Blockchain technology aims to expand the role of digital transactions on the Internet

alessio saretto

Despite the technological innovations that the Internet has brought, most economic transactions require the presence of at least one central intermediary who often controls the terms of trade.

Intermediaries are banks, insurance companies and other economic agents that take advantage of the interface between service providers and end users to facilitate transactions. However, they do so at a cost and sometimes raise some fundamental concerns.

First, the presence of an intermediary can give rise to market power that can potentially be abused. Second, there is the possibility of fleeting commitment and the potential for conflict of interest. Finally, almost all existing brokers 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 its operating system.

Blockchain technology, a relatively recent development, promises to address some of these structural problems. In simple terms, a blockchain is a ledger in which transactions are organized and recorded, in the same way that they would be in a ledger (Figure 1). Blockchain applications are being developed for a multitude of endeavors, including Finance, Supply chain management, gaming, digital identity, land titling and the letters.

Chart 1: Number of active blockchains over the past decade

Downloadable Chart | chart data

Although the number of blockchain initiatives has increased steadily over the past decade, most of the activity, as measured by the number of transactions, is concentrated on the largest chains, such as Bitcoin and Ethereum. They have contracted moderately in recent months (graph 2).

Graph 2: Number of transactions executed on the largest blockchains slows down after execution

Downloadable Chart | chart data

cutting out the middleman

In a traditional centralized brokered ledger, a single entity is responsible for approving, viewing, auditing, and deleting transactions. For example, if you don’t pay 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 anyone to use.

Because the ledger can be edited by many people, an inexpensive mechanism is required to ensure that no one tampers with its contents. Therefore, a transaction is recorded only if enough agents, called validators, agree that the transaction did, in fact, occur. To align the interests of validators with the interests of users, the network rewards validators in the form of a token (commonly known as cryptocurrency) that loses value if ledger integrity is breached.

Initially, blockchain technology was primarily conceived 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 instead of the 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.

One important feature is that, similar to a physical currency, the owner can directly control a digital token without centralized intermediation. This is possible because a digital currency has a unique and unforgeable identifier, a public key, that only the rightful owner of the currency can transfer.

This type of peer-to-peer system differs from traditional electronic payment systems, which are based on traditional fiat currencies (dollars, euros and pounds, for example) that are, in the end, a liability of the central bank that issues them. A traditional electronic payment system simply connects financial institutions and merchants, but ultimately requires net settlement at the central bank level.

‘Smart contracts’ execute transactions automatically

Most blockchains work seamlessly with smart contracts, programs that run automatically when specified conditions are met. This is because they process digital native transactions with digital native currency.

Smart contracts are key to applying decentralization through blockchains because they automatically follow predetermined rules. Imagine a bank that doesn’t make a subjective judgment about whether or not someone should get a loan, but only lends money if the borrower has enough collateral.

In the span of just a few years, blockchain technology has evolved from Bitcoin to a new economic system, web 3.0, in which decentralized applications use smart contracts to allow users to interact with each other and exchange value securely and anonymously without relying on a centralized brokerage platform.

A unique feature of the blockchain is the high level of transparency and decentralization of its infrastructure. All protocols are built through open source collaborations 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 view, audit, and copy. Transactions are visible so anyone can monitor and verify them.

Legolike Packaging of Financial Transactions

Another important feature is the concept of composability: “Legos money”, 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 bricks, to create faster, cheaper, and more convenient products.

For example, this composability will soon allow you to take out a home equity loan, exchange dollars for euros, buy a flat in Paris, hedge currency risk with futures, and donate unused funds to charity. The entire collection sequence will require just a few lines of code executed by smart contracts on a decentralized ledger that is owned and operated collectively by people anonymous to each other.

Navigating new challenges

There remain a number of challenges with blockchain. Finding consensus across a large network of users in a decentralized environment can be slow and expensive. The larger the network, the more expensive it becomes to operate.

Therefore, the main feature that makes blockchain attractive, its decentralized structure, could become the main obstacle to its wider adoption. Not coincidentally, most of the recent innovations have been geared towards creating faster and more efficient protocols, increasing their ability to scale applications.

The global reach 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 practices differ significantly between countries. To thrive, blockchain initiatives will need to find ways to create regulatory compliance mechanisms that differ from the traditional consolidated approach that centralized companies take.

For example, there is no identity in the blockchain and each user is identified by public/private key pairs. This is a core feature of blockchain technology and does not fit well with existing anti-money laundering practices. At the same time, blockchain technology is fully transparent and transactions are traceable. Bad actors can be identified and prevented from operating on most protocols and from moving into the traditional financial system.

While the resources dedicated 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 Consultant in the Research Department of the Federal Reserve Bank of Dallas.

The opinions expressed are those of the authors and should not be attributed to the Federal Reserve Bank of Dallas or the Federal Reserve System.

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