Governance, blockchain and transaction costs

Bitcoin Traces / Martin Nadal (ES)

Bitcoin Traces / Martin Nadal (ES)

Blockchain is attracting increasing attention as a new technology capable of ‘revolutionising’ governance, both in the private or public sector. In simple terms, blockchain is seen as an alternative to the way information is (securely) stored and rules are enforced, regardless of whether those rules are agreed in a contract, or result from legislation or administrative decision-making.

Some examples include the governance of illegal agreements to distort competition (cartels) (see eg this paper by Thibault Shrepel), or the management of public procurement (eg in this paper by Hardwick, Akram and Markantonakis, or these thoughts by Bertrand Maltaverne). These examples explore how the technology allows for the creation of ‘self-executing’ sets of rules that would be capable of overcoming so far intractable governance problems (mostly, about trust: eg among the cartellists, or in public officials).

This could create opposite effects in the governance of public procurement. For instance, this could make the detection and correction of bid rigging very difficult (if not impossible) or, conversely, allow for a corruption-free procurement architecture. Therefore, the impact of the technology (in principle neutral) on existing governance systems can ultimately be seen as an ‘arms race’ between the private and public sector as, ultimately, the one that gets ahead will be able to exploit the technology to its advantage.

This justifies some calls for both investment in new technologies by the public sector (as the private sector has its own incentives for investment), and regulation of private (and public) use of the technology. I have no objection to either of these recommendations. However, I think there is an important piece of the puzzle that tends to go missing in this type of analysis.

Indeed, most of this discussion brushes over the important limitations of smart contracts. These limitations are both linked to the fact that the computational logic underpinning smart contracts can only operate on the basis of complete information/rules, and that the computing power necessary to implement smart contracts can currently only process extremely simple contracts.

The latter issue may be dismissed as a mere ‘a matter of time’, but given that it has been estimated that it is currently only possible to create a blockchain-based procurement process capable of holding 700-word-long tender documentation (Hardwick, Akram and Markantonakis, 2018: 6), there seems to be a very long road ahead, even accepting Moore’s Law on the growth of computational power.

This first issue, though, is more difficult to set aside. As rightly stressed by Davidson, De Filippi and Potts in their ‘must read’ paper, ‘the obvious problem is that blockchains only work on complete contracts, whereas most in-the-world firms ... are largely (entirely?) made of incomplete contracts'; ‘a blockchain is an economic world of complete contracts’ (2016: 9).

In my view, this should raise significant doubts as to the likely extent of the ‘revolution’ that blockchain can create in complex settings where the parties structurally face incomplete information. Procurement is clearly one such setting. There are a few reasons for this, my top three being that:

  • First, the structural incompleteness of information in a setting where the public buyer seeks to use the public tender as a mechanism of information revelation cannot be overstated. If it is difficult for contracting authorities to design ‘sufficiently objective’ technical specifications and award criteria/evaluation methods, the difficulties of having to do so under the strictures of computational logic are difficult to imagine.

  • Second, the volume of entirely digital procurement (that is, the procurement of entirely digital or virtual goods and services) is bound to remain marginal, which creates the additional problem of connecting the blockchain to the real world, with all the fallibility and vulnerability that so-called oracles bring with them.

  • Third, blockchain technology in itself creates an additional layer of transaction costs—at least at the stage of setting up the system and ‘migrating’ to a blockchain-based procurement mechanism. Bearing in mind the noticeable and pervasive difficulties in the much simpler transition to e-procurement, this also seems difficult to overstate.

Therefore, while there will clearly be improvements in specific (sub)processes that can be underpinned by blockchain instead of other cryptographic/cybersecurity solutions, I remain quite skeptical of a blockchain-based revolution of procurement governance. It may be that I still have not advanced enough in my research to identify the 'magic technological solution’ that can do away with transaction costs, so any pointers would be most appreciated.

Does (outsorcing) procurement contribute to public sector productivity? (Dunleavy, 2015)

I have recently read P Dunleavy. "Public Sector Productivity: Puzzles, Conundrums, Dilemmas and Their Solutions", in J Wanna, H-A Lee & S Yates (eds), Managing Under Austerity, Delivering Under Pressure: Performance and Productivity in Public Service (ANU Press, 2015) 25-42. I found Prof Dunleavy's piece highly thought-provoking and would recommend it to anyone interested in the working of the public sector and current outsourcing tendencies, including mutualisation of (spin-off) public services.

Dunleavy offers a very straightforward proposal to start cracking the problem of measuring public sector productivity and reports the findings of a larger study based on relatively simple indicators. Focusing on public procurement, Dunleavy offers some insights that are worth pondering. His paper reports findings concerning the outsourcing of services and the hiring of IT consultants and stresses the following:

So, why does outsourcing not work? It is because government service offices are highly imperfect and they are not going to stop being highly imperfect if two or three contractors are brought in. The markets created are oligopolistic. In Britain we have large problems with our IT sector—62 per cent of the market is dominated by the top contractor, and the top five contractors have 95 per cent of the market. There are usually only two or three tenders for any given contract, and the tenders are very expensive. The idea that more firms can bid is not feasible, because a firm needs to have a large governmental relations unit and a contracting unit just to understand the e-procurement system; this will always be the case. Contract specification works directly against productivity because an organisation needs to specify what it wants the contractor to do. It has to fix a whole service specification and then as needs change, and demand changes, and society changes, it has to go back to the contractor and renegotiate (p. 37).
Public servants also tend to use outsourcing in a very rational way—if we have better business to be attending to and there is something that we really hate doing, we tend to outsource it. This means that nothing changes in that area. The contractor will not want to change—as soon as we outsource it to them, they will want to freeze the technology and keep things exactly the same. This may seem irrational, because at the end of the contract they will have to re-tender, but it is actually cheaper for contractors to work that way (p. 38).
One final note—contestability is a great word, and it may do some good when trying to introduce product diversity, or when attempting to engage different kinds of contractors. The arrival of mutuals might make a difference, but keep in mind that mutuals only have 1/70th of the outsourcing market in the UK, so they are not a serious threat to the big outsourcers yet. On the whole, outsourcing contestability will not grow government productivity (p. 39). 

These are challenges and structural difficulties that do not only concern the UK. And they support a serious strategy to rethink the most productive way of structuring the public sector and deciding which activities to retain in house and which activities to outsource. Dunleavy's general recommendation for the future in that regard is to think about the following:

The question is, can we have genuine demand transfers across suppliers? Can we get genuine supplier succession, genuine competition or contestability? I think we could if we had public sector suppliers who could scale up their services; who could move from one area to another and enlarge. More mixed public/private competition could also improve the situation, and mutuals may help in a small way here (p. 41).

These are all very suggestive ideas, but all of them are based on structural changes in the supply side of the market. I would stress the need for demand side reforms, aimed at improving the way the procurement rules are used, so as to tender shorter-term, adaptive and flexible contracts that avoid lock-in and promote effective supplier competition in more dynamic procurement markets. It would also be worth reconsidering to what extent the creation of markets for some services is too expensive and inefficient, so as not to compensate the transaction costs implied--to that extent, a "rediscovery" of OE Williamson's work on markets and hierarchies (notably, in The Economic Institutions of Capitalism. Firms, Markets, Relational Contracting, NY: Free Press, 1985) and its application to the public sector would certainly be beneficial. Plenty food for thought.