June 23, 2022
3 min read
May 31, 2022
10 min read
“If you take a broad enough definition of trust, then it would explain basically all the difference between the per capita income of the United States and Somalia.” Steve Knack, Senior Economist World Bank.
One of the central claims of the DeFi world is that it can dramatically increase trust in financial transactions. The ultimate expression of this idea is the ‘trustless’ smartcontract that eliminates the need for trust altogether. The good news is that, as the quote above argues, any increase in trust represents a truly immense value proposition. The bad news is that many of the discussions around trust and how DeFi will increase trust or even eliminate the need for trust demonstrate little or no understanding of what trust is, how it functions and the steps necessary to increase it. Nonetheless, DeFi does present an opportunity to create immense value by leveraging the very real advantages of blockchain technology.
One way of understanding trust is in contrast to faith. Faith is the strong belief in something for which there is no proof. On the other hand, trust is a reasonable belief or expectation based on evidence. But things are never so straightforward, and, as we all know, the universe is vast and confusing and unrelenting in forcing us to draw broad conclusions based on scanty evidence. Hence, even trust is always provisional and open to revision, but nonetheless necessary and powerful. It is central in any kind of cooperative endeavor and the greater the degree of trust achieved, the easier it is to complete complex tasks involving many participants, and on this claim the historical record is perfectly clear. Where something like GDP might serve as a reasonable proxy measure for accumulated cooperation, a per capita GDP in the US that is 500 times greater than it is in Somalia may indicate the tremendous and compounding impact that differences in trust can cause: while the differences in trust and cooperation may not differ too dramatically between these two countries on the everyday, person-to-person scale, once at the systemic scale we encounter two realities that are worlds apart.
How then might blockchain improve the balance of trust in the economy?
The whole point of the blockchain security process is to create an unalterable digital record that makes trust in digital ‘goods’ and transactions a rational expectation. How to implement counterfeit-resistant digital money had been a goal for about a decade before Bitcoin came along, which found a solution to the key point of failure of the earlier attempts that was the inability to trust the authenticity of each digital ‘dollar’. Satoshi’s development of blockchain protocols solved this central difficulty by creating an auditable history combined with cryptographic security. The rapid growth in dollar value of bitcoin and other cryptocurrencies and the booming growth in the DeFi world argues strongly that indeed improving security opens up a vast space of economic opportunity that had previously been located in terrain too swampy (untrustworthy) to develop in by even the most ambitious, yet still rational, surveyors.
As we all know, Bitcoin and Ethereum got this conversation started, notwithstanding their impurities. Yet for many in DeFi the vision has become intensified into a seamless system that should be, very importantly, completely ‘trustless’:
A trustless system means that the participants involved do not need to know or trust each other or a third party for the system to function. In a trustless environment, there is no single entity that has authority over the system, and consensus is achieved without participants having to know or trust anything but the system itself. [Ref]
However, this is not a ‘trustless’ system. Rather, while it was once necessary to trust an intermediary, like a bank, it is now required to trust the technology of the blockchain and one’s understanding of it. Smartcontracts do eliminate trust from certain types of links in the value chain; however, they also have a tendency to create a new burden of trust that must be borne by those parties who have opted-in to using it. The finality and lack of available recourse thus created by such smartcontracts thereby creates a new necessity: the necessity that I understand the technology extremely well lest, upon execution, I am stuck with an outcome that I hadn’t expected. Indeed, the more certain I am that the smartcontract will execute to the letter, the more hesitant I may become to use it. The reason early adopters of Bitcoin, Ethereum and the DeFi world generally have tended to be highly technically literate is because placing trust in a new technology requires one to have a reasonable understanding of how the technology functions — early adopters trusted their own expertise, but this has not been without hazard. The ETH-ETC hardfork as a resolution to the DAO attack demonstrated that the system contains risks for all those using it, experts and faithful (non-experts) alike. Additionally interesting for our analysis of trust are the preferences and values thus revealed by the response that the community accepted as a resolution. Feeling that permitting a ‘legal’ contract to drain vast sums of money from user accounts may undermine the short-term trust in a still-infant network and that this may cause issues for its subsequent growth and adoption, the community decided that it would be better to intervene and correct the ‘error’ via consensus despite the fact that, in so doing, was betraying and undermining a still-important, yet empirically subordinate, community value that is the sanctity of code as law.
But even Ethereum is quite young and many of its most interesting applications are still theoretical. There are in fact, old-world businesses that can offer countless lessons in trust and thus might be more easily understood without the complications of the new technologies that make smartcontracts possible.
To understand the actual functioning of trust in a legacy industry consider Ebay. Ebay was an early peer-to-peer transaction facilitator. Ebay currently has revenue of roughly $10 billion a year and accounts for about 4% of e-commerce. Their core business relies on sellers and buyers trusting one another enough to complete transactions. It is little exaggeration to say that Ebay’s entire business is building trust and they have evolved an incredible array of approaches in an attempt to increase trust. Amongst the programs Ebay has beyond simple advertising:
These are just a few of the steps Ebay takes to try to reassure that two parties can come to a mutually satisfactory transaction. They are all expensive, time consuming, and absolutely necessary. Ebay spends a huge amount of time and money attempting to gain the trust of their users and, still, it is one of their biggest hurdles. They are commonly known as ‘Epray’ — a joke that highlights the thin line between trust and faith when completing transactions.
Some argue that Ebay represents exactly what smartcontracts in a world of digital goods allows us to avoid. And it is true that the world of DeFi has many advantages over Ebay in that dealing with material goods that have to be shipped between parties presents all kinds of complications that are not, in theory, applicable in a digital world. But consider the case of OpenSea. OpenSea is a ‘peer-to-peer’ NFT platform that is one of the largest users of the Ethereum network. By any measure, they have been hugely successful and are growing rapidly as, like Ebay, a facilitator of peer-to-peer transactions. Despite all the advantages of blockchain and digital goods, they end up sounding a lot like Ebay. From OpenSea’s user guide:
OpenSea is primarily a self-serve, peer-to-peer marketplace. That means anyone can create and sell an NFT on OpenSea! Our user safety team actively monitors the platform, approves collections and removes malicious content as soon it’s discovered, or reported by users. This ensures OpenSea’s community remains vibrant while upholding our Terms of Service.
This monitoring includes providing verification scores for collections, warning screens for suspicious content, seller account activity information, verified user ratings for high profile or high volume accounts, and fraudulent content reporting. Further, OpenSea also provides price tracking and sales history data. In short, it is a digital Ebay. One can confidently predict that as OpenSea continues to grow, they will add even more oversight and more robust opportunities for dispute resolution. In theory, users do not need OpenSea to complete these transactions. In practice, having a content aggregator that provides some oversight and helps manage payments while providing pricing information adds immense value by increasing user trust. It moves some of the burden from buyers and sellers onto the platform. If I trust OpenSea’s price history, then I do not need to do the research myself. OpenSea, like Ebay, also helps facilitate payments and is working to create more cross-chain payment options. The value proposition in NFT platforms or other platforms is not necessarily in their employment of trustless smartcontracts but in creating environments where users feel confident in outcomes. And so all signs again point back to trust.
The underlying technology still makes a huge difference. Consider that the transparency of the blockchain means investors no longer have to trust companies who claim to hold certain assets, receive certain revenue flows, or make certain kinds of payments. As odd as it may seem today, in rural communities in the early 20th century general stores generally provided the only shopping opportunity. These stores did not price their goods but negotiated with each individual customer. Sears and Roebuck’s famous catalogue in the US succeeded in part because they printed clear prices that let customers know they were being treated fairly. Sears and Roebuck built an empire on transparency. One of the driving problems from the 2008 financial crisis was that third-party auditors, who were relied upon to assess the risks contained in mortgage backed securities, had a vested interest in the conclusion of their assessments thus creating serious conflicts of interests that, in the end, didn’t really make them third parties after all. Unsurprisingly, these not-so-trustworthy trusted reviewers of security quality failed spectacularly. The Enron failure was another scandal made possible by the impotence of so-called third-party auditors. In both financial collapses, lack of transparency and the need to trust third parties led to huge losses and, in 2008, global social disruption. With transparency, Enron’s asset flows and the underlying quality of mortgage backed securities would have been easily available to scrutiny and the collapses perhaps avoided.
Further, the use of private wallets to hold assets means that one does not have to trust an intermediary in many important applications. For instance, in the US about $3.5 trillion are locked up in 401(k) retirement plans. While these accounts are held in the retirees name, the accounts are generally held by an institution not by the individual. Significantly, these accounts are not federally insured and if an institution like TIAA CREF with $1.3 trillion dollars under management somehow went bankrupt retirees would lose some or all of their investments. While the probability may be low, the possible damages of such an event are much too severe to take the risk so long as there are viable alternatives available, at least ethically speaking. All of the same services of retirement investment and savings could be handled without having to trust an institution with holding one’s money. The widespread adoption of DeFi protocols would have a seismic impact on the stability and safety of financial markets worldwide.
As much as we’d like it to, technology does not really change the underlying nature of humanity: trust provides the platform we require to cooperate efficiently, and trust is grown from experience and knowledge. While many early adopters of DeFi care about and understand concepts like blockchain and smartcontracts, the vast majority of people do not. They cannot trust blockchain security technology because it is beyond their experience and current knowledge. What they can learn to trust, however, is dapps that use the technology to provide them with services that are better and/or different from what they can otherwise access. The value proposition for trust in DeFi is to leverage the significant technical advantages of DeFi in ways that most users can feel as valuable, consistent and reassuring. The technology may be revolutionary, but humans have not changed much in the last 100,000 years, let alone the last 10.
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