Streetwise Professor

July 13, 2018

Blockchain Wunderkinds: Solving Peripheral Problems, Missing the Big Picture

Filed under: Blockchain,Cryptocurrency,Economics,Exchanges — cpirrong @ 7:52 pm

Ethereum wunderkind Vitalik Buterin delivered a rant against centralized crypto exchanges:

“I definitely personally hope centralized exchanges burn in hell as much as possible,” Buterin said speaking to TechCrunch.

When bitcoin, the original cryptocurrency, was founded in 2008 by the anonymous Satoshi Nakomoto, the point was to create a decentralized financial future that renders middlemen useless. Nearly 10 years later, the centralized exchanges — those folks sitting in the middle of buyers and sellers — are among the most powerful players in the market for digital currencies such as ethereum and bitcoin.

Bloomberg News estimates they brought in $3 million a day last year. And exchanges such as Gemini and Coinbase are expanding at a clip, bringing on talent from Wall Street.

“It’s hard to ignore the irony that an asset created to allow decentralization is currently almost completely traded on centralized exchanges,” Peter Johnson, a vice president at Jump Ventures, said in an interview. Buterin, however, wants the crypto community to focus more on decentralization so that cryptos can more frequently trade peer-to-peer. Buterin’s remarks come as so-called decentralized exchange gain more attention.

Like many of his arrogant ilk, Buterin ignores the lesson of Chesterton’s fence: why does this thing you do not like and do not understand exist?

Yes, blockchain and cryptocurrencies allow peer-to-peer transactions.  They were largely designed to facilitate such transactions.  For some, the motivation is ideological: an anarchic belief in radical decentralization, and a deep distrust of centralized institutions.

But just because blockchain and related technologies reduce the costs of peer-to-peer transactions, doesn’t mean that such transactions are cheaper than centralized trading on exchanges.  Transacting requires finding a counterparty.  It requires negotiating a price (for a standardized thing, like a Bitcoin–negotiations of other terms for more complex things).  Negotiating a price is costly when information about value is diffuse, so in a decentralized setting not only is it necessary to search for counterparties, it is advantageous to search for information about prices to (a) find the best price, and (b) to be able to negotiate with better information about value .

Centralization reduces the cost of finding a counterparty.  It enhances competition, which tends to reduce bargaining costs.  It leads to better and more symmetric information about prices, which also tends to reduce bargaining costs.  Further, centralized markets can support specialized intermediaries–market makers–who specialize in smoothing out idiosyncratic temporal imbalances in buy and sell order flow, which further reduces trading costs.

Because of these features, centralized trading is frequently an emergent outcome of individual decisions, and one that economizes on transactions costs.  This is clearly what is happening in crypto world.  Indeed, the main puzzle at present is why there are so many exchanges.  The centripetal forces of liquidity will likely result in a huge consolidation in this space.

Buterin and others are attempting to find ways of mitigating some of the disadvantages of bilateral trading (bilateral just being another, more conventional, way of saying “peer-to-peer”).  Reducing the ways of finding people who want to take the other side of a transaction, for example.  But I am highly skeptical that these measures will overcome the inherent advantages of centralizing trading of homogeneous things that large numbers of people want to buy and sell pretty much 24/7, to the point that peer-to-peer will supplant centralized trading.  Buterin can rant all he wants, but centralization is here to stay, and if anything, this segment of the market will become more centralized.

Buterin’s error is seemingly the opposite of those who bewail the lack of centralization in some markets, e.g., those who want to make swaps trading more centralized and who rail against bilateral OTC transactions, but it is really the same mistake. Those who see too much centralization in some markets, and those who see too little in others, fail to recognize that trading mechanisms are emergent orders that develop diverse niches to accommodate the fact that transactors and transactions are heterogeneous.  Centralization is efficient for some transactors and transactions: bilateral/OTC for others.  That’s why we see both.

(This is a point I made at a Platts blockchain conference in November, BTW.  The theme of my talk was where decentralization can work, and where it is likely inefficient.  Trading of standardized instruments was one of the main cases I discussed.)

Alas, the ignorance of techno-geniuses is not limited to trading mechanisms.  One of the supposed benefits of blockchain that is that it allows the ownership of anything–a painting, a house, you name it–to be divided into shares, with the fractional interests recorded in an immutable register, and traded peer-to-peer.  That is, block chain facilitates equitization of assets.  A breakthrough!

Uhm, not really. The benefits of equitizing assets and risks has been long, long understood by economists.  In particular, it has long been understood that equitization facilitates more efficient risk sharing.

But long ago, economists also recognized that despite these apparent benefits, in fact very few assets and risks are equitized.  A vast literature has come up with explanations why.  Information and incentive problems–moral hazard and adverse selection–are notable among these.  A prosaic example: If I sell off shares in my car, what incentive do I have to maintain it properly and to economize on wear and tear and to reduce the probability of theft?  Who pays for maintenance? Who decides on what maintenance is needed?  When I sell the shares, I am likely to have better information about the value and condition of the vehicle, which would subject the buyers to an adverse selection problem, meaning that I am likely to get a low price for the shares–so why bother selling them?  There are other transactions cost problems associated with measurement (who verifies exactly what the asset is?) and opportunism and governance and control.   Related to the centralized trading point, if an asset is highly idiosyncratic/unstandardized, the desire to trade fractional shares will be small.

A potentially slightly cheaper way of recording and transferring fractional ownership does not address these far, far, far more fundamental impediments to equitizing (or should I say, “tokenizing”?) assets and risks.  But the coder geniuses miss the forest for the trees.  They see the issue that their technology can address, and think that it will be revolutionary, only because they do not understand the broader economic issues in play, and therefore think everyone born before them or who does not code must be an idiot.

No, not really.  They are looking at the capillaries, and missing the heart, veins, and arteries.

It reminds me of the Mark Twain quote: “When I was a boy of fourteen, my father was so ignorant I could hardly stand to have the old man around. But when I got to be twenty-one, I was astonished at how much he had learned in seven years.”  Except seven years haven’t passed for the Buterins of the world, and frankly, I seriously doubt that they will.  Instead, they inhabit a techno-Groundhog Day.

All of this is symptomatic of blockchain hype and froth.  There is an indication that we have reached peak hype.  R3, a bank-led blockchain consortium, is contemplating an IPO.  To me this is a signal that those on the inside of blockchain development, especially in the area where its benefits have been particularly hyped (finance/payments/settlement/fintech) understand that the reality will never match the hyperbole, so it’s best to sell out while hyperbole reigns supreme.  (Yes, they claim that they are being approached by those looking to buy the whole thing, but take that with a big grain of salt–I view it merely as part of the sales pitch.  “This is a hot little property right now.  Better get in before someone snatches it away.”)

In brief: don’t be the greater fool.

I think that blockchain and DLT will have some viable commercial applications.  But I am highly confident that they will not be nearly as revolutionary as the True Believers claim.  This is in large part due to the fact that it is clear that the True Believers have an extremely narrow, blinkered understanding of the broader economic issues associated with transacting, ownership, risk transfer, incentives, and governance.  Blockchain may address some issues, but many–if not most–of these issues are secondary or tertiary, not fundamental.  Some things are done more efficiently in a centralized fashion–the trading of standardized instruments being one.  Some things are not equitized/tokenized not because it is technically infeasible/prohibitively costly to issue and record fractional interests, but because fractional ownership entails substantial incentive and information problems.

So don’t believe the hype.  And take a pass on those R3 shares, if they do come to market.

Addendum: the dominance of crypto exchanges is even more remarkable, given how they, well, pretty much suck.  They are hardly comparable to modern futures or equities trading exchanges.  Yet people still strongly prefer to trade on rather clunky platforms with major potential security issues where you can’t easily convert digital into fiat currency and which are likely rife with manipulation than peer-to-peer.  That tells you something.

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  1. If I buy a tokenized asset on a decentralized system, who do I sue if the asset or counterparty disappears? The reason bitcoin works is because the asset is the transaction, with no counterparty.

    Comment by Sant cugat — July 15, 2018 @ 4:11 am

  2. “A prosaic example: If I sell off shares in my car, what incentive do I have to maintain it properly and to economize on wear and tear and to reduce the probability of theft? Who pays for maintenance? Who decides on what maintenance is needed? When I sell the shares, I am likely to have better information about the value and condition of the vehicle, which would subject the buyers to an adverse selection problem, meaning that I am likely to get a low price for the shares–so why bother selling them?”

    – Seems like you could write a bunch of quite nice smart contracts to cover all of these individually and within a system that would govern the way it operates overall. I guess that’s what the economists couldn’t really do before.

    Comment by cyborg — July 15, 2018 @ 1:20 pm

  3. There are counter parties in Bitcoin transactions. I remember years ago I heard about a new exchange starting up. They were pitching at a Bitcoin conference. Post pitch I asked three questions:

    You mentioned margin. How are you calculating margin?
    A: It’s 20%
    No, what’s the margin? If the underlying asset has high volatility does it change?
    A: It’s 20%
    When I trade, who am I trading with? Is there a trade register? How do I know the person will live up to the deal?
    A: No answer.
    How do you guarantee clearing and delivery?
    A: We don’t need a clearinghouse, we have a blockchain.

    The points on exchanges are well taken. I think Craig is spot on with a number of them. I think the tokenization of things like gold make no sense. But, the tokenization of many assets that are illiquid could make a lot of sense if the token can create liquidity and lower transaction costs and bring transparency. REITs might be one area.

    Comment by Jeff — July 15, 2018 @ 4:40 pm

  4. @cyborg–Perhaps what you write is satire, because it is in fact a brilliant satire of the smart contract cult.

    The fact is that contracts will always be incomplete, i.e., cannot specify actions under every contingency regardless of whether the contracts are embedded in code or on paper. Smart contracts do not circumvent this particular economic problem. At best, they automatize the execution of the subset of real world contingencies that can be specified.

    The example I give demonstrates this very well–which is why I chose it. I say “what incentive do I have to maintain it properly.” Well, how would you represent “proper” maintenance in code? How would you measure my compliance? The fact is that it is impossible to identify, let alone encode, all of the contingencies and factors that determine the optimal amount of maintenance.

    Further, it is well known that when contracts are incomplete, utilizing high powered incentives (of the type which I imagine you contemplate incorporating in a smart contract) can actually be extremely counterproductive.

    Property rights economics theories of ownership and the allocation of control rights recognize that contract incompleteness and imperfect measurement/monitoring often make it efficient to concentrate ownership and control in the hands of a single party. Smart contracts do not change that underlying reality.

    Comment by cpirrong — July 16, 2018 @ 6:06 pm

  5. The suckage of the centralized cryptocurrency exchanges is a reflection of the suckage (or at least incompatibility) of the fiat banking system. When I have to supply all manner of identity documentation to buy bitcoin, I get the worst of both worlds: the volatility and limited adoption of BTC, and the compromised privacy, forced custodial trust, and regulatory capriciousness of a dollar-denominated bank. It is bad enough just being an itinerant consultant with a transient address; for the majority of the world’s population, KYC/AML makes banking utterly inaccessible. Our esteemed blogging host lives in a world where trade happens freely and rule of law prevails, but the working poor in India, whose savings were wiped out in 2016 when 85% of the cash was demonetized overnight, may have a different view on the efficiency that comes from centralization.

    I think this is Buterin’s point, that the big exchanges cater to an economic model that misses the point of cryptocoin. Five years ago, the easiest way to buy bitcoin was to meet someone and pay cash. I would have liked to see that develop into retail places like “Bureau de Change” booths where you could change your deutschmarks for francs, but have bitcoin as an option, but what happened was bank-connected exchanges came on the scene, and even f*&*ing bitcoin ATM’s that take *cash* require ID for the smallest transactions. In the process, cryptocurrency lost its soul and became just another speculative asset.

    The best exchanges, in terms of tapping the revolutionary potential of cryptocurrency, are the ones that ignore national fiat currencies. Those places often don’t require any ID, and some, like, don’t require an account any more than Bureau de Change did. Beyond that, the technical foundation has been laid for fully decentralized exchanges, not because they are more efficient (to those in enlightened jurisdictions), but because on them, code will be law and no authority can change the rules in self-serving ways.

    And yeah, some of these smart-contract concepts are rather half-baked, and Buterin himself was as guilty as any of them when “The DAO” distributed investment fund got hacked. The better ones aim at co-ordinating communities along simple rules and don’t rely too much on interfaces (or “oracles”) to the real world. Even as a believer in the revolutionary potential of blockchain technology, I certainly don’t make myself Mr. Popularity at gatherings when I point out the security and practicality shortcomings of the latest Big Idea.

    Comment by M. Rad. — July 22, 2018 @ 10:56 pm

  6. Oh yeah, and regarding the point-counterpoint between @cyborg and @cpirrong, a smart contract governing the securitization of an automobile is a bit extreme, and any solution to it would require technical hooks into the hardware design (to feed “oracle” data into the self-executing contract) that would be like SIM-locking amped-up to the nth degree…not likely a workable business model. (A micro-rental co-op, on the other hand…maybe.)

    I would, however, dispute this statement from @cpirrong: “Property rights economics theories of ownership and the allocation of control rights recognize that contract incompleteness and imperfect measurement/monitoring often make it efficient to concentrate ownership and control in the hands of a single party. Smart contracts do not change that underlying reality.” Smart contracts do, indeed, change the underlying reality in important ways: they can *automate* transaction complexity and they can privatize dispute resolution without custodial trust. We treat Wal-Mart corporation as a legal person, for example, so I don’t have to sign a 50-page contract with a million stockholders to buy a pack of gum. And we rely on courts (ultimately) to resolve a dispute and enforce (via custodial banking) the fund transfers coming from their decisions. A smart contract (in principle at least…no one has written software for anything but the simplest cases so far) can take the place of the corporation and an arbitrator (via control of certain cryptographic keys) can choose between “pay” and “refund” without having the power to do anything else. It is too early to say how far such factors will change the world, but they are, wholly and completely, new. Nothing like this has ever happened and at least some of the old rules will change.

    The smart-contract world is in a state comparable to microcomputers in 1980. This new platform is here, and visionaries can see revolutionary potential in it, but the software to realize the vision is years away. We have many years of killer apps (word processors, spreadsheets, email) and stupid s%*t (Microsoft Bob, CueCat, copy-protected floppies) ahead of us.

    Comment by M. Rad. — July 23, 2018 @ 9:21 pm

  7. If there is room for a decentralied exchange to exist, why is it unclear how they will succeed?

    Comment by Andrew Cashion — November 8, 2018 @ 11:00 am

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