Blockchain-based Distributed Ledgers (DLs) promise to transform the existing financial system. The idea behind such a transformation is to replace centralized institutions that govern the system by a decentralized peer-to-peer network of nodes. I discuss a paper by (Catalini & Gans, 2016) that discusses economic consequences of decentralization.
The paper builds on economic theory to explain how blockchain technology can drive markets by reducing two key costs associated with economic activity: cost of verification and cost of networking 1. Due to absence of a central clearing house or market maker, these novel networks, when permissionless, exhibit low barriers to entry and innovation.
Another novelty of blockchain platforms is their ability to incentivize early contributions by developers, investors and early adopters using native token offerings.
Economic Consequences of Decentralization
Trade between any two parties relies on trusted intermediaries. In exchange for their services, intermediaries charge fees and capitalize on their ability to observe all transactions taking place within their marketplaces. They observe an informational advantage which offers them substantial market power and control over the participants. This results in increased costs, reduced privacy, barriers to innovation and single points of failure 2.
Blockchain mitigates this reliance by distributing trust and runnning decentralized networks of exchange. This allows for the creation of ecosystems where the platform operators do not have an undue advantage. Hence, blockchain platform exhibit low barriers to entry and innovation.
Cost of Verification
By using costless blockchain verification over a costly verification through an intermediary allows value to be transferred across the globe at a minimal cost, expediting market activity. However, this does not solve last mile problems of compliance (e.g. KYC & AML rules), linking offline world with the real world, etc. which require an additional cost. A lower cost of verification also makes it easier to define property rights at a more granular scale than before, as any digital asset (or small fraction of it) can be traded, exchanged or tracked at a low cost on a shared ledger.
Cost of Networking
Cost of networking refers to the inefficiencies that arise due to the market power of incumbent players. The digital marketplaces that emerge on blockchains allow participants to make joint investments in shared infrastructure and digital public utilities without assigning market power to a platform operator, and are characterized by increased competition and lower barriers to entry, and a lower privacy risk. Therefore, blockchains also reduce the cost of networking.
Materialization Issues
Performance
One of the key problem with the current design of blockchains is the Speed-Scalability Tradeoff since for blockchains to be a suitable replacement for traditional networks it will need to achieve a level of performance (in terms of throughput, latency, cost per transaction, etc.).
Regulatory Frameworks
Regulatory and Compliance requirements introduce an additional overhead in terms of cost and existing frameworks need significant revamping in order to mitigate this.
Limited Applicability
Blockchains are not a panacea for every possible technical and market challenge a digital ecosystem may face. Wüst and Gervais (Wüst & Gervais, 2017) explore suitable cases for applications of blockchain and point out common use cases where blockchains are not a suitable solution.
Related Work
I discussed various applications of blockchains in my previous article and the utility of blockchains in building decentralized exchanges and the caveats associated were discussed in detail in this article.
References
- Catalini, C., & Gans, J. S. (2016). Some Simple Economics of the Blockchain. SSRN Journal. https://doi.org/10.2139/ssrn.2874598
- Wüst, K., & Gervais, A. (2017). Do you need a Blockchain? Cryptology ePrint Archive, Report 2017/375.
