Blockchain Revolution (updated)

by Don Tapscott

  “Accountants are like mushrooms—they’re kept in the dark and fed shit,”52 said Tom Mornini, CEO of Subledger, a start-up targeting the accounting industry. Accounting has become known as the language of finance, unintelligible to all but a few disciples. If every transaction is available on a shared, globally distributed ledger, then why would we need public accountancies to translate for us?

  Modern accounting sprang from the curious mind of Luca Pacioli in Italy during the fifteenth century. His deceptively simple invention was a formula known as double-entry accounting, where every transaction has two effects on each participant, that is, each must enter both a debit and a credit onto the balance sheet, the ledger of corporate assets and liabilities. By codifying these rules, Pacioli provided order to an otherwise ad hoc practice that prevented enterprises from scaling.

  Ronald Coase thought accounting was cultlike. While a student at the London School of Economics, Coase saw “aspects of a religion” in the practice. “The books entrusted to the accountants’ keeping were apparently sacred books.” Accounting students deemed his challenges “sacrilegious.”53 How dare he question their “many methods of calculating depreciation, valuing inventories, allocating on-costs, and so on, all of which gave different results but all of which were perfectly acceptable accounting practices,” and other nearly identical practices that were nonetheless deemed entirely “unrespectable.” So Tom Mornini is by no means the first to criticize the profession.

  We see four problems with modern accounting. First, the current regime relies upon managers to swear that their books are in order. Dozens of high-profile cases—Enron, AIG, Lehman Brothers, WorldCom, Tyco, and Toshiba—show that management doesn’t always act with integrity. Greed too often gets the best of people. Cronyism, corruption, and false reporting precipitate bankruptcies, job losses, and market crashes, but also high costs of capital and tighter reins on equity.54

  Second, human error is a leading cause of accounting mistakes, according to AccountingWEB. Often the problems begin when Randy in finance fat-fingers a number into a spreadsheet and, like a butterfly flapping its wings, the small mistake becomes a big problem as it factors into calculations across financial statements.55 Nearly 28 percent of professionals reported that people plugged incorrect data into their firm’s enterprise system.56

  Third, new rules such as Sarbanes-Oxley have done little to curb accounting fraud. If anything, the growing complexity of companies, more multifaceted transactions, and the speed of modern commerce create new ways to hide wrongdoing.

  Fourth, traditional accounting methods cannot reconcile new business models. Take microtransactions. Most audit software allows for two decimal places (i.e., one penny), useless for microtransactions of any kind.

  Accounting—the measurement, processing, and communication of financial information—is not the problem. It performs a critical function in today’s economy. However, the implementation of accounting methods must catch up with the modern era. Consider that in Pacioli’s day, audits were done daily. Today they happen with the cycles of the moon and the seasons. Name another industry where five hundred years of technological advancement have increased the time it takes to complete a task by 9,000 percent.

  The World Wide Ledger

  Today, companies record a debit and credit with each transaction—two entries, hence double-entry accounting. They could easily add a third entry to the World Wide Ledger, instantly accessible to those who need to see it—the company’s shareholders, auditors, or regulators. Imagine that when a massive company like Apple sells products, buys raw materials, pays its employees, or accounts for assets and liabilities on its balance sheet, the World Wide Ledger recorded the transaction and published a time-stamped receipt to a blockchain. The financial reports for a company would become a living ledger—auditable, searchable, and verifiable. Generating any up-to-the-minute financial statement should be as simple as a spreadsheet function, where the click of a button gives you an immutable, complete, and searchable financial statement, free of error. Companies might not want everyone seeing these numbers, and so executives might give only regulators, managers, and other key stakeholders permissioned access.

  Many in the industry see the inherent implications of this World Wide Ledger for accounting. According to Simon Taylor of Barclays, such a ledger could streamline bank compliance with regulators and reduce risk. “We do a lot of regulatory reporting where we’re basically saying, here’s everything we’ve done, because what we’ve done sits inside a system that nobody else can see.”57 A World Wide Ledger and a transparent record of everything “means that a regulator would have access to the same base layer of data. That would mean less work, less cost, and we could be held to account in near real time. That’s really powerful.”58 For Jeremy Allaire of Circle, regulators benefit the most. “Bank examiners have had to rely upon opaque, privately controlled, proprietary ledgers and financial accounting systems to do their work—the ‘books and records,’” said Allaire. “With a shared public ledger, auditors and bank examiners could have automated forms of examination to look at the underlying health of a balance sheet and the strength of a corporation—a powerful innovation that could automate meaningful parts of regulation as well as audit and accounting.”59

  It bakes integrity into the system. “All fraud would be much harder. You have to do fraud on an ongoing basis and at no point can you go back and change your records,” said Christian Lundkvist, of Balanc3, an Ethereum-based triple-entry accounting start-up.60 Austin Hill argued, “A public ledger that is constantly audited and verified means you don’t have to trust the books of your partner; there is integrity in the statements or the transaction logs, because the network itself is verifying it. It’s like a continuous a priori audit that is done cryptographically. You’re not relying on PricewaterhouseCoopers or Deloitte. There is no counterparty risk. If the ledger says this is true, then it’s true.”61

  Deloitte, one of the world’s Big Four accounting firms, has been trying to understand the impact of blockchain. Eric Piscini, who heads up the Deloitte cryptocurrency center, tells clients that the blockchain is “a big risk for your own business model because now the business of banking is to manage risk. If tomorrow that risk disappears, what are you going to do?”62 Overripe for disruption is the audit business, and audit is a third of Deloitte’s revenue.63 Piscini said, “That’s a disruption to our own business model, right? Today we spend a lot of time auditing companies, and we charge fees accordingly. Tomorrow, if that process is completely streamlined because there is a time stamp in the blockchain, that changes the way we audit companies.”64 Or perhaps eliminates the audit firm altogether?

  Deloitte has developed a solution called PermaRec (for Permanent Record) whereby “Deloitte would record those transactions into the blockchain and would then be able to audit one of the two partners, or both of them, very quickly, because that transaction is recorded.”65 But if the third entry on the blockchain—time-stamped and ready for all to see—happens automatically, anyone, anywhere, could determine whether the books balanced. Conversely, the fastest area of growth for Deloitte and the other big three audit firms is consulting services. Many clients are already scratching their heads over the blockchain. This bewilderment provides opportunities for migration up the advisory value chain.

  Mornini, a plucky entrepreneur and self-described “eternal optimist,” likened periodic accounting to “watching a person stand up and dance in front of a strobe light. You know they’re dancing, but you can’t quite figure out what’s going on. And it looks interesting, but it’s hard to figure out all the steps in between.”66 Periodic accounting gives a snapshot. Audit is, by definition, a backward-looking process. Creating a complete picture of a company’s financial health by looking at periodic financial statements is like turning a hamburger into a cow.

  According to Mornini, most large corporations would never want a completely transparent accounting record in the public domain or even readily a
ccessible by people with special privileges, such as auditors or regulators. A company’s financials are one of its most guarded secrets. Furthermore, many companies want to ensure that management has a certain degree of flexibility in how it accounts for certain items, such as how to recognize revenue, depreciate an asset, or account for a goodwill charge.

  But Mornini believes that companies would benefit from greater transparency—not only in terms of streamlining their finance department or lowering the cost of audit, but in how the market values their company. He said, “The first public company with this system in place will see a significant price per share advantage, or price to earnings ratio advantage, over other companies where investors have to anxiously await the dribble of financial information that they are provided quarterly.” After all, he argues, “Who is going to invest in a company that shows you what’s going on quarterly, compared to one that shows you what’s going on all the time?”67

  Will investors demand triple-entry accounting to meet corporate governance standards? It’s not a far-fetched question. Many institutional investors, such as the California Public Employees’ Retirement System, have developed strict corporate governance standards, and will not invest in a company unless those standards are met.68 Triple-entry accounting could be next.

  Triple-Entry Accounting: Privacy Is for Individuals, Not Corporations

  Triple-entry accounting is not without skeptics. Izabella Kaminska, a Financial Times reporter, believes mandating triple-entry accounting will lead to an increasing number of transactions moving off balance sheets. “There will always be those who refuse to follow the protocol, who abscond and hide secret value in parallel off-grid networks, what we call the black market, off balance sheet, shadow banking.”69

  How does one reconcile non-transaction-based accounting measures, particularly the recognition of intangible assets? How are we going to track intellectual property rights, brand value, or even celebrity status—think Tom Hanks? How many bad films must this Oscar winner make before the blockchain impairs the Hanks brand value?

  The argument for triple-entry accounting is not against traditional accounting. There will always be areas where we will need competent auditors. But if triple-entry accounting can vastly increase transparency and responsiveness through real-time accruals, verifiable transaction records, and instant audit, then the blockchain could solve many of accounting’s biggest problems. Deloitte will need someone to assess in real time the value of intangibles and perform the other accounting functions that the blockchain cannot, rather than a large task force of auditors.

  Finally, is an immutable record of everything truly desirable? In Europe, courts are upholding the “right to be forgotten,” enforcing people’s petitions to remove their history from the Internet. Shouldn’t the same principle apply to corporations? No. Why do Uber drivers get rated on customer satisfaction but corporate executives get a pass? Imagine a mechanism—let’s call it a trust app—to record feedback in a public ledger and maintain an independent, searchable score for corporate integrity. Inside the black box of corporations, sunshine is the best disinfectant.

  Triple-entry accounting is the first of many blockchain innovations in corporate governance. Like many institutions in society, our corporations are suffering from a crisis of legitimacy. Shareholder activist Robert Monks wrote, “Capitalism has become a kleptocracy, run by and for the enrichment of CEOs, or what I term manager-kings.”70

  The blockchain returns power to shareholders. Imagine that a token representing a claim on an asset, a “bitshare,” could come with a vote or many votes, each colored to a particular corporate decision. People could vote their proxies instantly from anywhere, thereby making the voting process for major corporate actions more responsive, more inclusive, and less subject to manipulation. Decisions within companies would require real consensus, multiple signatures on an industrial scale, where each shareholder held a key to the company’s future. Once the votes are in, the decision as well as the board meeting minutes would be time-stamped and recorded in an immutable ledger.

  Shouldn’t corporations have a right to change their history, to be forgotten?71 No. As artifacts of society, companies have responsibilities that accompany their license to operate. Indeed, corporations have an obligation to society to publish any and all information about their dealings. Sure, corporations have a right and obligation to protect trade secrets and the privacy of their employees, staff, and other stakeholders. But that’s different from privacy. Increasing transparency is a huge opportunity for managers everywhere: uphold the highest standards of corporate governance, seize the mantle of trust as corporate leaders, and do it by embracing the blockchain.

  REPUTATION: YOU ARE YOUR CREDIT SCORE

  Whether you’re applying for your first credit card or seeking a loan, the bank will value one number above all else: your credit score. This number is meant to reflect your creditworthiness and therefore your risk of default. It is the amalgamation of a number of inputs, from how long you’ve borrowed to your payment track record. Most retail credit depends on it. But the calculation is deeply flawed. First, it is incredibly narrow. A young person with no credit history might have a sterling reputation, a track record of fulfilling commitments, or a rich aunt. None factors into a credit score. Second, the score creates perverse incentives for individuals. Increasingly, people use debit cards, that is, the cash in their account. Because they have no credit score, they get penalized. Yet credit card firms encourage individuals without resources to apply for credit cards anyway. Third, scores are very laggy: data inputs can be outdated and have little relevance. A late payment at the age of twenty has little bearing on one’s credit risk at fifty.

  FICO, an American company originally called Fair, Isaac and Company, dominates the U.S. market for credit scores, yet it doesn’t factor most relevant information into its analysis. Marc Andreessen said, “PayPal can do a real-time credit score in milliseconds, based on your eBay purchase history—and it turns out that’s a better source of information than the stuff used to generate your FICO score.”72 These factors, combined with transaction and business data and other attributes generated by blockchain technology, can enable a far more robust algorithm for issuing credit and managing risk.

  What’s your reputation? We all have at least one. Reputation is critical to trust in business and in everyday life. To date, financial intermediaries have not used reputation as the basis for establishing trust between individuals and banks. Consider a small business owner who wants to get a loan. More often than not, the loan officer will base the decision on the person’s documentation, a one-point perspective of identity, and their credit score. Of course, a human being is more than the sum of a Social Security number, place of birth, primary residence, and credit history. However, the bank does not know, and does not care, whether you’re a reliable employee, an active volunteer, an engaged citizen, or the coach of your kid’s soccer team. The loan officer might appreciate your acting with integrity, but the bank’s scoring system does not. These components of reputation are simply difficult to formulate, document, and use as social and economic systems are currently constructed. Most of these are ethereal and ephemeral.

  So what do the billions of people do who have no reputation beyond their immediate social circle? Where financial services are available to the global poor, many can’t meet the requisite identity thresholds, such as ID cards, proof of residence, or financial history. This is a problem in the developed world too. In December 2015, many large U.S. banks rejected the newly formed New York ID cards as a valid credential to open a bank account, despite the fact that more than 670,000 people signed up for them and the banks’ federal regulators had approved their use.73 Blockchain could solve this problem by empowering people to form unique identities with a variety of attributes, previous transaction history among them, and give them new alternatives beyond the traditional banking system.

  There are still many use cases—particularly in credi
t—where the blockchain establishes trust between parties when trust is needed. Blockchain technology not only works to ensure that loan funds move to the borrower, but also assures that the borrower repays with interest. It empowers both parties with their own data, strengthens their privacy, and generates a new kind of persistent economic identity based on factors such as one’s past economic history on the blockchain and one’s social capital. Patrick Deegan, CTO at identity start-up Personal BlackBox, said that individuals will someday “deploy and manage their own identity, and form trusted connections with other peers and nodes,” thanks to blockchain technology.74 Because the blockchain records and stores all transactions in an immutable record, every transaction can count incrementally toward reputation and creditworthiness. Further, individuals can decide which persona interacts with which institution. Deegan said, “I can create different personas that represent different sides of myself, and I choose the persona that interacts with the company.”75 Banks and other companies on the blockchain ought not ask for and aggregate more information than they need to provide service.

  This model has proven to work. BTCjam is a peer-to-peer lending platform that uses reputation as the basis for extending credit. Users can link their profile on BTCjam to Facebook, LinkedIn, eBay, or Coinbase to add more depth and texture. Friends can volunteer recommendations from Facebook. You can even submit your actual credit score as one of many attributes. None of this private information is released. Users start on the platform with a low credit score. But you can quickly build a reputation by showing you are a reliable borrower. The best strategy is to start with a “reputation loan” to prove you’re reliable. As a user, you will have to respond to investor questions during the funding process. Ignoring these questions is a red flag; the community will hesitate to fund you. With your first loan, start with a manageable amount, and pay it back on time. Once you have, your quantitative score will improve, and other members in the community might give you a positive review. As of September 2015, BTCjam had funded eighteen thousand loans in excess of $14 million.76