If crypto empowers better institutions, and better institutions are at the heart of a nation’s economic success, then cypto nations will win. (crypto is understood as synonym to permissionless blockchain systems and from here on referred to as distributed ledger technology)

Vitalik’s quote reminded me of an insightful book I read a few years ago called “why nations fail: the origins of power, prosperity, and poverty”, first published in 2012. Darin Acemoglu and James A. Robinson apply insights from institutional economics, development economics and economic history to investigate why nations develop differently. They provide a wide range of historical case studies, in order to examine why some nations succeed in the accumulation of power and prosperity and others fail. Before, geopolitical and economic theories based argumentation predominantly on environmental as well as cultural determinism. These assume that differences in geography and culture are the driving forces for different levels of economic growth. In contrast, modern economists argue that differences in institutions are the fundamental cause for long-run growth and prosperity.

The main thesis of Acemoglu and Robinson’s book lies in the observation that economic success is primarily dependent on inclusive political and economic institutions. Only a functional democratic and pluralistic state of law is capable of maximizing ideas and talent which are evenly distributed within a population. People are given a framework of trusted infrastructure and incentives for wealth creation. Therefore, inclusive institutions drive innovation and distribution of value as opposed to exclusive ones, which tend to extract value in the benefit of elitist groups.

So, let’s take a look at what institutions actually are. According to Wikipedia, “as structures or mechanisms of social order, they govern the behavior of a set of individuals within a given community. Institutions are identified with a social purpose, transcending individuals and intentions by mediating the rules that govern living behavior.” All social and economic activities are based on coordinating human activities into networks. Institutions in all forms are trusted sets of infrastructure to facilitate these activities. The term “institution” can both be applied to informal institutions such as customs, and to formal institutions created by entities such as the government and public services. They enable communication, trust and transactions among individuals in a given population.

Generally, activities within a population have always been constraint to means of coordination within networks. Socio-technological progress advanced our means of coordination. From speech, writing and printing to telecommunication networks and the Internet. At the same time, progress in formal institutions accompanied and complemented these advances. From tribe rules, money, feudalism and nation states to the European Union and international regulations for a globalized economy.

In this process, coordinating human activity became an increasingly global, borderless and efficient endeavor. The power of the Internet as open peer-to-peer network represents a fundamental milestone on the human learning curve in terms of the law of accelerated returns. It democratized information by distributing access to information more evenly and lowering cost of communication tremendously. Its inclusive nature stimulated freedom of speech, pluralism and creativity which enabled an explosion in innovation and economic growth.

The first era of the Internet was built on open protocols that were controlled by Internet communities. During the second era of the Internet, most notably Google, Apple, Facebook and Amazon (Gafa), built software and services that rapidly outpaced the capabilities of open protocols. Growth of smartphones adoption accelerated this trend. Eventually, users migrated from open services to these more sophisticated, centralized services. Recently, this has led to centralization of networked platforms which increasingly utilize their market dominance to extract an unproportioned amount of value. Internet platforms’ relationship to its users tends to move from attraction to extraction as platform maturity moves up the adoption S-curve. Cooperation becomes competition and displacement. Additionally, users give up privacy, control of their data, and become vulnerable to security breaches. The shortcomings with this elite of centralized Internet platforms are likely to become even more apparent in the near future.

Moreover, even though the Internet democratized information, trusted transactions still mostly rely on 3rd party institutions, intermediaries mirrored from our analogue institutional world into digital context. Distributed ledger technology (DLT) allows for a more inclusive infrastructure native to the Internet to facilitate trust on a peer-to-peer basis. It reduces the need for intermediaries and pushes power back to the edges of networks. It lowers the cost of transaction to coordinate human activity by orders of magnitude. More value will be created and evenly distributed because less value will be extracted.

DLTs are essential to the future of the Internet. They represent a new set of open protocols which will become basic IT-infrastructure within the Internet stack and maximize its utility. Anybody in the world can utilize these platforms. From an innovation perspective, open consensus mechanisms create purpose-agnostic platforms on which anyone with a connected computer can build, test, and run user-facing decentralized applications. In this sense, DLT mirrors the early Internet, and may one day become as indispensable as the Internet in facilitating free speech, competition, and innovation.

We can identify various areas where we see new forms of inclusive institutions working together to complement a new, open economic ecosystem:

Cryptocurrencies such as Bitcoin are native currencies to the Internet. Their peer-to-peer, censorship-resistant properties allow for anybody in the world to store, send and receive value without going through a third party or trusting particular formal institutions such as banks or governments. They offer efficiencies that existing electronic money transmission systems cannot.

The Internet lacks a native identity layer. Centralized platforms are continuing to monetize this missing identity link which should have been an open standard from the very beginning. By creating a shared and unowned platform for recording identity data, permissionless systems promise to enable global self-sovereign identities where users are in control of their data and reputation.

Business processes depend on being able to trust a promise. Moral code and reputation are mechanisms to enable this trust in small communities. When interacting with strangers, they are more difficult to apply, particularly in the case of the Internet. Smart contracts are an example of technological progress as mechanism for enforcing promises. They allow us to make credible commitments with each other on a blockchain, even with strangers in other countries. Smart contracts are enforced outside of the law and without need of legal jurisdiction or government.

Given that our legal jurisdictions are primarily tied to our geographic location, and many countries have unreliable legal institutions, this represents a huge societal advantage. It means that given an Internet connection, someone from one of the poorest countries in the world can make business deals and credible commitments with someone in Germany as easily as if they were German themselves. Anybody can just download an app and become an economic actor in a global network, literally banking the unbanked, people with no access to financial inclusion.

International business to business transactions are another area where intermediaries institutionalize trust. The letter of credit for example is one concept where inter-corporate activities are mediated by third parties such as banks and insurance companies. Even though the flow of information is digital, the transaction itself is very much still analogue and paper based. DLT and smart contracts can bring the necessary trust for this process naturally out of the box.

DLT enables decentralized data structures for device identity and user access authorization. It can help to ensure devices are interoperable and compatible as well as enabling machines to engage in commercial activity via tokenized assets such as data, micro-payments and smart contracts. Thus, it bears the potential to become the enabler for a true machine economy in the future.

A company itself is an institution for coordinating human activity. After all, a company is a legal entity made up of people who together engage contractually in pursuing commercial goals. Lean manufacturing already opened up the industrialization process into efficient supply chain networks. As companies’ activities become ever more intertwined, the concept of the company will evolve into a more decentralized coordinated process of value creation networks facilitated by DLT and smart contracts. In the long-term, the same evolution might apply to nation states as well.

Marketplaces, two-sided platforms, are probably one of the most disruptive business models. Successful Internet marketplaces can usually be characterized by the phases of a deal (economist’s “contract”) they improve the most. Phases of a deal include: (1) search: buyers & sellers finding each other, (2) negotiations, (3) performance, (4) post-performance incentivization. In total, trillions of USD of value have been created by using the Internet to improve the way people make and perform deals with each other. There are certain technical pieces that marketplace operators need to build to enable these transactions. These are not always visible to users, but it always includes: (1) a protocol to exchange value or a payment infrastructure, (2) a protocol to exchange data, (3) a hosting platform. DLT systems will facilitate the same infrastructure and trust throughout the tech stack of Web 3.0 as centralized platforms do today. They will enable more kinds of deals between differently lawed and cultured people at much lower transaction cost in the sense of the economist’s contract.

Crypto-economic networks might be the native business model of networks as they provide new mechanisms for organizing human activities utilizing programmable financial incentives. It’s an opportunity to design information networks which achieve unprecedented levels of scale by decentralization the infrastructure, open sourcing the data, and distributing value more broadly.

Concluding, DLT networks carry the promise to deliver new platforms for empowering extremely inclusive institutions on a global scale. Nations which embrace inclusive institutions succeed in efficiently coordinating human activity to foster wealth creation. The success of institutionalizing DLT systems within and across nations will depend on their compatibility with existing informal and formal institutions. Democratic systems with pluralistic societies and liberal economical frameworks stand to benefit significantly. Through creating trust where there was none, the world can be opened up like never before. This is why crypto nations will win. They will see an explosion in innovation and economic growth while distributing value and prosperity to the edges of the network.

Further readings: