The evolution of cryptocurrency, decentralized finance, and transactions: a transaction cost approach

Based on the perspective of transaction costs, the author provides a theoretically unified process of transaction evolution, and the current frontier of evolution is cryptocurrency and decentralized finance. The author shows that with each new development of currency, new forms of exchange or media must reduce transaction costs relative to related substitutes. The development of blockchain and cryptocurrency reduces the cost of transferring money, eliminates the need to provide a trusted third party to intermediate funds, and also provides the benefits of anonymity/pseudonym. Similarly, decentralized financing does not require a third party for intermediate savings and investment, and can provide occasional anonymity for borrowers. These innovations can significantly reduce transaction costs and attract investment from economically developed countries. The Financial Technology Research Institute of Renmin University of China (WeChat ID: ruc_fintech) compiled the core part of the report.

introduction

Among the typical forms of currency and its emergence, the purpose of using the medium of exchange through the exchange network is to reduce transaction costs: search costs, storage costs, transportation costs, and costs due to the lack of divisibility of exchanged goods. As long as it is believed that using a commodity as a generally accepted medium of exchange can successfully reduce transaction costs and enable economic actors to obtain the resources needed for economic activities or survival, then they will tend to adopt a generally accepted medium of exchange.

Although on the surface it is not very related to history, Menger’s causal-genetic narrative of currency evolution is a valuable starting point for two reasons. First, it recognizes the importance of sporadic changes under the guidance of profit discovery. Second, these profits are achieved by reducing transaction costs. Increasing profits incentivize participants to continue to create profits will also be transmitted to entrepreneurs to imitate and develop the behavior of those who obtain relatively high profits.

The latest frontiers of currency evolution include the increasing use of cryptocurrencies for transactions and their increasing use for financing. The unique feature of digital currency is that neither direct payments nor financial intermediaries require a trusted third party for intermediate transactions. For a mature cryptocurrency and crypto financial system, removing or relocating third parties to facilitate transactions and financial intermediation can significantly reduce transaction costs.

Transaction costs and the evolution of transactions

In the past few decades, people have increasingly realized that currency can reduce transaction costs, and the evolution of currency is closely related to the transaction costs it reduces. The evolutionary approach takes into account the importance of fixed costs, because fixed costs may inhibit the adoption of monetary systems that reduce marginal transaction costs.

With the advent of currency, there will be four transaction costs, namely search costs, storage costs, transportation costs and divisible costs. As the transaction cost of physical exchange rises rapidly with the increase in scale, producers are incentivized to incur fixed costs of currency exchange. Menger pointed out that people engaged in commercial activities will seek to obtain a tradable commodity in exchange. The attributes that promote the best-selling of products include storability, divisibility, portability and scarcity. Historically, precious metals have been used as a commodity to effectively promote exchange, and the cost of bartering is too high.

Financial intermediary

As one of the hallmarks of the modern capitalist economy, a strong financial market enables idle capital to be transferred from capital owners to entrepreneurs. The development of one or a few commodities for intermediate exchange greatly reduces the transaction cost of loans. Loans no longer have to be physical. On the contrary, alternative wealth in the form of currency commodities can be lent out.

Cryptocurrency and financial intermediary

The transaction cost method of currency evolution helps us understand the obstacles to the development of cryptocurrency and decentralized finance, and the potential impact of these technologies on economic organizations. Blockchain technology can greatly reduce the cost of electronic transfers and loan costs.

3.1 Digital currency

Although transferring money between users seems to be an obvious application of computing technology, the motivation to manipulate accounts in digital ledger has been an obstacle for many years after the Internet was widely adopted. The problem is not as simple as debiting one agent’s account, but crediting another agent’s account. Readers can achieve this by using excel spreadsheets or developing a program to implement transactions systematically. Two problems hinder the development of digital currency:

1) Anyone other than the account owner must be prevented from transferring funds from the account or granting other users the right to transfer a specific amount of funds.

2) Anyone who accesses the account must be prevented from double committing funds from the account. For decades, these problems were considered to require a trusted third party to manage the ledger. In fact, such trusted ledger operators appeared early in the history of the Internet. But it was not until 2009, with the advent of Bitcoin, that a completely decentralized practical solution was developed and implemented. The first problem can be solved using encryption methods that are also used to support the blockchain protocol. Unless the required password is provided, secure the account by preventing access. The second problem can be summarized as the so-called Byzantine Generals Problem, because it is difficult to sequence signals from multiple sources. This problem is more difficult to prevent dispersion, especially when users want to remain anonymous.

3.2 Anonymous and decentralized finance

Anonymity is also a factor in the cost of certain transactions. Just as the development of new financial instruments in the second half of the 20th century helped investors avoid certain regulatory and tax costs, anonymity and lack of third-party facilitators who can be easily regulated by the state can help borrowers and lenders avoid similar costs. .

For the purpose of diversified financing, as long as the loan is repaid, if the prophet has the support of a trusted party, this information may pass on the credit of the borrower to the lender without revealing the identity of the borrower at the same time. Information can be obtained from the traditional financial sector. This occasional anonymity allows decentralized financial applications to reduce transaction costs by providing only the information needed to demonstrate the soundness of a given loan. Although the information and execution costs are essentially unlimited in the case of complete anonymity, these costs are greatly reduced in the event of a default, because Oracle will automatically disclose identifying information to the lender. Therefore, if the borrower absconds with borrowed funds, it cannot simply start over. The game has changed from a limited repetition game to an infinite repetition game, because in the case of identity as collateral, equity extends from the borrower-lender relationship to any future interactions between the borrower and financial system members and institutions.

As a result, decentralized financing applications can simultaneously reduce the cost of borrowers who want to maintain a private identity, and centralized control of their funds will also reduce the cost of execution for lenders. Like the development of mobile money and cryptocurrency applications in African countries, borrowers who are at great risk due to institutional uncertainty will have a better chance of obtaining loans and ensure that these wealth will not be confiscated by the domestic government. Reducing the execution cost of the lender increases the possibility of repayment.

The future: lower transaction costs, currency stability, and financial exclusion

Coase believes that compared with acquiring resources in the market, companies exist because they reduce the cost of acquiring resources. He pointed out that innovation may further reduce the cost of organizational resources within the company. Coase then continued this instinct, pointing out that positive transaction costs would have a negative impact on economic efficiency. In particular, the clear definition and effective implementation of property rights have reduced transaction costs and improved entrepreneurs’ ability to form accurate expectations of future world conditions. Blockchain technology, especially cryptocurrency and decentralized finance, will improve economic performance in these two areas.

As transaction costs fell, investments that were once completely unprofitable became profitable. This is true for every stage of economic development, including those outlined here. But the development of cryptocurrency, blockchain technology and decentralized finance is unique in how it affects transaction costs. The effects of past innovations are often limited by the ability to accumulate new technologies and incorporate them into local economies governed by existing institutional frameworks. Cryptocurrency and decentralized finance are emerging in a world where the modern communication technology they need has been adopted by many developing countries.

in conclusion

In short, cryptocurrency and crypto finance have the potential to lead an era of international financial integration, which was unimaginable and unimaginable half a century ago. This new technology is the latest iteration of cost-reducing technology and is expected to have the most significant impact on areas that have traditionally suffered from financial exclusion. Regarding the broader impact of blockchain on economic development and organization in the form of supply chain integration, as well as the changing nature of enterprises, there are many things that need to be explained, but this is beyond the focus of the author’s discussion. The author stated that we are seeing preliminary signs that cryptocurrency and decentralized finance will have an impact on economic organizations. The transaction cost framework clarifies the importance of this development and suggests the future development trajectory.

The following is a screenshot of part of the report

The evolution of cryptocurrency, decentralized finance, and transactions: a transaction cost approach

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