The Promise of Decentralized Technologies
Decentralized technologies are playing an increasingly important role in the world of finance. They are so versatile that they can be used for very different purposes. Not all uses, however, are superior to the financial system we currently have. The prospect of decentralized technologies that remove elements of human decisions and thus discretionary power holds the promise for a less hierarchical system with greater reliance on ex ante commitments than ex post discretionary power. But they might just well exacerbate the problem of binding commitments under conditions of fundamental uncertainty. Depending on their use and design, these novel technologies can be co-opted by entrenched interests to solidify their power or, in the alternative, for building a more open and resilient financial system.
In this post, we use the analytical framework of the the Legal Theory of Finance to Finance to analyze the promise and perils of blockchain technologies, focusing on immutability, hybridity and hierarchy as their shared characteristics.
A blockchain is a tamper-proof ledger that contains a complete history of all state changes in transactions that take place on it. Smart contracts are pieces of code set to execute on the blockchain. Since every action on the blockchain is recorded automatically, blockchain-based smart contracts create an unprecedented level of granularity, completeness, and trustworthiness in the data gathered. A blockchain typically can only be written onto; it cannot be modified; smart contracts therefore create even more binding commitments than legal contracts, which are deemed incomplete because it would be too costly if not possible to anticipate all future contingencies and include them into the contract.
Blockchain thus provides enforcement and information gathering functions in ways that differ from conventional legal mechanisms. By transacting through blockchain-based smart contracts, participants agree to a set of coded rules that are enforced by deterministic computers. Furthermore, blockchain-based applications promise to realize the dream of complete contracts that has eluded the world of legal contracting. Whatever parties agreed to will be enforced. Smart contracts started as an attempt to memorialize commitments in digital code so that they could not be modified in the future. Such smart contracts would leave no room for renegotiation or for tampering with past commitments. Parties would not need to trust each other; in the ordinary course of transacting on coded platforms, they can even dispense with trusting courts, regulators, and other enforcement institutions; they only need to trust the digital code.
The code’s immutability has been touted as promising predictability and credibility. Yet, the digital code operates in a dynamic environment that is subject to change in ways that are difficult, if not impossible, to predict. Insisting on immutable commitments under conditions of fundamental uncertainty is bound to precipitate the system’s self-induced collapse. It may be possible to improve our understanding of future dynamics, but at a fundamental level, uncertainty cannot be eliminated. The challenge therefore is not to fix ‘bugs’ in the code, but to create a code that is adaptable to changing circumstances. This will require a clear sense of normative goals to guide the adaptation process.
The digital code promises purity. Smart contracts, virtual money, and immutable enforcement mechanisms are meant to replace state law, state courts, and perhaps most importantly, the state’s role as discretionary lender of last resort. Purity, however, comes at the price of heightened volatility and greater propensity to self-destruct. Most advocates realize this but seem to be willing to pay this price for purity. Whether such advocates can maintain this position is largely a question of scale. As long as digital systems are small and do not create negative externalities, their self-destruction is tolerable. As systems are scaled, the cost associated with their destruction may require a more interventionist stand.
The fundamental challenge for the coders of digital currencies is whether to address the problem of liquidity constraints heads on or implicitly on existing backstops, i.e. the state and its central banks. Either way, code cannot escape its interdependence with state institutions.
In the world of legally coded financial systems, law creates hierarchies by creating rank orders of legal rights. One of the great attractions of Bitcoin and other blockchain technologies, at least to its original adherents, was to eliminate this hierarchy and make the world as flat as most financial economists imagine it to be. Yet, hierarchy is baked into the digital code no less than into the legal code, and arguably even more so. Digital coders both create the platform (the virtual world in which transactions take place) and the rules of the game. They decide when to step out and renegotiate outside of the ‘immutable’ code structure and to set the terms for returning to the original code, or to modify it. Consider only the near collapse of The DAO in 2016, which was prevented only by the lead coders going ‘off-line’ to redesign the rules of the game. This is the equivalent of suspending the full force of law in times of crises, and raises the specter of discretionary power just as in the world of law.
It is widely believed that if only all actors played by the rules of the game, stability, if not a state of equilibrium, might be achieved. Advocates of credible contractual commitments and immutable codes harbor similar dreams. They all must assume that world is a static place or that we have unlimited capacity to predict the future. We caution that many of the lessons that apply to financial markets, which are legally constructed, also hold for digitally coded finance.
Katharina Pistor, New York