ASI fellow Preston Byrne explains why bitcoin’s recent problems do not mean the cryptocurrency-cum-payments-system is over. In fact, the promise of cryptography in payments and contracts is as exciting as ever.

Last week was a horrible week for Bitcoin: as “transaction malleability” (in effect, a form of distributed denial of service attack) entered the lexicon, $2.7 million of Bitcoins were stolen from Silk Road 2, Russia banned it and the App Store followed suit, the value of a single Bitcoin fell to roughly half – as against USD – as it was 14 days ago.

One could be forgiven for thinking it is “all over” for cryptocurrency; the sector is more than just Bitcoin, however, and as a whole the market tells a very different story. Slowly but surely, the one-trick crypto pony is becoming a multilateral ecosystem and one of the more interesting of these developments was the establishment of Ethereum, a project to build a platform to run smart contract protocols.

“What the hell is a smart contract?” You ask.

If Bitcoin is cryptography’s answer to payment systems, smart contracts are cryptography’s answer to commerce. Traditional contract law – the process of negotiating, creating, and enforcing agreements – is a complex body of rules, with something as straightforward as purchasing a cup of coffee involving a number of legal fictions which a court, on later review, can invoke to determine how an alleged breach of this notional agreement (much of which is implied by law rather than stated expressly, particularly in a consumer context) should be remedied, if at all, to do justice between the parties.

From a libertarian perspective, this system has a number of downsides, chief among them in that it empowers the state to interfere with the content of private contracts on the basis of, e.g., public policy (implied terms of employment, other statutory interference with the freedom to contract), taxation (VAT, stamp duty), or welfare objectives (planning gain) which limit individual liberty and interfere with price rationality.

One of the most popular proposed alternatives to the status quo is David Friedman’s, who proposed abolishing the courts entirely in favour of a system of private enforcement based on private arbitration agencies (in effect, gargantuan legal conglomerates) and a universal reputational rating and disclosure system akin to today’s credit rating agencies. In either Friedman’s case or that of the status quo, however, a “trusted third party” – be it a court or an agency – is required to administer the system, the problem Bitcoin was designed to solve. And just like Bitcoin is designed to remove trusted third parties from payment systems, Nick Szabo, the American legal and economic philosopher, wrote in 1997 that smart contracts would eliminate the trust problem from commercial agreements, too: in a world dominated by “institutions of written literacy,” he said, “we take for granted that contracts and law are written on this static medium, to be interpreted and enforced by human authorities.” But where smart contracts will pose a threat to financial intermediaries such as banks, they will also threaten the reach of those authorities to which those intermediaries customarily submit – regulators and the courts.

Where the programmer would say that the blockchain has removed the need for a trusted third party, the lawyer counters that the blockchain is the trusted third party, quite unlike any that has come before it. It is an automaton, carrying out very sophisticated functions, lacking personhood, located nowhere, owning nothing, making no representations or promises. It is more akin to a force of nature, like the weather, than the human institutions it was built to replace. It thus defies easy classification and raises more difficult questions than the manifestly obvious points about money laundering and terrorist financing which are currently in general circulation.

Say, for example, a miner finds a block but, through no fault of his own, winds up on the wrong fork. He has carried out a series of acts which, under English contract law, might otherwise constitute satisfactory performance of a unilateral contract, entitling him to the reward in full. His coins, however, are rendered worthless when the rest of the network abandons him by consensus; what recourse should he have? Who should he sue – the blockchain? Class-action against the network? What if a court awards specific performance – awarding the claimant coins on the correct fork – only to find that specific performance is mathematically impossible for the state to coerce? Would it find all of the users of the cryptocurrency in question jointly and severally liable to reimburse the claimant for the loss, or would it say that the caveat emptor principle applied – and the unfortunate miner implicitly consented to the possibility that the network might leave him behind?

Examining these transactions at a still more granular level, are units of cryptocurrency even property to begin with? A Bitcoin is not specie (a banknote), nor is it an amount credited to an account (which is not money, but a contractual obligation owed by a financial institution to a depositor pursuant to contract) – the blockchain, we will recall, lacks capacity to contract. A balance associated with a particular address is not a financial instrument or entitlement in itself, such as a cheque or promissory note; it is merely a history, evidencing that the transaction, and the provision of the relevant private key, has validly taken place in respect of it.

For broadly similar reasons, it strikes me that “private keys” which a blockchain generates also defy normal proprietary classification (see Oxford v Moss and the discussion in Palmer & McKendrick (1998)) – if you steal a piece of paper with a private key on it, that is theft, but what happens if you find a piece of paper with a private key, take a photograph of it, and access that wallet on your own?**

This isn’t to say that property – enforceable promises – cannot exist in respect of, or be denominated in Bitcoin, or any other cryptocurrency, or that cryptocurrency isn’t actually property: quite clearly they can and quite clearly it is (even if the law doesn’t yet recognize it as such). What I mean to say is that cryptocurrency, in solving the problem of the trusted third party, presents a more fundamental challenge to the logic of the established order than we once supposed – and this is only Bitcoin we’re talking about, to say nothing of the autonomous distributed corporations which are quickly approaching realisation.

What exactly will happen as the real world and cryptocommerce begin to get acquainted, no one can say. But I am sure of this: it will be a lot of fun to watch.

**N.B. – In the United States, insolvency filings made last week relating to a Bitcoin mining firm illustrate beautifully some of the teething problems to which cryptocurrency litigation will give rise. Read the transcript (Document 113 (pt 2)) here.

p. 61: “‘Interesting industry. How do we account for these bitcoins? What is it?’ And I said, ‘you know, that is right now a little bit of a question, but my client’s advice… is that when it receives bitcoins in accounts that isn’t income. It’s not income until it’s sold.’”

p. 106: “It’s not required that we have a simple, well-understood, well-established, common, conventional industry in order to be in bankruptcy court. This is new, and the fact that it is new is perplexing to a lot of people, and we have done our very best in trying to simplify it… it has taken some time to get our collective hands around this so that we can sort of convert the information and the data into a form that is sort of readily usable for all of the constituent parts of the bankruptcy system.”