The Broken Protocol Layer of Money

Abstract

Blockchain technology, being decentralized, provides a more secure and efficient approach to financial reporting than traditional methods, even surpassing the Sarbanes-Oxley Act (SOX). This is because blockchain mechanisms are uniquely capable of achieving collective human agreement on transaction history.

Background

Problems with SOX:

• One of the biggest issues with the double-entry system is trusting the human and fallible bookkeeper, messenger, or accountant. Also known as the Byzantine Generals Problem.¹
• The auditing procedures in place today lack transparency and rely heavily on human judgement. ²
• The closed-source environment limits access and scrutiny.

Solutions of Decentralization for the Market:

• Risk Redistribution through Consensus Algorithms: By employing consensus algorithms, traditional audit risk associated with verifying transactions are redistributed.
• Minimization of Third-Party Trust: By minimizing the trust of third parties, it enhances the systems security and autonomy.
• Innovation Potential in Consensus Tools: The adoption of distributed consensus mechanisms opens up possibilities for a range of innovative consensus tools that were previously not available.

Summary of the Auditability of the Market

In traditional auditing, financial statements are verified for accuracy through a series of checks against internal and third-party documents. Auditors collect, document, and use these to create the financial statements. Although this process offers reasonable assurance, it lacks the efficiency and transparency of blockchain-based systems.

def TraditionalFinancialStatements(companies):
    for company in companies:
        print(f"10-K for {company}...")  # Data then goes to the SEC through EDGAR.

TraditionalFinancialStatements(['Bitcoin', 'Apple', 'COIN', 'Solana', 'Ethereum'])

• EDGAR (opens in a new tab)
• Among fortune 500 companies, the bill is, on average, a 13.2 million dollar audit fee paid to Delloite, PwC, KPMG, or EY (big 4). ³

These conclusions should be easily traceable from the documentation they produce, facilitating review by a different third-party auditor if needed. In traditional markets, financial regulators and investors regard this information as agreement that a business transaction occured.

SOX Improvements Social and Regulatory Layer of Consensus

From SOX, the practice is heavily regulated and controlled, which is a benefit for user trust of the market. However, heavy regulation does not equal efficient, because at the regulatory layer and social layer SOX improved the efficiency of the system, but at the protocol layer of money the technological fabric is archaic.

We can do better. Improving the protocol layer is how we can save time and money leaving verification to systems, rather than human judgement.

The Broken Protocol Layer of the Market Money

To express the fault tolerance of 3rd-party verification accounting and decentralized systems mathematically, we can define the fault tolerance of a system as the number of faulty nodes the system can handle before it fails to disallow double spending.

For traditional 3rd-party verification accounting:

t = 2

For decentralized systems:

t_{decentralized} ≥ N/2

This is a significant improvement over the fault tolerance of traditional systems, which is a fixed number regardless of the size of N. Double-spending is a critical issue in decentralized systems without a central authority to prevent it. Bitcoin's PoW consensus algorithm, for instance, prevents double-spending by making it computationally expensive to alter past transactions. Once a transaction is included in a block and this block is added to the blockchain, altering that transaction would require recomputing all subsequent blocks, which is practically impossible due to the computational power required. ⁴

Decentralized Blockchains are How We Must Agree

Ethereum and Bitcoin are not reliant on a centralized entity for transactions. Instead, it distributes the "burden of proof" to a consensus algorithm.

The Bitcoin network employs the Proof of Work (PoW) consensus algorithm:

• Validators are chosen to create new blocks and validate transactions based on the number of coins they hold and stake, rather than computational power.

The Ethereum Network uses the Proof of Stake (PoS) consensus algorithm:

• Validators are chosen to create new blocks and validate transactions based on the number of coins they hold and stake, rather than computational power.

These mechanisms enable computers to agree on the ledger's state. Anyone with an internet connection can connect to the Ethereum blockchain to validate transactions. This permissionless verification process fosters a globally transparent financial system, that has attributes described in table 1.

Decentralization as a Core Value

In a recent blog post, Vitalik explained the values of a decentralized system and its benefits. While reading, I realized the alignment with the core ethical values of financial reporting. In this table, I illustrate the qualities that decentralized systems can have to benefit financial reporting.

Table 1

AI Auditors

An auditor's job primarily involves tracing or vouching the sequence of events and actions that lead to the creation of financial statements, accounting for a majority of their work, with a minimal amount dedicated to tracking the actual flow of money. They scrutinize how internal accountants record revenue and how employees perform internal controls. For instance, auditors may need to physically verify a company's inventory before approving its financial statements. This begs the question: Why not leverage AI agents to handle such verification tasks? This will be an interesting vertical that will develop, and I will dedicate substaintial resources to studying.⁵

Privacy Tooling for Financial Reporting

At the societal level, openly disclosing an entire company's financial records isn't feasible. Hence, the development of privacy tools like zero-knowledge proofs on blockchains is crucial for enabling companies to make transactions. Consensus, Verifications and Journal entries should occur at the protocol layer, but without ever revealing who or what is being transacted. Overcoming the privacy barrier is a formidable task, but it's a critical step towards a more transparent and efficient financial system that functions more as a GET request than a system of internal controls. More insights on this topic will be explored in my forthcoming writings.⁶

Centralization of Accounting Today

The big 4 firms share around 75% of the market share of financial reporting audits globaly⁷ and audit 99% of S&P companies⁸. Many people view and understand the existence of the big four accounting firms to be an organic reflection of the market, and see auditors as an extension of the government trying to help companies remain compliant. Government extensions to do not always play out in the ways that we wish, and it something that we should be cognicent of the negetives.

Crypto is Evolving and Building Systems that can scale

On the 15th anniversary of Bitcoin, I find myself filled with immense pride for the ecosystem surrounding not only Bitcoin but the entire crypto market. Despite challenges like attacks, regulatory uncertainties, and hacks, the crypto world is rapidly evolving. Developers are tirelessly working on building layers to the system, open-source work where there might not be a clear financial rewarded. The Ethereum Layer 2 vision is not just a concept anymore; it's becoming a reality.

References