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The Crypto State? | City Journal


Autumn 2020 issue preview

Throughout history, world powers—Spain, the Netherlands, France, Britain—have found themselves routinely replaced by more dynamic rivals. Today, many speculate about whether the United States will cede place to China as the global superpower. What if this is the wrong way to look at the question, though—and what if we’re living through a more radical transition? What if all contemporary states are in the process of being replaced by a new kind of “state,” as different from existing governments as they themselves differed from ancient empires or primitive tribes?

Technological development creates new sources of power, and it’s possible to discern a logic to that growth. First, information: Google knows more about you than your government ever will. Second, community: Facebook brings more people together on a single collective platform than any society, including China or India, can match. Third, currency: Bitcoin is a new kind of money, decentralized and free from political control. Fourth, law: smart contracts are computer programs working without human intervention. All that remains is to combine these elements, and a new form of governance will be born. What might it look like?

In an essay published in 2017, Mark Zuckerberg offers a philosophy of history to explain the rise of Facebook. The arc of that history moves from tribes to cities to nations—and now to something beyond. “Today we are close to taking our next step,” he writes. The truly remarkable thing is not that Zuckerberg thinks that humanity is becoming a global community—implausible as that claim is—but that he thinks his company, which he obviously does not regard as merely a company, can help make it happen: “Facebook stands for bringing us closer together and building a global community,” he says. “In times like these, the most important thing we at Facebook can do is develop the social infrastructure to give people the power to build a global community that works for all of us.”

When Zuckerberg calls Facebook the “social infrastructure” for community, the term is the very one that you would use to define the state. The state makes human communities possible; it builds them, organizes them, and keeps their members together. Or, as Zuckerberg puts it, it supports us, keeps us safe, informs us, and includes and engages us. Of course, Facebook, with no territory and no claims to territory, is dedicated to building a global community not in physical but in virtual space. By freeing itself from geographical constraints, this new community would be open to every person on the planet.

The story of the political travails affecting Facebook over the last few years—and to which Zuckerberg’s 2017 essay was an early response—shows that the aspiration to create a new kind of “state” was far tougher to realize than Zuckerberg envisioned. The problem is that Facebook lives a kind of double life. On the one hand, it says that it wants to enable a virtual community of global citizens. On the other, it is a company incorporated under the national law of already-existing nation-states. In this second aspect, it is subject both to the rules of market competition and to public regulations. Neither is compatible with the global political role to which Facebook aspires.

Cryptocurrencies—and crypto platforms more generally—offer an answer to this difficulty. Already, with Bitcoin, we have seen the advent of a new global infrastructure, where data and transactions can be endlessly recorded in a trusted blockchain ledger, without any of the usual intermediaries: no large multinational corporation captures the data, no banks are involved, and no state authority can tamper with the record. Disputes within the community are automatically settled by the existing ledger, which takes on the role of paramount authority.

As the media theorist Steven Johnson argues, the inventors of the open protocols that shaped the Internet failed to understand that what was being built was a community, and not just a machine. Or perhaps the error was to think that identity had already been defined in the real world and that the online community would merely replicate those external standards. Offline, we rely on public authorities to confirm to others that we are who we say we are. Marital status, property, age, taxes, health and school records, contact information—state authorities zealously keep all these records, and, normally, a society will work better if citizens can trust those authorities to fulfill that task. But online, the scale of information explodes. The vast volume of data collected online now bears no comparison with the primitive records available in the physical world. Thus, identity changes online. Human beings are transformed into streams of data, which can be recorded, analyzed, and assessed in real time. Technology firms collect thousands of data points about each of us; the profiles they create are like virtual avatars, doubles of our real selves.

Since no Internet protocols were put into place for individual identity, and since those available in the physical world were of limited use, the private sector swooped in to fill the vacuum, settling on a number of proprietary standards for establishing who you are and whom you know, with Facebook increasingly occupying center place. I think it’s fair to say that things did not turn out well in this area. The new global community that Zuckerberg wanted to build was being powered by something as pedestrian as targeted advertising: the springs of community life now had to serve the purpose of maximizing profits for Facebook and its advertisers. “Surveillance capitalism,” as author Shoshana Zuboff calls it, carries the threat of vastly expanded private mechanisms of social control, based on rendering human behavior fully predictable. At the same time, the extraordinary power that the new technology platforms were amassing awakened the interest of government regulators, raising the likelihood that the dream of a new global community, independent of traditional state structures, would not survive its first trial.

That is why, for example, Facebook’s digital currency, Libra, seems destined to fail. No sooner was it announced than congressional hearings started, and the chairwoman of the Committee on Financial Services called on Facebook to halt its development. Unlike Bitcoin, Libra is centrally controlled by a particular firm, and thus an easy regulatory target.

An alternative is conceivable: each individual would own his digital identity, which different services could use according to their current interests and choices, instead of that identity being recorded and updated by large Internet platforms and then sold to advertisers without consulting the people to whom these online selves ultimately belong. With a distributed database of the kind first introduced by Bitcoin, something truly remarkable became possible for the first time: a community coming together with no other authority than the database that records its members’ collective lives. The ultimate promise of crypto lies less with digital currencies than with the replacement of other state structures. When programmer Vitalik Buterin started to think about the next stage of technological evolution after Bitcoin, his main intuition was that the blockchain could be used to record every social process, with money transactions being just one example.

Bitcoin’s main challenge was to create a simulacrum of time. To construct a database that would contain every transaction, present openness had to be brought together with past inviolability—it had to be possible, that is, to add new transactions to the ledger, while making every past act final or inviolable. The way that challenge has so far been addressed is with proof of work as a mechanism through which the nodes—the computers or servers that record the transactions—gain the right to participate in the system. The purpose is to make block creation—the process by which new transactions are successively added to the ledger—computationally difficult. In Bitcoin, this consists of solving a completely unpredictable pseudorandom function through trial and error.

“Bitcoin was a response to the excesses of financial markets and the unlimited power of the state.”

It’s the process of adding new transactions to the blockchain while getting rewarded for it with new bitcoins that we call “mining.” The metaphor is suggested by the computational difficulty, and thus the net cost of the process. As Bitcoin’s creator, the presumably pseudonymous Satoshi Nakamoto, wrote: “The steady addition of a constant of amount of new coins is analogous to gold miners expending resources to add gold to circulation.” Once the order of transactions has been secured in this way, and since the underlying cryptography protects the rest of the system, there is no way for a malicious attacker to appropriate funds that belong to someone else. Each person uses his or her own private key, and no amount of violence can solve a math problem.

As the record grows longer, any attempt to redo the earlier work becomes harder, to the point of impossibility, as it would also require redoing all the blocks chained after it. Besides, as Nakamoto cleverly pointed out—he is politically very subtle—if an attacker is somehow able to assemble more computational power than all the honest nodes in the chain, he would have to choose between using it to defraud people by stealing back his payments, or using it to generate new bitcoins. He ought to find it more profitable to play by the rules, which would favor him with more new coins than everyone else combined, than to undermine the system and the validity of his own wealth. The blockchain backed by the largest quantity of proof of work—thus, the longest blockchain—is taken to be the definitive truth.

Nakamoto left a message in the first Bitcoin block ever mined, noting a headline in the Times of London announcing a second massive bailout for banks. The date: January 3, 2009, the height of the global financial crisis. Bitcoin was intended as a response to the distempers of a global financial system that somehow manages to give private companies free rein to enrich themselves, while keeping public authorities ultimately in charge. It was a response, in other words, both to the excesses of financial markets and to the unlimited power of the state. Nakamoto made a fundamental claim: the financial system as it exists today relies on trusted third parties, predominantly banks and other financial institutions, in order to function. This need for mediation increases transaction costs, limiting the minimum practical transaction size, and thus cutting off the possibility for small, casual transactions. Further, nothing in the current system makes the record of assets and transactions inviolable. Fiat money remains under the ultimate control of governments. Financial crises show that this is not an idle consideration, but even under more routine circumstances, every government is prone to use monetary and fiscal tools to tamper with the historical record—the very record that Bitcoin enthusiasts regard as irreversible. People also want to do many things with money that politicians, bureaucrats, and political activists want to prevent them from doing. Cryptocurrencies come out of the efforts of “cypherpunks” to build a libertarian utopia in cyberspace using real computer science instead of fantasy physics. The goal, to a very great extent, is to strip money of dependence on, or even vulnerability to, governments.

Once a system of decentralized information and governance has been developed, money is only one area where public control may change hands. The universal record of transactions—the “sequence of events witnessed,” as Nakamoto calls it, or the “state transition system,” according to Buterin—could be used not just to move wealth around but also to take over certain roles of courts and, more generally, the laws. In short, anything that can currently be represented by a computer is admissible to the decentralized recording process. At this point, the logic behind the new technology becomes much clearer, even to the uninitiated.

Whether Nakamoto had these possibilities in mind when he created Bitcoin is open to debate. His paper is limited to the special case of an electronic currency, but that in itself is unsurprising. One would always have to start with money because all the people building, maintaining, and improving any radically decentralized system need to be rewarded for their efforts. Nakamoto devotes considerable attention to the classic problem of “incentives.”

Buterin proposed dropping the specialized approach of Bitcoin and building the ultimate abstract foundational layer: a blockchain with a programming language, allowing all people to write smart contracts and decentralized applications where they can create their own rules for ownership, transaction formats, and state transition functions. He called the system “Ethereum.” Significantly, money becomes no longer just an output but also an input. All programmable computation in Ethereum is subject to fees. The fee schedule is specified in units of gas, and these can be bought using Ether, the system currency.

Smart contracts automatically process social and economic exchanges according to a predetermined algorithm. For example—as Buterin argued—one might have a contract of the form “A can withdraw up to X currency units per day, B can withdraw up to Y per day, A and B together can withdraw anything, and A can block B from withdrawing.” Or think of a vending machine. Without a shop clerk or another trusted intermediary, it enforces the contract of selling a beverage at an advertised price to the customer, who inserts sufficient money into the till. The logical conclusion of this concept is decentralized autonomous organizations, smart contracts, or sets of contracts that contain the assets and encode the rules of an entire company or organization.

Just as a computer with no Internet connection has limited capabilities, so, too, do smart contract platforms that cannot connect to outside functions. As crypto takes on an increasing number of functions, however, one approaches a singularity: the moment when it no longer consists of an artificial system, separate from reality, but instead becomes the control room steering or governing events in the real world. From that point on, it would acquire at least some of the nature of a state.

Many issues related to the interface between Ethereum and the real world have been actively discussed and researched. In some cases, ingenious solutions have been advanced. Most deal with the ways in which the system may be made receptive to real-world inputs. Making it capable of producing outputs effective beyond the blockchain is a more demanding challenge.

Let’s start with the inputs and leave the outputs for a concluding—and more speculative—section. Ethereum promises its users a generalized system where they can do much more than just trade an internal currency. They can, for example, develop hybrid protocols connecting crypto-assets to conventional financial instruments. Stablecoins are crypto-assets backed by collateral linked to gold or the dollar. Synthetix, another Ethereum project, allows the creation of “synthetic assets,” whose prices can track currencies, cryptocurrencies, and commodities. All these options require access to the market price of the asset being tracked. Insurance smart contracts will need data feeds related to the insurable event in question. For example, did the flight you had insurance for arrive on time? Trade-finance smart contracts would need data about shipments, supply chains, and customs for the goods being shipped, so as to confirm fulfillment of contractual obligations. The sources of information from the world outside the system are known as “oracles.”

The question immediately arises of how to design an oracle that does not falsify the logic of the system. Suddenly, the need to rely on a central authority to feed valuable data into the blockchain seems inescapable, but then we’re no longer operating a decentralized and unforgeable universal database; we’re back where we started. In 2019, for example, a Synthetix oracle transmitted false data to the platform, which a trading bot then exploited. Though no users were affected, Synthetix had to pay a significant sum to the bot owners to fix the unintentional hack.

Another illuminating example is a betting market, an application always presented as perfectly suited for the Ethereum blockchain. I could place a bet about, say, the name of the next American president as a smart contract that would automatically execute a money transfer once the election takes place. The advantages of a smart contract are obvious: I have no need to trust my counterpart or an intermediary, and there is no way to cancel or change the bet. The problem, of course, is how to feed the correct information of the election result to the smart contract. Many different solutions have been tried. One option: to create a decentralized oracle network, asking multiple nodes to fulfill the same request for data—that is, who won the election—and then reducing their reports to a median value before returning that answer to the smart contract. As Sergey Nazarov has argued, just as a smart contract needs to be extremely reliable to be useful, so the external data fed into the smart contract needs to be extremely reliable. What makes no sense is to have a centralized oracle feed data into a decentralized network.

According to the founder of Chainlink—one of the hottest companies in the crypto space right now—blockchains and oracles can both produce “definitive truth.” That is, the Bitcoin blockchain establishes definitive truth about Bitcoin ownership. Chainlink delivers definitive truth about the external world using the same basic method: multiple independent nodes confirm data from different, independent oracles. Similarly, in Augur, a decentralized betting platform, the consensus established by a body of “reporters” is considered the “truth” for the purpose of determining the prediction outcome.

Scraping web content for data might seem like a promising idea, but smart contracts can operate only in the blockchain they reside in. To communicate online, they need intermediaries, which is to say, oracles. A software oracle will draw important information needed for a smart contract to complete its task from various web sources. Conversely, a hardware oracle could be something like a sensor installed, say, to collect temperature data and deliver it to a smart contract for insurance.

We have now reached the crux of the matter. Because individual assets in such a system are protected by cryptographic keys, and the system itself is protected by a fully decentralized protocol, existing nation-states are increasingly finding it difficult to track or control the economic activities and transactions happening on the blockchain. If the state and the banking system cannot see the transactions in the new crypto economy, the ability to tax disappears. Tax rates for the rest of the economy will have to go up to compensate for the revenue loss, but the tax hike will likely drive more people to the crypto economy. And so on. It’s not surprising that crypto transactions first became part of the U.S. Internal Revenue Service tax-return form for 2019. Those pulling up the 2020 form will now see it almost immediately. Beneath the initial section for basic personal details is the fresh query: “At any time during 2020, did you receive, sell, send, exchange, or otherwise acquire any financial interest in any virtual currency?”

At first glance, this does not seem to be a sustainable dynamic for crypto. The nation-state still enjoys a monopoly of violence, after all. In fact, the blockchain has no access to violence. As Buterin once told me, if by control over physical violence, we mean the act of preventing it, there is indeed a growing toolbox of techniques, involving obfuscated smart-contract wallets, that make it tough for an attacker to use force to acquire crypto-assets. But if by control, one means the act of triggering violence, things get far more complicated. There is no obvious way by which a crypto system could acquire control over the use of violence in this sense, the defining trait of a modern state.

“If the state and banking system can’t see the transactions in the new crypto economy, the ability to tax disappears.”

But here are my provisional suggestions on how things could go. The critical issue is, of course, taxation. It is here that crypto issues the more determinate challenge to the core powers of the modern nation-state. Some in the crypto space believe that the slow erosion of the state’s tax powers will eventually determine its final collapse, at least as we know it today. Others have told me that they expect all nation-states to disappear over the coming decades, with the notable exception of China, which alone, they maintain, has the political and social resources to penetrate or disable fundamental choke points in the crypto system. China is responsible for something between half and two-thirds of global Bitcoin mining, but local authorities have made it clear that they regard the crypto space with enormous suspicion. In 2017, China banned fund-raising through initial coin offerings, and all digital-currency exchanges were shut down. If Beijing decides to cut off the Bitcoin network in China, it could make it hard for mining pools to sync their data on blockchain with the rest of the world.

The Chinese case does offer a possible template for the ongoing power rivalry between crypto and nation-states. In this scenario, crypto systems would double down on their technological superiority, while states would necessarily appeal to their secret weapon: the monopoly of the legitimate use of physical force. But a second scenario seems much more plausible, at least outside China. Public authorities and crypto systems could reach a grand bargain or agreement, whereby the state would be able to tax crypto-assets in exchange for security guarantees for crypto. Legacy institutions and structures in the political world aren’t going away anytime soon, so it’s critical for blockchain projects to be able to interface with them. I believe that legacy systems can also benefit from this. The Swiss canton of Zug has taken initial steps in this direction: recently, it announced that beginning in 2021, taxes can be paid using Bitcoin and Ether.

One could even develop a form of smart contract—or chain of smart contracts—by which this agreement might be automated. A payment message routed to a centralized infrastructure processing tax revenue would be made dependent on the regular functioning of crypto exchanges and mining nodes. If the latter were closed, the output would be suspended or frozen. The solution would be akin to a “slashing” algorithm, where a node is penalized if it acts in a malicious or detrimental way toward the network or if it undermines protocol guarantees. Slashing events usually involve a combination of the partial or total burning of locked funds or their temporary or permanent removal from the network.

What if slashing meant state slashing? Some would conclude that the coercive apparatus of the nation-state had been effectively absorbed by the system—the successor state.