Tag: Blockchain

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When a State Has 80% Homeowners Lawsuits in the Country, How Can We Do Better in Risk Management?

The Takeaways:

  1. Risks are inevitable, losses don’t have to be — if we do risk management right.
  2. One-way attorney fees and assignment of benefits (AOB) are the two big legal loopholes pushing up insurance cost and lowering down private insurance affordability and availability in Florida.
  3. Four technological platforms or tools are very useful in risk management: ChatGPT, Smart Contract, Internet of Things (IoT) & Tango. Together they have the potential to revolutionize insurance business by significantly reducing insurance costs and increasing fare & efficient insurance coverage.
  4. ChatGPT will be trained to read and explain lengthy and complicated legal documents such that ordinary citizens can quickly understand the gist of a 200-page contract. This will significantly reduce the currently indispensable role of human attorneys (they may be needed to proof check the ChatGPT answer but that should not take very long.)
  5. Another ChatGPT development is customized, always on, mobile and industry- or even firm-specific ChatGPT. The program will be locally pre-trained by records of past risks and past losses, and then provide intelligent and insightful answers to inquiries of all employees in dealing with new but similar problems.
  6. Smart contract associated with blockchain will effectively reduce the problem of legal system abuse, over-crowed or jammed court rooms, long waiting lists of scheduled litigations — by drafting really smarter contracts that are filled with very detailed, context specific “what if” terms and conditions (ChatGPT can help draft and interpret the document), taking into account all relevant historical cases and eliminating extra spaces for misinterpretation and post hoc litigation, while keeping the feature of automatic execution of a predetermined agreement.
  7. Internet of Things (IoT) will establish a field monitoring network at critical junctions of business operation to record objective evidence admissible to the court of law, deterring frivolous lawsuits and prevent predatory practices of trial attorneys.
  8. Tango is the easiest and most intuitive training tool for employees by providing step by step guides with intuitive screenshots every step of the way that everyone can understand and easy to follow. In the future new employee orientations will be mostly done by watching Tango generated PDF files. Numerous risk management field guides can be developed with context specific Tango flowcharts to reduce the chances of misbehavior and mishandling.

This is a more detailed (and longer) version of my proposal for the “In2Risk23” Conference to be held on October 5-7 in Washington D.C. by the CPCU Society of the Insurance Information Institute or the Triple-I as it is called.  

Bad & Then Good News from Florida

Don’t get me wrong, I only have California state insurance (and financial) license so what happens in Florida does not really concern me. Yet insurance everywhere bears similarities, and it doesn’t hurt to learn from the mistakes in another big state like Florida.

The Insurance Information Institute (Triple I), one of my favorite sources of insurance related information, has recently issued a two page news brief on Florida Property /Casualty (P/C) Insurance crisis. It tells us the bad news first, and then some good news.

Perhaps the best way to start a story is by providing some quick statistics: “Florida accounts for nearly 80% of the nation’s homeowners’ insurance lawsuits, but only 9% of all U.S. homeowners’ insurance claims are filed.”

Wow, there are disproportionally way more insurance lawsuits than other states adding together! As a result of excessive or runaway lawsuits, it “costs every Florida household more than $5,000, and the state more than 173,000 jobs annually,” according to the American Tort Reform Foundation’s “Judicial Hellhole” report.

So what’s going on here?

“Legal system abuse and misuse of assignment of benefits ‘are creating a lose-lose, contributing enormously to the net underwriting losses for the few remaining insurers in the state,’ said the Triple-I CEO Sean Kevelighan.”

The CEO only talked about assignment of benefit or AOB problem in Florida, another is “One-way attorney fees” to be discussed later in more detail.

The good news is that, as the above briefing points out, “Reforms put in place in the closing weeks of 2022 and proposed in the first quarter of 2023 suggest Florida is now quite serious about fixing the fraud and legal system abuse that have contributed to the state’s insurance crisis.”

The Underwriting Losses in Florida

Let’s look at another shocking figure from Florida:

“Florida’s homeowners insurers cumulatively incurred net underwriting losses of more than $1 billion in both 2020 and 2021 and expect larger losses for 2022 when year-end results are tabulated.”

The figure of $1 billion loss in Florida has to be placed in the context of national figures to make more sense. According to this report, “In 2021, the insurance industry experienced a $3.8 billion net underwriting loss, after a $5.2 billion underwriting gain in 2020.” In other words, the entire country had a gain in 2020 when Florida had a loss, and of the national loss of $3.8 billion in 2021, Floridan contributed $1 billion, more than 25% of it.

One crucial term in the above news is “underwriting losses.” According to ChatGPT, “Underwriting loss is the financial loss incurred by an insurance company as a result of the claims paid out to policyholders being greater than the premiums collected from those policyholders. In other words, underwriting loss occurs when an insurance company pays out more in claims than it receives in premiums.”

Simply put, underwriting losses happen when insurance companies have to pay out more money for insurance claims than they received from policyholders’ premiums. You don’t have to be a genius to figure out that is not good.

To be sure, insurance companies make money in several ways, not just from premium. Therefore, underwriting losses are not the only factor to determine the company’s overall financial health. Investment income is another major source of revenue.

When an investment company receive policyholder’s premium payment, they won’t let the money sit there collecting dust. Instead, they invest the premiums to security market to generate additional income.

In addition, operating expenses such as salaries, rent, and marketing costs can also affect an insurer’s bottom line. If an insurer has high operating expenses, it may be more challenging to achieve profitability even if its underwriting results are strong.

Still, other things equal, having an underwriting loss is definitely not a good news.

Trouble with Assignment of Benefit AOB

Assignment of Benefits or AOB is common primarily in property & casualty insurance but also in others like healthcare insurance. it is a legal agreement that involves the transfer of insurance benefits from the policyholder to a third party, such as a contractor or healthcare provider.

It seems to be a harmless arrangement. For example, say you have some illness and your physician successfully treated you. If that illness is covered by healthcare insurance, you know you will be reimbursed. So instead of you paying the physician and then get reimbursed from your insurance, you can choose to assign your physician to get all the insurance payment because he did all the job and earned it, right?

The answer is not that simple. While AOBs can be useful in certain situations, they are generally not recommended because they can lead to a variety of problems for both the insured and especially the insurer (i.e., the insurance company).

A main problem is insurance fraud. In some cases, contractors or healthcare providers may exaggerate the cost of their services to get paid for work they never did. Or they can perform unnecessary work in order to increase their profits, sometimes charging the patients with free medicines they received from marketer, for example.

I know this happens a lot in China, where hospitals over-examine patients because those imported medical equipment (e.g., an MRI scanner) cost a lot of money and hospitals don’t want the machine sitting there collecting dust. Doctors ask most if not all patients to have a medical imaging done first, even though it is clearly not necessary for some, and the procedure sometimes costs enough to send a family back to poverty!

Another issue with AOBs is to make it difficult for insurance companies to manage their claims because there is a third party involved in the claims process. The insurance company have to verify the work that was done and to ensure that the costs are reasonable. Delays and higher costs become common.

The bad news is that ultimately it is the insured person will bear the extra cost due to AOB. If the third party performs work that is not covered by the insurance policy, the insured person may be responsible for the additional costs.

Problems with One-way Attorney Fee

Another major problem in Florida that reduces insurance affordability and availability is the so called “One-way Attorney Fees,” also called “fee shifting.” This determines who is responsible for the litigation cost and to pay the attorney(s) involved in the case.

One-way attorney fees are meant to shield policyholders from legal bills if they need to sue an insurer, but critics say attorneys and contractors exploit the law to file unnecessary suits with the goal of collecting attorney fees.

The Triple-I briefing has this to say: “Before the reform, state law required insurers to pay the fees of policyholders who successfully sued over claims, while shielding policyholders from paying insurers’ attorney fees when the policyholders lose.”

Here is how one way attorney fees work: Policyholder can sue their insurer at limited risk for legal fees. If they win the case, insurance company will pay for their attorney fees; but if they lose, they will only pay their own attorney fees and let insurance company pay their own.

Honestly, the name “One way attorney fees” may have created the impression that win or lose the policyholders won’t have to pay for any legal cost, and insurer will take care of that. That is not true. A better way is to call it “asymmetric attorney fees,” where the asymmetry exists in demanding for more financial responsibility from insurance company such that if they lose the case, they will have to pay for attorneys for both sides. But if they win, they cannot ask policyholder to do the same for their legal cost — although policyholder still must pay for their own lawyer(s).   

Such a legal arrangement is not out of line but rather reasonable. After all, insurance companies have a deeper pocket than an insured.

But perhaps this is one of the things where the rule looks fine on paper but not so in practice. The reality is that there are way too many lawsuits filed by policyholders against insurance companies. As a result, several private insurance companies either had closed down or packed up to leave Florida.   

What are the problems? There are several:

  • Increased Litigation against insurance companies, caused by the asymmetric (i.e., lower) financial responsibility for policyholders than for insurance companies. We have marginal or meritless legal dispute that people just hope to extract a favorable settlement from the insurance company.
  • Difficulty in estimating claims costs, a relatively minor problem: One-way attorney fees can make it difficult for insurance companies to estimate the total costs of a claim, as it is challenging to predict the outcome of a lawsuit, which determines whether the insurance company will have to pay the plaintiff’s attorney fees.
  • Higher Settlements: One-way attorney fees can push up settlement amounts for claims. This is because insurance companies may be more willing to settle claims, even if they have a good chance of winning in court, to avoid the possibility of having to pay the plaintiff’s attorney fees in the event of a loss. This means settlement is better than attorney fees.

Going from Florida to the Nation

Florida insurance crises are basically supply sided problems. I mean look at how many private insurance companies left or shut down there. But if we look around the entire country, you’ll find insurance losses across lines but especially in Property & Casualty.

Prove to yourself by entering the search phrase “News about insurance underwriter loss” and you will see many headline pieces. For example, “Private U.S. property/casualty insurers saw a $5.6 billion net underwriting loss in the first nine months of 2021,” according to this report on February 15, 2022.

State Farm provides another example, as its main auto unit generated $8.6 billion in underwriting losses through the first nine months of 2022.

One obvious solution is to raise insurance rates. This USA Today report tells us that auto insurance rate will go up this year. “Drivers nationally are spending an average of 2.93% of their income on car insurance this year, based on an average annual premium of $2,014 for full coverage insurance.” and “car insurance rates increased by nearly 14% between 2022 and 2023, compared with an overall rise in yearly inflation of 6.5% in December.”

What about California? “Progressive recently received approval for a 19% rate increase for those renewing their policies or buying new ones.”

Risk Transfer & Risk Management

In insurance business, there is a familiar saying that risk is inevitable, loss does not have to be — if we do risk management right.

Compared with raising price, risk management is a more efficient, sustainable and proactive way of lowering insurance cost and ensuring just and fair coverage for losses.

ChatGPT says the following: “Risk management and risk transfer are two different approaches to managing risks, and each has its own advantages and disadvantages. However, risk management is generally considered a better approach than risk transfer for several reasons:

  • Retaining Control: Risk management allows an organization to retain control over the risks it faces. By implementing risk management strategies, an organization can identify and assess potential risks and take steps to mitigate or avoid them. In contrast, risk transfer involves passing the risk to another party, which means giving up control over how the risk is managed.
  • Cost Effectiveness: While risk transfer can be a quick solution, it can be more costly in the long run. Risk transfer often involves paying premiums to an insurer, which can add up over time. Risk management, on the other hand, can involve implementing cost-effective measures to reduce the likelihood and impact of a risk.
  • Tailored Approach: Risk management allows an organization to tailor its risk management strategies to its specific needs and circumstances. This can result in more effective risk management than a one-size-fits-all approach, which is often the case with risk transfer.
  • Reputation: In some cases, risk transfer can damage an organization’s reputation, particularly if the transfer is seen as an attempt to avoid responsibility. In contrast, implementing effective risk management strategies can enhance an organization’s reputation by demonstrating a commitment to responsible and proactive management.”

The above answer provides a good overview of why risk management is better than risk transfer (i.e., insurance). However, the best approach is to do both risk management AND risk transfer. We cannot bet entirely on risk management because there are things out of our control. But we can do everything in our power of control to reduce and/or control risks. I propose the followings along that line:

  1. The key to risk management is to empower employees and/or clients to quickly and easily learn the right and crucial things to improve risk reduction. The term “risk management” sounds like only managers are the stakeholder but that’s not the case. The best risk management is to mobilize all employees and clients to get the job done. Reaching that goal requires first and foremost modern technological tools.
  2. ChatGPT, Smart contract, Internet of Things (IoT) & Tango are the four most important technologies for risk management with the potential to revolutionize insurance business by proactively and significantly reducing insurance cost and making insurance sustainable. Of the four, ChatGPT is likely to play the most important role because it is approachable by ordinary employees and clients. All we need to do is to expand its functionality to make it useful to professionals.
  3. ChatGPT will not just give everyday texts for fun but will be trained professionally to understand, and then to explain, complicated legal documents such that even ordinary citizens can comprehend the gist of a 200 page legal document. This will significantly reduce the currently indispensable role of human attorneys (they may be needed to proof check the ChatGPT answer but that should not take very long.) The key is to reduce our reliance on the middlemen like attorneys by empowering the end users.
  4. Another ChatGPT development is customized, always on, mobile and industry- or even firm-specific ChatGPT. The program will be locally pre-trained by records of past risks and past losses, and then provide intelligent and insightful answers to inquiries of all employees in dealing with new but similar problems. Localized and customized ChatGPT can do many things faster, better and cheaper.
  5. Smart contract associated with blockchain will effectively reduce the problem of legal system abuse, over-crowed or jammed court rooms, long waiting lists of scheduled litigations — by drafting nothing less than really “smarter” contracts that are filled with very detailed, context specific “what if” terms and conditions (ChatGPT can help draft and interpret the document), taking into account all relevant historical cases and eliminating extra spaces for misinterpretation and post hoc litigation, while keeping the feature of automatic execution of a predetermined agreement. The idea is to work with a better beginning to save time and energy toward the end.
  6. Internet of Things (IoT) will establish a field surveillance network at critical junctions of business operation to record objective evidence admissible to the court of law, deterring frivolous lawsuits and prevent predatory practices of trial attorneys. Even with caseload remaining the same as before, having historical field evidence will still speed up the litigation process.
  7. Tango is the easiest and most intuitive training tool for employees by providing step by step guides with intuitive screenshots every step of the way that everyone can understand and easy to follow. In the future new employee orientations will be mostly done by watching Tango generated PDF files. Numerous risk management field guides can be developed with context specific Tango flowcharts to reduce the chances of misbehavior and mishandling.
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Blockchain Cryptocurrencies & NFTs Financial talks at dinner table

Blockchain & Cryptocurrency

After yesterday’s talk on editable blockchains, the family comes back today to continue their conversation on blockchain and cryptocurrency mining. The conversation is mostly between Emily, who believes she is not good at technical details, and her parents.  

Greg: I hope you all had the time to find something related to blockchain. Yesterday we talked about philosophical issues of absolute or relative immutabilities, today I think the issues may be more detailed and more technical.

Emily: I guess I’m not good at technical stuff. Can you help me with “Proof of Work?” versus “Proof of Stake?” I know one of the top cryptocurrencies, Ethereum I think its name is, is moving toward “Proof of Stake” while Bitcoin stays with “Proof of Work.”

Kimberly: That’s right. I read a report from the Fortune magazine that Ethereum is currently running both “Proof-of-Work” and “Proof-of-Stake.” But when they finish the highly expected upgrade, which we don’t have a set date yet, it will be “Proof of Stake” only.

Lily: And I read an article published by Bitcoin magazine that says Bitcoin will not, and could not, switch to “Proof of Stake” because Bitcoin code is immutable.

Joy: It’s important to remember that first of all, “Proof of Work” and “Proof of Stake” are different ways of doing cryptocurrency mining. Perhaps even more importantly they are both “Proofs of Resources” in the sense anyone possessing more resources has a better chance to become a winner in crypto mining.

Emily: You said “a winner” so there is just one winner? Also what is cryptocurrency mining? Why are so many people interested in mining?

Joy: Let’s begin from the last question, which is the easiest: People want to mine crypto for the same reason today as people came to California during the “gold rush” in the 19th century. They want to win something big.

Emily: How big is “big?” I mean the size of miner reward.

Joy: Let’s find out. Jason, could you Google today’s Bitcoin price for us please?

Jason: Sure. “Hey Google, what’s the price for Bitcoin today?” Here it is: $31,119.80 for one bitcoin on May 15, 2022.

Joy: Thank you! Just to be clear, a winning miner will get far more than $31,000 because she receives more than one bitcoin, 6.25 coins to be accurate for now, every time she successfully mined one block of crypto transactions. We multiply the unit Bitcoin price of $31,119.8 Jason just found for us by the number 6.25, which is $194,498.75.

Emily: You said, “for now.” So 6.25 coins are not constant all the time?

Joy: No, how many coins the winner gets are not constant but keep decreasing by half roughly every four years, until it goes to zero in 2140 when there will be 21 million Bitcoin in total.

Emily: How does the decreasing reward work?

Joy: It’s called “block halving event” and let’s show it with numbers. I will quote this website called bitcoinblockhalf.com that does a good teaching job. I have it downloaded to my phone. Here it is: “When Bitcoin first started, 50 Bitcoins per block were given as a reward to miners. After every 210,000 blocks are mined (approximately every 4 years), the block reward halves and will keep on halving until the block reward per block becomes 0 (approximately by year 2140). As of now, the block reward is 6.25 coins per block and will decrease to 3.125 coins per block post halving.”

Emily: I understand these numbers but why the decreasing rewards. That’s not fair to later miners don’t you think?

Joy: This is a good time to tell the entire crypto rewarding story, or why miners get rewarded in the first place. Let me ask a question first: Who do you think is authorized to issue the paper money?

Lily: The central banks. In the US that’s the Federal Reserve.

Joy: That’s right. Now, who has the authority to issue Bitcoin, Ethereum and other cryptocurrencies?

Lily: No one. They are decentralized currencies I believe.

Emily: Wait, what are “decentralized currencies” versus “centralized currencies?”

Lily: The dollar bills we use every day are centralized money because every dollar bill is issued and controlled by the Federal Reserve, nobody else can do that. That monopolistic and central control makes the dollar centralized currency.

Greg: Now that we are on the topic, centralized versus decentralized is not the same as distributed. I read an article talking about how the three systems differ. Briefly, centralization or decentralization refers to mode of control, while distribution is about location.

Joy: Yeah I heard about that, too. Bitcoin, or more accurately its blockchain, is decentralized but also distributed: “Decentralized” because decisions are made not by a central authority but by consensus; “distributed” because the nodes in a peer-to-peer computer network are all over the world.

Nodes in a peer-to-peer network

Greg: Here is a picture of the three systems I found online. Centralized has all links pointing to a single center, kind of like the Chinese political system where everything is eventually determined by Beijing. Decentralized does not do that, although it may contain hubs of links, kind of like the federation system this country has, where hubs are different states. Distributed has neither a center nor hubs. It is like “direct” or “pure” democracy if you will, getting rid of the representatives altogether.

Lily: I don’t know you guys but if we were treating all three systems as modes of control for decision making, I will pick the one in the middle, the decentralized mode, although I understand the “distributed” system is for locations, not exactly for controlling.

Kimberly: I feel the same! Decentralized has advantages from both sides, just like “representative democracy” is better than centralized dictatorship and distributed “direct democracy.”

Three Systems of Decision Making & Location

Greg: Going back to cryptocurrencies, they are all issued and controlled by algorithms, not by government agencies.

Emily: What are algorithms?

Greg: An algorithm is a predetermined set of rules for computing. In this country we have rule of law for governing human behaviors. Algorithms are the rule of law for governing computer behaviors.

Emily: Interesting. I did not realize how important algorithms are in our lives.

Greg: Bear in mind though algorithms are initially designed by humans. Once started, an algorithm can obtain its own life, or works by the designed logic until we decide to change the rules later.

Joy: I really want to comment on the algorithms in cryptocurrency, more specifically Bitcoin, has been well thought of. Let’s ask ourselves this question: Why was the algorithm designed to reward miners? This is highly relevant to Emily’s question of why the miner rewards are reduced by half every four years.

Lily: From what I have read, it’s all economics. When Bitcoin first started, it must compete with the monopoly power of central banks. The way it competes is through mobilizing as many people as possible, to get them involved in creating and owning cryptocurrencies. Offering reward in Bitcoin — not in dollars — is the best way to go, because miners would have their personal interests lined up with increased value of Bitcoin, or all cryptocurrencies for that matter.

Joy: That’s right! Decentralized power comes from having a large number of people all working for the same goal with shared interest. The economic reasoning behind cryptocurrency rewarding is to give higher reward at the beginning, when Bitcoin was a brand new “startup money” and not many people knew about it.

Lily: It also reflected the lower value of Bitcoin in terms of dollars back when it started in 2009.

Joy: Exactly! The priority back then was to attract more miners to join the digital “gold rush,” to make some “cryptocurrency noise,” to increase decentralized power, which all add up to benefit the value of Bitcoin or other cryptocurrencies.

Kimberly: I see the logic now: The algorithm assumes the value of Bitcoin will get higher and higher as time goes on, so there is no point in keeping the same number of rewarding Bitcoin for the winners.

Emily: I see it, too. Even though the number of Bitcoin rewarded goes down from 50 in 2009 to 6.25 today, the dollar value is perhaps higher than 2009 given the current Bitcoin price. The miners today can take home much more than earlier miners.

Greg: That’s exactly what happened. One thing I love about this country is that you can always find the information you want. I was searching for the price history of Bitcoin and came across this article from Investopedia called Bitcoin’s Price History. We can see Bitcoin had a price of zero when it was introduced in 2009. That changed on July 17, 2010, when its price jumped to $0.09. So indeed the 50 bitcoins received by the first miner meant nothing in 2009, while 6.25 bitcoins are enough to bring six digit income now, even with the recent cryptocurrency price crash.

Joy: This is why I had a hard time believing Warren Buffett actually said that he would not buy all the Bitcoin in the world for even $25, because he said he could not find any use of Bitcoin. He seems to have forgotten what he has been doing for all his life: investing in something for better returns. That’s exactly what one can do with Bitcoin. Let’s say someone sold Buffett 50 bitcoins back in 2010 at the historical price of $0.09 per coin, and he kept those until today, he would have gained how much? Jason, could you do the calculation for me?

Jason: No problem. 50 bitcoins times the unit price of bitcoin today at $31,119.8, that’s $1,555,990, more than $1.5 million! Let’s take out his historical cost of $4.5 in 2010, his net profit would still be $1,555,985.5!

Greg: Let’s calculate his rate of returns. Divide his gain of $1,555.985.5 by his cost of $4.5 and then multiply 100 to make it a percentage figure. What do we have, Jason?

Jason: Wow! That comes out to be 34,577,456%!

Greg: That was phenomenal, and I doubt if Buffett’s other investment records can beat that.

Emily: I still have a concern for miners after 2140, when the algorithms will stop paying reward as there won’t be new Bitcoin released once the algorithm reaches its goal of 21 million Bitcoins.

Joy: I won’t worry too much about that. Miners are still capable of charging fees against Bitcoin users because transactions will still need to be audited by miners. Miners have other privileges like voting for Bitcoin rule changes as well.

Greg: I think we’ve had an interesting discussion on things like decreasing mining reward, centralized versus decentralized currencies, distributed nodes and the value of cryptocurrencies as “investible assets.” But we have yet to answer Emily’s questions about what mining is in any details, about “Proof of Work” versus “Proof of Stake.” We’ll have to stop here as it gets late. Do I have everyone’s consensus to continue the talk tomorrow?

The answer is “yes” and that marks the end of conversation for today.

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Blockchain Financial talks at dinner table

Blockchain & Relative Immutability

It has been weeks since the Kingstons had a conversation on NFTs, Bitcoin and Blockchain based on the blog post written by Devin Finzer, co-founder of OpenSea the largest NFT marketplace in the world. Greg has been busy writing a research paper, and the rest of family had to mind their own business. But today is a good day as everyone feels the need to catch up where they left off last time.

Kimberly: I feel like we should talk more about blockchain. Last time we briefly touched on it, like how a blockchain keeps ownership of NFTs or transactions unique or “non-fungible.” But there must be more to blockchain, right?

Jason: Wait, what is a transaction that you guys keep talking about? Is it buying or selling something, like I paid my friend Lee $1 yesterday to buy two sweetest apples from his family trees?

Joy: Yeah, business transactions are the most obvious that involve at least two people and usually money changing hands. But not all transactions involve two people nor money. If your friend simply gave you an apple for free, that could still be called a transaction.

Emily: Some transactions do not involve different people, either. If I change my weekly budget to cut down food spending and increase book spending, those changes are recorded as transactions, too.   

Greg: To answer Kimberly’s question, of course there are more, much more to blockchain. Last time we were mostly talking about NFTs, the stuff that Devin Finzer and OpenSea focus on. We can go deeper into blockchain today if you guys want.

Joy: Let’s do that. To start, I remember reading this interesting article from Investopedia with a flashy title of “Forget about Bitcoin: Blockchain is the future.” It basically calls Bitcoin a small side show and the blockchain the big drama.  

Lily: I’ve seen that, too. Somehow I feel the article is exaggerating the case. Some people are only interested in Bitcoin and know little about blockchain, while others believe blockchain represents the future technology, or the greatest invention since the Internet.

Joy: I agree. we don’t have to forget about Bitcoin in order to remember blockchain. Historically, blockchain came to us much earlier than Bitcoin did, so in that sense blockchain is the “chicken” and Bitcoin the “egg.”

Kimberly: It is also true though that many people discovered or became aware of blockchain only because of Bitcoin. It’s almost like they ate the “egg” first to then realize the value of the “chicken.”

Emily: Yeah, like I did not know much about the Titanic ship tragedy until the other day when I watched the movie Titanic with Kate Winslet and Leonardo DiCaprio in it.

Jason: So you are saying the Titanic movie is your “chicken,” the real Titanic ship is your “egg?”

Emily: I’m saying it can go both ways. A “chicken” for someone can be the “egg” for someone else. We don’t have to settle down on one order and put that in stone.

Joy: You have a good point. If I were to write that Investopedia article, I would use a title like “Appreciate Bitcoin but Understand Blockchain.” People use flashy titles all the time to catch more eyes and ears, and I get that. But everything has a limit, we should not go too far on that.

Greg: I like the way Emily said it: putting something in stone. That old expression now may have a new way of saying it. Some people may stop saying “set in stone.” They’ll probably say, “set in blockchain!”

Kimberly: Interesting. I assume it is because blockchain makes everything in it immutable or, to put it in plain English, permanently unchangeable. But how exactly does blockchain do that?

Greg: First thing first, I don’t want you guys to think blockchains are absolutely immutable. Everything is immutable with the right amount of resources, like money and time.

Lily: Are you saying the stuff inside a blockchain is changeable? I have never heard anyone saying that before, everyone seems to be saying a blockchain is immutable database.

Greg: There are two kinds of thinkers in the world. Some just see further than the rest of us, not necessarily because they are smarter — they usually are — but more because they ask the right questions, assign themselves more challenging jobs and do not blindly follow others’ thinking trail just because it’s popular.

Joy: You are talking abstract. Any example please?

Greg: I’ll cite this article by Dr. Gideon Greenspan who works on private blockchains, and I believe it raises some excellent points. I’ve downloaded it to my phone.

Emily: Wait! What is a “private blockchain?” Are you talking about different ownerships of blockchain? So a private blockchain is privately owned by someone?

Joy: Public or private blockchains are not exactly about ownership. A private blockchain for example can be owned by governments just as likely as by private firms. I think it is better to call them “permissioned” or “membership” blockchains, meaning you need permission or membership to get into them, much like you need a valid username and password to enter your email accounts.

Greg: That’s right. Since Bitcoin started on a “permissionless” blockchain, most blockchains are in that category, meaning they are open for any strangers to see all the transactions inside. They are “open to public” but not necessarily owned by public.

Jason: Unlike the public library we visited last weekend that is open to public and is owned by the city government.

Joy: Correct. Speaking of “permissioned” blockchain, I’ve read something from Investopedia that says some banks claim they build blockchain but they’re not, because their blockchain is private or requires permission, which according to the author, has little to do with the innovation behind Bitcoin.

Greg: The voices against private blockchain are louder than that because, like Greenspan puts it: “immutability has become a quasi-religious doctrine – a core belief that must not be shaken or questioned.” Imagine the response when someone’s religious belief was challenged.  

Lily: Interesting. I did not see immutability as a religious doctrine for blockchain but did take it for granted. So what does Greenspan say about blockchain immutability?

Greg: He challenges the common wisdom and calls the blockchain immutability a “myth.”

Joy: Is he trying to use a flashy title to make news?

Greg: I can’t read what’s on his mind, but he does make several convincing points. First and foremost, he answers the fundamental question by critics of private blockchain: What is the point of developing a blockchain if its contents can be changed or edited? Would anyone guess what his answer is?

Joy: I don’t know what he would say but I would argue that we humans want different things. Sometimes information security or immutability is the top priority, for that blockchain immutability serves us the best; but other times controllability is the king, meaning we want to keep the capability to change things as we see fit. At the end of day, no matter how powerful our computers are, we still want control them, not they control us.

Kimberly: I agree. For financial transactions it makes perfect sense to keep all the records straight and not to be modified or edited once they enter a blockchain. We also don’t want our passports, our driver’s licenses or our tax returns to be changed, especially not by anyone else.

Emily: I see what you mean. But mom is right, some records or transactions we do want to make changes from time to time to fix human errors, frauds. The law changes, too, which means legal contracts sometimes need to be updated.

Joy: That’s right, even smart contracts may need updates.

Lily: I think part of the problem is that blockchain was made popular by Bitcoin. Some people only see the Bitcoin side of the blockchain story. I don’t know if this is a good analogy but to me blockchain is like the gunpowder: We can use it to make fireworks for the Fourth of July, but the same gunpowder can be used to make weapons. A kid only knows the former, but a terrorist is only interested in the latter.

Emily: So to ask why anybody wants an “editable blockchain” is like a kid asking why anybody wants to use gunpowder for anything other than fireworks.

Lily: Something like that. But dad, you haven’t told us what the answer from Greenspan is.

Greg: Well, his answer is long and although I like the points he makes, he does sidetrack himself a bit and spends much time telling us why no immutability is perfect even with “permissionless” blockchain. His point is well taken there because it is true immutability depends on the tradeoff between what we want and what resource we have. So immutability is a relative thing, not an absolute one.

Lily: So he did not tell us why an “editable blockchain” is needed.

Greg: Not really. Your mom actually does a better job in answering that “why” question. There is also this webpage by Accenture called “Editing the Uneditable: Blockchain Needs to Adapt to an Imperfect World,” which essentially says the same thing as your mom did. Let me see if I can find the page.

Kimberly: The title seems to offer a clue to the answer: We need editable blockchain because the world is not perfect and static.

Greg: Yeah. I’ve found the page and here it says: “In most instances, immutability is an obvious benefit. But it’s also increasingly apparent that instances will arise where absolute immutability is a hurdle standing in the way of blockchain’s adoption.” Then it goes on to list areas where editability or mutability is good and needed, like in data storage, illegal actions, operational errors, permanent mischief and regulatory concerns.

Kimberly: I can understand why relative immutability is good and necessary, but I have a more basic question: Relative or absolute, how does blockchain ensure immutability?

Emily: I want to ask that question, too. How about you, Lily?

Lily: Same here.

Greg: I think this is a good place to stop for today. Why don’t we all do some homework on that and come back tomorrow to share our findings?

Everyone agrees and the talk comes to an end.

Categories
Cryptocurrencies & NFTs Financial talks at dinner table

First Family Conversation on Non-Fungible Tokens

Three days had passed since the Kingston family last had a long chat at the dinner time. Today Emily raised a question that interested everyone.

Emily: So has anybody heard about the thing called NFT?

(All except Cleo raised hands)

Emily: Jason, you heard about NFT, too?

Jason: Yeah, why, you found it hard to believe? A friend of mine was a big fan and he kept telling me all the stories about NFT, like some kid in Asia sold his selfies for more than a million dollars.

Kimberly: Oh I heard crazier stories than that: This Seattle based teenager artist built a collection of NFTs valued at more than $26 million.

Emily: Yeah, I heard that one, too. The funny thing is that the kid was selling stickers and prints for $5 a piece online just one year ago.

Kimberly: So who can tell us what NFT stands for?

Lily: I know the first letter “N” means “Non” and “T” for “Token” or Tokens. Someone once told me the meaning of “F” but I forgot it now.

Emily: “F” means “Fungible,” which means “replaceable” or interchangeable with something identical. So “Non-fungible” basically means not replaceable or not identical to something else. But if something is non replaceable, it must be unique. That’s what it says.

NFTs that Emily asked about

Lily: How do you know so much about NFT? Are you gonna create your NFT and sell it?

Emily: Not really. Our arts teacher asked us to write an essay on NFT.

(Turning to Greg), speaking of the essay, dad, what do you think of NFT? Do you see much value in it?

I look at some NFTs and I don’t understand why someone’s selfie deserves more than a million dollars.

Greg: It’s natural to feel that way, and I am sure you are not the only one with questions. I myself have been thinking of it a lot lately.

Kimberly: Do you look at it more from a financial perspective or a commonsense perspective?

Greg: It’s interesting you put that way, but I believe both ways are needed to fully understand NFTs. In fact, not only financial and commonsense but we may even need an artistic perspective. After all, those non-fungible tokens are mostly seen as arts.

Joy: Wow. This conversation is getting more interesting! I have a nonprofit client who is familiar with arts and museums. We were chatting the other day about NFT, and I asked her opinion. She said the same thing you just said that it is easier to understand NFTs if you know arts.

Emily: Oh good! I’m glad you guys mentioned that. I came across this interesting and fairly recent article on Washington Post published last December that talked about just that. It’s pretty long but let me pull it out on my phone to give you a few highlights.

Greg: Is the one written by a journalist who went to Miami, Florida to cover American’s most prestigious art fair, I forgot what is called.

Emily: Yeah. It is Art Basel Miami Beach, which attracts the world’s art collectors.

Greg: That’s a good piece and I liked it. It has lots of information in it and brought us the latest stories in NFTs, crypto, blockchain and the art world.

Emily: I think so, too. Anyway, the first section of the article has a definition that says an NFT “is a unique digital representation of a good — for our purposes, a work of art. It’s akin to a certificate of authenticity or a deed and it’s recorded on a blockchain.”

Jason: I have heard the name before but what exactly is a “blockchain?”

Emily: I’ve learned a lot this time from writing my essay. The best way to define a blockchain conceptually is a “distributed and decentralized database.” In case you did not know, a database is just a bunch of data stored in a computer that allow people to access for information.

Blockchains asked by Jason

Jason: Well, how do they make database “distributed and decentralized?”

Emily: The key is to create “information redundancy.” Before blockchain, databases are separated and isolated from each other, each owned by a different organization.

Jason: What’s wrong with that?

Emily: Well, to see what’s wrong, the first thing is to recognize that those databases are centralized because no matter how big a company or a government agency is, it only has one database.

Kimberly: Yeah, now that you mentioned it, a good example is IRS, the government agency that collects citizens’ taxes. Pretty much everyone pays taxes, right? And the IRS has a huge database for all taxpayers’ transactions, not just this year but way back. Think of how many records there must be in the IRS database.

Emily: Exactly. The danger with centralized databases is that they attract hackers. But even without hackers there are natural disasters like fires, earthquakes, floods, power outages and lightening hits. It is called “a single point of failure” for all centralized databases.

Jason: So blockchain stores the same database with multiple copies in multiple places.

Emily: Exactly. Multiple databases are decentralized because there is not a single database that controls all others. All duplicated databases are equal and if one database is hacked or corrupted, others won’t, and we can quickly find out the bad copy and kick it out of the system.

Greg: What you said is a nice conceptual definition of blockchain, I want to add a technical note to it: Anything registered in a blockchain is truly non-fungible, meaning unique or unreplaceable because it is designed to be that way. A blockchain is a bunch of blocks each with a unique time stamps with information in it and these blocks are connected to form a chain.

Kimberly: So let’s see, that means no two Bitcoins are identical because they each will have a unique trace on the blockchain, right?

Greg: That’s exactly right and that’s the beauty of digital currency, unlike fiat currency, where one dollar is just one dollar, the one dollar bill on my left hand is fungible or identical with the one dollar bill on my right hand.

Jason: What is fiat currency?

Greg: Oh, it’s just a fancy way to call the traditional money issued by government, like the American dollars we use every day, or Japanese Yen, or the Euros.

Joy: Speaking of fiat money, I’m thinking that no two dollars are identical, either. I bet the one dollar on your left hand will have a different serial number than the one on your right hand. However, the two dollars do have identical value, just like two Bitcoins.

Greg: That’s right, I forgot about the serial numbers. Good point!

Jason: I have a few dollar bills left from my lunch money. Let’s see: Yeah, this bill has a serial number F30022163M, the other one says K61556364C. They are different.

Kimberly: If blockchain can make two units of the same digital currency, like Bitcoin or Ethereum, non-fungible or unique, it certainly will make all NFTs unique, right?

Lily: I think we should separate two kinds of uniqueness. Yes you are right to say that on a blockchain everything is unique, and nothing is identical with anything else, even between two bitcoins or two dollar bills. But do we really care about that kind of technical or trivial uniqueness? I doubt it.

Emily: That’s an excellent point. I was thinking along the same line but with NFTs. One big problem with NFTs is that people can always make copies of the same popular NFTs for themselves. If they all registered their individual copies on a blockchain, they will be unique in some ways, like when they were entered, and who the owners are. But from commonsense perspective, that kind of uniqueness is really no big deal, as these copies are all identical except for the blockchain generated uniqueness.

Kimberly: I like the term “blockchain generated uniqueness.”

Joy: So the issue is how we maintain “commonsense uniqueness” above and beyond the “blockchain uniqueness.”

Jason: But why does commonsense uniqueness matter?

Kimberly: Because we human beings all want to be unique; you don’t want to be just a carbon copy of someone else, even with someone you love or admire, right?

Greg: Going back to what Emily said, the problem we face today is not scarcity but the opposite of it: abundance. We can easily copy and paste anything digital that in a commonsense view are identical to each other. This is very different from the old days when making an identical copy of the masterpiece was impossible. The best one could do was to have a fake one that looks like the original, never identical.

Lily: Like back in the days for Picasso, Davinci or Monet, right?

Greg: Yeah. Today’s technologies allow us to produce identical copies so easily and in so large quantity that the “art hackers” in the old days could not even dream about.

Joy: So you are saying the big question today is how to restore or save scarcity in the age of abundance?

Greg: Exactly.  

Joy: Well, one way to do that is through algorithms. Like the number of Bitcoin was programmed to be no more than 21 million ever. There, not only do we have scarcity but know exactly the size of supply.

Emily: The same logic works in NFTs. It turns out owning a free and identical copy is not enough for some people, they want to possess the one that is original and are willing to pay a big price for that.

Greg: So Bitcoin scarcity is created by the creator of the digital currency, but for NFTs scarcity is saved by some buyers on the demand side.

Kimberly: That makes sense, because there is always only one original NFT, regardless of how many free copies out there.

Lily: Not only that, but the more copies out there, the more valuable the original becomes. Whoever bought the original can always brag that she or he bought the one out of a million, which sounds much better than one out of 10.

Greg: This gets me to think that the basis of value today is different from Picasso’s time. In the old days, the value of artworks was attached to the artists, who were “the one and the only” to produce masterpieces that nobody else could match.

Joy: So only masters could produce masterpieces. Using the chicken-egg metaphor, the masters were “chickens,” masterpieces were “eggs,” and the chickens always came first. As long as there is only one Picasso in the world, the value of his artworks would be fixed, regardless of how many imitations there are.

Kimberly: But isn’t that always the case that a particular artist produces a particular piece of artwork, so the “chickens” always come first?

Greg: Well, yes and no. Different NFTs will be produced by different artists just like before but today’s artists do not have the same “monopoly power” as Picasso had. Think of what has changed?

Kimberly: Well, like you said earlier, there is an abundance of virtually identical copies today.

Greg: Yes. In the old days there was just one copy for each masterpiece of Picasso for the entire world. It’s a natural monopoly. If you wanted to see the masterpiece, you visited a museum. But nowadays everyone can have a personal copy of a NFT if she wants.  

Kimberly: But that’s just easy accessibility, which does not kill monopoly power. There is still only one Picasso in the world.

Greg: There is only one Kimberly Kingston in the world, does that give you the same monopoly power as Picasso? Monopoly power is not about being the only one, but about your capability of changing or influencing the behaviors of others.

Kimberly: I see. Sounds like the abundance of identical copies shifts the power from NFT artists and sellers to buyers and we have a “buyers’ market” for NFTs.  

Lily: But wait, in a buyers’ market the price goes down, why do we still see some skyrocketing prices in the NFT market?

Greg: Interesting question. But it’s getting late and let’s continue the conversation tomorrow.

Video highlight of what the family has learned on NFTs