The Essence of Blockchains11 Dec 2021
What are blockchains for? Why are they useful?
I contend that the essence of blockchain is that they are decentralized trust engines.
Decentralized trust has a lot of benefits, but the one I'm personally excited about is that it enables permissionless innovation.
Below I explain what the hell I mean by decentralized trust and permissionless innovation.
Who do you trust?
Whenever you perform some action online, you're always implicitly trusting some entity.
For instance, if you run a computation on Amazon Web Service (AWS), or even in Google Sheets, you trust Amazon and Google not to alter the result of the computation.
If you host files on Dropbox, you trust Dropbox not to alter their content, and to not arbitrarily destroy your backup.
You trust that Google won't return you completely fabricated search result to get you to take some specific decision (e.g. a purchase) that is in their interest. (They certainly influence search results, but they don't (yet?) fabricate them.)
You trust that your bank won't take your money. You trust that your insurer will actually compensate you in case of accident.
You might also trust all of these companies with the privacy of your data.
You might object that these companies won't do these shady things. They stand to lose a lot, including reputation, customers, future revenues, etc! As for banks and insurances, they are heavily regulated.
That's true — although I will say these companies have gotten away with a surprising number of things. But more importantly it means you can only deal with entities that either (a) have something to lose or (b) comply with draconic and time-consuming regulations — and mostly that means big entrenched companies. We'll explore this when we talk about permissionless innovation.
Also consider that companies might be forced to do something, probably by some government.
The fundamental proposition of blockchains is the following: What if you did not have to trust a single entity, a single company?
In blockchains, there is a network of nodes (aka verifiers, validators, stakers, miners, ...) that verify the operations of the blockchains. As long as a majority of these nodes are honest (e.g. 50% of them, this changes between blockchains), you can trust that anything that happens on the blockchain follows the rules of the blockchain. And dishonesty has dire consequences for validators — because of sunk costs, or because of explicit penalties.
This changes your trust assumption from trusting a single entity to trusting that a majority of validators are honest.
The more validators there are, the less collusion is likely. Said otherwise, the more decentralized the system is, the less trust you need to put in the system.
It is also of paramount importance that anyone be able to become a validator of the network. Otherwise, the network is really controlled by the gatekeeper of the validation rights. This is less easy than it sounds — you have to make validation costly enough, otherwise an attacker could just spin a huge number of nodes and take over the network — a sybil attack. Preventing sybil attacks is the main technical breakthrough of blockchain technology. I explain the solutions (proof-of-work and proof-of-stake) in my article: Freaking blockchains: How do they work?
Applications & Trade-Offs
Let's go back to our examples. Am I saying that blockchains will supersede AWS, Google Sheet, Google Search, Dropbox, banks and insurances?
In reality, there is a trade-off. Nothing is truly trustless or riskless. Running most web apps on AWS is really fine, because the risk that Amazon is going to manipulate your results is close to zero, and the downside if they do is very low. Even if you're running with a brand-new competitor, you're not risking all that much.
But for some applications, trust and security are a really big deal. In particular, where money is concerned. It's not by accident that finance is stringently regulated. And similarly, it's not an accident that most popular applications of blockchains right now deal with money. It's doubly important when you're dealing with anonymous blockchain developers with no pre-existing reputation (more on this in the section on permissionless innovation).
Finally, we come to what is to me the most exciting consequence of decentralized trust: permissionless innovation.
On computation-centric blockchains, like Ethereum, the network certifies computation, and the code of the computation is a public smart contract stored on the blockchain, you can trust the contract to do what its code says, nothing more and nothing less.
This means that anybody can deploy a new smart contract, and other people can use it as long as they trust the code. The contract author does not need to have resources, a reputation or even to comply with regulations (1) to deploy his contract, or for you to trust that the contract will be executed faithfully.
(1) He has to, legally speaking, but blockchains being novel, it's unclear which rules apply in the first place. Such FUD would normally stifle innovation — but not on the blockchain where the barrier to entry is low, and many developers are anonymous.
This is super exciting! It has already led to numerous innovations in the financial realm, such as automated market makers (AMM), as well as many new forms of clever incentivization mechanisms such as liquidity mining, liquidity purchases via bonding, and more.
Besides brand new constructions, it also makes opportunities available to everyone that were previously available only to a few. Option protocols such as Lyra make it possible for everyone to profit from market-making the option market: a process where the market maker sells an option, which is hedged by the underlying, in order to pocket the option premium. (If this is Chinese to you, see my articles on options and on gamma squeezes.) Previously, this lucrative and relatively safe opportunity reserved to big investment banks. On-chain, everyone can add their money to a pool and participate!
And this is just an example amongst many. Another one would be lending to overcollateralized borrowers.
Hopefully, more areas can benefit from this innovative drive besides finance. One area that looks promising at the moment is gaming. Increasingly, game development is financed by the sales of in-game assets (skins, character customizations, convenience features, ...). One could be hesitant to buy into a relatively unknown game. Using the blockchain to encode these assets incurs many benefits: it can be made certain that they won't disappear at the whim of the developer, that they are tradeable without the developer investing any resources to make them so. Even better, another developer could decide to reuse the assets, and give them a function within his own game.
I think the use of blockchain in gaming is at the same stage where peer-to-peer (P2P) technology used to be some 20 years back. P2P had a terrible reputation as a thing used only to download copyrighted material. Yet only a few years later it became a common way to distribute big games and their updates, proving invaluable at handling the load on release day.
Or maybe crypto gaming doesn't work out. Who knows? There are many other areas in which people are building on the blockchain at the moment. Most projects will fail, but those who succeed might create immense value (I'm talking about usefulness, not money), and these wouldn't have gotten built without the blockchain.
I'll simply recap the thesis: blockchain are decentralized trust engines. Instead of trusting a single service provider, you trust a majority of the validators to be honest — and they are incentivized to be.
On decentralized computation blockchains like Ethereum, this enable anybody to deploy a smart contract, and anybody else to trust that the code will be executed faithfully (it still requires reading and understanding the code!).
This enables permissionless innovation: anybody can innovate, not only big companies with a reputation, or with government sign-off — even when money is involved.
It also enables anybody to port existing constructions to the blockchain, for all to take advantage of (e.g. option market-making).
Hopefully, these innovations will spread outside finance in the future.
The subject seems to be momentous, and here are two excellent recent pieces that harp on the value of decentralization:
- Avoiding Internet Centralization talks about the importance of decentralizing the internet's infrastructure, but many of its arguments are valid arguments against centralization in general. (It also makes clear that blockchains aren't really the solution for low-level internet infrastructure.)
- Is Web3... anything? is similar to this post and explains blockchains as "a protocol/architecture for near-trustless commitments".