People don’t trust blockchain systems – is regulation a way to help?

Blockchain technology isn’t as widely used as it could be, largely because blockchain users don’t trust each other, as research shows. Business leaders and regular people are also slow to adopt blockchain-based systems because they fear potential government regulations might require them to make expensive or difficult changes in the future.

Mistrust and regulatory uncertainty are strange problems for blockchain technology to have, though. The first widely adopted blockchain, bitcoin, was expressly created to allow financial transactions “without relying on trust” or on governments overseeing the currency. Users who don’t trust a bank or other intermediary to accurately track transactions can instead rely on unchangeable mathematical algorithms. Further, the system is decentralized, with data stored on thousands – or more – of internet-connected computers around the world, preventing regulators from shutting down the network as a whole.

As I discuss in my recent book, “The Blockchain and the New Architecture of Trust,” the contradiction between blockchain’s allegedly trust-less technology and its trust-needing users arises from a misunderstanding about human nature. Economists often view trust as a cost, because it takes effort to establish. But people actually want to use systems they can trust. They intuitively understand that cultures and companies with strong trust avoid the hidden costs that stem from everyone constantly trying to both cheat the system and avoid being cheated by others.

Blockchain, as it turns out, doesn’t herald the end of the need for trust. Most people will want laws and regulations to help make blockchain-based systems trustworthy.

Problems arise without trust

Bitcoin’s creator wrote in 2009 that “The root problem with conventional currency is all the trust that’s required to make it work.” With government-issued money, the public must trust central bankers and commercial banks to preserve economic stability and protect users’ privacy. The blockchain framework that bitcoin introduced was supposed to be a “trustless” alternative. Sometimes, though, it shouldn’t be trusted.

In 2016, for instance, someone exploited a flaw in the DAO, a decentralized application using the Ethereum blockchain, to withdraw about US$60 million worth of cryptocurrency. Fortunately, members of the Ethereum community trusted each other enough to adopt a radical solution: They created a new copy of the entire blockchain to reverse the theft. The process was slow and awkward, though, and almost failed.

Securities traded on the floor of the New York Stock Exchange are subject to lots of rules – unlike most blockchain transactions. AP Photo/Richard Drew
A new type of investment, called initial coin offerings, further illustrates why blockchain-based activity still requires trust. Since 2017, blockchain-based startups have raised more than $20 billion by selling cryptocurrency tokens to supporters around the world. However, a substantial percentage of those companies were out-and-out frauds. In other cases, investors simply had no idea what they were investing in. The blockchain itself doesn’t provide the kind of disclosure that regulators require for traditional securities.

The initial coin offering faucet slowed to a trickle in the second half of 2018 as the predictable abuses of a “wild west” environment became clear. As regulators stepped in, the market shifted toward selling digital tokens under the same rules as stocks or other securities, despite the limits those rules impose.