Ronald Coase, an economist, came up with the idea that the cost and complexity of doing business in enterprises is the key factor in driving up (or down) the size of an efficient enterprise. Companies can keep getting bigger and more profitable so long as the cost and complexity of managing a process internally is lower than the cost of assembling the same pieces on the open market from multiple different suppliers.
The transaction costs that Coase talks about are not the simple matter of swiping a credit card. They involve the true cost of negotiating agreements and implementing them, tying together business rules, payments and covering the terms of an exchange between parties. Cutting a check or sending a wire transfer costs just pennies. Negotiating and implementing business agreements costs thousands of dollars. Blockchain champions who think the future is just about low-cost money transfers are missing a big part of the vision and transformative power of this technology.
This post is part of CoinDesk's 2020 Year in Review – a collection of op-eds, essays and interviews about the year in crypto and beyond. Paul Brody is EY's global innovation leader for blockchain and a CoinDesk columnist.
For more than a century, information technology has made companies more efficient and better organizations. And consequently much bigger. At nearly every turn, from telegraphs to mainframes, manufacturing planning (MRP), enterprise planning (ERP) and finally the web have made it possible for companies to operate efficiently at ever larger scale.
Industries that used to have dozens or even hundreds of companies today have only two to four dominant players worldwide. There used to be dozens of companies that made telecom equipment, for example. Nearly every European country had its own national champion, not to mention Nortel in Canada and AT&T in the U.S. Today, that same market is dominated by just a handful of global firms including Huawei, Ericsson, Nokia and Samsung. That pattern repeats itself across nearly all the world’s biggest industries.
In every case, IT has made it possible to organize companies on a larger scale and to replace individual variability in implementing processes with a systematic approach to shared information across geographic boundaries. It has also made it possible to gather and aggregate demand and flows of money into vast centralized funding pools that support enormous capital expenditures.
The installed base of the industrialized world’s electricity and transport infrastructure alone is worth trillions of dollars, and it was all funded by taking just a few cents from each consumer’s electricity bill or gas tank at a time.
Information technology was essential in managing that river of pennies to fund industrial development because within an organization, under centralized control, the cost of transactions could be kept very low.
The New York Central Railroad, struggling under the weight of four million annual logistics invoices, became the second commercial customer for a Hollerith Punch Card Tabulating machine from the company that would, in time, become known as IBM. Customer Information and Control System (CICS) was the first large-scale mainframe transaction processing system, and it was developed by IBM to help electric utility companies manage their customer billing.
Blockchains will transform global commerce because they are going to change the cost of transactions between firms. When that happens, firms and finance will unbundle themselves. In 2020, all the paths towards this future suddenly accelerated. I count five particularly important milestones in acceptance and development this year:
The first has been a ramp-up in mainstream comfort with digital assets. From China’s Digital Currency Electronic Payment (DCEP) program to capital allocation decisions by Square and MicroStrategy, governments, enterprises and capital markets all took big steps forward this year. It’s estimated that PayPal and Square alone, in choosing to offer bitcoin to their users, are buying up more bitcoin than the entire mining process is producing this year. Expect the range of those assets to rapidly expand in 2021, both in the number of companies and governments engaged as well as the type of assets.
Secondly, regulatory frameworks are maturing in a way that further supports rapid acceleration. The European Crypto Framework, released in September, is a strong positive step. The Bank of England’s decision to build a regulatory framework around digital tokens based on fiat currencies is likely to be especially impactful because these fiat-based/fiat-backed stable-coins are now the most popular digital assets in use by both individuals and enterprises.
Most importantly, the industry’s ecosystems and technology choices are starting to converge. In particular, it’s increasingly clear that two public blockchains, Bitcoin and Ethereum, have each, in their own way, become the dominant architectures. Bitcoin has a market cap that exceeds the next twenty combined. Ethereum has more developers and users than all the others combined.
This is a completely normal and expected development, at least if you are a student of the history of technology. The internet itself followed this path, with early users preferring the comfortable walled gardens of AOL and Compuserve or private enterprise networks.
As usage widened and security tools matured, the power and value of the public internet overwhelmed the world of walled gardens and private networks. Bitcoin and Ethereum both have tens of millions of users, thousands of nodes and millions of developers. The largest private blockchains have dozens of nodes, at best.
In the last few years alone, thousands of startups focused on those ecosystems have been funded. These are orders of magnitude more diverse and vibrant ecosystems than any private blockchain environment. With the arrival of enterprise-grade privacy tools like Baseline Protocol (which uses Nightfall privacy technology that EY developed and donated into the public domain) enterprises can now use the public Ethereum blockchain and do so for a fraction of the cost of building a private network.
I often compare this to the choice companies had between software-based Virtual Private Networks that ran over the internet or actually building a private leased-line network. The cost- and time-to value differentials are staggering.
Private blockchains and their related companies and services are not going to disappear overnight. Netscape arrived in 1994 and the future of the web was immediately visible, but not everyone got on board right away. The AOL user base didn’t peak until 2002. Technology decisions have powerful inertia and take years to adjust, particularly in the enterprise, even if the endgame looks very clear.
The final big milestone of 2020 has been the acceleration and expansion of decentralized finance (DeFi). As novel as DeFi seems to be, it is, in fact, just the logical extension of how blockchains are supposed to work. Blockchains like Ethereum are designed for the creation of programmable digital assets. Until recently, the level of maturity in these smart contracts was very low. The smart, in smart contracts, often consisted of little more than managing the supply of tokens and list of owners.
With DeFi, suddenly there was real programmability. Smart Contracts could execute functions like loans and insurance, holding assets for others and actually doing things with them and being linked through oracles like Chainlink to the outside world. The total value of assets being used in the programmable frameworks has risen by factor of more than 20 this year, and while it is still a drop in the overall financial ocean, this is now a large enough amount of money to start attracting serious engineering talent into this space.
Rainstorms over rivers
Transaction costs between companies have always been much higher than those within companies. Common information systems, common leadership and a degree of internal trust make it possible for large enterprises to assemble solutions internally at scale. Externally, things get harder because not only is there a lack of trust but there is also no continuity of information systems, business process and rules across company boundaries. The result is a loosely coupled environment with lots of redundant (and expensive) verification.
Blockchains change this model because they hold out the potential for transactions between companies to converge closely in cost and speed with those internally. This kind of as-close-as-being-in-the-same-company integration already exists without blockchains but it is very costly and is only done on a bespoke basis between enterprises that already have long standing and deep ties, often in cases with a big power imbalance as well (big company tells weaker supplier to join its network). That’s a very small minority of business relationships.
Blockchains drive standardization and interoperability: Tokenization will turn just about every form of asset transfer and data transfer into an inter-operable standard. Smart contracts will do the same for business process and logic. Companies will have the ability to add or subtract suppliers easily and even small businesses will be able to move in sync with enormous global networks because they are all linked into a common set of tools and processes.
See also: Paul Brody – Enterprises Need Third Parties for Oracles to Work
This year is seeing the very first small steps of this approach taking shape, with the arrival of DeFi and business applications on the public Ethereum blockchain. At first, you can expect much of this to be a re-creation of traditional enterprise processes, but now faster and cheaper on the blockchain. EY and Microsoft managed to cut cycle time for contract management using a blockchain by 99%, so there’s lots of fat to cut.
Inevitably, however, innovators will move on from recreating to re-arranging the Lego blocks of finance and operations and, in so doing, they will start to unpack the traditional model of the enterprise. If working with external partners is just as easy as internal ones, the minimum economic scale of many companies starts to drop a great deal. This is not a new pattern either: In my time at IBM, we found that digital manufacturing technologies like 3D printing were already starting to cut the minimum economic scale for manufacturing in some industries by as much as 90%.
If you can use a blockchain to get a 1,000 small suppliers to work as efficiently as a 100 big machines in a centralized factory, do you need to aggregate revenue from millions of customers into a massive, centralized store of capital to fund a huge factory? Probably not.
Won’t decentralized financing go nicely with decentralized infrastructure? A shower of pennies across a wide range of small companies that are linked on the blockchain may be just as useful as aggregating them into a river of capital. What does the model of the firm look like when the corner store can compete with the biggest hypermarket on price?
The past is not our future
As disruptive as this year has been, and as transformational as blockchain technology is set to be, the future is not the same as the past. The immense diversity of local and regional enterprises in the past existed in part because information systems did not support global operations, not simply because it was nice to have local companies serving local clients. In the future, much of that business ecosystem diversity will revive, but it will not simply be replication of what came before, because it will be possible to serve small market segments globally without needing an enormous production scale. Whatever the future model looks like, we will look back on 2020 and see it as the starting point.