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Unruly Innovation: Distributed Ledgers, Blockchains and the Protection of Transactional Rents

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Unruly Innovation: Distributed Ledgers, Blockchains and the Protection of Transactional Rents Unruly Innovation: Distributed Ledgers, Blockchains and the Protection of Transactional Rents We present a new conceptual model of disruptive innovation and apply it to the emerging financial technology of distributed ledgers and smart contracts. Our analysis illustrates the new features of this technology and why there is an argument that, in several respects, the combination of distributed ledger technology and cryptographically enabled contracts changes the economic framework within which individuals, firms and policy makers reside. This foundational level of disruption appears to have several new features, more notably a fundamental change in the game played by economic actors: the ability to self-deregulate. The paper clarifies these complex interactions and illustrates the main points using a recent case study from the Distributed Autonomous Organizations of the Ethereum project as well from a mathematical standpoint. Automation and distribution with powerful computing languages boost the speed of seizing opportunities as well as of tripping into (in-eliminable) severe risks. Key words: Disruptive Innovation; Combinatorial Innovation; Smart Contracts; Crypto currencies; Theory of the firm and creation; FinTech. 1. Introduction “Unruly. adjective. Disorderly and disruptive and not amenable to discipline or control.” Oxford English Dictionary, 2016 (Our emphasis). Distributed ledgers combined with cryptographically enabled programs to operate on such ledgers (smart contracts) permit the ad-hoc creation of virtual organizations that ascribe ownership rights on virtual assets with almost limitless flexibility. This ability to program organizations able to run on anonymous end points and open hardware without recourse to existing legal frameworks opens up a universe of innovation possibilities for Financial Technology (FinTech), with very low transactions costs and high levels of flexibility. One of the earliest financial application of distributed ledgers was just distributed payment systems such as Bitcoin (Nakamoto 2008). In time, more sophisticated technologies have emerged to capture key financial components such as Exchanges. For instance, Massacci et al. (2017a) illustrates a market structure with auctions, clearing, trading and settlement of 1 contingent claims: the ledger technology is mixed with many different types of cryptographic technologies that provide evidence of position for participants, whilst tracking the solvency of each individual and the market as a whole. This type of organizational construction has several hundreds of individual components. Typically, modular technologies of this type have enabled periods of sustained and innovative growth that often disrupts existing incumbents (disruptive innovation). Yet, we argue in this paper that this type innovation proffers both a fascinating example of how technology can facilitate innovation in FinTech but expose organizations to new risks not present in traditional markets. Whilst Massacci et al. (2017a) finely specified such FinTech constructions to prove the equivalence with a centralized Exchange platform, several other distributed platforms (e.g. Ethereum, Nexos, etc.) propose themselves as vehicles for arbitrary constructions by making full use of expressive programming languages (Turing-Complete) to encode smart contracts. This definitely allows for a great degree of flexibility. However, to be Turing complete the programming language used to implement the nexus of contracts enshrines a level of complexity such that in the worst case the only way to understand its outcomes is to execute the program itself. For sufficiently expressive programs, e.g. with dynamic generation and evaluation of fragments of the code, unintended states of nature may occur by mistake or mischief. From an ethical viewpoint1, those states may be demonstrably unfair. However, as pointed by Lessig (1999), in a distributed scenario there is no legal framework to resolve disputes surrounding the initial intentions at incorporation. The code itself determines the authentic interpretation of its alleged specifications by being jury, judge and executioner. We argue that there is a need to both disentangle and re-integrate these concepts to appropriately model the impacts of these new technologies for FinTech, given their role as both a ‘product’ and a ‘legal framework’ for the creation, management and destruction of quasi firm-like entities. The contribution of this paper is to introduce this new notion of unruly innovation and document the implications on FinTech technology both with a qualitative case study as well as with a mathematical interpretation. To our knowledge this is the first paper to synthesize these 1 Using the legal concept of the viewpoint of the ‘resonable-ness’ of an average person representing society. 2 areas. 1.1. A Primer on the Underpinning Technologies The underpinning technologies that drive this new medium are distributed ledger technologies (DLTs for short), block-chains and cryptocurrencies. DLTs are databases that are distributed across a large number of computing nodes in some form of network. The interesting feature of a DLT is that no one component of the network controls the overall information on the DLT, but can dynamically query it. This technology allows a ledger to be maintained that tracks transactions and attempts to ensure that no (small) group of individuals can subvert the ledgers’ integrity. The ledger can record almost any information, but the commonest example of a financial use is in maintaining a ‘block-chain’. This is a systematically updated record of transactions that allows the ledger to allocate debits and credits and to ensure that some desired properties are maintained (for instance no double spending and no improper routing of finances). The values recorded in the transactions can be provided by a central bank, as recently proposed by Danezis and Meiklejohn (2015), exchanged with commodities or other existing currencies (Ripple Labs 2015) or created by engaging in a specific action such as solving hard computational problems such as proof of work (Nakamoto 2008). The key issue is that no single machine or individual entity controls the distributed ledger (so that potentially all entities have a copy of it and hence the term distributed) and all participating entities run protocols that guarantee the security, integrity and coherence of the distributed copies through “Byzantine Fault Tolerance”, (i.e. where a minority of actors can behave in arbitrary ways). Essentially, if a ledger obeys these mathematical principles it should be highly unlikely that an individual or group of individuals coordinating could corrupt the ledger for financial gain, or commit economic injury to the other members, (Ben-Or 1983, Lynch 1989, Castro and Liskov 2002). In the first instance, this innovation aims to replace standard payment transaction networks, this includes cash, but more importantly real time gross settlement (RTGS) of centrally banked money. Whilst some limitations exist on transaction volumes, frameworks built around DLTs are generally simple to scale as individual participants can choose to migrate to a technology 3 if the marginal benefit exceeds marginal cost, with very low fixed costs. In this respect, block chains are not overly different from the disruptive technologies based around the development of the rigid disk drive discussed by Christensen (1993) or Christensen et al. (1998). However, our interest focuses on the next stage developments in the arena of DLTs and block chains, that of cryptographically enabled contracts, sometimes referred to as smart contracts that replicate normal contracts but correspond to i) executable pieces of code, ii) enforceable through a cryptographically enable ledger. In this instance, the financial value of the contract (either through some proof or work, or proof of initial capital exchange) is assigned as a property right subject to specific rules. Recombination of these contracts into a nexus can be used to form contractual entities that resemble firms and markets. We argue that this property provides a more fundamental form of disruptive innovation where incumbents are more than simply firms in a particular market, as it challenges the very notion of a firm as a legal entity and the legal medium that enables contract enforcement. 1.2. The Underlying Unruliness of the Technology A foundational point in the disruption literature focuses on the notion of an innovation, be it a technology or some more abstract innovation concept, that comes to replace existing offerings or frameworks and requires incumbents to adapt/resist or be replaced by new entrants, see Markides (2006) for an introspection on the various modelling frameworks in this area, or Christensen (1993), Christensen et al. (1998) for a proposed simple typology (sustaining versus disruptive technologies). Whilst the ideas from Christensen (1993) have proven controversial and provoked considerable debate in the innovation literature, this debate has centered on the notion of a company as the innovation nexus. We argue that the types of new technologies discussed herein, re-center this argument and hence, the notion of disruption. The founding notion of a firm lies in the ability to make contracts, either implicitly (under the shadow of the future) or more usually explicitly as a series of enforceable agreements backed by a legal process (often by a civil process that enacts torts or delicts, that remediate breaches of the
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