B School for Public Policy

Professor Kevin Werbach

Can Blockchain Truly Work? The Question May Be One of Trust

Wharton legal studies and business ethics professor Kevin Werbach talks about the transformative potential of the blockchain, the underlying technology behind cryptocurrencies such as the bitcoin. While the adoption of cyber-currencies is running into headwinds, the blockchain is finding more practical use across industries. Its nature as a distributed ledger in which transactions are transparent among parties creates a “new architecture of trust,” Werbach adds. One doesn’t have to trust another party in a blockchain to do a transaction even if there is no centralized authority, such as a bank or government, in charge.

An edited transcript of the conversation follows.

Knowledge@Wharton: If you follow business news you may have seen the story surrounding the investment price of Bitcoin, and the fact that it has been soaring. Bitcoin has been around for some time now, but for the most part it still hasn’t garnered the level of usage some would have hoped. Still, it is a chance to innovate the world of finance. Likewise, many other new ideas have the chance to innovate and produce shifts in industry and build blockchains. But can blockchain truly work? The question may be one of trust. Wharton professor, Kevin Werbach recently discussed the impact of blockchain while down in Washington, D.C. on Capitol Hill as part of a program that the Penn Wharton Public Policy Initiative has put together, and how it may affect public policy in the future. And Kevin is joining us here in the studio right now. Good to see you.

Kevin Werbach: Good to be here, Dan.

Knowledge@Wharton: Thank you. The use of blockchain seems to have the opportunity for significant growth moving forward, correct?

Werbach: Oh absolutely. This is a foundational architecture. It’s a new, broad approach to network-based infrastructure that can be applied to just about anything. For example, you mentioned the price of Bitcoin; what gets a lot of people interested who aren’t otherwise familiar with the technology is that Bitcoin is an investment product. I can buy Bitcoin at $200 and then sell it later at $1,000. That’s interesting, but it’s fairly small, and in some ways we have a bubble with a lot of people who really don’t understand the underlying technology who go and buy Bitcoin just because the value is going up. The potential though, of the underlying technology that makes Bitcoin possible, is huge.

Knowledge@Wharton: There are a lot of people out there, speaking of Bitcoin, that actually think it is a currency; something you can hold in your hand. To a degree, however, Bitcoin itself is a platform and users need to have an understanding of what it is.

Werbach: Well, how many people that use money really understand the theory of finance and what money is? So to use Bitcoin as a currency you don’t necessarily need to understand the technology, and frankly if you’re just investing and you’re looking for a speculative investment class, an investment opportunity, and you can do a technical analysis on the price, you don’t need to understand the technology of Bitcoin necessarily to do that.

On the other hand, if you are saying, well gee, I think this is going to go to the moon because it is going to be the new currency that everyone is going to use, and you’re making certain assumptions about its application and its security and its growth and so forth, and that’s the basis by which you are putting your life savings into something, well that is problematic.

Knowledge@Wharton: In your address on Capitol Hill you discussed the element of trust in block chain. Talk about this a bit, because trust in this type of genre is probably hard for government entities, even corporations, to be able to give forth.

Werbach: Well let’s start with money again. So you look at the bills in the United States and they’ve got a legend on there that says, “In God We Trust”. But that’s really not what is going on, right? If you’re saying I am going to spend money, it’s not because you’re religious or you believe in God or something. No, fundamentally you believe in the United States government, that ultimately it is going to stand behind that transaction. You’ve got to have some level of trust to know that this is a dollar bill that I am going to exchange for something of value, I can actually buy something with it, versus just a green piece of paper.

There is trust underlying the monetary system, but trust underlies a whole lot more. All of our relationships with organizations and with the government, as well as with relationships between parties, transactions that go on in the market, depend on some level of trust. And the basic idea is that block chain, which is the underlying technology that makes Bitcoin possible, but a lot of other things as well, I think is a new architecture of trust. It’s a new way to make a transaction trusted. I can believe that this will happen in a trusted, effective way without necessarily having to trust any of the individuals or the organizations who are part of enabling that transaction.

Knowledge@Wharton: A new level of transparency.

Werbach: That’s another part of it. So one aspect of the technology of the blockchain is that it uses what is called a distributed ledger. So the idea is basically you’ve got a bunch of parties that are doing something, and again this could be anything, this could be money or this could be—for example, I was just reading today about advertisers online talking about using a block chain network to deal with fraudulent online advertising. This could be a loyalty points system, this could be banks doing transactions, etc.

Knowledge@Wharton: In the past we talked about the music industry and how it is changing because of the licensing agreements and musicians needing to be sure that they are being compensated for it.

Werbach: Right. Anything where you have a shared truth, where you’ve got a bunch of entities that have to agree on some information, that is something that in theory you could put on a blockchain, which is a kind of shared database. And it’s potentially transparent because again everyone is seeing the same thing, and that has a lot of value.

And you mentioned why it’s interesting to governments, well for one thing so much of what government does is based on trust, and quite frankly part of the crisis that we’re in now in this country and around the world is because there has been such a tremendous erosion of trust. In government, in corporations, in the media, across the board, lots of studies are showing that.

Blockchain potentially offers a new way to create a trusted environment for transactions. And so people tend to think about, oh Bitcoin, it’s this thing that’s outside of the government, it gets used for drug deals and so forth, it’s inherently a threat to government. It’s actually a tremendous opportunity for government and policy makers to make new trusted environments.

Knowledge@Wharton: But for them, and part of the reason why you no doubt had this discussion down at Capitol Hill is the fact that the majority of people that are on Capitol Hill don’t have the understanding of what this could potentially do, and the potential for change for policy here moving forward in the next couple of decades.

Werbach: Yeah, there’s two pieces to this. One is the question of law and regulation applying to Bitcoin or to blockchain based transactions. So there is a whole set of legal questions, which Congress and the various regulatory agencies like the Comptroller of the Currency and the Securities Exchange Commission, and so forth, are starting to look at as well as their counterparts elsewhere in the world.

So those are things like, if I buy some Bitcoin and I buy it for $200, and then I sell it for $1,000, do I have a capital gain? What are the tax implications of that? What about the companies that I am buying and selling it from, or the companies that are creating digital walls that hold my Bitcoin? Are those money transfer agents? Are they banks? How are they regulated?

Companies are doing now providing what is called Initial Coin Offerings or ICO. It is similar to an IPO. Instead of issuing stock in your company they issue these coins, which are digital tokens on a blockchain. So they’re not necessarily Bitcoin, they are a different kind of token, but they represent an asset in your system. And so a number of companies, startups, have raised $10, $20, $30 million in the last couple of months just offering these coins.

This brings up the question, “Is that a securities offering, which needs to be regulated under U.S. laws?” Blockchain brings up a whole set of questions that Congress is starting to think about, although it is moving really fast.

There’s another set of questions which actually I am more interested in, which is less about how do you regulate these things, but how do these systems, the blockchains themselves, act as regulatory entities? How do they govern activity? Which comes back to this notion of trust.

Knowledge@Wharton: To a degree then you are putting control, or that trust, into the system itself and not necessarily in the hands of other people, correct?

Werbach: Absolutely. Although it turns out as always to be more complicated than it seems. And what I have been talking about in my writing, including law review articles and a book I am working on, is it is too simplistic to think these systems get rid of the need for having law or government.It’s also too simplistic to say they are just going to fail because eventually the power of the state, or the power of corporations, is going to triumph.

There is going to be a mix of both, and what we need to understand is, where can these technical systems solve problems better or more easily than traditional legal regimes? And that is very much a reality. Where actually are there problems technological systems can’t solve very well where we need to have a backstop? For example, if someone puts their life savings in one of these initial coin offerings and it’s a scam.

Is it okay to say, well you shouldn’t have invested in something crazy like that? We would never say that in an IPO, right? We would say no, they’ve got to have perspective, we’ve got to comply with SEC rules and so forth. And if that is misleading then those people making the offering have fiduciary duties, they have responsibilities, why should it be any different if what you’re getting is a token as opposed to a share of stock?

So there’s a whole set of questions like that, and what we need to understand is what things go on one side of the line, what things go on the other side of the line, and where do we need more experimentation?

Knowledge@Wharton:Unfortunately, with a lot of these things though, seemingly the government or whoever it may be, the companies themselves, to a degree aren’t they playing catch up in terms of trying to understand this, and where this could potentially be moving? Because to a degree this is still basically a brand new concept to them, whether it be the idea of blockchain, or, as we were saying earlier, what Bitcoin is.

Werbach:You would be surprised. We often generalize about the government, and you’ve got to realize even if you’re just talking about the U.S. government we’re talking about thousands and thousands of people, and dozens and dozens of organizations. So do most of those people understand the technology of Bitcoin? No. But do most of the people at Goldman Sachs understand the technology of Bitcoin? No. And those are the ones who are the most sophisticated. Do most of the people at Microsoft or at Google who are very technically knowledgeable understand Bitcoin? No.

There certainly is a gap, and as I said a lot of these things are happening so fast. Like these ICOs, these coin offerings have just blown up in the last six months or so. Hundreds of millions of dollars raised well before the regulators have even taken action on where the line should be drawn. That’s potentially a problem, but it’s not that the regulators are incapable of understanding it. If you look at, for example the central banks, the Fed in the U.S. and other major central banks in the United States, they have all been looking at Bitcoin and block chain technologies for years.

There are white papers out of the U.S., out of various European countries, the People’s Bank of China has been doing a virtual crypto currency, a Bitcoin-like currency experiment. So I’m not necessarily saying that they’ve all worked it out, or they all understand it fully, or all of the governments are doing the right thing, but look, everyone knows technology advances, and I think we tend to give short shrift to think that no one in government is capable of having any clue about this.

Knowledge@Wharton: But when you think about the use of this type of system moving forward, for whatever the entity might be, we mentioned music and obviously there is a variety of other areas as well, I would think that probably when you are on a unified system, and obviously the transparency is there, that the costs associated with a lot of things end up being lower, and that companies or whatever entity it might be ends up seeing a benefit from that perspective as well.

Werbach:Oh absolutely. There are a lot of benefits, and that is why this is getting adopted. The initial push behind Bitcoin came from a group of technologists and financial experts who wanted to create a private currency that was outside of the scope of governments. It has gone far beyond that. I mean, that community is still there but the adoption is happening because big companies, including very established financial services companies, are saying wow, this is an opportunity for us.

For example, look at Wall Street. The retail trading that individuals and institutions do seems very sophisticated, but if you look below the surface, for example at the settlement process it’s not quite still be done on paper but it’s pretty darn close. It’s a whole lot of these mainframe computer systems that are actually getting things wrong, or that are slowing things down, or are inefficient behind the scenes.

So yes, there is a tremendous opportunity for cost savings and efficiency gains and automation potential, but there are also problems. And the fact that you can digitize some pieces of it with a block chain doesn’t mean you digitize all of it. For example, we talked about buying and selling Bitcoin, well if you got an exchange that you’re using, I put in dollars, I want to get out Bitcoin. I put in Bitcoin, I want to get out dollars. Well, that’s a centralized marketplace, that’s not crypto currency, that’s not Bitcoin. That’s just like a currency that says I put in dollars, I don’t want to get out euros. There may still be inefficiencies and so forth at all of those centralized points on the network.

Knowledge@Wharton: How much development do you think there really needs to be still? In other words, if we are going 1 to 100 here, how far along in the process are we now?

Werbach: Two or maybe three. We are in a very early stage of development. The Bitcoin paper that was first published in late 2008 was based on a lot of pre-existing cryptography research, but that was, in effect, the starting gun. We are nine years in; but the real advances in this technology are within the last five years. It’s growing explosively. 

It’s very much like, pick some year in the mid to late 1990’s, and say that is where the Internet was. I remember being on the Federal Communications Commission talking about government regulating the Internet and coming up with policy in 1994 or 1995, and that was similarly very early. And all of the people working on Internet policy at the time understood that it was going to change the world. 

And we were involved in it, but most of the world wasn’t. At that time, it was only five, ten, fifteen, twenty, fifty million people on the Internet, not the approximate five billion that we have today. An that’s where we are at with blockchain. It is huge, it is a big deal, but it is just getting started. 

Knowledge@Wharton: What is your expectation then in terms of the growth of the use of blockchain here in the next several years? I mean, seemingly there are sectors out there that see the value of using it for a variety of different reasons, but it almost feels like—and correct me if I’m wrong, that with the successes that are there, and obviously there is still a development process that needs to happen, that there are benefits companies, organizations, different sectors of industry currently see that other entities will be joining in on this in the years to come.

Knowledge@Wharton Oh absolutely. Right now we are seeing a whole set of pilot projects. Pick any of the top tier financial service firms, pick any of the top tier global retailers, transportation logistics companies, and so forth. Virtually all of them are doing serious exploration of block chain based solutions. How soon they will go into production, and exactly how that will look remains to be seen, because there are all kinds of competitive dynamics here as well in terms of who will participate and and who will not.

But clearly there is going to be that large scale investment. Most of that is behind the scenes. The real kind of transformative opportunity is found in questions such as, will companies primarily fund themselves using these tokens, these coin offerings, versus stocks? There are arguments that is going to happen, there are arguments that it’s just a better way, and at some point in time that will be the norm and not the exception. That is going to take time.

Knowledge@Wharton: And that will shift Wall Street?

Werbach: Absolutely.

Knowledge@Wharton:That’s incredible.

Werbach: But you know what? Think about how far Wall Street has come in 200 years. Wall Street is good at shifting. And I’m not making a prediction about it’s going to be five years, ten years, 20 years. Directionally you can see where it’s going to go, and there’s going to be ups and downs. I mean, there is going to be—right now we are clearly seeing a bubble in the prices of things like Bitcoin. That is going to crash at some point, not because it doesn’t work but because things that go up tremendously don’t stay that way.

Knowledge@Wharton:  And that is why a lot of people are just waiting for the other show to drop. Where the Bitcoin price is, the fact that it’s over $3,000 right now, and the fact that it has gone up, what, double or triple here in the last several months? I mean, it’s just the process of what investment is right now.

Werbach:  Right, and when you have something that has gone up that fast, and there’s lots of evidence that people are buying on margin, which is of course a classic red flag. People in China, who are not very sophisticated investors who are just looking for some other asset class that they can invest in that gets away with the regulation—they are investing a lot in Bitcoin. All of these things suggest that something will happen to spook the market, which doesn’t mean that Bitcoin just doesn’t work, or that it’s a hack. In the long run, we will look back and the impending crash will look like a blip. When it happens, however, it is going to be a big deal.

Knowledge@Wharton: But when you think of blockchain overall, I mean truly we’re talking about a mindset shift here, in terms of what we are going to know as kind of the processes of doing business, or moving forward with currency, whatever it might be, in the next few years. This is going to be a mindset shift that so many more people are going to be really involved in in the years to come.

Werbach:  Marc Andreessen, the creator of Netscape and venture capitalist, Joi Ito, the head of the MIT Media Lab, Reid Hoffman, the founder of LinkedIn, all tremendously successful technology futurists, investors, adn so forth, All of htem said the same thing when they understood Bitcoin and blockchain, they siad, this is the internet again. This is a foundational technology, it will take time to unfold, we don’t know exactly how, there will be ups and downs, but it’s going to chang the world.

It’s a basic shift in how we do things, and it’s got this tremendous potential, and that’s what’s exciting about it. It hink that’s right, but that doesn’t mean if you’re saying, well at what point will this particular thing change? Or will this be the right solution? Of what are the platforms going to be?

Knowledge@Wharton: Right. You can’t put a timetable on it.

Werbach: If you want to make a bet, you can. Say, if I’m a venture capitalist and I’ve got to make a bet about the timetable, or if I’m an investor, then that’s fine. But I’m looking at it at the general level, about what does this mean for business, what does this mean for law, what does this mean for society. And directionally I think it’s quite clear where this is going.

Knowledge@Wharton:  Great seeing you again. Thanks Kevin.

Werbach: You as well.

Knowledge@Wharton: All the best.