Bitcoin is going through the roof as speculators hope to make a quick buck, but if you really want to see how blockchain could change financing, try taking a look under the hood
Blockchain is poised to overhaul the way entrepreneurs raise capital for their startups. Firms have raised millions of dollars by offering a share of some newly issued digital currency in exchange for cash. The success of these ‘initial coin offerings’ (ICOs) suggests there is a market for new forms of financing. But, in future, blockchain – the technology that underpins Bitcoin and other cryptocurrencies – could have a much larger role to play in raising finance: it could be used to produce ‘smart’ contracts, based on reliable and time-stamped records of transactions, offering fundraisers greater flexibility than bank debt or other traditional assets.
Blockchain is a cryptographically secure distributed database for recording and verifying transactions: in broad and simplistic terms, an ongoing, open and secure ledger of transactions and timestamps. The idea was first proposed in a white paper written by an individual or group of individuals under the pseudonym Satoshi Nakamoto as a way to create electronic cash that did not require trusted intermediaries to verify transactions. The resulting cryptocurrency (Bitcoin) has experienced truly extraordinary price increases since its creation: from reaching $1 in 2011 to around $17,000 today.
Bitcoin may succeed or fail as a global currency, but the underlying blockchain technology has, on its own, much broader potential applications: both startups and incumbents in the financial services industry are exploring its potential in speeding up transactions and slashing operating costs. It is seen by some as having as much revolutionary potential as the internet.
Launching a firm is an inherently risky and difficult endeavour, and anything that makes that more challenging is unwelcome
In a new research paper, Blockchain and the Future of Optimal Financing Contracts, I have developed a theoretical model of contract design in the new blockchain environment. I explore the impact of so-called smart contracts – contracts that automatically execute predetermined actions when predetermined conditions are met – and show that, under optimally designed contracts, external financing would be as cheap as internal funds, and more accessible to agents with no proof of cash flow or collateral assets (a common bugbear for entrepreneurs raising money).
One of the biggest hurdles entrepreneurs face is financing their projects – particularly in emerging markets where it is more difficult to raise funds than it is in the West. Even in richer economies, it is more difficult to obtain angel and venture capital financing for innovative projects in Europe than it is in the US. Launching a firm is an inherently risky and difficult endeavour, and anything that makes that more challenging is unwelcome. Conversely, technology that eases the pain of growth will be coveted. Blockchain potentially widens the pool of people who can raise finance. In theory, anyone anywhere in the world could access cash – or at least have the chance to.
But there is more to blockchain than cutting costs and saving time: it may fundamentally change the types of financing contracts borrowers and lenders use. It is even possible that traditional debt and equity contracts could become more expensive and restrictive than they already are.
In theory, anyone anywhere in the world could access cash – or at least have the chance to
We are living in a world where entrepreneurs are able to analyse data faster and faster: the potential of blockchain to provide reliable and up-to-date transactions data will probably amplify that trend. Traditional assets lack the flexibility to react to entrepreneurs’ changing incentives as new information arrives: when, as now, incentives can change at a faster and faster rate, this lack of flexibility becomes increasingly costly. A key feature of smart contracts on the blockchain is that they can benefit from time-stamped transaction records, and react to the arrival of new transactions data in a predetermined but flexible manner.
High early sales can be either an indication that a product is gaining popularity among its target consumers, or an indication that the target market is becoming exhausted. Which one is the case is forecastable given the product and its target market characteristics: the producer of an innovative gadget is likely to consider early sales success a signal that future sales will be high too, while the opposite is likely to be true for the producer of a temporarily fashionable item.
A smart contract, which takes the form of a dynamically adjusting profit-sharing rule, benefits from incorporating this information and making financing ultimately cheaper. For example, the optimal financing contract for an innovative gadget producer is one where the entrepreneur obtains a higher share of early sales revenues to get things going, and a smaller share of future sales if revenues are high; the same contract maintains the entrepreneur’s incentives to continue their selling efforts should they be initially unlucky.
The main benefit of blockchain is that, under a flexible smart contract, entrepreneurs need less or even no collateral to obtain external financing
Simple equity contracts are less than perfect because the share of sales revenues the entrepreneur retains is fixed – and it needs to be high enough to keep the entrepreneur incentivised even in the worst-case scenario. This makes access to financing more difficult as the contract does not benefit from the fact an entrepreneur would be ex-ante willing to give up a bigger share in the best case scenario to access financing more easily and cheaply.
Equity is still noticeably less expensive than debt contracts, and gives the entrepreneur an incentive to quit early following initial bad luck: there is little reason for them to continue to put their best efforts into selling a product if nearly all revenue they make goes to the financier. This undesirable feature of debt becomes a bigger obstacle in an environment where you can learn from sales data ever more quickly, i.e. the sooner an entrepreneur can ‘see’ they’re not making as much money as they would like, the sooner their efforts will slip.
More broadly, it has been argued blockchain benefits debt contracts as it safeguards the lender from fraud (such as the borrower pledging the same collateral twice) and it could even automatically transfer the ownership of pledged collateral assets if the borrower fails to repay. My analysis suggests this argument should be taken with some caution. First, the main benefit of blockchain is that, under a flexible smart contract, entrepreneurs need less or even no collateral to obtain external financing. Second, if one limited the contracts on blockchain to debt contracts, it would hamper the potential efficiency gains blockchain can bring and not increase accessibility to financing.
With better sales data, faster processes and wider access to capital, the blockchain could encourage the creation of new types of flexible profit-sharing contracts. These are better positioned to handle the increased capabilities in data analysis, and the trend towards more short-term engagements and the so-called ‘gig economy’.