Random Thoughts – Modularity and Trust

Trust in a transaction. In another one of my favorite books  (Design Rules: modularity) there exists the concept of trust between physical components of an integrated system. This book stands in contrast to Nobel Economists’ work in defining the “Firm” and organizational boundaries in Transaction Cost Economics (TCE). But the technical theory of modularity is amazingly consistent with the concepts of “boundaries” in TCE. In modularity, there are 4 core rules for separating technical components:

  1. Specififability
  2. Verifiability/Measurability
  3. Predictability
  4. Abstraction (ie Interfaces)

If these 4 rules can not be met, a technical component (physical or software system) must be tightly integrated and part of a component that will abide. As I came from the Aerospace Industry, and 8 yrs at NASA, I think of the Space Shuttle. Engines and control systems were units created by different manufacturers, each with different specifications and a certification/testing for the unit as well as the integrated whole.  Note I covered this topic more deeply in Small Wins.

…. the “microstructure” of designs affects the economics of design processes in deep and unavoidable ways. In particular, the many coordinating links that are needed to implement an interdependent design process will have a profound impact on the costs of getting things done under different contractual regimes.

In Ronald Coase’s Transaction Cost – Nature of a Firm outlined “when” it made sense to separate a company (or process) into another entity. Coase’s work focused heavily on contracts. Contracts are a superset of the 4 rules of modularity with the addition of economic terms and risk .

In today’s literature, DLT and DAOs are very active in these areas (see DAO Blog). Defining perfect contracts with perfect ability to specific and verify operations is very hard. This is why I believe the first wave of DLT adoption will be amongst existing participants where DLT improves an existing process and trust relationship.

Key Point. No legal contract is this detailed. While specifications of systems is highly detailed, contractual interaction between parties (abstraction/interface) is not. In place of the concepts of modularity is assumption of financial risk (ex indemnification). The ability to “trust” the services/components of a counterparty is based on their ability to assume financial risk. Companies in turn depend on banks/investors to underwrite the risk.

What is Trust?

“Trust” is an amorphous concept that represents an entity’s current and historical ability to operate in the context of a process or relationship. For example, deliver against requirements in a complex process. Trust is proportional to economic alignment and ability to bear risk and inversely proportional to modularity criteria.

Commercially, trust communicates identity, contexts, ability to bear financial risks, deliver against expectations, manage privacy, and surpass auditing and legal/regulatory requirements. Banks, investors, and financial intermediaries enhance trust where necessary.

Payments implications and Opportunities

In a commercial transaction, trust is needed for each actor, item and interface/boundary. Within payments, entities included

  1. Manufacturer of the physical good
  2. Sale (ie retailer)
  3. Authenticator
  4. Shipper
  5. Financial Intermediary
  6. Support/Warranty

The list within a purchase process is thus rather long.

  1. Trust in the Buyer/originator
  2. Trust in the Seller/Merchant
  3. Trust in the Financial Transaction 
  4. Trust in the manufacturer/author
  5. Trust in the Item (authenticity/operation/Reputation/quality)
  6. Trust in delivery/shipping (ie Chain of custody)
  7. Trust specifications (will this work)
  8. Trust in Acceptance/Verifiability
  9. Trust in support (?Retailer/OEM)
  10. Trust in the contracts that manage the above. WHO is responsible in each phase?

In retail, it is the seller that takes on most of this responsibility. The retailer also has the ability to simplify the process into a simple “one step” consumer trust relationship. For example, I trust Walmart to sell me goods that are safe and functional. If I’m not satisfied, they manage my return and refund.  The list above is important to keep in mind when considering payment schemes and specialists. Specifically “Who can simplify” the complex contractual needs and bear the financial risk of those that they are dependent on.

Bank Opportunities

Today, banks excel in managing the trust (identity and risk) of the buyer, merchant and banking intermediaries. There would seem to be opportunities for much innovation in this process. For example, used construction equipment is a $20B a year market. Online marketplaces proliferate, yet they are challenged in working with any bank given they are not the owners of the equipment they are selling. A commercial bank would need to hold the title and perform the inspection on the equipment before they could take part. Thus only specialist banks perform this task. The first opportunity would be for a verification specialist in used equipment (creating trust in the item).  The next step would be to create a specialist asset registry with trust assertions. 

Citibank did much of this in the art world in its private bank (see https://www.privatebank.citibank.com/we-offer/art).  These services included custody, vaulting, advisory and inspection services. 

Generically Speaking, Banks should be the leaders in the “trust” function

  • Define standardized processes and contracts (ex commercial leasing agreement)
  • Work to build network of approved actors (ex authenticity, shipping, marketplaces, …etc)
  • Provide financial underwriting to approved actors
  • Build network of expert inspectors/auditors.
  • Manage an inventory of historical performance (enhanced bureau)
  • …etc

Random thoughts, feedback appreciated.

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