Startups and investors often talk about value creation and value capture. Value creation comes mostly from the product itself as well as the value proposition it provides to users in the form of increased efficiency, increased productivity, and lower cost. Value capture is like harvesting a crop and selling it in the market. Value capture methods include monetization, liquidity, and so forth.1 Experts will tell you that creating value before capturing it is important because most users have a learning curve to adopting new products before they realize its full potential.
Because blockchain is a nascent technology, creating value is still an ongoing effort, and new value propositions are still emerging. In that regard, most people are still fuzzy about value propositions, how to capture value, monetizing and pricing dApps, and financially sustaining decentralized platforms.
However, blockchain has proven and continues to provide significant value of verification of state changes, ledger, documents, contracts at a much lower cost than traditional methods and without intermediaries. The value created by the low cost of transaction verification made cryptocurrencies possible. Smart contracts later showed that blockchain’s value can be extended to contracts that result in nonfungible asset transfers. This ability to verify state (of transactions) at a lower cost has proven to be a valuable function for network participants.2
Because the cost of verification is low, participants in those transactions can be incentivized to perform actions that create network effects at a much lower cost than traditional ways of, let’s say, marketing, rewards, and stocks. This theory has been put in place in decentralized autonomous organizations (DAOs) and other token-powered platforms, which I discuss later.
Anchoring information to the blockchain and using it to prove that the information exists, and hasn’t been altered, is all the rage these days. Protocols and infrastructure exist to verify proof of existence, proof of integrity, proof of ownership, and so forth. Whereas the actual document is stored off-chain or in a decentralized storage, hash, or a digital fingerprint of a document, is added to the public blockchain. That sounds like a notary or attestation service on blockchain. There are numerous services such as Tierion, Poex, and Stampery that provide proof of existence services for a nominal fee.
As Figure 9.1 shows, hash of the user data, or document, you wish to time-stamp is created and turned into a Bitcoin address. By making a small payment (a Satoshi, or 0.00000001 Bitcoin) to the address, the payment is stored on the blockchain, Bitcoin in this case, along with the address you paid to. Since only the hash is stored on the Bitcoin blockchain, no one can tell what data you stored, but given the prehashed data, you can prove the data was created prior to the block that contains the payment made to that address.
Figure 9.1 Hash of user data added to blockchain as a proof of existence and integrity
Once the transaction is confirmed, the document is permanently certified and proven to exist at least as early as the time the transaction was confirmed. If someone creates a second hash of the same document and adds to the blockchain, the second hash is not the same as the first.3
It is important to note that proof of existence does not provide proof of ownership or authenticity.4 The proof of existence does not provide any information about the source of the information and only communicates that a document, or a piece of data, exists at a specific point in time. The proof of existence of an asset or token must be supported by its proof of ownership. On chain, ownership of the transaction that was used to register the token or asset is signed by a private key.
However, physical assets such as homes, cars, and stocks that are regulated must be tied to legacy identity. Whoever owns the private key must be tied to the legacy identity. This brings up the issue of asset custody and identity registration services provided by a trusted third party.
Proof of ownership and/or proof of existence of a document can be proven by adding a digital hash of the documents such as invoice, waybill, bill of lading, tickets, certificates, and so forth. By comparing the digital hash of a new document with the hash of the original document, one can determine whether the document has been tampered with. To ensure that the original document’s hash exists, the hash is recorded with a transaction in the blockchain. Figure 9.2 shows how the hash (or digital fingerprint) of documents is compared in the blockchain. This also ensures that the original document has not been tampered with. Such a method of verifying the proof of integrity ensures that the asset, or attributes, has not been tampered with.
Figure 9.2 Comparison of authentic and fake documents by comparing hashes recorded in blockchain
Proof of {X}, as I call it, is critical in creating a new tokenized economy. If we were to convert assets to nonfungible digital tokens, then all three proofs of existence, ownership, and integrity must be implemented. This implementation ensures that tokens representing assets can be properly transferred, shared, and distributed with a minimized role of intermediaries who would traditionally perform these three functions, replaced by properly designed smart contracts.
In multistakeholder systems such as airports, maritime ports, health insurance markets, and international supply chains, managing provenance of decisions is critical to aligning incentives of the stakeholders. By decisions I mean approvals along a chain of command, along with verifications and validations of a decision or a physical document. IBM noted in its blog that a typical shipment can pass through as many as 30 unique organizations and generate 200 different communications on its passage.5 By “typical,” it probably meant international shipments from end to end. Domestic shipments do not have to pass through 30 unique organizations, but only a handful. A port in Mexico, where I led a blockchain proof of concept project, has over six agencies, public and private, touch the same document describing shipment information before loading onto a waiting ship. The shipment will go through a similar rigorous process at its destination port before it is released.
Ports in many countries are coping with increased volume in and out of limited footprint ports. Hence, the ports must process the containers much faster without compromising the underlying process of information validation and verification. Blockchain will greatly assist because it reduces the need for visual verification of documents moving through a single window system, thereby increasing the throughput of containers in and out of the port.
At ports, agencies must operate with trust, and therefore transparency and accountability are critical. Hence, immutable provenance of decisions pertaining to information verification keeps track of who approved what and when, who sold assets when and to whom, and who approved what and when.
Ports are a great example of where shipping manifests are verified and approved by multiple entities such as a customs agency, terminal operators, port authority, or banks before a ship is loaded. In such a multiparty environment, it is important to track provenance of decisions in the workflow in order to create an accountable and transparent environment. Figure 9.3 shows manifests-related documents produced by various stakeholders in the container export process are recorded in the blockchain using smart contracts. This ensures that the documents are not forged, and the stakeholders can ensure that no unauthorized containers enter the port or are loaded onto a ship.
Figure 9.3 Hashes of shipping manifests during the container export process added to blockchain
In the ports project, accountability was designed around provenance of decisions by public and private entities. Such decisions were time-stamped and recorded in an immutable ledger that no single entity can unilaterally modify to allow containers to enter the port. This ensures that public entities are not providing favors to any company.
One of the benefits of smart contracts is that every transaction is signed with the public keys of parties involved and stored in an append-only immutable database. Traceability and provenance of decisions on blockchain are simple to implement because parties agree that no single party can unilaterally tamper with transactions. Asset transfers are a typical occurrence in supply, securitization, and so forth. Title companies and other intermediaries play the role of a neutral third party to guarantee that asset transfers will take place and have taken place between transacting parties. This is also typical in food and pharmaceuticals traceability, which requires transacting parties to notify each other of transfer of ownership of goods during supply chain.
In Figure 9.4, nx are the transacting parties. It shows an example of container shipments changing owners several times before they reach a consignee while the container is on the way to the consignee. The current process of maintaining a paper trail is costly for all transacting parties. If all parties agree that instead of extensive documentation, they use public blockchain to maintain a trail of transfer decisions, then it will reduce costs back to office operation.
Figure 9.4 Ownership change of assets is recorded in an immutable ledger
By doing so, the cost of sending and settling final invoices will also be simplified. For external and internal auditors, tracing ownership and sender’s and receiver’s public key addresses is simple and indisputable because those transfers are encoded within blockchain transactions.
One of the biggest challenges with businesses is settling invoices and issuing payments. Health care, logistics, and insurance companies have armies of accountants handling back office operations to verify, validate, and approve invoices sent by vendors and contractors. There is no such thing as intelligent filtering of invoices in which X percent of invoices are automatically approved by an algorithm for settlement. By sharing transaction terms and conditions in immutable smart contracts, invoices don’t have to be reconciled, which is often the most time-consuming step before issuing payment.
For this to happen, both parties need to maintain, or at least agree on, the common data definition of terms and conditions and resulting invoice. That is the difficult part because there are no common data definitions or businesses to maintain their own nomenclature and practices. In addition, both parties need to agree to honor the smart contracts that define the terms and conditions of payments and also agree on conditions that trigger payments by smart contracts.
Such conditions may include proof of delivery, proof of completion of tasks, proof of receipt of goods, and so forth. If these conditions can be digitally confirmed by both parties, then they can be sent to smart contracts using oracles, described later, and issue payments without even requiring invoices.
A furniture importer in South Florida once told me that she had over a dozen accountants verifying every invoice they receive from suppliers all over the world. Before an accountant issues a payment, he or she must (1) ensure invoices are correct with names, addresses, and so forth of the suppliers, (2) ensure the amount is the same as the one previously agreed on, which means they must cross-check with price quotes from the exporters, and (3) verify that the furniture has been received in the conditions agreed on.
The first two tasks can be automated with artificial intelligence and clever optical character recognition algorithms. The third task requires, at least in this case, visual inspection by someone in the company specially mandated and competent to inspect received furniture and trigger “proof of receipt.” Hence, unless all three tasks can be fully digitized, the benefits of using smart contracts are half baked.
Tokenization of Nonfungible Assets
Tokenization is a digital representation of ownership of an asset. It converts ownership of assets into tokens, which can then be recorded and transferred using blockchain. Tokenization allows assets that are difficult to be traded and liquidated to be done so easily using smart contracts, which maintains an immutable ledger of transfers and ownership of tokens. Such a transfer of tokens would be instantaneous and verifiable in the blockchain.
For example, a piece of land worth $100,000,00 can be tokenized as 100,000 tokens. In the absence of tokens, there is no way of owning $1.00 worth of land. By tokenizing the land, someone can hold 1 token worth $1.00 equivalent of land and thereafter easily trade and transfer the token. By extrapolating that idea allows any physical asset to be tokenized and traded to create immediate liquidity of the asset if doing so makes economic and legal sense.
Fungible assets, such as company stocks, precious metals, and natural resources, are traded daily without tokens. However, these trades are expensive because they require the involvement of trusted intermediaries to facilitate asset transfers and maintain ledgers. They are also a lot easier to tokenize because they can be divided into smaller pieces. A barrel of crude oil can be divided into several gallons without changing its inherent market value.
Pricing the value of fungible assets is easy because they are already traded in the market and possess a reference price. We know the price of a barrel of crude oil because they are traded on the Chicago Mercantile Exchange. The sale, or transfer, of tokens would be recorded on the blockchain, and traders have the option to divide the tokens into smaller pieces.
Nonfungible assets such as copyrights, art pieces, domain names, and patents are difficult to price. We do not hear about patents being traded daily on an online exchange. Nonetheless, they are still assets and are easy to tokenize if prices are defined, and this is a challenge by itself. Tokenizing a work of art means creating its digital signature, which cannot be altered.6 As Figure 9.5 shows, a certified curator verifies that there is an art piece and that it belongs to someone specific. A digital signature of the art piece is created and stored in a blockchain. This ensures that you are not creating digital signatures of an art piece in a museum. Tokens representing monetary value and ownership of the art piece are issued using a smart contract.
Figure 9.5 Issue ownership tokens representing a digital asset using smart contracts
The digital token representing a unique piece of art can then be further divided into smaller tokens. In doing so, shares, so to speak, of a unique piece of art can be traded, and ownership can be distributed. The difference between ERC-20 fungible tokens and ERC-721 standards for nonfungible tokens is the need to keep track of ownership of smaller tokens when they are first awarded and later transferred.
The concept of a nonfungible token applies to fractional ownership of assets, such as cars, boats, homes, and trucks. More than one person will own a car based on agreement on who will use it and when it was encoded in a smart contract. This will reduce the cost of car ownership because risk is distributed among more than one person.
One of the nonfungible assets that I am excited about is invoices. Especially in supply chain and manufacturing, it takes days and weeks for a service provider to get paid after submitting an invoice to the purchaser of a service. Invoice financing, as it is known in the industry, involves the service provider with an invoice seeking financing from a financial institution such as a bank.
The financial institution, or lender, will charge the service provider 3 to 5 percent, as is the case in the United States, after careful vetting of the invoice. The vetting process involves validating the invoice from the service purchaser. It may require hours, sometimes days, to contact the purchaser. If the invoice had been generated from the smart contract, which is signed by the service purchaser, then the financial institution can simply validate the invoice by auditing the smart contract.
The invoice can be validated in seconds rather than days and with little effort. Also, the financial institution doesn’t have to charge a 3 to 5 percent fee because the cost of back office operation would reduce significantly. Assuming tokenized lending will greatly reduce the operational cost of invoice lending, will it allow large institutions to serve smaller businesses using blockchain as a trusted ledger? If that happens, then smaller lenders will compete in that space with bigger institutions. How would that impact the lending industry? If an invoice is tokenized, then it can also be broken into pieces, which means multiple lenders can finance a single invoice and spread their risk. Tokenization further increases the velocity of asset trading if it supports faster clearance of payments.
Since tokens are stored in a smart contract, holders of tokens can sell them to anyone in the world at any time and get paid in another token or cryptocurrency without waiting for bank transfers.7 However, handling of the underlying assets must be done with transparency and security. He also makes an interesting argument that the new asset class will have to satisfy the highest custodian standards and be subject to periodic audits.
Less Verification Cost Means Reduced Transaction Cost
As I indicated in the introductory part of this chapter, blockchain has the potential to reduce the verification cost of transactions. In Bitcoin, if you are not going to wait for 51 percent of the nodes to confirm your transaction, then whether you are sending $1.00 million worth of Bitcoin or $1.00 worth of Bitcoin, the protocol treats both verifications the same way—the underlying proof of work mechanism of consensus. The same concept applies to Ethereum and smart contracts. Whether the contract is built to transact $1.00 or $1.00 million, the system verifies and executes both contracts the same way, unless you want to increase the gas fee for faster confirmation.
There is no doubt that transferring cryptocurrencies is inexpensive and cheaper than bank-to-bank transfer because the cost of verifying transactions by the banks is expensive on account of national and international banking laws, KYC regulations, administrative costs, and so forth.
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1 The Venture CFO. January 22, 2015. “What is the Difference Between Creating and Capturing Value?”, Venture CFO. http://theventurecfo.com/blog/2015/01/23/what-is-the-difference-between-creating-and-capturing-value.
2 C. Catalini and J. Gans. June 2019. “Simple Economics of the Blockchain,” National Bureau of Economic Research Working Paper No. 22952.
3 “Proof of Existence”, NewsBTC, https://www.newsbtc.com/proof-of-existence/, (accessed September 23, 2018).
4 M. Greco. April 10, 2018. “Does Proof of Existence establish Provenance?”, Medium Corporation. https://blog.chronicled.com/does-proof-of-existence-establish-provenance-5028fbd8c6da.
5 T. Scott. April 20, 2018. “Enterprise-Ready Blockchain Brings Transparency to Supply Chains,” IBM Corporation. https://www.ibm.com/blogs/blockchain/2018/04/enterprise-ready-blockchain-brings-transparency-to-supply-chains/.
6 O. Dale. July 31, 2018. “What is Tokenization? Democratizing Ownership and Real-World Assets on the Blockchain,” Blockonomi. https://blockonomi.com/tokenization-blockchain/.
7 D. Raykhman. April 19, 2018. “Asset Tokenization, What, Why, and How,” Medium Corporation. https://medium.com/coinmonks/asset-tokenization-what-why-and-how-73650c49afe0.