Blockchain: The Next Great Arbitrage Opportunity (Part 2, Cooperation Arbitrage)

In Part 1, we made the case that blockchain technology can be profitably deployed only if the solution can be defined in terms a specific economic arbitrage opportunity.  For those taking exception to the word “economic”, bear in mind that any addressable problem can be expressed in economic terms, and thus be potentially described in terms of economic arbitrage.

In Part 2, we introduce the concept of Cooperation Arbitrage, a unique form of arbitrage which may exist in certain service-based ecosystems, and discuss how a blockchain solution can help take advantage of this phenomenon.

As an example, I’m going to take an area with which we, as active investors, are intimately familiar — due diligence of private assets.

For those of us who make investment decisions on a regular basis, the process of due diligence can be frustrating, inefficient, and costly.  Even at its most basic, a process of diligencing a private asset costs thousands (sometimes tens or hundreds of thousands) of dollars and takes weeks or months to complete.  Even when finished, much of the output is subjective, based on the opinion of an analyst or consultant carrying out the work.

Let’s consider a simple numeric example of a unique arbitrage phenomenon which exists in this ecosystem.  Here’s how it works:

Assume that two investors are interested in analyzing the same private investment opportunity.  Each hires a well-respected consultant to perform necessary due diligence analysis, and provide a report.  

We are going to further assume that each consultant charges the same price for their work product, $A, and spends the same resources, $B, to produce this work product.

The economic model of this small ecosystem looks as follows:

  • Each customer pays $A
  • Each consultant earns $A – $B
  • Total Gross Revenue = 2 x $A
  • Total Gross Expense = 2 x $B

Now imagine that all four participants know and trust each other, and decide to cooperate.  Each investor hires both consultants who split the work equally. In that case, the cost of work product becomes ½ x $B for each consultant.  

Let’s say that with doing only half the work the consultant will happily charge 75% of the full price.

Magically, the economics of the ecosystem transforms:

  • Each customer pays ¾ x $A
  • Each consultant earns ¾ x $A  – ½ x $B
  • Total Gross Revenue = 1.5 x $A
  • Total Gross Expense =  $B

Here’s what just happened: we reduced the cumulative revenue by 25% yet the expense of the ecosystem dropped by 50%.  Each customer received the same completed work product for 25% less, while the consultants substantially improved their margins by reducing the cost of their work by 50%.

There are other ways in which this arbitrage may present itself.  Say, each of the two consultants produces a complete report and offers it to both clients.  In theory, a client should value two opinions more than one, especially if they provide different perspectives.  In that case, wouldn’t the client be willing to pay slightly more for better quality information? Assuming the client pays just 20% more for the opportunity to access the opinions of two experts, we are in a win-win scenario again.  The customer gets a premium product, and each consultant gets 20% more revenue for doing the same work.

This simple arithmetic exercise points to the existence of a huge arbitrage opportunity.  Assuming a fully cooperating ecosystem of many participants, the same two consultants would have access to all customers looking for the same work product.   The resultant economics would continue to improve for all participants, until a new equilibrium is found. The difference between that equilibrium and the original pricing structure is arbitrage.   It is only possible to extract these arbitrage profits when there is a cooperation among participants.   Hence, we coin the term “Cooperation Arbitrage”.

There are many benefits to solving the Cooperation Arbitrage conundrum: paying less for the same product, paying the same price for a much better product, increasing speed of work product delivery, lowering the cost of work product, etc.

Unfortunately, in the real world it is highly unlikely that the ecosystem participants trust each other enough to cooperate in this manner.  As a result, everyone suffers.

Enter the distributed ledger solution, aka blockchain.  With proper implementation of the blockchain technology, it is quite possible to achieve the necessary level of cooperation and trust among anonymous participants.   No centralized system can assure such cooperation; blockchain in essence changes participants’ behavior by offering substantial economic incentives to cooperate, without imposing an offsetting cost.  In the process, the large inefficiency we call Cooperation Arbitrage will be eliminated.

At DDX Technologies, we are hard at work mapping the future of due diligence.  We believe that some problems have not been addressed only because a technological solution has not been found.  That is, until now. The blockchain applications in various consulting ecosystems can potentially disrupt these large, multi-billion dollar industries.  We are focusing on one specific use case that we know intimately — due diligence of thousands of private assets. To learn more about our efforts, sign up for updates on our website.