Outsourcing vertical integration: introducing the V-form network

With Sinclair Davidson and Jason Potts. Originally a Medium post.

The Nobel laureate Oliver Williamson distinguishes between U-form companies and M-form companies.

Traditional U-form companies are unitary— their units are divided by business process (for instance, accounting, human resources, component manufacturing, assembly) and are not treated as separate cost centres.

M-form companies are multidivisional — their units are self-contained divisions that report profits and losses to an umbrella central body. They’re fully owned by a parent company, but they tend to have their own business services (accounting and human resources departments, for instance) and even market relationships.

But now we see a new corporate form — the V-form network — made possible because thanks to the application of distributed ledger technology to supply chain problems.

These V-form networks consist of a number of fully independent companies that effectively operate as one vertically integrated company through blockchain technology, coordinated and supplied by a third party.

This is a big change to the nature of the firm. We can already see V-form networks in the real world. They date as far back as January. It is surprising the economic community haven’t noticed them yet.

The IBM and Maersk TradeTech

Two weeks into 2018, IBM and the shipping giant Maersk announced a joint venture to develop a digital supply chain management system on their Hyperledger blockchain platform. Hyperledger is a private blockchain which requires permission to access.

In a previous Cryptoeconomics piece, we described how international trade is an information problem. As goods are shipped around the world, they are accompanied by information — really stacks of paperwork — that describe their provenance, destinations, regulatory and tax liabilities and so on.

In the IBM-Maersk system, each firm and bureaucracy in the supply chain — producers, shippers, port authorities, regulators, importers, retailers — will access and update a shared blockchain ledger containing all the information needed by each organisation.

And each organisation would have access to that information everywhere, ensuring complete visibility on where goods are in the world and which economic and regulatory hurdles they next need to overcome.

Before blockchains, there were only two basic ways to coordinate a supply chain: vertical integration, or regulation.

Vertical integration has problems. Large conglomerate firms struggle with the challenges of specialisation, and size tends to make firms less efficient.

Regulation has even worse problems. At the very minimum, regulation only works plausibly well within a single nation. The cost of multilateral harmonization — which includes things like treaties and global courts — is very high.

Blockchains can work to coordinate supply chains without the need for either (traditional) vertical integration or regulation. The vertical integration is outsourced to a distributed ledger. The blockchain provides the managerial service that coordinates each ‘unit’ (that is, firm) in the supply chain.

Regulators in any country can deal any firm in the supply chain as if it was a small unit of a larger, global company.

Each firm in the supply chain get the benefits of vertical integration through a network rather than a hierarchy.

The crucial role of IBM and Maersk

In this, the IBM and Maersk joint venture plays a novel economic role.

We’ve written in the past about the paradox of trust in the blockchain world: it takes a lot of trust to establish a trustless ledger.

Imagine a supply chain with seven firms in it: primary producer, manufacturer, exporter, shipper, importer, wholesaler, retailer. Each firm has an established and trusted business relationship with the firms above and below them on the supply chain. But do they have a similar relationship with those one- or two-steps removed? Would the wholesaler in one country necessarily trust the primary producer in another?

A supply chain of two or three firms would be able to easily come to an agreement over shared digital systems. They wouldn’t even need a blockchain — market discipline would be enough to ensure stable coordination.

But firms which do not have direct market relationships with each other face a trust problem when they try to coordinate.

IBM-Maersk provide the trust. They are a large trusted firm that can broker a solution — get all parties around a table — and build the network.

This is a different sales and service model to the IBM of the 1960s. But not that different. With Hyperledger for supply chains, IBM is selling a single solution to multiple clients — just as they did with mainframes or do today with their Watson artificial intelligence machine.

It is only possible because IBM (and Maersk) has already built up deep client relations over past century or so. It is both trusted and has internal information and knowledge about client needs.

(A regulator has none of this information. Neither would a potential corporate raider attempting to vertically integrate through a merger and acquisition strategy.)

We expect to see competition between firms (IBM and and other full-stack technology/strategy/management consultants) to seek ongoing (that is, locked in) contracts for these sorts of services.

The innovative thing here is that they aren’t offering their services to individual firms. They are consulting to a group, or chain, or network of firms — a network that they may have themselves helped create. Economic coordination in the simplest sense of the term.

That’s why IBM is involved. But why is Maersk? The shipping company in this case is the firm with the most to gain from the adoption of the new technology and architecture — that is, which would benefit most from reducing the costs of the existing market architecture.

Vertical integration can be outsourced elsewhere

In the V-form network, the blockchain’s token establishes the consortium, and incentivizes cooperative behaviour.

The token also serves to move rents around the network. In this way, the blockchain provides a market mechanism to solve the sort of bargaining problems described by another Nobel laureate, Ronald Coase, that may occur as the network operates.

Outsourced vertical integration could be applied to many industries that are now integrated. Energy firms that currently integrate the exploration, production, generation, and retail of electricity might be better decomposed, with blockchains and tokens taking the place of head offices. The token economy, rather than energy regulators, could make decisions about the distribution of rents around the network.

We expect that a blockchain economy will have more, smaller firms linked together by protocols. One question — which we expect will preoccupy regulators for decades to come — is how just many protocols? It’s worth pointing out that these networks are inherently global, and any regulatory questions global as well.

Governments might be able to exploit the V-form network themselves. Instead of selling a vertically integrated state-owned asset to shareholders (and then controlling rents with price regulation) they could then privatise components directly on a blockchain network. Ports and airports might be privatised successfully in this way.

In that sense governments would provide the initial coordination now being provided by IBM and Maersk — a trusted third party to broker and establish a decentralised economic network.

A Genuine Commercial Justification for Interchange Fees

With Sinclair Davidson and Jason Potts

Abstract: Ronald Coase famously argued that “if an economist finds something – a business practice of one sort or other – that he does not understand, he looks for a monopoly explanation”. So it is with credit card interchange fees. Intellectual confusion has led to the phenomenon of interchange fees being misdiagnosed as being a monopoly problem leading to inappropriate policy intervention. Following George Stigler’s path breaking analysis of the US Security and Exchange Commission he claimed that financial regulation was “founded upon prejudice and … reforms are directed by wishfulness”. In our opinion, Australian regulatory attitudes towards interchange fees should be placed into the same category: reforms initiated by ignorance and anti-bank prejudice.

Working paper available on SSRN

Regulation and Technological Change

With Darcy Allen. Published in Allen, Darcy WE and Berg, C (eds), Australia’s Red Tape Crisis, Connor Court Publishing, Australia, Forthcoming

Abstract: This chapter explores the relationship between technological change and regulation in both directions. New technologies such as artificial intelligence, machine learning, and distributed ledgers are likely to drive structural changes in decades to come, not least in the way firms comply with regulation and how regulators enforce regulation. Regulatory technology, or ‘RegTech’, presents opportunities to reduce the regulatory burden on firms and make regulation more efficient and less harmful. On the other side, regulators need to come to terms with new technologies that may challenge existing business models or regulatory constructs, and we propose policymakers adopt a ‘permissionless innovation’ principle in response, ultimately allowing experimentation with new technologies by default unless direct harms can be demonstrated.

Available at SSRN

 

Tradetech and the problem of international coordination

With Darcy Allen, Sinclair Davidson, Mikayla Novak, and Jason Potts. Originally a Medium post.

International trade is an information problem.

As goods move between firms and across borders, information about the provenance, characteristics, and compliance liabilities (whether they are subject to taxes or tariffs) of those goods move alongside them.

Handling companies need to know which goods are going where.

Regulators and trade authorities need to know whether the goods crossing a national border are compliant with domestic regulations.

(Does a good need an import permit? Does it require any special documentation? In Australia the Minimum documentary and import declaration requirements policy is a 27 page document.)

And end-users increasingly demand information about where their goods came from and how they were produced.

(Consumers want to know where their food is grown, whether it was grown to organic standards, or was manufactured gluten-free or nut-free. Advanced manufacturing firms want assurances that components — such as aircraft or wind turbine parts — are of high quality. And everyone wants assurances that their goods have been looked after while in transit.)

The result is piles of documentation shipped alongside internationally traded goods.

And the demand for documentation is growing. Supply chains are getting more complex. Regulatory requirements are increasing. End-users want more information about what they’re buying.

Introducing TradeTech

FinTech is the application of new technology — particularly developments in computer science — to the financial services industry. RegTech does the same for regulatory compliance.

Now we have TradeTech — the application of information technology to reduce the information costs of international trade.

TradeTech can reduce transaction costs, increase transparency for firms, regulators, and consumers, facilitate trade finance, and significantly lower regulatory and tariff compliance burdens.

Tackling border costs

One TradeTech application, blockchains used to manage supply chains, have the potential to provide a new digital services infrastructure for international trade in goods.

Blockchains use a combination of cryptography and economic incentives to allow people to come to a consensus on a shared digital ledger without the need for a trusted third party. Blockchains are a technology for secure non-hierarchical information governance.

Blockchains can store information about the provenance and distribution of tradable goods through the entire supply chain in circumstances where firms (and regulators) through the supply chain do not necessarily trust each other.

The invention of the shipping container in the 1950s radically transformed international trade by tackling the high cost — and unreliability — of getting goods on and off ships intact.

But in the 2010s, it isn’t the cost of transport that is the biggest burden on international trade. According to IBM and Maerskthe costs of bringing goods across borders are higher than the costs of transport costs.

In 2018 and 2019 we expect blockchains used in supply chains and to facilitate global trade will be one of the breakthrough blockchain use cases.

The impact of this sort of TradeTech will provide an enormous boost to the potential for global trade.

Facilitating trade flows

The information flows that facilitiate international trade are still to a remarkable degree governed and organised on a one-to-one basis and using paper. Each firm in a global supply chain passes off information relating to a tradeable good to each other one step at a time, vouchsafing that information until it can be passed to the next firm on the chain.

Furthermore, despite two decades of the digitisation of global commerce, it is still the case that international trade is a significantly paper-based process — which is slow, error-prone and raises fraud risks.

The growth of the regulatory state over the last thirty years has significantly increased the compliance costs of trade. While regulatory harmonisation and tariff reductions have encouraged larger volumes of trade, these have been matched by greater demands for information those goods travelling across borders.

New regulatory concerns about labour, environmental, chemical, and biosecurity standards are being reflected in international trade agreements and are translating into more regulatory requirements at the border.

Longer and more complex supply chains as a result of globalisation has multiplied these compliance burdens.

Blockchains can provide a ‘rail’ on which all this information travels.

Blockchains are uniquely suited for an era of advanced globalisation, the regulatory state, and demand for information about product origins and quality.

But TradeTech needs multilateral coordination

Private industry is developing the technology for blockchain-enhanced supply chains.

But there is the need for an international coordination to ensure that industry is able to exploit the opportunities this technology presents.

For example: information rmanaged on blockchains needs to be accepted as valid and compliant by domestic regulators.

One risk is that industry-developed blockchains might not be not treated as compliant with existing regulations. Goods could then remain subject to existing paper-based processes, necessitating double-handling of compliance and reducing the benefits of blockchain-enhanced trade.

Another risk is that individual trading countries adopt their own standards, which would also necessitate double-handling.

A further risk is that standards are developed by early market leaders in the blockchain-facilitated trade space, are adopted by regulators and trade authorities on an ad-hoc basis, and through regulatory lock-in limit the contestability of this trade infrastructure.

The benefits of TradeTech will be realised in a world of open-standards, rather than closed ones.

Multilateral bodies like APEC (Asia-Pacific Economic Cooperation) should be considering these questions now.

We don’t think governments should try to regulate the development of blockchain technology, or compel its introduction. The blockchain is an experimental technology that needs space to evolve. But there is a clear role for multilateral bodies to set standards for information managed through blockchains.

TradeTech doesn’t need government regulation or direction. But it does need government cooperation.

Some public economics of blockchain technology

With Sinclair Davidson and Jason Potts

Abstract: Distributed ledger technology emerged in 2009 as the protocol behind bitcoin, a cryptocurrency with origins in the ‘cypherpunk’ community who sought to use cryptography to secede from government control of money. Bitcoin’s pseudonymous inventor, Satoshi Nakamoto said Bitcoin would be “very attractive to the libertarian viewpoint” and many in the crypto-anarchist community saw, and still see, cryptocurrencies as a means to free citizens from the monetary depredations of governments. But from these revolutionary secessionist origins, it has become apparent that not only are there many possible use cases of distributed ledger technology for government, but that government action through both regulation, legislation, and public investment might be a key factor in the adoption and development of this technological innovation. Governments can use blockchain technology to exploit the service efficiencies they may bring. But also, and perhaps counter-intuitively given their revolutionary origins, blockchain applications are likely to need government cooperation to facilitate adoption and the development of the blockchain economic system.

Working paper available at SSRN.

Subjective Political Economy

With Darcy Allen. Published in New Perspectives in Political Economy (2017), Vol 13, no. 1-2, pp. 19-40.

Abstract: We extend the Institutional Possibility Frontier (IPF) – a theoretical framework depicting the institutional trade-offs between the dual costs of dictatorship and disorder – by incorporating the notion of subjective costs. The costs of institutional choice are not objectively determined or chosen by a society; rather, they are subjective to the political actor that perceives them. Our methodologically individualist approach provides a new, highly adaptable extension of the IPF enabling examination of the political bargaining process between dispersed actors, the bounds and evolution of institutional innovation and discovery, and follower-leader dynamics in long-run institutional changes. Our new Subjective Institutional Possibility Frontier (SIPF) helps to integrate ideas into the economics of political systems, creating the foundations for a more subjective political economy.

Available in PDF here.

KodakOne could be the start of a new kind of intellectual property

With Sinclair Davidson and Jason Potts.

It’s easy to be a bit amused about Kodak’s new blockchain and cryptocurrency, the KodakOne. The old photography company is the classic case of a firm that failed to keep up with technological change.

But now Kodak is exploiting one of the most interesting characteristics of the blockchain (the technology behind Bitcoin) to reshape how we understand and manage intellectual property.

Just like Bitcoin demonstrated it was possible to have a digital currency that didn’t require third parties (banks or governments) to validate transactions, KodakOne hints at a future where intellectual property works without the need for third parties to enforce property rights.

Blockchains are a system of decentralised, distributed ledgers (think of a spreadsheet or database that is held on a number of computers at once). Transactions are verified and then encrypted by the system itself.

Kodak’s plan is to use the Ethereum blockchain to build a digital rights management platform for photographs. Photographers will register their photos on the KodakOne platform and buyers will purchase rights using the KodakCoin cryptocurrency.

The platform will provide cryptographic proof of ownership and monitor the web for infringement, offering an easy payment system for infringers to legitimise their use of photographs.

In one sense, KodakOne resembles one of the many supply chain (or “provenance”) applications for blockchain, which track goods and their inputs (think agricultural products or airplane parts).

But photographs are purely digital assets. In a sense, what we’re seeing is a new form of intellectual property.

In KodakCoin, the underlying asset – the thing that is being bought and sold, the thing that has the economic value – is no longer the photograph, per se. Rather, it’s the entry on the global blockchain ledger. Control of that entry constitutes ownership of the asset.

KodakOne only really gets halfway to this idea. Like so many blockchain applications, the question is how this elegant system will interact with the messy real world. It’s one thing to detect infringing uses of a photograph, it’s quite another to enforce terrestrial copyright law on unco-operative infringers. And KodakOne is hardly the only firm working on digital asset management on a blockchain.

A new kind of intellectual property

But there’s another, more pure example of what blockchains can do for intellectual property that is worth discussing – CryptoKitties.

CryptoKitties is a silly little blockchain game, but the economics are worth taking seriously. Players buy digital cats – cryptographically secure, decentralised, censor-proof digital cats – and breed them with each other. Each cat has a mix of rare and common attributes and the goal is to breed cats with the rarest, most-in-demand attributes.

That’s the game. But in fact what CryptoKitties has invented is a new form of intellectual property. Each cat is a completely unique, entirely digital good. And it is completely, cryptographically secure. It can’t be copied.

Usually the protection of intellectual property requires lawyers and courts. But with CryptoKitties, the intellectual property protection is part of the asset itself – it’s baked in.

This is what blockchains were invented to do. Before blockchains, digital goods could be easily duplicated. That’s a great feature – unless you want to create digital money. Digital money won’t work if everybody can just copy their money and spend it over and over again.

The creator of Bitcoin, known as Satoshi Nakamoto, solved this problemwith Bitcoin’s blockchain. Previous attempts to solve the double-spending problem had relied on trusted third parties like banks to validate transactions. Nakamoto managed to get the network to validate itself.

KodakOne (and CryptoKitties) show us that intellectual property has much the same problem as digital currency – and may have the same solution. There’s no need for trusted third parties (governments) to enforce property rights. The blockchain does that for us.

Of course, there’s a lot of work to be done before we see real benefits from this sort of blockchain-enhanced intellectual property. CryptoKitties is its own new form of intellectual property – but can we retrofit “traditional” cultural goods like photographs, music and movies onto the blockchain?

Digitisation has challenged the protection of intellectual property like never before. Cultural producers need to find some way to be paid for their work. This is the direction we should be looking.

What Diplomacy in the Ancient Near East Can Tell Us About Blockchain Technology

Published in Ledger (2017), vol. 2, pp. 55-64.

Abstract: A blockchain is an institutional technology—a protocol—that allows for economic coordination between agents separated by boundaries of possible mistrust. Blockchains are not the only technology in history to have these characteristics. The paper looks at the role of the diplomatic protocol at the very beginning of human civilisation in the ancient near east. These two protocols—diplomatic and blockchain—have significant similarities. They were created to address to similar economic problems using similar mechanisms: a permanent record of past dealings, public and ritualistic verification of transactions, and game-theoretic mechanisms of reciprocity. The development of the diplomatic protocol allowed for the creation of the first international community and facilitated patterns of peaceful trade and exchange. Some questions about a generalised ‘protocol economics’ are drawn.

Available at Ledger

Exit, Voice, and Forking

With Alastair Berg

Abstract: This paper offers a new framework to understand institutional change in human societies. An ‘institutional fork’ occurs when a society splits into two divergent paths with shared histories. The idea of forking comes from the open-source software community where developers are free to copy of a piece of software, alter it, and release a new version of that software. The parallel between institutional choice and software forking is made clear by the function and politics of forking in blockchain implementations. Blockchains are institutional technologies for the creation of digital economies. When blockchains fork they create two divergent communities with shared transaction ledgers (histories). The paper examines two instances of institutional forks. Australia can be seen as a successful fork of the United Kingdom. The New Australia settlement in Paraguay can be seen as an unsuccessful fork of Australia.

Working paper at SSRN

Blockchains Industrialise Trust

With Sinclair Davidson and Jason Potts

Abstract: Blockchains are the distributed, decentralised ledger technology underlying Bitcoin and other cryptocurrencies. We apply Oliver Williamson’s transactions cost analysis to the blockchain consensus mechanism. Blockchains reduce the costs of opportunism but are not “trustless”. We show that blockchains are trust machines. Blockchains are platforms for three-sided bargaining that convert energy-intensive computation into economically-valuable trust.

Working paper available at SSRN.