The inherent limits of the Bitcoin economy: a brief guide to the steps that still need to be taken to build a decentralized economy.

Stefano Capaccioli

di Avv. Giorgio Maria Mazzoli

1. The inherent limits of the Bitcoin economy

We should all agree by now that Satoshi’s essential goal was to build an electronic payment system allowing parties to make payments without having to rely on a trusted party such as a financial institution. Financial institutions operate in a “fiat system”, as I like to call it, a system in which almost any economic relationship may only take place with the necessary intermediation of a centralized institution (starting from the government itself, who has hoarded any power on money and the monetary system).

Quote: [Commerce on the Internet has come to rely almost exclusively on financial institutions serving as trusted third parties to process electronic payments. While the system works well enough for most transactions, it still suffers from the inherent weaknesses of the trust based model. Completely non-reversible transactions are not really possible, since financial institutions cannot avoid mediating disputes. The cost of mediation increases transaction costs, limiting the minimum practical transaction size and cutting off the possibility for small casual transactions, and there is a broader cost in the loss of ability to make non-reversible payments for non-reversible services. With the possibility of reversal, the need for trust spreads. Merchants must be wary of their customers, hassling them for more information than they would otherwise need. A certain percentage of fraud is accepted as unavoidable. These costs and payment uncertainties can be avoided in person by using physical currency, but no mechanism exists to make payments over a communications channel without a trusted party. What is needed is an electronic payment system]

Satoshi himself expressly mentioned the benefits of such a system:

a) The elimination of certain “costs and payment uncertainties”, such as the “cost of mediation” due to the fact that, in a “Fiat Economy”, “non-reversible transactions are not really possible…” and “…financial institutions cannot avoid mediating disputes

b) The reduction of the “minimum practical transaction size”with “the possibility for small casual transactions

Although he mentioned only these aspects, the reference to Wei Dai’s “B-Money” essay makes it clear that an electronic payment system has to be primarily seen as an essential precondition for the foundation of a fully decentralized economy.

We should always keep in mind that Wei Dai’s “B-Money” was proposed in the context of a cypherpunks mailing-list and that in Wei Dai’s words money is essential to “define” a community as such.

Quote: [A community is defined by the cooperation of its participants, and efficient cooperation requires a medium of exchange (money) and a way to enforce contracts. Traditionally these services have been provided by the government or government sponsored institutions and only to legal entities.]

In Wei Dai’s vision electronic money is the first thing we need to get governments out of our way as much as possible.

Quote: [Government is not temporarily destroyed but permanently forbidden and permanently unnecessary]


That would work just fine for me. Nevertheless such a system would necessarily have some inherent limits. Once again Wei Dai’s words are clear enough.

Quote [It’s a community where the threat of violence is impotent because violence is impossible, and violence is impossible because its participants cannot be linked to their true names or physical locations].

Such a system may perfectly work and it may even coexist with the “Fiat system”, yet, as Wei Dai himself puts it, it may do so only if and in so far as the members of the community “cannot be linked to their true names or physical locations”.

This would generally discourage and may exclude from the decentralized system any transaction to be made with the physical presence of the parties to that transaction (such as cash transactions).

Moreover, the possibility that the parties may wilfully opt to manage their economic and contractual relationship through a decentralized system may be hindered for any other transaction that, due to the characteristics and/or the nature of the relationship between the parties, may expose one or both of them to the risk of being identified (whether in their name and/or also in their physical location).

Furthermore, since, as Wei Dai puts it once again in his own words, a community not only needs a medium of exchange, but also “a way to enforce contracts”, a decentralized system definedas a “crypto-anarchy” in accordance with his vision would by definition be limited to:

a) Those economic relationships in which the exchange between the parties is instantaneous (which in the traditional law of contracts do not even constitute contracts, although the are consensual and do involve a trade);

b) Those economic relationships in which:

(i) One or more of the undertakings of the parties, defined as a promise, shall be performed at some future time


(ii) The risk of any such promise remaining unfulfilled in such future time is either eliminated or reduced at a level deemed as acceptable by the parties (because of the values at stake).

Summing up Wei Dai’s decentralized economy would only include a limited number of transactions:

– Those that do not require the physical presence of the parties;

– Those which do not require such presence but at the same time expose one or more of the parties to the risk of being identified (whether in their name and/or also in their physical location) and in which such a risk is not accepted by the party exposed to it;

– Those in which either the exchange between the parties is instantaneous or the risk of default by a party is zero or otherwise deemed acceptable by the counterparty (because of the values at stake).

These aspects represent the inherent limits of such a model of a decentralized economy. Should we accept Wei Dai’s vision? I believe that if we do so we would underestimate the possibilities we have now that an electronic payment system such as Bitcoin has been invented. In the following part I will try to explain the reason why and what could be done to extend the values and the benefits of a decentralized economy to a greater scope.

2. Toward a decentralized economy.

First, let me stress out that I knowingly chose not to treat the argument regarding the risk we are now facing on the deanonymization and linkability of cryptocurrency transactions such as bitcoin. I am aware that they may hinder at the root the very functioning of a decentralized electronic payment system, since such a system necessarily requires the permanent updating of the unspent transaction outputs (UXTO) and the sharing of such information among the nodes and anyone, as the blockchain is and has to be public.

Nevertheless I am also aware that from a technical point of view some solution have already been found to the problem and that further improvements will be soon done in that direction.

I am not underestimating the risk: I rather think that theoretically the anonymity of the parties may hamper the development of a decentralized economy if such anonymity prevents any possibility of identification of a party in the event such a party does not properly fulfil his obligation and promises to the counterparty.

Since whenever there are promises to be performed in a future time by a party there is always a risk of default of such party, unless we accept Wei Dai’s vision of a decentralized economy, with its inherent limits, an economic relationship will not be established unless the counterparty, in the event of default, has the possibility to either obtain otherwise the enforcement of the unfulfilled promise or at least to recover damages: i.e. unless the parties have a guaranteed access to a judicial system (which, by the way, does not necessarily mean a government run judicial system as I will try to explain later).

I will neither treat the argument of scalability since I believe that it is primarily a technical issue, in the sense that it requires a technical solution and even if such a solution should presumably be essential to expand the boundaries of the decentralized economy beyond the above said limits, the argument does not seem to be relevant for the scope of this analysis.

Bitcoin is just the first step toward a decentralized economy

Having said that it is clear how all the above consideration define the very scope of smart contracts, since in a “crypto-anarchy”, conceived as in Wei Dai’s vision, a smart contract may only be conceived if and in so far as the risk of default by a party is either eliminated at the root (for instance because the exchange is instantaneous or because the promises to be performed at a future time have been transformed into self-enforceable obligations) or otherwise governed so as to guarantee the counterparty that in case of default he may obtain otherwise the enforcement of the unfulfilled promise or at least recover damages he incurred in or suffered.

And it is also clear that a guaranteed access to a judicial system requires first that the parties have the possibility to identify each other reciprocally, at least if and when this may be needed because a specific dispute actually arose between them.

In my previous experience on smart contracts in 2015 as a lawyer I learned how even in the simplest economic and contractual relationship as the one established with a sale and purchase agreement, there is no possibility to govern and control the whole relationship and to eliminate the risk of default of a party, with regard to some obligations and warranties: we may conceive a smart contract governing an escrow account with the instruction to pay the price to the seller only upon delivery of the item sold and to reimburse such price to the purchaser in the event such item is not delivered within the agreed time limit. Such a smart contract would eliminate some risks of default by the seller (i.e. the risk of the seller breaching is obligation to deliver the item sold to the purchaser). Nevertheless, it is hard to imagine how a smart contract could ever manage other risks typically connected to any such contractual relationship such as the risk that the item does not match what has been ordered by the purchaser, the risk of a malfunctioning of the item sold or after-sale guarantees which the seller shall always provide to the purchaser.

This lead me to the conclusion that unless we find a way to assure the parties have the possibility to govern such kind of risks, smart contracts will have limited applications.

Then, what is needed at this purpose is:

a. A system in which each party has the power to decide if, when and with whom any data on his personal identity shall be shared; a system in which, therefore, any party may have a pseudonym or even two or more of them and in which, unless such party agrees to share any data on his personal identity, no other party may ever have access to such data. I conceive this system as a network where the personal identity of participants may be certified by some nodes of the network who had access to the relevant data, without sharing such data with other participants. Other participants would not need to know the personal identity of such party if such identity was previously certified by a reliable node. I will thus call this system a decentralized system of identification since the certification of personal identity would not depend on government or any central authority, but rather on several nodes which would operate as “Trust Aggregators”.

b. A system in which each party to an economic and contractual relationship, in the event of default of the counterparty, may either obtain otherwise the enforcement of the unfulfilled promise or at least recover damages. This would need:

b.1 One or more protocols allowing parties to manage and resolve any dispute which may arise between them. At this end it may be useful to underline that the Convention on the Recognition and Enforcement of Foreign Arbitral Awards, also known as the “New York Arbitration Convention”, allows the parties to an economic relationship, whether contractual or not, with an agreement in writing, to submit to arbitration any dispute concerning a subject matter capable of settlement by arbitration (Article II) and provides that the arbitral award shall be recognized and enforced in any jurisdiction of the Contracting States. By invoking the New York Convention the parties to an economic and contractual relationship may then have a guaranteed access to a judicial system which is not run by any government but fully recognized by most of them. In such a system the designation of the arbitral authority and the rules on the arbitral procedure may be determined by the parties themselves. And the parties may even determine that the arbitral award may not be appealed. This would strongly limit government intervention and may be of great help for the development of a decentralized economy.

b.2 A mechanism allowing parties invoking an arbitral award to obtain its enforcement without having to rely once again on government intervention. This presuppose that participants to the system shall have the possibility to build a network with other participants and to establish, for each network, the amount that each party has to put at stake in order to be accepted in the network and that such amount may be sent to any other participants should an arbitral award be issued provide so and to the extent it does. This stake should work as a check on poker and would have the same function of a generic warranty of each participants on his ability to fulfil any future obligation such party may undertake to perform at a later stage within the network.

Upon these conditions I envisage that several networks would be created, each one with its own rules regarding the level of data that participants shall share among them on their personal identity, the participation to the arbitral procedure, the recognition of any arbitral awards and its enforcement, allowing parties to benefit from a decentralized economy in which the role of governments is progressively eroded.

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