Blockchain Pushes Information Economics To the Second Stage - Trust Economics

In the second episode of "Looking for the Power of Blockchain" series launched on August 13, Professor Eric Maskin of Harvard University and Chen Long, Luohan Academy Executive Director, discussed the operation and mechanism design of blockchain technology in the market, information asymmetry, signaling and along with a host of other economic issues. 

 

1. Micro-information economics and asymmetric information

Information economics is a branch of information science that studies the economic phenomena of information and its movement characteristics. The 1996 Nobel Prize in Economics was awarded to Professor James Morris of the University of Cambridge in the United Kingdom and Professor William Vickery of the University of Columbia in the United States for their contributions to the study of Information Economics. The 2001 Nobel Prize in Economics was awarded to three American economists: Joseph Stiglitz, George Akerlof, and Michael Spence, to commend their essential contribution of "use asymmetric information for market analysis." Akerlof’s clarifies the fact that the existence of phenomena such as sellers being able to sell low-quality goods to buyers is due to the asymmetry of the information held by both parties in the market. Information imbalance may even make inferior second-hand cars crowd out the premium car market. Spence reveals how people should use the more information they have to achieve greater benefits. Stiglitz provided relevant theories for market parties with less information on how to make market adjustments. The three professors' analytical theories are versatile, and their ideas form the core of modern information economics.

The asymmetric information environment is one of the important conditions of micro-information economics. Asymmetric information means that both parties to a transaction possess private knowledge unknown to others. Information economics refers to the party who owns private information as an agent. The party who does not know this information is called the principal. Therefore, the general asymmetric information problem can be attributed to the "principle-agent" model. In an asymmetric information environment, the condition for establishing the "principle-agent" relationship is that the principal's payment to the agent is not lower than the latter's opportunity cost of participating in the contract, while at the same time maximizing its own profits. Under this condition of participation, constraint, and incentive compatibility constraint, what should be the principal's best choice? The game theorist John Harsanyi has done an in-depth study on this and defined the Bayes-Nash equilibrium to find the optimal contract or institutional arrangement to make the agent confess the truth. The client can also obtain information through some signals, such as prices, honors, and advertisements. The perfect competition model of microeconomics is challenging to find in reality. The research on the market under incomplete information has gradually developed into micro-information economics.

At present, the primary research method of information economics researchers are gradually transitioning from the contract theory under asymmetric information (search for information such as various signals, the cost of information and transaction costs) to the field of macro information economics.

2. Central bank digital currency

Bitcoin cannot replace the currency issued by the central bank because there is no credit support system provided by the government. Cryptocurrency may weaken the effectiveness of central bank monetary policy. Central banks of various countries have launched digital currencies (CBDC), which profoundly impact monetary policy adjustments. Professor Maskin hopes to see the eventual disappearance of Bitcoin and other private cryptocurrencies. While Executive Director Chen Long does not think this will happen, he agreed that Bitcoin could not replace the currency issued by the central bank. Due to the lack of confidence in Bitcoin value and the lack of state and government support, payment efficiency (using cryptocurrency) is rather low. It is a destructive force on the financial system.

For the blockchain to succeed, it is especially important to have the proper mechanism design and the correct incentive mechanism to solve some challenging problems. At the same time, some people want to use blockchain to store assets and make payments. Still, Executive Director Chen Long doesn’t think it will replace traditional currencies: “All over the world, governments and central banks are concerned about cryptocurrency. They are trying to develop their own cryptocurrency, which is a wiser approach. But their development still raises many questions.”

Many countries are gradually developing towards a cashless society, so the form of currency has been transferred in electronic form. However, when we talk about the central bank’s digital currency, we are talking about a smarter version of encrypted currency that has memory, provides more information, and can do more things. The Federal Reserve said while they are concerned about this issue, the United States may not need a central digital currency. Other countries are different and are actively researching and developing digital currencies. The bottom line is that countries and central banks very much differ on central digital currencies.

One area where central bank digital currencies can really play a role may be cross-border payments. Cross-border payments usually take a lot of time and effort to verify identity due to a lack of trust. The central bank digital currency can improve this situation. Financial services are based on information. Most small and micro enterprises and individuals do not receive financial support because of information asymmetry and lack of trust. An example is cross-border payments. Filipino figurines working abroad remit money back to the Philippines. The cost of remittance is 8% or even 10%. Technology can help them reduce this cost.

The new digital currency can play a role in improving efficiency and solving the problem of trust in information. We spend too much energy to verify information, and the new digital currency can provide effective solutions. Many countries are exploring these solutions with different approaches. Professor Maskin predicts that in 20 years, all money will be electronic. Digital currencies will eventually replace traditional currencies. Executive Director Chen Long believes that it is almost sure that we will enter a cashless society, and we need to think about the relationship between the central bank's digital currency and the current financial system.

3. Blockchain helps reduce the problem of information asymmetry

Professor Maskin said that to make a transaction, one must know the other party very well. Blockchain takes transactions to another level. You don't need to trust the other party to conduct transactions, because the technology itself will protect you, and you can transact with more people and more companies. Therefore, the blockchain has the potential to increase transaction volume, thereby increasing global output significantly. When output increases, everyone benefits. Since the 19th century, the global economy has achieved great success; the reason behind it is the rapid increase in output.

Executive Director Chen Long agrees that the most exciting blockchain's most exciting future does not lie in cryptocurrencies such as Bitcoin, but its vast potential to solve the problem of trust. Digital technology has made information so cheap that we can connect and trade with people thousands of kilometers away. Digital technology also provides more information, and we can use big data to make more informed decisions.

Information is a new the "collateral"

A lack of trust means most loans are based on mortgages (collateral). For example, if Bob offers something worth $1,000, then Alice might lend you $500. In the past few years, Ant Financial has provided loans to 20 million SMEs and start-ups without asking them to provide any collateral. These loans are based on big data, and big data allows us to see the potential of these companies. Information is a new form of collateral, and more information means more trustworthy. With this information, we don't need to trust specific individuals.

Information is powerful, and the trust it brings can be spread. Many start-ups, supply chains, and many people can get financial support this way so that they can do more. The enormous potential of blockchain lies in alleviating the lack of trust, which can be called the digitization of trust. Recently, the Ant Group put forward the "Ant Chain," which is a unique way of enhancing confidence, not just using blockchain. Even if there is no blockchain, we still have big data. There are indeed many ways to solve the trust problem. The world needs more information and a higher degree of digitization. However, Chen Long thinks the more important issue is how to establish an environment of trust. This will improve the prospect of cooperation and bring more about opportunities. “This is the most exciting part,” he added.

4. The impact of blockchain on contracts and corporate organizations

Ronald Coase, another Nobel Prize winner, once said in the article "The Essence of the Company" (Coase, 1937) that a company's existence reduces or avoids transaction costs.  If blockchain-based smart contracts can really enable better contract execution and reduce transaction costs, will companies still exist? Will corporate functions such as legal affairs, human resources, or outsourcing disappear? 

Professor Maskin believes that the use of smart contracts will encourage more company functions to be outsourced. If you can solve the trust problem, let those who are good at them do it more efficiently than yourself. Therefore, there will be more outsourcing of corporate functions, but he does not think it will disappear.

A company can still bring important things, such as brand and reputation. Even if a company has many functions outsourced, its existence is still meaningful, for example, it can ensure that the quality standard reaches a certain level. Even if Armani completes all production activities outside of Italy, will quality control be outsourced? Armani understands the meaning of quality, but in traditional contracts and smart contracts, it isn’t easy to write down the quality attributes you want. It would help if you had the final judgment on quality. Therefore, quality control cannot be outsourced.   

Executive Director Chen Long believes that from an economic perspective, a company is a set of contracts. However, to use smart contracts, you must ensure that related matters can be agreed through the contract. Unfortunately, the contract cannot cover everything. In a company or an organization, we will cooperate in many ways. It is impossible to write all single things into the contract. There are too many things that cannot be written into the contract. Therefore, we need a responsibility mechanism, and the responsible person is responsible for it. All systems and mechanisms try to use the right incentive measures to alleviate the problem that the contract cannot cover everything.

Smart contracts improve the efficiency of performance and reduce risk 

Executive Director Chen Long gives another example: “Suppose Eric decides to lend me 100 dollars, and we want to sign a simple contract. If I refuse to pay the money, what can Eric do? It is difficult for him to sue me in court because that would cost a lot of money. It is costly to verify all this in the contract. There are many cheap contracts or informal contracts, where people borrow money from each other, but the cost of verifying and executing the contract is very high.

However, we can use smart contracts based on blockchain. Returning to the previous assumption, Eric and I signed a smart contract for this $100 loan. When the repayment time comes, the smart contract will return the money in my account to Eric. Of course, after negotiation between the two parties, the smart contract can also contain other execution matters.

All in all, the cost of verification and execution becomes very low. Even if the loan amount is only $5, it is feasible. The goal is clear and can be put into the smart contract. Using such technology, there will be more outsourcing activities around the world. But for companies, there are still many high-value issues that require cooperation. Because these matters cannot be included in the contract and cannot be outsourced, the company will always exist.”

Blockchain will improve cooperation between institutions

Executive Director Chen Long mentions that Bitcoin is based on an open blockchain public chain, and everyone can participate without trusting anyone. “If Eric were to send me 1 cent, then we might have to spend 20 dollars to verify that he sent the money. There is a lot to do to prove that he gave me 1 cent. The cost is too high; why? Because everything needs to be verified. Blockchain can bring about massive changes. Assume that five institutions decide to sign a contract to realize cooperation through the blockchain. The actual verification cost is meager, and the efficiency is greatly improved.

If you use smart contracts on the blockchain, you can solve it in a few seconds. Therefore, my view is that blockchain and smart contracts will significantly increase efficiency and improve cooperation between institutions. As I mentioned earlier, outsourcing will become more accessible because of these technologies. This is the future direction of development.”

5. Blockchain, inequality and signaling mechanisms

Professor Maskin believes that blockchain can be a weapon against inequality. The gap between resourceful companies and those with a tight budget, big companies, and small companies will be narrowed because blockchain will help the weak. However, this will not eliminate the gap. For example, quality cannot be fully reflected in the contract, and some items cannot be included in the contract. Quality is not a completely definable term. Otherwise, you can write it into the contract and implement it completely. Even in the blockchain world, large companies that are known for producing certain quality products will continue to maintain their advantages. The reputation brought by good quality is valuable and will not disappear because of new technologies.

Professor Maskin believes that information asymmetry is one of the basic obstacles to successful transactions and one of the leading causes of inequality. Even if the poor have good ideas, they cannot get loans, nor can they get loans to pay for their tuition. Because they cannot provide mortgages, mortgages are an old-fashioned way to deal with information asymmetry. The rich can provide mortgages to get loans and become richer, while the poor remain poor. Blockchain can help us overcome the obstacles caused by information asymmetry and make it easier for poor entrepreneurs to obtain loans. In this way, the poor can catch up with the rich.

Blockchain will change the signaling mechanism

Blockchain does not eliminate signaling attempts, because unobservable information, such as ability and quality, cannot be objectively reflected on the blockchain. Markins believes that blockchain can reduce signaling temptation, but it cannot be eliminated. One of the essential forms of signaling is this: if one wants another to lend him or her money, then one will take specific actions, not because these are particularly effective actions, but because this helps make the lender believe the borrower is trustworthy.

People consume a lot of capital to convince others that they are credible. This is signaling. Blockchain can significantly reduce the cost of signaling and has great potential to alleviate the problem of information asymmetry. The impact is that the amount of attention spent on surface work will be reduced. For example, we no longer need gorgeous skyscrapers and offices, but the trust brought by blockchain has nothing to do with these. Some items cannot be put into the contract, and may never be. These matters include quality, signal delivery, and so on. If I'm from Armani, I want you to believe that the brand has always maintained a high-quality standard. I might do some advertising and maybe organize a fashion show. These activities are necessary, not because they are valuable in themselves, but because they make you believe that the quality of the product has not been compromised. This signaling will continue to exist, but many of the most apparent signalings can be eliminated.

Ming Qiu  

Ming Qiu is a senior expert at Luohan Academy and former deputy dean of Ant Group's Financial Research Institute. 

Ruobing Han

Ruobing Han is an Economics Ph.D. candidate at Standford University and an intern at Luohan Academy.  

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