The blockchain, the end of transaction costs and new challenges for government authority

If you haven’t been living under a rock, you have by now heard about the blockchain. To recap, a blockchain is a record of transactions that is kept on a distributed network of computers. Each new transaction gets added to the blockchain and the distributed copies are identical. There is no central authority that oversees the transactions. Because of its distributed nature, the blockchain cannot be falsified. The most prominent application that uses blockchain technology is Bitcoin, a cryptocurrency that has seen a meteoric rise in value over the last year.

However, the currency aspect of Bitcoin may not be its most important feature. Rather, the blockchain idea goes far beyond the basic functions usually ascribed to money (means of exchange, a store of value and unit of accounting).

There is no reason why the blockchain should be restricted to recording who has transferred what amount of money to whom. The peer-to-peer distributed ledger that is the blockchain can hold all kinds of information, including the terms of contracts between parties. That way, contracts can be executed automatically, in an if-this-then-that fashion. This eliminates a large chunk of transaction costs usually involved in contract monitoring and enforcement.

The drastic reduction of transaction costs might prove the greatest disruptive potential of blockchain technology. As Ronald Coase has famously argued in his 1937 paper “The Nature of the Firm”, transaction costs that result, inter alia, from monitoring and enforcing contracts, are the main reason why firms and organizations exist at all. Without the existence of transaction costs, contracting could be left to independent parties in the market place.

Oliver Williamson has added several important aspects to Coase’s work, among them the notion of asset specificity. If assets are specific to a certain task, the incentives for shirking on contracts increase. Asset specificity is also paramount when thinking about human capital and its use. Under which conditions are workers willing to invest in industry-specific or even firm-specific human capital assets? This is one of the questions that has given rise to the varieties-of-capitalism literature and its argument that asset specificity in human capital formation can only be achieved if it is embedded in a context of robust welfare state provisions that act as insurance in case the asset specific human capital investment loses its value.

Blockchain technology has the potential to reduce transaction costs that stem from monitoring and enforcement requirements and that have contributed to the existence of firms. The Ethereum platform, for example, implements a programing language than can be used to write self-enforcing, so-called “smart” contracts that do not rely on trust or third-party involvement. Contracting could become a lot easier and more efficient if possibilities of shirking and reneging on contracts are minimized or altogether eliminated. A simple example for a trustless contract between a vendor and a buyer can be found here.

Smart contracts also have important implications for governments and their authority. The following is just one example from a rather specific field but it illustrates the point: Many countries’ legal provisions know the institution of a “legitimate”, i.e. that part of a deceased person’s estate over which the decedent does not possess full legal authority. In these countries, a certain part of the inheritance goes the testator’s children, spouse or parents, irrespective of the stipulations in the will. In other words, the testator is limited by legal provisions in the use of his or her estate after death has occurred.

Now imagine a man called Peter who wants to leave everything to the Humane Society. Peter likes animals a lot better than people and certainly more than his son, Bob. Bob is a low-life, up-to-no-good 40-something who has had every opportunity in life and who has squandered it all. However, under current legislation in, for example, Germany, Bob is entitled to 25 percent of Peter’s estate (barring special circumstances).

Knowing this, Peter sets up a smart contract that gets triggered in case of his death. The contract stipulates the automated payment of all of Peter’s money to the Humane Society. If the money itself is stored on the blockchain as a cryptocurrency, no involvement of a third party like a bank is necessary. Obviously, this would make it a lot harder for any government to enforce Bob’s legal right to his legitimate. If the entity to which Peter has bequeathed his estate is in a different jurisdiction, things might become altogether impossible for Bob . Maybe most importantly, Bob would have no possibility to find out how large Peter’s estate was in the first place. If the record is not kept in a bank and if it is protected by sophisticated cryptographic technology – as the blockchain is – then the government acting on Bob’s behalf would have no access to any records – where would the court send the subpoena?

In other cases, blockchain technology can make up for insufficient state capacity. Many poor countries don’t have a functioning real estate register where titles are kept and can be produced in case of a property transfer. Smart contracts could fill this void and make real estate markets more efficient and title ownership more transparent, creating spill-overs into mortgage markets and capital markets more generally. Along the way, the state would have lost some of its (potential) relevance as the keeper of a reliable registry.

Beyond all the hype about bitcoin et al. are two much more important developments. First, transaction cost reductions through smart contracting will dramatically alter the incentives that in the past have led to the formation of companies and other organizations. Their shape, size and boundaries with their environment will change, and those companies that understand these impeding changes will be more successful in a distributed-ledger smart-contract environment. Second, as third parties are eliminated through smart contracting, the legal authority of governments around the world will be challenged. Their capacity to monitor and enforce the compatibility of private-agents’ contracts with national law will be further diminished. As such, sophisticated blockchain technology contributes to the shrinking authority of the nation state in a globalized world.