When we first fractionalized the ownership of institutions or companies we called the units of ownership shares. We made them transferrable and tracked their movement on notarized paper ledgers that were copied and sent around the world. The basic underpinning of stocks hasn’t changed much since that first iteration. Granted, we’ve digitized it and made it accessible to a wider audience but the digital systems of today have essentially replicated these initial paper systems including inheriting most of their flaws. So today I’ll be writing about the flaws in that system and the inherent benefits of blockchains in solving them.
Today, our financial system doesn’t even know who owns what at any given time. This is ironic for a system whose whole purpose is to track things. The formal term for this T+1 settlement. Our financial system is structured around (and even legally enforces) trusted counterparties. The lending system for securities enable naked shorting and despite it being illegal it regularly happens. The stock market shuts down whenever it isn’t a convenient time in New York City despite serving users globally. There are egregious and high-profile abuses of power like Robinhood famously disabling the buy button on a certain stock when a bull run was inconveniencing some powerful people. More recently we have legally authorized funds being withdrawn from government program bank accounts and a veritable constitutional crisis over Congress’ “power of the purse.” Blockchains offer solutions to all of these issues with a set of blockchain superpowers: atomicity, neutrality, finality, and intrinsic rights.
Atomic
Back in the days of paper ledgers if a bank customer wanted to transfer money from their account to pay a bill it worked something like this:
- The bank customer would write a check.
- The check would route to somewhere there was a vault with both institutions.
- The bank with the customers funds would add a line to their ledger that said $X out to the receiving institution.
- The receiving institution would add a line that said $X in from the customers bank.
- After the bank hours some clerk would eventually move gold corresponding to the check amount from one cell in the vault to the other.
- If there wasn’t a vault shared with the bank and receiving institution, god help you.
At the end of this process there is now an entry in both institutions ledger: a credit and corresponding debit. This system was designed in a world where there could be large physical distances between those ledgers and no legal jurisdiction they shared. It was designed to provide evidence that could be taken to various court system and enforced if there was ever an erroneous line written to one ledger. However, this system required multiple actions to settle each payment and those actions could occur at different times and places. This led to a system with necessary delays and also where transfers could be “pending”. Here’s a thought exercise, what happens if the debit transaction is written to the ledger of your bank and then the receiving bank doesn’t promptly add the credit transaction to their ledger? The payer no longer has access to their funds, the gold doesn’t move, and the payee is left waiting.
Today internet speeds can enable almost instant settlement if all the computer systems in the chain act immediately but the core problem is actually much deeper than communication speeds. The core problem is that there are multiple ledgers at all. When Tradfi digitized these systems they essentially replicated the design of these initial paper systems rather than moving all settlement to a single database that would act as a universal ledger. On a database, you could make the entire transaction atomic. This guarantees that either the payer or payee would have access to the money at all times. However, this creates a new problem: trust.
Neutral
Who gets to maintain the single ledger? You might say, well the government of course. But what happens when one bank is in China? Do you think the Chinese bank wants to trust the US Government with that single ledger? Blockchains provide the same atomic guarantees as a relational database but with credible neutrality so that every institution around the world can adopt them without the threat of government overreach. With a blockchain, everywhere has the same copy of the ledger.
Doing this on a paper ledger system would have been impractical. It would have required an institution in every jurisdiction to maintain the full ledger of every bank in their jurisdiction. That would have required an impossible amount of mail and clerks and it would make dispute resolution a nightmare. The problem is always reconciling a discrepancy between the books of two banks. The bank that is accused of the discrepancy has a jurisdiction, so the customer that isn’t receiving their funds raises a lawsuit in that jurisdiction against their bank, provides a notarized copy of the ledger from the payers bank as evidence to the court, and hopefully a judge forces the bank to credit the payee.
With modern internet speeds and computers the logistics of maintaining a universal ledger are actually practical and dispute resolution is a non-issue because mathematical proofs back every transaction. A court could order one institution to use a different version of the ledger, but the erroneous balance wouldn’t be valid outside that jurisdiction and if it is spent locally then whomever gave them the good or service would get money that would also be invalid outside that jurisdiction. Over time this corruption would spread to the entire ledger. Being unable to trust that the money you are being paid for a good or service is legitimate and actually spendable would threaten the faith in the banking institutions. This inevitable outcome practically enforces that no government can coerce an institution to use a fraudulent ledger. Compared to a database where there is always a sysadmin who can edit any table blockchains offer a fundamentally different authorization model that prevents coercive influences. This is extraordinary.
Final
Fundamentally a blockchain is a consensus machine that outputs a time-series of events that we can prove the authenticity of. This ledger of events is append-only. There are no takebacks. This is called finality. Unless someone sends you your tokens back in a new transaction or the token proactively enables administration actions to change balances they are gone forever. Finality means that we know who owns what and that isn’t subject to change in the future except by the consent of the owner. It’s a guarantee that you can build upon in a non-fragile way. Combined with atomicity and neutrality, finality gives us a universal, practically incorruptible ledger about whatever you like that anyone in the world can access and trust.
Tradfi has only ever managed to create the illusion of this. They only ever figure out who owns all of a stock retrospectively. A court can always undo a transaction or counterparties involved in a transaction can fail to deliver. Anytime you get an instant confirmation of a trade from a web2 app that confirmation isn’t real; it’s only an optimistic estimate backed by the trusted relationships of a bunch of institutions you have no direct relationship with, didn’t knowingly consent to use, and which could misbehave at any time.
Finality enables instant financial transactions and removes so much complication on edge cases related to risks of retrospective changes. A Defi lending protocol can receive an asset and generate a loan for you instantaneously. Your assets never have to sit in an account for months and season before they can be used as a down payment for a mortgage. Most tokens are enforced as bearer instruments by the chain. There is no code to handle bankruptcy claw backs. The chain will not care whether your local laws agree with this. This is the most uncompromising version of property rights to ever exist.
Intrinsic Rights
The difference between a web2 confirmation and a web3 confirmation is an entire court system. The rights carried with the ownership of the asset in web2 are extrinsic to the asset. If the bank wrongly forecloses on your home you are entirely out of a home until you take them to court, prove it was wrongly seized from you, and have the courts enforce your rights. That not only comes at a high cost, but also no guarantees. The financial system today has to not only pay the cost of various middlemen but also underwrite the execution and enforcement risk of every legal obligation delegated to those middlemen. This is, to put it mildly, expensive, slow, and bureaucratic. There are also of course countless examples where someone was legally in the right but lost in the court system to someone who was better financed.
Contrast this to web3. A Defi lending protocol can receive an asset and generate a loan for you instantaneously. It doesn’t need a court system to adjudicate the possibility that you didn’t own the asset you deposited, that a bankruptcy proceeding a month later from some company you received the asset from might claw back the asset from you, or that the asset has been pledged as collateral multiple times. It has a rock solid guarantee that the transfer of a token means that you and only you had legal possession of the token. Because there’s nothing to adjudicate with a court system a smart contract has no need to ever pursue legal action against you so it doesn’t need to know who you are and where you are in the world. Also, unlike Tradfi where there is a byzantine maze of laws for intersecting jurisdictions, smart contracts work the same way for everyone everywhere in the world. Just imagine how many lawyer hours will be avoided by this simple fact. This is a multi-trillion dollar value add to the world.
Made possible thanks to support from Index Coop—explore crypto trading with up to 3x leverage and built-in liquidation protection.