by Don Tapscott
The third distinction is value: where information on the Internet is abundant, unreliable, and perishable, it is scarce, tamperproof, and permanent on the blockchain. To this last characteristic, Antonopoulos notes: “If there is enough financial incentive to preserve this blockchain into the future, the possibility of it existing for tens, hundreds, or even thousands of years cannot be discounted.”
What an amazing concept. The blockchain as part of the archaeological record, like the original stone tablets of Mesopotamia. Paper records are ephemeral and temporary, whereas (ironically) the oldest form of recording information, tablets, is the most permanent. The implications for corporate architecture are considerable. Imagine a permanent, searchable record of important historical information, like the history of finance. Corporate staff responsible for developing financial statements, annual reports, reports to governments or donors, marketing materials for prospective employees, clients, and consumers—will start with this public, indisputable view of their firm, maybe even creating a filter that enables stakeholders to see what they see at the press of a button. Companies could have transaction ticker tapes and dashboards, some for internal managerial use and some public. Rest assured: All your competitors will construct such feeds and dashboards of your firm as part of their competitive intelligence programs. So why not put those on your Web site and draw everyone to you?
This provides enormous incentive for firms to look for resources outside their boundaries, as they have almost infinitely better information about the qualities and record of candidates, be they individuals or companies.
Companies like ConsenSys are developing identity systems where job prospects or prospective contractors will program their own personal avatars to disclose pertinent information to employers. They can’t be hacked like a centralized database can. Users are motivated to contribute information to their own avatars because they own and control them, their privacy is completely configurable, and they can monetize their own data. This is very different from, say, LinkedIn, a central database owned, monetized, and yet not entirely secured by a powerful corporation.
Could Coase and Williamson have imagined a platform that could drop search costs so that firms could find capability outside their boundaries that cost less and could perform better?
2. Contracting Costs—What Do We Agree to Do, Anyway?
How do we come to terms with other parties or enter into an agreement? It’s one thing to lower the costs of finding people and resources that can do the job. But that’s not enough to shrink a firm significantly. All parties must agree to work together. The second reason why we have firms is contractual costs, such as negotiating the price, establishing capacity, and spelling out the conditions of a supplier’s goods or services; policing them and enforcing the terms; and handling remedies if parties don’t deliver as promised.
We’ve always had social contracts, understandings of relationships in the specialization of roles where some people in the tribe hunted and protected the tribe, and others gathered and sheltered the tribe. People have traded physical objects in real time since the dawn of modern man. Contracts are a more recent phenomenon, as we began trading promises, not property. Oral agreements proved easily manipulated or misremembered, and eyewitnesses were unreliable. Doubt and distrust tempered collaboration with strangers. Contracts had to be fulfilled immediately, and there were no formal mechanisms for enforcement of the terms beyond what you could take by force. The written contract was a way of codifying an obligation, of establishing trust and setting expectations. Written contracts provided guidance when someone did not hold up his end of the bargain, or something unexpected happened. But they couldn’t exist in a vacuum; there had to be some legal framework that recognized contracts and enforced each party’s rights.
Today contracts are still made of atoms (paper), not bits (software). As such they have huge limitations, serving to simply document an agreement. As we shall see, if contracts were software—smart and distributed on the blockchain—they could open a world of possibilities, not the least of which is to make it easier for companies to collaborate with external resources. And just imagine how the Uniform Commercial Code might look on the blockchain.
Coase and his successors argued that contracting costs are lower inside the boundaries of firms rather than outside in the market—that a firm is essentially a vehicle for creating long-term contracts when short-term contracts are too much effort.
Williamson advanced this idea by arguing that firms exist to resolve conflicts, largely through making contracts with various parties inside the firm. In the open market, the only dispute mechanism is the court—costly, timely, and often unsatisfactory. Further, he argued that in some cases like fraud, other illegal acts, or conflict of interest, there is no market dispute mechanism at all. “In effect, the contract law of internal organization is that of forbearance, according to which a firm becomes its own court of ultimate appeal. Firms, for this reason, are able to exercise fiat that the markets cannot.”15 Williamson conceived of the firm as “a governance structure” for contractual arrangements. He said that organizational structure matters in reducing the costs of managing transactions and that “recourse to the lens of contract, as against the lens of choice, frequently deepens our understanding of complex economic organization.”16 This is a recurring theme in management theory, perhaps most powerfully explained by economists Michael Jensen and William Meckling. They argued that entities are nothing more than a collection of contracts and relationships.17
Today, some erudite blockchain thinkers have picked up on this view. Ethereum inventor Vitalik Buterin argues that corporate agents (i.e., executives) could use corporate assets only for certain purposes approved by, say, a board of directors, who in turn are subject to shareholder approval. “If a corporation does something, it’s because its board of directors has agreed that it should be done. If a corporation hires employees, it means that the employees are agreeing to provide services to the corporation’s customers under a particular set of rules, particularly involving payment,” Buterin wrote. “When a corporation has limited liability, it means that specific people have been granted extra privileges to act with reduced fear of legal prosecution by the government—a group of people with more rights than ordinary people acting alone, but ultimately people nonetheless. In any case, it’s nothing more than people and contracts all the way down.”18
That’s why the blockchain, by reducing contracting costs, enables firms to open up and develop new relationships outside their boundaries. ConsenSys, for example, can architect complex relationships with a diverse set of members, some inside its boundaries, some outside, and some straddling walls, because smart contracts govern these relationships rather than traditional managers. Members self-assign to projects, define agreed-upon deliverables, and get paid when they deliver—all on the blockchain.
Smart Contracts
The rate of change is increasingly setting the stage for smart contracts. More people are developing not only computer literacy, but also fluency. As far as evidencing transactions goes, this new digital medium has significantly different properties from its paper predecessors. As cryptographer Nick Szabo highlighted, not only can they capture a greater array of information (such as nonlinguistic sensory data) but they are dynamic: they can transmit information and execute certain kinds of decisions. In Szabo’s words, “Digital media can perform calculations, directly operate machinery, and work through some kinds of reasoning much more efficiently than humans.”19
For the purposes of this discussion, smart contracts are computer programs that secure, enforce, and execute settlement of recorded agreements between people and organizations. As such, they assist in negotiating and defining these agreements. Szabo coined the phrase in 1994, the same year that Netscape, the first Web browser, hit the market:
A smart contract is a computerized transaction protocol that executes the terms of a contract. The general objectives of smart contract design are to sa
tisfy common contractual conditions (such as payment terms, liens, confidentiality, and even enforcement), minimize exceptions both malicious and accidental, and minimize the need for trusted intermediaries. Related economic goals include lowering fraud loss, arbitration and enforcement costs, and other transaction costs.20
Back then, smart contracts were an idea all dressed up with nowhere to go, as no available technology could deploy them as Szabo described. There were computer systems such as electronic data interchange (EDI) that provided standards for the communication of structured data between the computers of buyers and sellers, but no technology that could actually trigger payments and cause money to be exchanged.
Bitcoin and the blockchain changed all that. Now parties can make agreements and automatically exchange bitcoin when they meet the terms of the agreement. Most simply, your brother-in-law can’t weasel out of a hockey bet. Less simply, when you purchase a stock, the trade settles instantly and the shares are immediately transferred to you. Even less simple, when contractors deliver the software code that meets the necessary specifications, they get paid.
The technological means of executing limited smart contracts has existed for some time. A contract is a bargained-for exchange enforceable before the exchange. Andreas Antonopoulos explained with a simple example: “So if you and I were to agree right now that I would pay you fifty dollars for the pen on your desk, that’s a perfectly enforceable contract. We can just say, ‘I promise to pay you fifty dollars for the pen on your desk,’ and you would respond, ‘Yes, I would like that.’ That turns out to be ‘offer acceptance and consideration.’ We’ve got a deal, and it can be enforced in a court. That has nothing to do with the technological means of implementation of the promises that we have made.”
What interests Andreas about the blockchain is that we can execute this financial obligation in a decentralized technological environment with a built-in settlement system. “That’s really cool,” he said, “because I could actually pay you for the pen right now, you would see the money instantly, you would put the pen in the mail, and I could get a verification of that. It’s much more likely that we can do business.”
The law profession is slowly plugging into this opportunity. Like everyone in the middle, lawyers may become subject to disintermediation and will eventually need to adapt. Expertise in smart contracts could be a big opportunity for law firms that want to lead innovation in contract law. However, the profession isn’t known for breaking new ground. Legal expert Aaron Wright, coauthor of a new book about the blockchain, told us, “Lawyers are laggards.”21
Multisignature: Smart Complex Contracts
But, you say, wouldn’t the costs of complex and time-consuming negotiations of smart contracts outweigh the benefits of open boundaries? The answer at this point appears to be no. If partners spend more time up front determining the terms of an agreement, the monitoring, enforcement, and settlement costs drop significantly, perhaps to zero. Further, settlement can occur in real time, possibly in microseconds throughout the day depending on the deal. Most important, by partnering with superior talent, companies can achieve better innovation and become more competitive.
Let’s consider the use of independent contractors. In the early days of digital trade, the blockchain accommodated only the simplest two-party transactions. For instance, if Alice needed someone to complete a piece of code quickly, she would post an anonymous “coder needed” request on an appropriate discussion board. Bob would see it.22 If the price and timing were right, he would send work samples. If his samples met Alice’s needs, then she made Bob an offer. They agreed on terms: Alice would send half the fee immediately and half upon receipt of completion and successful test of the code.
Their contract was straightforward—an offer to hire and an acceptance to do the job, and it needn’t have been in writing, though their interactions on the blockchain made it so. Their ownership of bitcoins was associated with digital addresses (long strings of numbers) that had two components: a public key that served as an address, and a private key that gave its owner exclusive access to any coins associated with that address. Bob sent Alice his public key, and she directed the first payment there. The network recorded the transfer and associated those bitcoins to Bob’s public key wallet.
What if, at this point, Bob decided that he didn’t want to do the project? In this two-party transaction, Alice would have little recourse. She couldn’t go to her credit card company to reverse the transaction. She couldn’t (yet) go to civil court and sue Bob for breach of contract. Beyond a randomly generated alphanumeric code and an online advertisement, she would have no way of identifying Bob unless he’d posted his ad on a centralized platform that could track Bob down, or they’d exchanged e-mails through a centralized service. She could, however, indicate that his public key was not to be trusted, thus lowering his reputation score as a coder.
Without assurances of the other party’s trustworthiness in fulfilling off-chain actions, the deal was a prisoner’s dilemma of sorts: it still required some trust. Reputation systems could mitigate this uncertainty to some extent. But we needed to introduce trust and security into this anonymous and open system.
In 2012, “core developer” Gavin Andresen introduced a new type of bitcoin address to the bitcoin protocols called “pay to script hash” (P2SH). Its purpose was to allow one party “to fund any arbitrary transaction, no matter how complicated.”23 Parties use multiple authenticating signatures or keys rather than a single private key to complete a transaction. The community usually refers to this multiple-signature feature as simply “multisig.”
In a multisig transaction, parties agree on the total number of keys generated (N) and how many will be required to complete a transaction (M). This is called an M-of-N signature scheme or security protocol. Think of a lockbox requiring multiple physical keys to open. With this feature, Bob and Alice would agree in advance to employ a neutral, disinterested third-party arbitrator to help them complete their transaction. Each of the three parties would hold one of three private keys, two of which are needed to access the transferred funds. Alice would send her bitcoin to a public address. At this point, those funds can be viewed by anyone, but accessed by no one. Once Bob sees the funds have been posted, he fulfills his end of the bargain. If, upon receipt of Bob’s good or service, Alice is unsatisfied and feels cheated, she could refuse to provide Bob with the second key. The two parties would then look to the arbitrator, holder of the third key, to help them resolve their disagreement. The intervention of such arbitrators is called for only in cases of disputes like these, and at no point do they themselves have access to the funds—a mechanism enabling the rise of “smart contracts.”
To contract remotely, let alone automatically, you need a certain degree of trust that the system will enforce your rights under the deal. If you can’t trust the other party, you have to trust the dispute resolution mechanisms and/or legal system behind it. Multisig technology allows these deliberately disinterested third parties to bring security and trust to anonymous transactions.
Multisig authentication is growing in popularity. A start-up called Hedgy is using multisig technology to create futures contracts: parties agree on a price of bitcoin that will be traded in the future, only ever exchanging the price difference. Hedgy never holds collateral. The parties place it in a multisig wallet until the execution date. Hedgy’s goal is to use multisig as a foundation for smart contracts that are completely self-executable and fully evidenced on the blockchain.24 Think of the blockchain as a dialectic between anonymity and openness, where the multisig feature reconciles the two without loss of either.
Among other things, the smart contract changes the role of those within firms who are in the business of finding and contracting for talent. HR departments need to understand that talent is outside their boundaries, not just inside. They need to step up to the challenges of using smart contracts to lower the costs of building relationships with external resources.
&
nbsp; 3. Coordination Costs—How Should We All Work Together?
So we’ve found the right people and you’ve contracted with them. How do you manage them? Throughout his writings, Coase discussed costs of coordinating, meshing, or otherwise orchestrating the different people, products, and processes into an enterprise that can effectively create value. Against traditional economists who argued that there were internal markets within firms, Coase said that when “a workman moves from department Y to department X, he does not go because of a change in relative prices, but because he is ordered to do so.”25 In other words, markets allocate resources via the price mechanism, but firms allocate resources via authoritative direction.
Williamson went on to explain that there are two significant coordinating systems. First is the price system for decentralized resource allocation needs and opportunities (the market). But second, (traditional) “firms employ a different organizing principle—that of hierarchy—whereupon authority is used to affect resource allocation.” Over the last few decades, hierarchies have come under scrutiny as structures for killing creativity, undermining initiative, disempowering human capital, and scapegoating responsibility through opacity. To be sure, many management hierarchies have become unproductive bureaucracies. However, hierarchy as a concept has gotten a bad rap, as has its most eloquent defender, Canadian-born psychologist Elliot Jaques. In a classic 1990 Harvard Business Review article, Jaques argued, “35 years of research have convinced me that managerial hierarchy is the most efficient, the hardiest, and in fact the most natural structure ever devised for large organizations. Properly structured, hierarchy can release energy and creativity, rationalize productivity, and actually improve morale.”26