Blockchain: Technology and Mechanism Design

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Blockchain is not only an integrated technology but also a new decentralized organization model for information sharing based on consensuses. It is designed to make complicated transactions in a larger scale and at a deeper level by leveraging the computer games among the nodes in the system. These tractions will be operated in certain computer apps in accordance with certain algorithms.

Compared with the centralized system, blockchain, a decentralized decision-making system to realize certain social goals, boasts the following two advantages:

·Bring Pareto Efficiency to resource allocation;

·Prevent opportunistic behaviors caused by asymmetric information with incentive compatibility.

More importantly, blockchain is dedicated to designing and creating rules and algorithms that will yield balanced results with economic theories. The combination of economic mechanism design with network theories, cryptography, computer technology and AI will enable blockchain, the disruptive technology, to bring fruitful results to our economy in this new era.

What is Blockchain and How it Becomes What it is Today

Since the white paper Bitcoin: A Peer-to-Peer Electronic Cash System was released by Satoshi Nakamoto in 2008, researches and applications of bitcoin and the blockchain technology have been on the rise. That being said, blockchain was a marginalized topic followed by technologists and start-ups for a very long time.

The year 2017 was a tipping point since when attention on blockchain, cryptocurrencies and smart contracts has been rapidly increased, making blockchain a hot-debated topic. Optimists believe that blockchain is the fifth disruptive innovation of computing paradigms following mainframe computers, personal computers, the Internet, the mobile Internet and the social network and the fourth milestone in the evolution of credit in the human society preceded by blood relation, precious metal and banknotes issued by central banks.

The root of blockchain can be traced back to the Byzantine Generals Problems in the Eastern Roman Empire. It is by nature a decentralized and dynamic gaming mechanism or algorithm that deals with problems caused by asymmetric information by making sure that information is reliably and completely delivered to all parties so that they can take consistent actions.

Technology wise, blockchain consists of such sophisticated technologies as point-to-point transmission technology, distributed technology, cryptography and network theory. Vitalik saw the potential of blockchain and cryptocurrencies in 2011 and published Ethereum Whitepaper in Nov. 2013.

Function wise, the major advantage that blockchain can offer is to build a trustless distributed system where point-to-point transactions, collaboration and cooperation can be carried out without centralized authorities by using data encryption, timestamp, distributed consensus models and economic incentives. In this way, prevalent challenges for centralized organizations like the high cost, low efficiency and insecure data storage, will be efficiently resolved.

Thinking wise, in 2016, Out of Control: The New Biology of Machines, Social Systems, and the Economic World authored by Kevin Kelly pointed out 4 features of a distributed system:

· no compulsory controlling centers;

· autonomous secondary units;

· closely connected secondary units;

· nonlinear causality relationship brought by the point-to-point network.

Rather than being an object, the distributed network is more like a process.

Application wise, Internet companies like BATJ (Baidu, Alibaba, Tencent and JD.com) are actively getting into the blockchain industry, accelerating its development. In May 2018, China Blockchain Industry Whitepaper released by the Information Center of the China’s Ministry of Industry and Information Technology pushed Chinese governments at all levels to position blockchain as an important industry and optimize its policy system and supervision. In the same year, Jack Ma stated that Alibaba was investing in 3 major technologies: AI, blockchain and IoT. Only by combining blockchain with Internet finance, can we build financial systems and standards in the 21st century of data and information.

Besides, blockchain has become a mainstream research topic. The essay “Blockchain Revolution and Smart Contracts” by Professor Cong Lin and Professor He Zhiguo at Chicago University published on NBER in Mar. 2018 demonstrated that this decentralized system could contribute to increasing social benefits and consumer surplus. In Jun.2018, Professor Fang Hanming at Pennsylvania University said professors in the department of economics voluntarily started a study team on blockchain and bitcoin. They read essays and reports in turn, discussed the mechanism of blockchain and studied the cryptographic and economic foundations of blockchain as well as its potentially innovative applications.

Blockchain, a Decentralized Decision Making Mechanism

By connecting nodes with a decentralized technology, blockchain aims to realize complicated transactions in a larger scale and at a deeper level. Judging by the development of economics, blockchain has directly responded to the debate between the centralized decision making mechanism and the decentralized decision making mechanism that has been controversial in economic theories and practices for over 100 years. Besides, the features of blockchain represent a new organization structure different from any companies, challenging the traditional structures.

It is not only a new technology applied into the real economy, but also an organization and mechanism design competing with traditional economic mechanism. The advantage is that it solves Pareto Efficiency in resource allocation and incentive compatibility while the disadvantage is the high information cost involving technologies and algorithms like cryptography, network structure, computing, big data, deep learning and AI.

Centralized Decision Making Mechanism

Traditionally, in the centralized decision making mechanisms, individuals have to report their private information like marginal cost, utility, income and consumption demand to a central planner. This planner will make decision about production, investment, consumption and cash transfers based on these reports and inform the decisions to the individuals. In this process, the central planner has to calculate the numbers in the input-output tables involving millions of simultaneous equations.

During the development of economic theories, the centralized decision making mechanism is originated from the Revelation Principle put forward by scholars like Gibbard and Meyerson. The Revelation Principle states that in the economic environment of asymmetric information, the equilibrium results of any indirect mechanisms can be replicated by a direct revelation mechanism with unique mathematical structures. This principle simplified mechanism design and enabled it to focus on designing mechanisms that provide direct revelations. The centralized decision making mechanism is a direct display mechanism in terms of gaming rules and the way of information transmission.

The Mechanism of Blockchain

Blockchain is a distributed network featuring decentralization, information sharing, consensuses and responsibility sharing. From the perspective of mechanism design, information sharing and consensuses are demonstrated by passing information from participants to participants.

By competing with traditional economic mechanisms, blockchain helps the transactions of the traditional real economy to shift from the centralized decision making organizations to decentralized ones. In this connection, the important role blockchain plays in social development is self-explained. It is worth mentioning that blockchain adds more dimensions to the information space and assigns more complicated computing tasks to individuals in the system.

Blockchain Mechanism Brings Incentive Compatibility and Pareto Efficiency

In the social development over the recent a hundred of years, centralization mechanisms have been controlled by central authorities while decentralized mechanisms are distributed in which decisions are usually made by the market. Hayek, Laurate of the 1974 Nobel Economics Prize posed the Economic Calculation Problem to challenge the planning economy. He contended that the correlations among different economic activities made it difficult to make plans as we liked to and once the freedom of the economic activities in the market was constraint to a certain degree, planners would have to lose their restrictions until the day all restrictions would be lifted.

Recently, Hurwitz, Laurate of the 2007 Nobel Economics Prize found that the priority of mechanism design was to establish evaluation criteria recognized by the majority of economists for economic systems. The widely recognized criteria are information efficiency, incentive compatibility and Pareto Efficiency in resource allocation.

Blockchain Operates at a High Information Cost

Hayek criticized the planning economy for an important reason that it takes a very long time to collect information and calculate equations. Interpreted in the mathematical language, every individual has to verify a great number of equations in the high dimensional parameter space, so the information space becomes huge. In this connect, Hurwitz, Father of Mechanism Design, pointed out that information cost was one of the basic criteria to be considered by mechanism designers. Information efficiency is an important criteria for evaluating an economic mechanism and it can be measured by the size of the information space. The larger the space, the higher the cost the mechanism will take to operate.

The distributed mechanism of blockchain operated at a very high information cost. Cross-validation is a must have to prevent the prevalence of conspiracy, which increases the cost of information processing. Fortunately, computing efficiency has been significantly improved with the development of big data, smart computers, cloud computing and the Internet technology, reducing the information cost of blockchain. The rapid development of computing technology and information storage technology is also prerequisite to the applications of distributed business models.

Blockchain Meets Incentive Compatibility

Social choice and mechanism design usually run into the problem in which individuals tend to hide or distort their private information to protect their own interests. Such behaviors are detrimental to collective interests and the implementation of social objectives, causing Pareto inefficiency in resource allocation. Only by meeting incentive compatibility, can the economic mechanism balance the individual and collective interests when the information in this mechanism is asymmetric. Therefore, incentive compatibility, fundamentally resolving incentive challenges in information asymmetry, is indispensable for evaluating economic mechanisms.

Blockchain meets incentive compatibility by cross-validating transactions to make it nearly impossible for individuals to fabricate information. So the probability of getting true information in blockchain is 100%, higher than that in the centralized mechanism as individuals may report false information.

Blockchain Makes the Best Resource Allocation with Pareto Efficiency

ical economics, Pareto Efficiency should also be employed to evaluate mechanism design. Compared with the centralized mechanism, blockchain can bring better Pareto Efficiency in resource allocation as it resolves the problem of information asymmetry.

As we all known, Pareto inefficiency in resource allocation caused by asymmetric information troubles all organization and mechanism design. But incentive mechanisms can be designed to reduce or even prevent inefficiency and the best mechanism is the one that balances incentive compatibility constraints and participation constraints. Contradictions between compatibility constraints and participation constraints are also called principle-agent contradictions, which are the fundamental contradictions in the mechanism design of asymmetric information. As blockchain is free from asymmetric information, its Pareto Efficiency will be obviously higher than that of the centralized mechanisms.

Invaluable Influence on Human Society

In his book New Rules for New Economy, Kevin Kelly stated that in the following a decade or more, enormous profits brought by the new economy should be attributed to the development and exploration of the distributed and autonomous network. As a new distributed mechanism design for resource allocation, blockchain, emerging in the age of Internet economy, will bring invaluable influence to human society.

In the future, we need to combine mechanism design with network theories, cryptography, computer science, etc. in the form of applications and algorithms operating on the Internet to build new rules and markets. At present, blockchain is considered to be a product of computers and researches on blockchain are filled with terms of computer technology like bitcoin, consensus protocols, state channels, Hash algorithm, shard and Raiden network. These computer technologies are, of course, indispensable for building incentive mechanisms and improving efficiency in blockchain. But it is more important for blockchain to design and create rules and algorithms that can bring balanced results with economic theories. The combination of economic mechanism design with network theories, cryptography, computer technology and AI assists blockchain to yield meaningful results in the new economy and giving birth to more and more new business models and decentralized autonomous organizations. Distributed organizations, the third hand following the visible hand (governments) and the invisible hand (market), will be more easily produced when technologies and mechanisms are coupled.

*The Chinese version of this article was originally published on Shanghai Securities News and authored by Xiao Feng, VP of Wanxiang Group, President and CEO of Wanxiang Blockchain, Tian Cunzhi, Professor and PhD Supervisor in the Finance Department of the Economics College at Jinan University, Xiao Xinrong, Professor and PhD Supervisor of the Finance College at University of International Business and Economics and Yang Yue, Chief Economist Beijing Sylincom Technology Co., Ltd.

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Wanxiang Blockchain is dedicated to building an open platform and offering resources to develop blockchain and promote its application in different industries.

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