A few years ago, I found myself in a wholly unremarkable experience in modern India: stuck in a traffic jam on the outskirts of Bengaluru. I was in in India learning how mobile payments might reduce the costs of microfinance loans. In retrospect, this event was particularly serendipitous: the traffic jam vividly demonstrated a key benefit that cryptocurrencies might provide.
In this case, a truck had broken down and drivers in both directions had to now share the remaining lane. In much of the US (and even in other parts of India), the two drivers would respectfully alternate who was allowed to pass through the lane.
On this road, the front two drivers both concurrently decided to use that remaining lane. Neither trusted the other side would let them through if they waited. The result: both drivers were now stuck yelling at each other as traffic piled up behind them.
The contrasting behavior is due to a trust gap. In the US, drivers follow written and unwritten rules that often causes them a momentary delay because it benefits the whole system. Most American drivers won’t even question why they behave this way, though there was a time when this behavior was far from the norm.
On many Indian roads (and even a number of US roads), drivers take every advantage they can get, as other drivers will do the same. Kinder drivers who disagree with the status quo will likely never be able to move, leading to a vicious cycle of selfish behavior that increases net travel time for everyone much like the classic prisoner’s dilemma.
Imagine how the choices would be different if both drivers knew they were guaranteed to get the right of way if they waited patiently.
While cryptocurrencies have received broad interest today due to skyrocketing valuations, the truly tantalizing promise they offer is a world where rules are promulgated and enforced — without external oversight.
Cryptocurrencies thus offer us a powerful trifecta: they allow us to remove costly middlemen, reduce certain forms of regulations, and crucially, engender trust where none existed before. They can lead a more collaborative world that enables commerce that would have been otherwise impossible.
The simplicity of crypto finance
Though cryptocurrencies may seem complex, at their core they are just a connected series of simple “if… then” statements.
Our financial world is filled with these rules today:
- If someone has a certain ID, then give them access to the money (a money transfer)
- If a car accident happens, then distribute this insurance coverage based on whose fault it is (auto insurance)
- If this customer requests their money, then give it to them (a basic rule that all banks are legally required to follow)
In a world before cryptocurrencies, these rules would be set by the government and financial institutions, and ultimately enforced by courts. By contrast, cryptocurrency contracts let us create a set of rules that all external parties can pre-inspect and that are hard to deviate from. The cryptocurrency provides a language to express these rules, and then enforces them.
We still may need some trust — for example, we may depend on a real world outcome that has to be attested to on the blockchain — but the trust is often reduced compared to today’s system.
Consider a simple product that I saw when I used to work at the Gates Foundation: an investor wants offer a crop insurance policy to a small scale farmer in Africa if adequate rain doesn’t fall. The small scale farmer reduces the risk of a bad season, while the investor has the potential to get a return on their capital.
Today, few people would trust an insurance policy offered by a random person online. You’d never know if a random person was actually good for their promise to eventually pay — and many would likely take the money and run.
This is one reason insurance is so heavily regulated. This regulation allows us to trust the product and protects consumers, but impacts innovation and increases the cost of the insurance policy. It favors large companies who can meet onerous rules and means the market chronically underprovides the needed insurance coverage. It also requires an honest, well functioning, and cost effective legal system and government — a high bar in many parts of the world.
In cryptocurrencies, by comparison, the random online user could fund an insurance contract, with the contract taking full ownership of the funds.
Unlike a human, this contract is governed by preset rules that dictate when and how the money is paid out. If the policy must pay out, the contract automatically gives ownership of the funds to the policy holder with no further input from the original investor. Otherwise, our original investor has made a return, with no money siphoned by an insurance company.
While this is a simplistic example that has its own set of flaws (no one today would trust a smart contract denominated in a volatile cryptocurrency — and it depends on third-party oracles), it’s instructive to see the power of smart contracts. (For much more on crypto contracts, see the pioneering reflections by Nick Szabo over decades)
This new form has huge benefits by cutting costs paid to middlemen, reducing certain financial services regulations, and enabling trust. For something so transformative, it also opens up a host of challenges we’ll need to confront.
Disintermediating financial institutions
First, this contract reduces the need for middlemen, cutting costs for all parties involved.
Bitcoin’s key innovation was turning a single trusted, regulated party — today’s Visa — into a decentralized market where many parties (miners) would be forced into price competition. It turned a monopolistic industry into a more competitive market.
In this example, an insurance company may now be a boilerplate crypto contract that just requires investors and farmers — but few middle parties. It also forces investors to compete against each other.
Beyond meeting onerous regulations, creating a financial services company often requires a trusted brand — a high bar that favors large, well organized companies. Before FDIC bank deposit insurance in the 1930s, consumers would have to individually assess the likelihood that their bank might go bankrupt.
With cryptocurrencies, the barriers to creating a financial provider are much lower. Our old world insurance company may simply be a matching mechanism — akin to Tinder — matching investors and those who need insurance.
While central bankers and the cypherpunks share little in common, they are both animated by the possibility of disintermediating financial institutions. It disrupts the existing system, while providing a lower cost services to consumers.
Second, cryptocurrencies will reduce the need for some important forms of financial regulation.
Financial services are heavily regulated partly because the parties involved can steal or misuse your money. The government polices nearly every financial institution we interact with (your bank, your stock exchange, your broker). This doesn’t even scratch the surface of regulation required for many complex transactions on Wall Street.
After numerous financial institution failures (hundreds of banks would collapse each year in the Great Depression), an alphabet soup of US regulatory agencies (OCC/OTS, FDIC, CFPB) rigorously regulate financial institutions so that deposits are secure.
Insurance companies are similarly overseen by each individual American state to ensure that insurance policies can be paid out. For a national insurance company, this means meeting 50 separate state’s requirements. To start a money transfer agency like Western Union, an American entrepreneur needs substantial capital and to meet an onerous set to rules in each state to get a money transmitter license.
On one hand, this protects consumers. On the other, it makes it hard for upstart financial institutions to start, severely impedes innovation, and raises costs for businesses and consumers. It also favors large companies with lobbying power and large regulatory departments.
By comparison, the Lightning Network — a money transfer layer being built on Bitcoin — allows many parties to help route your payment to a destination without requiring you trust any one of them.
This is akin to giving money to a random person in New York City and expecting that money to eventually turn up in your recipient’s account in Mumbai after being passed through the hands of 20 other strangers who may never meet again. All these 20 parties can help transport your money, but are prevented from being able to steal it. In short, we’ve removed custodial risk without requiring any regulation.
For conservatives, cryptocurrencies offer the potential for greater self-regulation, substantially reducing the need for government oversight. For liberals, consumer rights are even more rigorously protected, while increasing access to financial services. More broadly, utilization and trade goes up.
Most importantly, cryptocurrencies allow us to bootstrap trust in environments where none existed. Suddenly, we can transform Indian drivers’ attitudes to that of American drivers — and more.
If the two parties can’t trust the other, they won’t be able to trade — or share the road effectively. Crypto finance lets us bootstrap trust where none existed, creating a world where trusting various parties will be the natural reaction. If an Indian driver knew others would behave favorably (or be forced to), it’d make it much easier to wait their turn.
With crypto finance, unknown investors and farmers can suddenly trade with each other without worrying the money will be stolen or that rules will be arbitrarily changed. They (or others) have examined the rules of their contract, and know that only a few specific outcomes are possible (more likely, others will examine the code, and deem it appropriate). They also know that the cryptocurrency will enforce the rules.
Over time, you might not even need the underlying crypto contract if parties slowly expect that this is how their partners will naturally behave. Suddenly, we’ve created trust in an environment where little previously existed.
Today, with new mobile apps like Coinbase’s Wallet and Ethereum, an insurance contract like we discussed is nearly trivial — and over time, easily accessible to anyone around the world with a mobile phone.
These cryptocontracts are especially powerful in emerging markets where the legal system may be slow, expensive, and corrupt. For years, the World Bank has published it’s Doing Business indicators which show just how challenging the legal system is in many countries. Cryptocurrencies begin to offer us an impartial — if stickler — judge that can be used the world over.
We don’t even have to go that far to see these changes already: in Zimbabwe, it’s likely much more appropriate to trust Bitcoin than a currency issued by the national government. The preset rules that Bitcoin has — namely that the currency will grow at a preset pace — engenders greater trust among users.
The prior example — a weather insurance contract — is quite rudimentary, and simple innovations like this may augur entirely new models of companies and collectives like DAOs. Many forms of commerce that were heretofore impossible are suddenly available to all.
A future world of trust
Cryptocurrencies are hardly a panacea. They comes with new risks that we will have to undoubtedly confront.
What happens if the rules have a mistake? What happens if the rules are followed, but are unfair? What will the process be to change rules? Will we need many more regulations to ensure that people’s cryptocurrency credentials are secure? What happens to the power of existing legal systems?
Despite my optimism, I’m hardly going to predict the replacement of our legal systems or the death of all financial regulations. Crypto contracts are good today at simple rules with simple arbitration mechanisms and won’t be replacing entire legal systems anytime soon, if ever. Cryptocurrencies also need regulation to check its worst excesses — and systems to fix bugs and malevolent actors.
And yet, they offer the tantalizing prospect of a world where we trust each other — and trade in ways we never thought possible.