Why do firms exist? Ronald Coase, - the eminent British economist and University of Chicago professor, - addressed this question in The Nature of the Firm, - a seminal paper published in 1937 which along with other major achievements earned him the 1991 Nobel Prize in economics.
Professor Coase explained that, in principle, a firm should be able to find the cheapest, most productive, highest quality goods and services by contracting them out in an efficient, open marketplace. However, markets are not perfectly fluid. Transaction costs are a kind of friction incurred in obtaining goods and services outside the firm, such as searching for the right supply chain partners, establishing a trusted relationship, negotiating a contract, coordinating the work, managing intellectual property and so on. Firms came into being to make it easier and less costly to get work done.
A recent IBM report, - Fast forward: Rethinking enterprises, ecosystems and economies with blockchains, - harks back to Coase’s paper to analyze the potential value of blockchains. The report notes that while transaction costs are lower within firms, “in recent years as enterprises have scaled, the added complexity of operations has grown exponentially while revenue growth has remained linear. The result? At a certain point, organizations are faced with diminishing returns. Blockchains have the potential to eradicate the cost of complexity and ultimately redefine the traditional boundaries of an organization.”
At the same time, Internet threats are growing. Large-scale fraud, data breaches, and identity thefts are becoming more common, and companies are finding that cyber-attacks are costly to prevent and recover from.
Why is the Internet so vulnerable to these threats? Why wasn’t stronger security designed into the original Internet infrastructure? MIT research scientist and Internet pioneer David Clark addressed this question in a recent article about the early design choices that have led to today’s Internet.
The Internet is basically a general purpose data network that supports a remarkable variety of applications. Being general purpose was a major design choice, that has enabled the Internet to become one of, if not, the most prolific innovation platform the world has ever seen. But while the Internet has enabled many innovations, it’s extensive use has led to new, serious risks in business and economic activity. Foremost among them is security.
A major reason for the Internet’s ability to keep growing and adapting to widely different applications is that it’s stuck to its basic data-transport mission, i.e., just moving bits around. The Internet has no idea what the bits mean or what they’re trying to accomplish. That’s all the responsibility of the applications running on top of it.
Consequently, there’s no one overall owner responsible for security. Responsibility for security is divided among several actors, making it significantly harder to achieve. As Clark points out, “the design decisions that shaped the Internet as we know it likely did not optimize secure and trustworthy operation.” Hopefully, that’s what the blockchains will now help us achieve.
As firms now rely on ecosystem partners for many of the functions once done in-house, one of their major organizational challenges is how to best manage their increasingly complex operations across a network of interconnected companies. Distributed operations can lead to increased risks, unanticipated consequences and new kinds of serious frictions.
“The long history of human progress has been a steady march against friction,” wrote the IBM report in its opening sentence. “From the introduction of money to replace barter and the gradual replacement of wax seals by digital signatures, we have seen steady progress facilitated by digital innovations. The internet primed friction for a free-fall. Since then, some frictions fell while others rose.”
Three types of frictions predominate today:
- Information frictions: Participants in a transaction don’t have access to the same information; the required information is not easily accessible; and security and privacy risks keep rising, - e.g., hacking, cybercrime, identity theft.
- Interaction frictions: Intermediaries are needed to help deal with growing scale and complexity; transactions take longer due to arcane global processes; and a lack of trusted marketplaces in many economies around the world.
- Innovation frictions: These include legacy systems, bureaucratic processes and institutional inertia; restrictive regulations that stifle innovation and change; and growing uncertainties and threats that make it harder to move forward.
Blockchains promise to significantly reduce these frictions by bringing one of the most important and oldest concepts, the ledger, to the Internet age. Ledgers constitute a permanent record of all the economic transactions an institution handles, whether it’s a bank managing deposits, loans and payments; a brokerage house keeping track of stocks and bonds; or a government office recording births and deaths, the ownership and sale of land and houses, or legal identity documents like passports and driver licenses. They’re one of the oldest and most important concepts in financial transactions and other mission critical applications.
As the IBM report notes, “Today, transactions are recorded in multiple ledgers. Each one captures at best a moment in time and reflects the information held by a single party: Bank X purchased or sold a mortgage, for example. They don’t record what happens next, what came before, or the role of others - partners, suppliers, consumers - in the transaction. Moreover, they’re prone to human error and vulnerable to tampering. By contrast, distributed ledgers can be shared and updated in near real-time across a group of participants.”
The report lists five major distributed ledger or blockchain attributes that will help reducie these frictions:
- Distributed and sustainable. “The ledger is shared, updated with every transaction and selectively replicated among participants in near real-time. Privacy is maintained via cryptographic techniques and/or data partitioning techniques to give participants selective visibility into the ledger; both transactions and the identity of transacting parties can be masked. Because it is not owned or controlled by any single organization, the blockchain platform’s continued existence isn’t dependent on any individual entity.”
- Secure and indelible. “Cryptography authenticates and verifies transactions and allows participants to see only the parts of the ledger that are relevant to them. Once conditions are agreed to, participants can’t tamper with a record of the transaction. Errors can only be reversed with new transactions.”
- Transparent and auditable. “Because participants in a transaction have access to the same records, they can validate transactions, and verify identities or ownership without the need for third-party intermediaries. Transactions are time-stamped and can be verified in near real-time.”
- Consensus-based and transactional. “All relevant network participants must agree that a transaction is valid. This is achieved by using consensus algorithms. Blockchains establish the conditions under which a transaction or asset exchange can occur.”
- Orchestrated and flexible. “Because business rules and smart contracts that execute based on one or more conditions can be built into the platform, blockchain business networks can evolve as they mature to support end-to-end business processes and a wide range of activities.”
Most everyone agrees that the Internet has been transforming economies, societies and our personal lives. What’s the long term promise of blockchains?
“Over the years, businesses have overcome multiple sources of friction. Institutions and instruments of trust emerged to reduce risk in business transactions. Technology innovations helped overcome inefficiencies. Still, many business transactions remain inefficient, expensive and vulnerable. Blockchain technology… has the potential to obviate intractable inhibitors across industries.”
“As frictions fall, a new science of organization emerges, and the way we structure industries and enterprises will take novel shape. With transparency the norm, a robust foundation for trust can become the springboard for further ecosystem evolution. Participants and assets once shut out of markets can join in, unleashing an accelerated flow of capital and unprecedented opportunities to create wealth.”