i3 | November 20, 2018

Rethinking Business Block by Block

Jack Cutts
Blockchain graphic

Blockchain could massively reduce inefficiencies in business.

Depending upon whom you ask, blockchain is either the next big thing in tech or is just more of the dross drummed up by the never-ending tech hype cycle. Like many things in the world of tech, the reality likely will fall somewhere in between those two extreme ends of the spectrum. As a broad technological concept, blockchain has the potential to reduce inefficiencies in certain economic processes, disseminate information in a more democratized way and help mitigate unfairness or conflicts of interest when different parties’ incentives may not be aligned.

How Does Blockchain Work?

At its most basic, blockchain is a distributed database whose transactional data is stored sequentially in a way that cannot be edited, deleted or re-ordered without a consensus of other parties who are also maintaining the same transactional database. Those counterparties can be friend, foe, neither or both. Data stored in the blockchain is hashed – encrypted in a way that values or info stored in the blockchain can be verified without being readable by non-parties to a transaction.

Unlike encryption/decryption, data that is properly hashed cannot be unhashed, greatly bolstering its security and usefulness for this type of application. Using hashing in this way, a doctor’s office, for example, could verify your Social Security number by having the patient give them the hashed value of their number which the doctor’s office could compare against the hashed value stored in the blockchain. Similarly, the blockchain can store images, video clips, code or anything that can be stored digitally — all securely hashed.

Reducing Inefficiency with Blockchain

As startups around the world have proven, there are plenty of antiquated business models out there that are ripe for disruption by someone who is willing to rethink a process, become more customer-centric, or anger more established players.

One industry ripe for this disruption is the shipping industry. The increasingly globalized nature of commerce means that transoceanic shipping is as important as ever for the free flow of goods around the world.

Perhaps emblematic of that importance, long-haul shipment of goods often come with hundreds of pages of paperwork to help it pass through the hands of the various ports, dock workers, insurers, transport companies and governments it interacts with on the way to its destination. At best, shippers use a 60-year-old system called electronic data interchange (EDI), whose best days are well behind it. Delays in certain key pieces of paperwork and transmittal of data can delay a shipment for hours, days or even weeks.

Some heavy hitters within the shipping and tech industry are setting out to change that. IBM and Danish shipping titan Maersk teamed up on a new project called TradeLens that uses the power of blockchain to help goods move faster and more efficiently around the world. Projects like TradeLens seek to streamline shipping by, for example, encoding all necessary paperwork and approvals in the blockchain before a container leaves its port of origin. Normally, the alternative is waiting weeks or months for contracts to be executed and payments to be made to the various parties involved in a shipment.

Further, using the power of smart contracts — code that is embedded in the blockchain and executed when certain conditions are met — a payment to a port could be triggered automatically once cargo is inspected and approvals get obtained, allowing a ship to easily set sail for its next waypoint.

The mortgage underwriting process can also benefit from blockchain. Now, each party requiring information requests copies of relevant documents individually using delivery methods as diverse as electronic upload, email, fax, courier and carrier pigeon. A blockchain that can encode frequently requested documents and keep them safe could be a boon to hopeful home buyers during an extremely stressful and invasive time.

Imagine a mortgage underwriting process where the potential buyer inputs all relevant financial documents into the blockchain, making the title company, the buyer’s agent and so forth readily available for the underwriting bank.

Increasing Transparency with Blockchain

Blockchain technology can also use the power of the “distributed ledger” to increase transparency among parties to a transaction and, potentially, those who have oversight over a certain industry or group of companies.

One of the primary causes of the housing bust of the late 2000s was overleverage. Many individuals and small-time investors got caught up in the housing boom and spent more on their house (or houses) than they could afford. Money was cheap, so to speak, and lending standards were lax compared to prior eras in American history.

Many banks were overleveraged as well. Not only did certain banks make loans that turned out to be bad bets, many investment banks traded in collateralized debt obligations (CDOs) that were derivative securities designed to securitize and sell cash flows generated by mortgage payments made by individuals.

However, because of the nature of the derivatives trade in CDOs, there was nothing stopping a mortgage on the house at 123 Pine Street in Miami from being securitized and sold three, five, even 20 times in a short time span. If the mortgagee pays on time, then all is well, and banks make money. However, if the mortgagee defaults, the economic damage spreads beyond the lien holder to all the banks holding CDOs based on the underlying mortgage.

The damage from default on that mortgage has the potential then to be three, five or even 20 times worse. In some cases, banks packaged derivative CDOs made of other CDOs (dubbed a “CDO-squared”), bringing about the potential for exponentially more financial harm.

What if blockchain allowed all parties and potential parties to a transaction to see exactly who owned each side of a financial transaction, thereby making an opaque transaction more transparent? What if a central bank, for example, could use blockchain to determine which local markets were the most overleveraged in the CDO market and use that information to warn banks, adjust underwriting standards or modulate interest rates to mitigate risk?

By using blockchain to tie all CDOs and CDOs-squared back to the underlying asset, parties making a transaction could untangle a mess of intertwined transactions to determine just how leveraged an asset really was, thereby allowing them to price their risk accurately.

Another interesting use of blockchain to increase transparency comes from the world of the Internet of Things (IoT). The blockchain’s ability to store video footage could be used to store video feeds from a police officer’s body camera. If data from the body camera were stored not just on the camera itself but uploaded to a cloud-based blockchain each maintained by, for example, the police department, the police union and the state’s attorney general, then footage could neither be added, deleted or edited to cover up misdeeds or corruption.

In this example, the blockchain increases transparency by being a solution that overcomes the misalignment of incentives between a police department, a union representing employees and an attorney general’s office looking to stamp out corruption or other transgressions. By encoding data into the blockchain in multiple locations, video footage cannot “go missing” or be altered. Events like turning off a body camera or device failure could also be encoded in the blockchain for all to see and verify.

Overcoming Misaligned Incentives with Blockchain

A third major benefit of blockchain is its ability to overcome misaligned incentives and asymmetry of information in certain situations. Real estate is another tradition-bound industry that is on the cusp of significant disruption. Anyone who has ever bought or sold a house can tell you about the opacity of the negotiation process between the buyer’s and seller’s agents. It is not uncommon for sellers’ agents to negotiate the sale price of a home over the course of hours or days while the seller waits by the phone for news of the final sale price.

Sellers can inquire as to the details of offers made on a property, but the timing and nature of bids from potential buyers, especially in multiple-bid situations, are often not disclosed or glossed over. Further, in a competitive bidding situation, the seller’s agent is the only party to the transaction who holds all the information on bids and other negotiated terms. It is not inconceivable that a seller’s agent, who is motivated first and foremost to generate a successful sale, might steer a home sale away from a buyer who offers more money than the next highest bidder simply because the high bid carries more risk for the underwriter and therefore might inadvertently scuttle a sale at the eleventh hour.

Blockchain can help solve a couple of issues inherent in the scenario described above. If bids are encoded in blockchain, the timing and quantity of bids can be known by all parties and potential bidders. Second, technology exists to determine if an incoming bid is higher or lower than a bid already recorded in the blockchain, even if that value is hashed and not human-readable.

That way, a home seller can verify the quantity, timing and competitiveness of incoming bids while a buyer’s agent can bid enough to be the high bidder without causing their client to overpay for a home. It is important to point out that the majority of buyer’s and seller’s agents are honest people working in the best interest of their respective clients, but it is rare to find an economic system or arrangement that cannot benefit from some measure of increased transparency and reconciliation of incentives.

No Silver Bullet

Blockchain is not the perfect solution to every problem. Many of the problems described above could, in theory, be solved with a database and a well-crafted and vigilantly enforced legal framework. The power of blockchain to solve these challenges lies primarily in its distributed nature along with its ability to be both open to inspection (and therefore transparent) while also protecting its data from loss, theft, alteration or misuse.

Further, there is a potential cost of non-participation if certain players in an industry like shipping or real estate choose not to work within the blockchain ecosystem. Imagine being the only port in southeast Asia to still require faxed paperwork or being the last real estate agent in town who only accepts bids over the phone and won’t disclose relevant details.

Blockchain is still in its infancy. Many exciting projects with interesting applications of the technology have been announced. Many of those projects will never make it beyond the press release. Some will fail because they were misapplications of a headline-grabbing hot-this-year buzzword. But we will surely see unique situations where blockchain is the best and most logical solution to a problem that, as of yet, we have failed to solve.

November/December 2018 i3 Cover Issue

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