Betting on Blockchain: Mining the possibilities of blockchain technology
Jonathan Johnson thinks blockchain will change the world. He leads Utah venture capital firm Medici Ventures, which invests in startups seeking to leverage blockchain “to develop products that will transform everything from capital markets to land transfer to voting systems.” The firm is a wholly owned subsidiary of Utah-based Overstock.com, whose executives are betting big on the technology.
I’ve been following blockchain for years—like Johnson, I believe it will transform transactions to a similar degree that the internet transformed communication—and I still have only a basic grasp of its functionality. Despite its complexity, we’ll all be adopting it soon enough if Johnson and his fellow enthusiasts are right. After all, you don’t need to understand something to use it. (How many of us truly understand cell phone transmission, internet protocols or even electricity?)
Let’s start with cryptocurrency
We’ve all heard of bitcoin by now. It’s an example of blockchain applied to currency. Cryptocurrencies—of which there are nearly a thousand, with bitcoin being the largest—fuse “cryptography, networking and open-source software,” writes Andy Greenberg in a 2011 Forbes article, “Crypto Currency”.
To assist in a rudimentary cryptocurrency explanation, I’m relying heavily on the excellent overview on cryptocurrencyfacts.com.
Cryptocurrency is an encrypted, decentralized digital currency transferred between peers and confirmed in a public ledger via a process known as mining.
At the core of a cryptocurrency, people (or rather their computers) solve puzzles. Really hard puzzles. Remember the 2014 movie The Imitation Game? We’re talking about cryptographic complexity way beyond that. People who solve the puzzles are known as miners, and the successful solution of the latest computational problem rewards the victorious miner with some amount of the currency. Miners can be anywhere on the globe; so long as a person has internet access and sufficient processing power, he or she can participate.
Meanwhile, people pay one another in the cryptocurrency, and their transactions are recorded in a public ledger. When a miner solves a puzzle, the latest group of transactions, known as a block, is added to the ledger. The solution of the puzzle secures the transactions as legitimate and makes them permanent and of public record. The ledger is the history of all blocks, otherwise known as the blockchain.
Why base a currency on puzzles?
At first blush, the solving of puzzles seems an odd choice as a currency foundation. Dig a little deeper, though, and it aligns perfectly with other historical mediums of exchange.
First, at the heart of any currency—from the shells of indigenous peoples to gold coins to modern government-issued money—is scarcity and consensus. In other words, a critical mass of people must agree that a given unit is acceptable as a medium of exchange, and that medium can’t be too readily available. Cryptography provides the scarcity factor. Puzzles increase in complexity, and the amount of computation required to solve them increases proportionally. The high production cost of the currency is a feature, not a bug: the effort required to mine a currency unit places a limit on the number of units available.
Second, cryptography secures another vital currency element: trust. Trust is tied to scarcity and authenticity; gold cannot be created, as centuries of disappointed alchemists have demonstrated. Ditto to shells. The Federal Reserve backs the United States dollar-based currency and maintains a monopoly on its creation, punishing harshly any encroachment (counterfeiting). In all three examples—gold, shells and dollars—trust is secured because participants know that the system is nearly impossible to game.
Cryptocurrency security—hence trust—arises from three primary factors:
- The public nature of blockchain transactions. Any past transaction is open to inspection by anyone, anywhere. Any malfeasance would be visible to all.
- The staggering complexity of the computational puzzle. Each solved block has been attached to the chain and would need to be somehow reverse-engineered (not to mention that such reverse-engineering, were it even possible, would be obvious to all).
- The cumulative nature of the blockchain. Nick Szabo, cryptocurrency pioneer, uses the analogy of an insect entombed in amber. The more layers of amber—blocks added to the chain—the more securely encased the insect. Each addition to the chain makes previous blocks exponentially safer from tampering.
I mentioned above that currency must amass a critical number of users to become viable as a medium of exchange. Isn’t cryptocurrency a fringe phenomenon? Not anymore. In early 2014, Overstock.com announced that it would accept bitcoin as payment. It was the first time that any major retailer officially recognized the value of a cryptocurrency. Bitcoin has increased some 450 percent in value in 2017 as of this writing (early September). The list of companies accepting bitcoin continues to grow.
Bitcoin’s sister cryptocurrency, Ethereum, has grown 2,000 percent YTD in value. A number of prominent companies, among them Microsoft and JPMorgan Chase, think the Ethereum software can empower a “post-central bank world” and back the massive Enterprise Ethereum Alliance. Cryptocurrencies are becoming increasingly mainstream. And, simultaneously, their underlying blockchain technology is finding uses far beyond its original application.
In late 2014, about a year after announcing it would accept bitcoin, Overstock.com spun off Medici Ventures. Jonathan Johnson, chairman of the board of directors at Overstock, was a natural choice to lead Medici. “Overstock recognizes the enormous investment opportunity that exists in the blockchain space,” says Johnson. “We believe the industry is still in the nascent stages of its growth.”
Disrupting the financial services sector?
Financial services is a massive industry, accounting for around 7 percent of the U.S. economy, per Johnson. The sector’s size is driven by its “role in intermediating all manner of financial transactions.” Blockchain’s distributed ledger system could potentially render intermediaries irrelevant.
According to a recent article in Harvard Business Review, “the [financial] system is rife with problems, adding cost through fees and delays, creating friction through … onerous paperwork, and opening up opportunities for … crime.” The inefficiencies of the system add huge additional cost, “with consumers ultimately bearing the burden.” Blockchain will remove friction, inefficiency and crime: “for the first time in human history,” the authors claim, parties will be able to “forge agreements, make transactions, and build value” without the clumsy mediation of banks, governments and other institutions.
One of Medici Ventures’ portfolio companies, tZERO, uses a blockchain-based platform that facilitates securities trades. “Rather than the three days it currently takes for trades to clear,” says Johnson, tZERO aims to bring “instant trade settlement” to the investing masses.
Today, lawyers typically mediate contracts between parties, while governments keep records of them. Blockchain-based “smart contracts” promise a direct, transparent and instantaneous contractual transaction between any two parties. Because the contracts don’t depend on government intervention, they can be transnational.
According to blockgeeks.com, “smart contracts not only define the rules and penalties around an agreement … but also automatically enforce those obligations.” The contractual system is based on the issuance of a “digital entry key” which “works on the If-Then premise and is witnessed by hundreds of people.”
Example: Person A pays person B and the blockchain generates a digital receipt and a “digital entry key” held by person B. On fulfillment of the terms of the contract, person B sends the key and person A enters it, signaling contractual fulfillment. If the key is not entered by a specified date, the contract is cancelled and the funds returned to person A. A trusted third party must validate that person B has fulfilled the contract; third-party validation represents the biggest hurdle the system must resolve.
The applications for blockchain are vast. It can verify and store ownership of assets, from land to commodities futures. It can facilitate frictionless, fraud-free voting. It can protect and verify our digital identities. It can keep healthcare records across institutions—a patient would possess an encrypted key that accesses all their data from the beginning of time and could make that key available to their trusted providers. Blockchain promises to streamline insurance claims; secure Internet-of-Things (IoT) items like smart appliances, cars and home security systems; provide transparency and efficiency for supply chains; and much more.
Medici Ventures wants to be at the leading edge of blockchain adoption. The company has made investments in nine portfolio companies, says Johnson. These companies span six key areas that Medici Ventures has prioritized: capital markets, payments, land, identity, voting and infrastructure.
Johnson believes his portfolio companies “have potential long-term market opportunities in the hundreds of billions of dollars.” I think he’s right about that.