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Bitcoin’s underlying technology, the blockchain, is widely expected to find applications far beyond digital payments. It is celebrated as a “paradigm shift in the very idea of economic organization”. But the OII’s Professor Vili Lehdonvirta contends that such revolutionary potentials may be undermined by a fundamental paradox that has to do with the governance of the technology. I recently gave a talk at the Alan Turing Institute (ATI) under the title The Problem of Governance in Distributed Ledger Technologies. The starting point of my talk was that it is frequently posited that blockchain technologies will “revolutionize industries that rely on digital record keeping”, such as financial services and government. In the talk I applied elementary institutional economics to examine what blockchain technologies really do in terms of economic organization, and what problems this gives rise to. In this essay I present an abbreviated version of the argument. Alternatively you can watch a video of the talk below.  First, it is necessary to note that there is quite a bit of confusion as to what exactly is meant by a blockchain. When people talk about “the” blockchain, they often refer to the Bitcoin blockchain, an ongoing ledger of transactions started in 2009 and maintained by the approximately 5,000 computers that form the Bitcoin peer-to-peer network. The term blockchain can also be used to refer to other instances or forks of the same technology (“a” blockchain). The term “distributed ledger technology” (DLT) has also gained currency recently as a more general label for related technologies.In each case, I think it is fair to say that the reason that so many people are so excited about blockchain today is not the technical features as such. In terms of performance metrics like transactions per second, existing blockchain technologies are in many ways inferior to more conventional technologies. This is frequently illustrated with the point that the Bitcoin network is limited by design to process at most approximately seven transactions per second, whereas the Visa payment network has a peak capacity of 56,000 transactions per second. Other implementations may have better performance, and on some other metrics blockchain technologies can perhaps beat more conventional technologies. But technical performance is not why so many people think blockchain is revolutionary and paradigm-shifting.The reason that blockchain is making waves is that it promises to change the very way economies are organized: to eliminate centralized third parties. Let me explain what this means in theoretical terms. Many economic transactions, such as long-distance trade, can be modeled as a game of Prisoners’ Dilemma. The buyer and the seller can either cooperate (send the shipment/payment as promised) or defect (not send the shipment/payment). If the buyer and the seller don’t trust each other, then the equilibrium solution is that neither player cooperates and no trade takes place. This is known as the fundamental problem of cooperation.There are several classic solutions to the problem of cooperation. One is reputation. In a community of traders where members repeatedly engage in exchange, any trader who defects (fails to deliver on a promise) will gain a negative reputation, and other traders will refuse to trade with them out of self-interest. This threat of exclusion from the community acts as a deterrent against defection, and the equilibrium under certain conditions becomes that everyone will cooperate.Reputation is only a limited solution, however. It only works within communities where reputational information spreads effectively, and traders may still defect if the payoff from doing so is greater than the loss of future trade. Modern large-scale market economies where people trade with strangers on a daily basis are only possible because of another solution: third-party enforcement. In particular, this means state-enforced contracts and bills of exchange enforced by banks. These third parties in essence force parties to cooperate and to follow through with their promises.Besides trade, another example of the problem of cooperation is currency. Currency can be modeled as a multiplayer game of Prisoners’ Dilemma. Traders collectively have an interest in maintaining a stable currency, because it acts as a lubricant to trade. But each trader individually has an interest in debasing the currency, in the sense of paying with fake money (what in blockchain-speak is referred to as double spending). Again the classic solution to this dilemma is third-party enforcement: the state polices metal currencies and punishes counterfeiters, and banks control ledgers and prevent people from spending money they don’t have.So third-party enforcement is the dominant model of economic organization in today’s market economies. But it’s not without its problems. The enforcer is in a powerful position in relation to the enforced: banks could extract exor

Source: The blockchain paradox: Why distributed ledger technologies may do little to transform the economy — Oxford Internet Institute