognition, and trust). Beyond the modernization of economics and finance, successful implementations of blockchain technology could point themselves towards the broader societal goal of cognitive easing over cognitive efforting for resource attainment in both the present (economics) and the future (finance).

Melanie Swan is a philosopher and economic theorist at the New School for Social Research in New York, has an MBA in Finance from the Wharton School of the University of Pennsylvania, and is the author of the best-selling book: Blockchain: Blueprint for a New Economy.

This post is dedicated to Lee Corbin, a reader of this blog and always-thoughtful interlocutor.