What can be learned from Drug Dealers, Contract Killers, and Soviet Russia

Quis custodiet ipsos custodes?

Who watches the watchers?

Jaume Escofet / Flickr CC by 2.0

In the late stages of the cold war, President Ronald Regan adopted the Russian proverb: доверяй, но проверяй, or “Trust, but verify.”

This system worked well in dealing with the Soviet Union, when a breakdown of trust could mean global nuclear annihilation. After the countries agreed to a reduction of nuclear arms, a contingent of scientists and inspectors traveled through each nation-state’s nuclear facilities to verify the contractual nuclear disarmament agreement had been followed.

However, the Soviets also developed a system called Deadhand, designed to automatically launch a retaliatory nuclear strike in the event of a Western attack. It seems their trust of Western words only went so far.

There are two methods of assuring trust in the world – reliability by confidence (diplomatic agreements), and reliability by design (a dead man’s switch). The advantages of baking trust into the fabric of a relationship cannot be denied, chilling consequences notwithstanding.

Trust issues extend to the financial industry as well; a famous example of trust going awry is Bernie Madoff’s billion-dollar hedge fund collapse in 2009. Madoff’s fund was ‘verified’ by the SEC multiple times over the decades, but the entire operation turned out to be a fraud.

The government’s reaction? Impose additional ‘verification’ measures.*

Meanwhile, a private group of programmers developed a strategy to remove the human element and bake trust into the financial transaction design.

This technology is the blockchain, which is most prevalently seen in Bitcoin.

Most people, when they think of Bitcoin, think of the clandestine drug deals and murder-for-hire of the infamous ‘Silk Road.’ But when you think about it, both drug dealers and hitmen are forced into a similar trust issue as the United States and the Soviet Union during the Cold War. How can you trust that the other side will honor their agreement?

A person who wants to hire a hitman is dealing with an inherently risky and untrustworthy situation. The solution is to make all transactions publically viewable and verified via a community consensus.

As a founder of Bitcoin, Satoshi Nakamoto, (a pseudonym) wrote in his whitepaper:

A purely peer-to-peer version of electronic cash would allow online payments to be sent directly from one party to another without the burdens of going through a financial institution… We propose… using a peer-to-peer network. The network timestamps transactions by hashing them into an ongoing chain of hash-based proof-of-work, forming a record that cannot be changed without redoing the proof-of-work.

The market for these clandestine and illegal activities operated successfully because the system for trust was inherent – no one needed to employ a third party to verify a transaction, and you did not need to trust the hitman or drug dealer in order to hire him.

But why should you trust your financial advisor more than a hitman? Both suffer from an agency problem, or weight of self-interest versus their principal’s best interest. Once again, think of the Bernie Madoff scandal. The SEC has input safeguards to ensure another Bernie Madoff doesn’t happen, but undoubtedly confidence men will continue to attempt to defraud the system.

A solution to the fiscal opacity of financial advisors is to bake trust into the system. Like the drug deals of the Silk Road, if all financial transactions and trades are publically verifiable ledgers, that agent has more incentive to be honest because the cost of readily identifiable cheating will be greater.

A happy side-note is that as the cost of cheating goes up, prices for consumers will decrease and profits for businesses will increase. In the current system, a certain amount of fraud is expected, and therefore added to the sticker price. The fraud that is eliminated no longer needs to be added to the cost of the good. In addition, as third party middlemen are eliminated, the heavy transaction costs they impose will also go away.

It’s no longer “trust, but verify,” but “trust, by design.” Where the stakes are high, trust by design is superior to trust by confidence. It is time learn from the Soviets, hitmen, and drug dealers, and bake trust into the system.

*A humorous story: in Did I Ever Tell You How Lucky You Are? by Dr. Seuss, the entire town of Hawtch-Hawtch is charged to watch watchers that are watching other watchers. This all leads up to the first watcher, who was watching the lazy town bee in order to motivate the bee to work harder. Since the bee did not work harder, it was judged that the watcher was not watching hard enough, and needed to be watched.