Blockchain's Role in Infrastructure Investment

Nov 07 • Qiao Han

blockchain in frastructure

While it is true that much of the excitement surrounding blockchain technology has been generated by the financial service industry along with a few other specific sectors, it’s readily accepted that the benefits of decentralized ledgers extend far beyond just speculating with e-currencies. The underlying technology that powers mainstream tokens such as Bitcoin, Ethereum, and the like can be applied to almost any industry or endeavor that can benefit from using a decentralized ledger, letting parties facilitate, verify, and log any transaction type in a way much faster, simpler, and more secure than ever before. Now while this is undoubtedly true for private market solutions, the public sector is potential even more in need of innovation.

Blockchain technology doesn’t just transform how we exchange currency, but it can reshape how we distribute critical commodities and how we undergird the systems that support them. And unlike financial services, infrastructure – which includes our roads, water pipelines, electrical grids, etc. – are intrinsically physical. Governments around the world together invest trillions of dollars in public projects in an effort to revitalize these depreciating assets and stimulate economic growth, with close to $80 trillion worth in public projects estimated to be funded in the coming decade.
Unfortunately, many of these large-scale projects are bogged down by red-tape, inefficiencies, and most problematic of all, corruption.
Even first world countries that otherwise seem reputable suffer from this problem, with The American Society of Civil Engineers estimating that corruption costs within the United States alone costs an extra 10 to 30 percent to the overall project cost. In less developed countries, these figures can go even higher, and together amount to trillions in potentially wasted funding that would have been otherwise avoidable.

It’s for these reasons that it’s not surprising blockchain enthusiasts jump at the opportunity to recommend decentralized solutions to this area. Asides from the potential ways blockchain technology can be implemented into existing public service bidding frameworks; it can allow the creation of alternative investment vehicles that everyone can participate in while also offering potentially superior financing options for cash-starved infrastructure projects, especially in less developed nations whose governments can’t afford to subsidize every project. 

 

The Current State of Infrastructure Development

 

 

infrastructure development

Before we explain just how decentralized financing options can benefit the industry as well as some examples of them, it’s worth taking some time to further underscore the current problems infrastructure development faces. As mentioned above, the current situation concerning infrastructure development isn’t stellar, but there are differences between the first world and developing nations. For the former, corruption still remains a significant issue, with the 2017 Corruption Perceptions Index issued by Transparency International proving that the public works sector (which includes infrastructure projects) remains the worst sector for bribery and corruption. Many studies have shown that high levels of corruption are correlated with more upfront investment capital, lower revenues, and an inferior project end result. 


At the same time, close to nine out of ten public projects exceed their original projects, with some on average going over by 50 percent or more. Much of this can be attributed to the needlessly bureaucratic organizational layers that are now the norm of public works projects, with seemingly endless chains of contractors, subcontractors, and sub-subcontractors making it difficult for project managers to get access to information in a timely fashion in the first place.

Unfortunately, the fact that these projects have earned such a poor reputation makes both private investors as well as government organizations less likely to fund these massive projects in the first place.
Feasibility studies, while better than nothing, are often awarded to the lowest bidders, and many investors are reserved about funding these studies since many projects don’t get approved for development, resulting in wasted funds. As such, many well-intentioned projects stall in these earlier approval stages due to unrelated factors out of their control.

As for the developing world, corruption remains as big of a problem as in their more well-developed counterparts, but with the added problem that capital isn’t as easy to come by. Traditional financing methods leave much to be desired, as debt financing within the current banking system in these nations means some projects simply can’t get started in the first place. According to the World Bank, close to $622 billion internationally has been invested in developing countries infrastructure, but much of this funding from international private markets counts of the fact that these infrastructure projects are backed by national governments. 
The problem here is that many developing nations simply lack the budget to support every infrastructure project they could benefit from, with many projects that could be crucial failing to secure backing.
This means that international investment usually will not take part in projects that, while otherwise viable and beneficial, lack the security of government backing. As such, many projects fail to see the light of day.  But in either case, infrastructure investment requires plenty of capital, which unfortunately leaves out potentially trillions of dollars worth of retail investors that might be willing to invest in these projects but can’t due to their small investment sums, along with the above-aforementioned problems culling their enthusiasm. That’s where a decentralized solution comes in.

 

 

The Power of Blockchain Technology

 

Blockchain technology is a part of the family of “distributed ledger” solutions, functioning as a distributed peer-to-peer database that records transactions between different parties. In a sense, these ledgers operate on a larger public level, keeping track of all transactions on the network, with each computer operating on the network sharing the information. As such, there is no central authority, and for a transaction to be included on the blockchain, it has to become verified by all participating nodes on the network. This validation process – also called a consensus mechanism – means that no single user can singlehandedly overrule a specific transaction. Once approved, the result is an un-editable and transparent record of all transactions.

 

 

Blockchain explained

 


While this is just a basic primer, the implications that this technology brings are massive. For one, it allows all payment events and key project performance metrics to be recorded onto a blockchain, fully transparent to everyone on the platform to see for themselves. Applying decentralized technology to every financial transaction on an infrastructure project ensures that every penny spent is irrevocably stored and recorded in a way that unalterable. Once confirmed, it cannot be undone no matter how swayed, bribed, or corrupted any individual might be. Stakeholders and civilians alike can freely monitor, verify, and control public service providers as never before. These financial details are now open to be audited and scrutinized as well at a later date. Hiding traces of corruption, as well as the flow of money, becomes much harder to pull off as inconsistencies can be easily recognized.

Additionally, blockchain technology aids in the flow of information. In a decentralized platform, all stakeholders have access to information regarding the project and are able to contribute easily. If a sub-contractor notices that there are some problems with implementing the design of a project, they can make additions to the project/bring up concerns easily to everyone on the platform, rather then dealing with a never-ending chain of managers and the inevitable delays that follow. Every team, company, and contractor involved in a infrastructure project can quickly relay their progress and where they stand through decentralized technology, as well as easily automate their payments through smart contracts.

We are already seeing many governments experiment with these kinds of blockchain-powered transparency systems to ensure their bidders remain honest.
The Canadian government announced in January 2018 that the National Research Council Industrial Research Assistance Program (NRC IRAP) was creating a pilot project backed by the Ethereum platform.

The team would go on to say that “These are early days yet, but the experiment is expected to provide constructive insight into the potential for blockchain technology and how it may be used for more open and transparent function of public programs.” Every time a grant is given, a permanent record of the data is stored on the blockchain and the details are posted online. This way, Canadian citizens can also search past projects and look through the financial value, region, date and recipient of said grants. As is the case with many blockchain projects, the use of smart contracts is critical in making these applications work. Smart contracts have logical clauses preprogrammed into their code that executes when certain events occur under specified conditions of said contract. Since these contracts can’t be altered once they’ve been programmed, they ensure that there’s an incorruptible element to the entire process.

 

 

Some Alternative Solutions

 

Blockchain technology has already been implemented in small-scale infrastructure projects to help increase efficiency but also to do so in a more local, distributed manner. The Brooklyn Microgrid, for example, leverage blockchain technology to make peer-to-peer energy trading possible amongst a small community. Users can generate and sell excess solar power they collect with their solar panels instantly and securely and are able to purchase units of energy in smaller quantities than would otherwise be possible through dealing with their local utility providers.

Other examples include the Smart Cities and Suburbs Program. Back by the Australian government, millions of dollars are being funded in a blockchain-enabled technology that would reimagine how both electricity as well as water are distributed across the nation.
Even shipping giants such as FedEx and UPS are working to explore blockchain technology to better track shipments, manage logistics, and replace freight brokers – avenues that could be worth close to $500 billion in market value alone according to Morgan Stanley. But while all of these are great in and of themselves, another equally innovative way this technology can influence infrastructure development is through new, decentralized investment methods.

 

Smart Bonds, Tokenization, and Decentralized Investments

 

Blockchain technology has already made investing easier and more readily available to the legions of retail investors that have otherwise been left out of the traditional financial investment market. As a trend, the decentralization of investing will begin opening up a variety of markets that otherwise would not have been easily accessible.

In part, this takes place in the form of tokenization. Assets with large capital requirements such as real-estate have barriers to entry for most people to begin investing in since they mostly lack the capital required to participate. While these investors are still able to invest in mutual funds, buying small shares of a larger fund in a specific market they wish to invest in, they do not have the agency to choose the particular investments they want to participate in.

Tokenization is a process enabled by blockchain technology that takes hard, real-life assets and converts ownership of it into a digital, tokenized form.
The closest comparison to this in our current markets would be the advent of stock shares, where individuals can electronically buy and store small portions of public companies. At the same time, tokenized assets can be bought, sold, and traded amongst millions of potential retail investors that didn’t have access to these investments in the past. As mentioned, real-estate tends to be the biggest example that comes to mind, but tokenization can also involve non-physical assets such as copyrights, brands, etc. Coupled with some of blockchains most well-touted benefits such as reduced costs and no transfer delays, it’s possible to see how blockchain-powered markets for these tokenized assets can emerge.

If harnessed correctly, blockchain technology can play a major role in opening up access to trillions of dollars of untapped capital. At the moment, there is an estimated US $120 trillion under management between global insurance companies, pension funds, and other institutional investment firms. Unfortunately, very little of that ends up going to infrastructure projects, despite their critical importance to the growth and economic health of a country (for reasons we mentioned above). In fact, the OECD estimates less then 2 percent gets invested in these areas.


Smart Bonds

 

While tokenization opens up asset ownership to the masses in a way similar to a decentralized stock exchange; an equivalent process can be made to decentralize the loans market. Using blockchain technology, “smart infrabonds” can be created as a counterpart to regular bonds and used as a part of financing a project as an alternative. Like traditional bondholders, the holders of these smart bonds would receive debt service payments, but would be executed automatically through smart contracts, as opposed to conventional legal language.

One key benefit of this smart bond technology is that it eliminates much of the middle and back office involved in these dealings, including the bond registry, legal expenses, etc.
Additional benefits include the potential for a simultaneous settlement as opposed to the days it can require. As mentioned above, creating a smart bond market would open up the market to smaller investors that could pool these resources together for more extensive projects previously outside of their investment reach.

Let’s use an example of a $300 million toll road project in Kenya. Normally, only one or two large investors might buy bonds – issued by the project developer – alongside debt financing issued by project finance lenders, to be able to finance the project. After the road has been built and is beginning to earn revenue, the bondholders and lenders would receive regular debt service payments from the developer.

Using blockchain powered smart contract technology, these “smart bonds” can be used as one part of financing the project. Like traditional bondholders, owners of these smart infrabonds would receive payments, but the additional pool of potential investors brings a few benefits. For one, the investor base can be drawn from all over the world, greater expanding the pool of potential investors. This would also mean it can be easier for borrowers to find investors willing to offer better yields than local lending providers. Additionally, the decentralized nature of blockchain technology lets these payments be made accurately, automatically, and immediately – all without the intermediation costs associated with traditional project bonds.

These reduced transaction costs can also mean that smart infrabonds can be denominated in smaller amounts, opening the infrastructure market to a wider range of investors, such as small pension funds, micro-hedge funds, etc.
This would be especially helpful in developing countries as governments and banks alone cannot fund the combined infrastructure capital demands that are sorely needed in these parts of the world.

However, that’s not to say these types of decentralized investments will be desirable to everyone, of course. Smart bonds as a funding mechanism would bring higher levels of risk. Prior to the financial crisis, capital markets have traditionally been seen as being less stable then debt markets, but this isn’t necessarily the case anymore. Local institutional bond investors, which have stereotypically been associated as being more risk averse then their capital markets counterparts might not take well to these riskier, alternative loans. Especially since the nature of the construction industry tends to be higher risk.

However, there are some other potential benefits worth noting. Bondholders are typically locked into their investments for a fixed number of years, an inconvenience that bond investors have largely accepted over the past decades. Decentralized smart bonds would be able to let investors cash in and out of their investments at any time, again, without fees or delays that are usually expected from early withdrawals. Of course, how much flexibility that could be provided would depend on the blockchain network empowered these smart bonds.

 

Current Smart-Bond Iterations


Regardless of whether this is the case, smart bonds as a concept have been moving forward at a rapid pace. In August of 2018, the World Bank initiated the creation of a blockchain-based bond created through Australia's Commonwealth Bank (CBA). This new financial asset, called the “bond-I” or a “Blockchain Offered New Debt Instrument” has been referred to as “the first global bond to use distributed ledger technology,” according to a twitter post from the World Bank.

Relying on the Ethereum platform to create these bonds as well as having been reviewed by Microsoft to ensure sound programming design, the CBA team partnered with an announced law firm to plan the issuance of these smart bonds to the general public. Blockchain expert Matthew Di Ferrente – who previously has worked for the Ethereum Foundation – said that “financial instruments like bonds are easily ported to blockchains/smart contracts, but it’s not the be-all and end-all for mainstream financial institutions. The real usefulness will come when many different institutions and industries are all using compatible blockchains.” He added that these bond-I’s are a “good first example” of how blockchain can revolutionize the debt markets.

While this move from the World Bank isn’t the first time a big financial institution considering moving to blockchain technology, it could be the canary in the coal mine for what’s to come for the rest of the market, with many other large companies potentially making similar products in the future. While these types of smart bonds are undoubtedly more “centralized” then “decentralized” – considering their operation and ownership by a central bank – that doesn’t mean there cannot be private platforms and blockchain networks dedicated to this cause. Many start-ups have already identified this need for decentralized financing and have jumped on the opportunities. 

 

Final Thoughts 

 

Regardless of the viability of current iterations of smart bonds, it’s undebatable that decentralizing debt markets and sources of loans can make a massive impact on how we fund and manage our infrastructure projects.

These alternative investment vehicles can not only open an entirely new pool of investment funding.
Through smart contracts, it’s very much possible to install certain transparency conditions for funding to be approved. Funding can be released in waves, for example, with each subsequent funding wave releasing 10-20% of the total bond value assuming certain conditions regarding the project’s transparency have been met. This can do much to mitigate the prevailing problems in the infrastructure construction industry, as well as improving the reputation of public works in general.

Even on a bare bones level, blockchain-powered systems can be used internally within the projects construction phase along with existing bidding systems. No matter how one looks at the issue, blockchain technology has a tremendous potential to change completely how we handle our infrastructure, arguably one of the most important aspects of a growing and functional economy.  

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