Blockchains, Transaction Immutability, and the Judiciary

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The rise of Bitcoin and other cryptocurrencies as a recognized financial asset class has somewhat distracted pundits and observers from the original intent of these blockchain technologies, namely as a decentralized medium of exchange of goods and services. When viewed as a pure store of value instead, much like gold, a cryptocurrency's functional performance becomes peripheral to the belief system that sustains it. (That observation, and how the drive for profit might mechanize the creation of pure belief systems, is an interesting aside--perhaps, for another time.) To be sure, much is being developed on the functional side with 2nd layer infrastructure (Lightning Network, for example, to address scaling issues). So the vision of a functioning decentralized crypto-economy is still very much alive.

The crux of this post is a call to attention that the rise of the blockchain poses unique challenges to the judicial system. I write this not in the belief my arguments and conclusions are necessarily correct, but with the worry that it's an issue we should cover sooner than later. If economic prosperity is premised on sound property rights and well functioning courts, then to drink the Cool-Aid we must also consider what is to replace a withering judiciary. Transaction immutability, we shall see, the very principle held most dear to the community, lies at the heart of the issue. But before delving there, let us back up and consider the basic components of any transaction.

Trust Multifaceted in Transactions

It's easy to forget, but whether bartering, or exchanging a good or service for currency, there are always at least 2 types of items being exchanged in any given transaction. Each type of item exchanged introduces its own type of risk. Is the gold real? Are the apples rotten? Is it counterfeit money? Is the title clear?

The issue of trust (the other side of risk) presents itself not just in the examining the quality or provenance of the goods/services being traded, but also in how ownership is conveyed (or transferred--IANAL but am taking liberties with the real estate law sense of convey).

Traditionally, the state has acted as a sort of guarantor in various capacities in a well functioning marketplace. Indeed, the minting of hard-to-forge currency can be seen as a means for facilitating trust on the monetary side of transactions.

Ownership Records

But that protection does not extend to the goods/services being purchased. For these, we largely depend on evolved structures and institutions. Ownership in certain asset classes (such as land) has historically been recorded, and in modern times the state has assumed the role of recorder of many a such asset--real estate, vehicles, come to mind. In other cases, this recording is delegated to existing evolved institutions in the marketplace. Here in the US ownership of shares in public companies, for example, is recorded with an independent entity, the transfer agent--or at the brokerage house (in so called "street name"), if held in a margin account. And for centuries across bazaars in the middle east, wholesale goods in storage have often changed hands only in book entry form.

Regardless how (and whether) property is recorded, the power of the state to intervene and transfer the ownership of property (usually not to or from itself) is implicit in the marketplace. Indeed, it is generally (if implicitly) understood that property rights are rights granted and protected by the state. In well functioning market economies (not necessarily democracies) this power is exercised both sparingly and judiciously. While most transactions clear without its direct involvement, the state (usually through its judicial arm) intervenes in a minority disputes. Ultimately, the exercise of this power rests in the state's ability to force property records (whether private or public) to convey ownership. And these records also include those of financial assets and currency.

Blockchains: Code as Law

The rule of law has always been essential to the proper functioning of the marketplace. If the traditional interpreter and arbiter was the judiciary, the new interpreter of contracts and law in the crypto-economy is code. This new interpreter is guaranteed to be impartial. It follows the rule book to the letter, and its records are final. Moreover, neither it nor any sovereign can force a change to its records to convey ownership.

In the land of Code as Law, the only remedies are legislative: an amendment to the rule book. Legislative measures, however, usually target classes of stakeholders; they seldom address individual transactions and in any event cannot scale to remedy any significant number of transactions in dispute. An example of such a legislative fix was the Ethereum fork to undo the DAO heist--of which I griped about here.

Caveat Emptor: Mixed Legal Regimes

A transaction involving the purchase of a good or service with bitcoins, then, falls under two separate and independent legal regimes. On the buyer's side, the conveyance of the goods or the performance services purchased is governed and protected under the local laws of the state or relevant jurisdiction. On the seller's side, however, currency is conveyed under the Code as Law regime. Because neither regime can ultimately force the other to change its property records, the two legal regimes are largely disjoint.

From a theoretical standpoint, jurisdictional power enjoys a slight upper hand over Code as Law. While in the face of a court judgement an individual may be unwilling to give up their secret key in order to, say, return ill-gotten bitcoin gains, the state can still induce cooperation by depriving them of liberty.

What about smart contracts? Here, jurisdictional power seems to enjoy a bigger advantage. In the event a smart contract conveys ownership of, say, a hard asset, the state (again, usually through its judicial arm) may potentially overrule the new record of ownership (title) on the blockchain. Same if it involves an exchange of financial assets (such as shares in a public company). And this fact, in turn, clouds the authority of records on blockchains that reference assets that ultimately fall under the purview of the state.

Returning to the simple purchase of real goods using bitcoins use case, the risk asymmetry for buyer and seller is accentuated. Consider the following: would you feel more comfortable buying from a vendor who deposits your money at the local bank or one who immediately wires it to an account in the Cayman Islands? Buyer be wary.

Remarks

I am deeply skeptical that any system of commerce can prosper without the protections of a functioning judiciary. If commerce is to extend to the blockchain, then the blockchain must offer something in place of the courts. And if it does, then its records cannot be immutable in the strict sense we have espoused.

Let us then contemplate how a judiciary on a blockchain might work. If no transaction is ever [effectively] final, then perhaps there are a set of cryptographic keys that can override all others. One approach that comes to mind is to employ a proof-of-stake (PoS) strategy for constructing a blockchain. Some PoS protocols leave out how the initial stakeholders come to be: Algorand is an interesting recent example. What if a central bank were to issue crypto coins backed by fiat currency? That would take care of bootstrapping the initial stakeholders (anyone holding the pegged fiat currency would be provided a mechanism to be a stakeholder). Also, there might be special keys held in trust by the courts, that are collectively empowered to override all others. Just how the state manages [not to lose] its keys is obviously an open question.

Yes that is a perversion of the trustless, decentralized ideal. But what if the ideal is impractical? What if we are forced to build the analogous trust hierarchies on the blockchain as have already evolved in the real world?

And why would a sovereign consider issuing coins this way, besides? Perhaps because it couldn't risk being second.

Second Thoughts on Smart Contracts and Crypto Gold

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Note: I began writing this post a little after Ethereum's DAO project ran into trouble. I put thoughts down slowly, and over the course of penning it, to my surprise, the community pulled off the hard fork to save the DAO's funds.

Though a fan of cryptocurrencies, and blockchain technologies in general, I've harbored doubts about the wisdom of adopting smart contracts as instruments of finance since well before the recent demise of Ethereum's DAO project. It was a fine idea: a sort of VC fund (expressed as a smart contract on the Ethereum blockchain) that would seed other projects and enterprises. Trouble was there was a bug in this contract (not in Ethereum itself) that enabled a slow motion $50 million dollar heist in broad daylight. The bug (the exploit) was discovered well before the DAO's funds (ethers) had been depleted, but little could be done to stop it. For smart contracts are programs written in stone (the blockchain, itself), executable code whose state (when conditions are met) inexorably advances as new blocks are added to the chain.

Real world contracts, by contrast, are interpreted by humans, which unlike machines, are far more forgiving. We allow for syntactic errors--errors in punctuation, grammar, spelling, etc. (Recall the 2nd amendment to the US constitution.) We can even tolerate a moderate degree of illogic. When the meaning of a contract is in dispute, we (the courts, or other empowered arbitrators) analyze and interpret both the letter of the contract and intent of the parties to that contract. This ability to re-interpret contracts, to clarify, amend, or even annul them in the future is an indispensable tool of human progress. If society were governed by immutable contracts (think slavery), we'd all be screwed.

The Trouble with Financial Instruments as Smart Contracts

The collapse of the DAO was viewed by many in its community as a blow to the ecosystem itself. Considerable resources (people, time, energy, dollars and ethers) had been expended, and the project's success was to underscore, validate--indeed some would argue kick off a demonstration of the true purpose of--the foundational Ethereum it was built on.

How to save the DAO? There was considerable wrangling about just how this could be done, but none involved fixing the contract itself, since by the rules of the game (Ethereum blockchain), contracts are immutable. No, the only way the DAO could possibly be saved was by somehow actually changing the rules. And the only way that could be done was (and always will be) by consensus.

Of course in blockchains like Bitcoin's and Ethereum's (proof-of-work based) "consensus" means a plurality in mining (hashing) power: the more computing power that you can plug to the network, the more say you have (at this time, the proof-of-stake version of Ethereum is still in development). The details, tradeoffs, and risks of the proposed solutions (soft fork vs. hard fork, etc.) are not important here. As it turned out, the community successfully pulled off a hard fork. Rather, the issue here is how a bug in a contract put the larger system (Ethereum itself) in play.

Systemic Risk: At the Intersection of Randomness and Determinism

Forget the challenges of crafting bug-free contracts. Let us assume we've achieved a bug-free ecosystem of best practices, and the contracts themselves work as intended. The larger and more important question is whether the system itself (the totality of the contracts) will work as intended.

In particular, what happens when financial contracts (on a blockchain) fail to price in risk correctly? Regrettably, the history of finance is filled with examples of ruin such mis-allocations of capital have caused (the 2007-2008 crisis being the most recent in memory). It is easy to imagine a blockchain embedding a web of contracts (recall, they can invoke each other's public interfaces) going down an execution branch that would have previously been considered a 6-sigma event. As we pile more contracts atop existing ones, the ability to analyze the future paths the blockchain might take becomes computationally hard. This calculation is compounded by the fact that, generally, the order of execution of the contracts cannot be guaranteed on the blockchain--there are therefore even more paths to consider given the combinatorics of ordering.

That last observation, by the way, holds irrespective of the richness of the programming language expressing those contracts--be it Turing-complete (as Ethereum claims with some caveats--gas), or one in which the execution path is constrained to a directed acyclic graph. Each contract is properly seen as a thread of execution and the blockchain, the current state of a highly concurrent system. The very nature of concurrency is disorder.

The '07-08 crisis, while still fresh in memory, is instructive. Financial institutions had sold insurance against outlier events that they had priced as astronomically unlikely. They insured against various forms of default: mortgages, corporate debt, the solvency of the insurers themselves. There was so much insurance being traded around that the impenetrable pile looked safe, and soon the insured were themselves insuring the insurers through circuitous paths few could see. Quite the contrary, the pile of paper instruments was viewed as a marvel of modern financial engineering.

And then, of course, a brick fell out of that fragile wall: mortgages. When the market realized that the default rate on these had surpassed all historical norms, the entire model on which everything was priced was called into question. The pile was now a tangled web of obligations no one could properly unravel. Counter-party risk became paramount: no financial player could trust that the other was actually solvent. The credit markets were frozen.

While the manner in which the Federal Reserve (and Congress) responded in the aftermath of the crisis can be legitimately scrutinized, putting aside questions of fairness and accountability, there's little doubt that some form of intervention was necessary. Some have argued that we should have left the chips fall where they may. But there was real risk that ATMs would soon stop working. Something had to be done. Someone had to suspend the rules of the game.

Which brings us back to smart contracts. Who will intervene when a pile of smart contracts form a dumb collective? In the case of the DAO, the Ethereum community's intervention manifested itself as a hard fork (a change in the rules that is not backward-compatible with the old rules). It was an impressive, if messy, feat. And it also brought controversy, as it called into question the very immutability of transactions on blockchains. But these are early days for Ethereum. It's doubtful a fork like this could have been pulled off if the project were in a more mature state like, say, Bitcoin.

Much has been made of the "lessons learned" about the DAO's failure and how a more rigorous, better tested, bottom-up approach promises a better second-go at it. I want to believe. Still, the real lesson, I'm afraid, might be that contracts written in stone are a bad idea, period.

And a Bit Glum About Bitcoin..

If having struck such a downer note, I might as well list some personal peeves about Bitcoin (a sort of cleansing of my mind). I will try not to bore you with technical peeves others have already made--that the system is an inefficient energy hog, for example.

So you might argue, What's the harm in a contract that records the transfer of ownership, of say, a car? Not much really. Except that the world is filled with unsavory actors. What if someone is holding a gun to your head? Would you buy into a system of ownership in which the courts cannot undo a transaction even after you've proven that it was executed under duress? (That no central authority can govern its transactions is in fact the key feature of the distributed ledger that is the blockchain.)

Now this argument must apply equally to Bitcoin, too. Owning bitcoins is much like owning gold in an impenetrable, pass-phrase-protected vault in your basement. If you store much gold there, you might want to take additional security measures--a security camera, for instance (so a would-be thief is less inclined to hold that gun to your head). Except, again, that with bitcoins, the camera is of little use, since the courts will have a hard time returning the stolen goods. Indeed, the courts generally have difficulty returning anything stolen from your safe--which is why we tend to prefer the banking system.

This doesn't necessarily mean that bitcoins are an unsafe store of wealth. Indeed, bitcoin is arguably safer than gold. For one, gold is more fungible than bitcoins: gold atoms are indistinguishable from one another, whereas the transaction history of any [fractional] bitcoin can be traced back to its beginning (when it was first mined). Bitcoins are thus less anonymous than once supposed, and this can make spending the loot harder for a thief. Two, the total supply of bitcoins is easier to predict than that of gold. The supply of gold is sensitive to one-off events, like the discovery of new sources (say a newly discovered mine, or more fantastically, imagine a bus-size gold asteroid landing in Siberia), whereas the maximum future supply of bitcoins is bounded (the sum of a decaying geometric series), and the network's mining power growth rate is relatively steady. And third, bitcoins are easier and safer to transport ('cause you don't).

But for me, investing in Bitcoins burdens me the same way as owning gold: great care must be taken to protect any significant amount of it from theft. I am far too sloppy to invest in either (and own too little to consider changing my ways worthwhile). No I think bitcoin's most important feature is that it functions unimpeded across geographical, governmental, jurisdictional boundaries--though, I've yet to actually need any of this.

A Better Name: Bitgold

I'm not suggesting, of course, that Bitcoin should be renamed. But bitcoins are more like precious metals than currency. Currencies, after all, aim for price stability. Ideally, a basket of everyday goods costs the same over time in a given currency. But Bitcoin, like gold, owing to its limited supply, tends to appreciate in value relative to most common goods and services that over time become ever more abundant through innovation and technological efficiency. So if it's a currency, Bitcoin is deflationary one.

Deflationary currencies, however, are ill-suited for tallying debt. A lender has little incentive to lend bitcoins long term. And a borrower's obligations tend to balloon in real terms over time thereby increasing credit risk even more. So bitcoins can be lent more like Treasury bonds: they can be used as collateral for other debt, but are themselves seldom borrowed for any meaningful length of time. (Typically, you borrow long term T-bonds short term, in order to sell them short in anticipation of a quick drop in price.)

Now some argue that debt and usury are evil twins that we'd best do away with anyway, that a system of finance that discourages credit is just what the doctor ordered. It's a questionable argument, supported by only a minority of economists. (To wit, the total value of bitcoin debt is minuscule when compared to aggregate supply, even though a good number startups provide intermediation services for such lending in the marketplace.) Whether right or wrong, whatever its merits, it seems to me buying into the Bitcoin system is somewhat synonymous with abandoning long term debt: the system inherently favors equity over credit.