The Firm as a Nexus of Smart Contracts? How Blockchain and Cryptocurrencies Can Transform the Digital Economy, by Christian Catalini

by Guest Blogger — Wednesday, June 7, 2017

Through his seminal work on transaction costs, Nobel laureate Ronald Coase highlighted key frictions that prevent organizations from relying exclusively on market transaction to achieve their goals. Uncertainty, asymmetric information and the risk of moral hazard, by undermining the ability to write complete and effective contracts, force organizations to internalize operations and depend on more complex forms of governance in order to effectively create and capture value. At one extreme, Jensen and Meckling define firms as little more than a nexus of contracts between the many stakeholders that gravitate in their ecosystems. As platforms are increasingly becoming the fastest growing organizational form – connecting ideas, talent and capital on a global scale – a new technology promises to accelerate the digital transformation started by the internet. Whereas the internet brought the ability to cheaply transfer information, before the diffusion of cryptocurrencies, the transfer of value still required traditional, trusted intermediaries to secure market transactions. While still in its infancy, the suite of technologies associated with blockchain and crypto-tokens has the potential to fundamentally change how organizations and individuals source and allocate resources in the economy.

Blockchain technology is associated with a reduction in two key costs: the cost of verification, and the cost of networking (Catalini and Gans, 2016). The first allows for the costless verification of any transaction attribute that has been previously stored on a distributed ledger at almost zero cost. As a result, market efficiency is improved, as credentials, reputation systems, provenance and other attributes of individuals, goods and services can be more cheaply tracked with higher integrity throughout the economy. The second enables entire platforms to be bootstrapped without the need for a central actor through the use of a token of value aimed at rewarding early investments in the new ecosystem and at funding its operations (as in Bitcoin). This architectural change in how digital marketplaces operate, has implications for competition and incumbents’ ability to retain control over existing ecosystems and resources.

Of course, intermediaries will still be able to add substantial value to the transactions enabled by cryptocurrencies, but the nature of intermediation is likely to change, as some of the tasks they used to perform and appropriate value from – such as settlement and reconciliation – are now commodified. In the long run, consumers are likely to benefit not only from the resulting lower costs and increased competition, but also from the new types of applications and services that could not be provided in a cost-effective manner without the technology. Whereas the first wave of entrepreneurial experimentation in this area has been mostly focused on the financial sector, there is increasing interest in exploring how distributed ledgers can improve efficiency in contracting, logistics, healthcare records, identity and digital rights management.

At the same time, for the applications built on top of cryptocurrencies such as Bitcoin or Ethereum to replicate some of the more complex forms of governance actually needed to run a digital platform, smart contracts will have to evolve from small-scale experiments into a reliable technology. Researchers at the intersection of computer science, economics and law will also have to further understand the security, economic and legal challenges posed by decentralized platforms and smart contracts. Moreover, new internet standards will be needed to ensure interoperability and safety, and regulators will have to adapt current frameworks to allow for this new wave of innovation to reach mainstream use.

The risk, is that by overreacting to some of the inevitable early failures, regulators will not provide startups with a sandbox within which to experiment with a wide range of technologies and business models, stifling innovation in this promising new space.

Christian Catalini is the Fred Kayne (1960) Career Development Professor of Entrepreneurship and Assistant Professor of Technological Innovation, Entrepreneurship, and Strategic Management at the MIT Sloan School of Management (http://blockchain.mit.edu).

This post is part of an online symposium entitled “Blockchain: The Future of Finance and Capital Markets?” You can read all the posts here.

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