1.

Institutional cryptoeconomics
Sinclair Davidson and Jason Potts

1. INTRODUCTION

Blockchain technology was invented in 2008 by the pseudonymous Satoshi

Nakamoto and was implemented in 2009 as a cryptocurrency: Bitcoin.
Blockchain – also known as distributed ledger technology – enabled a digital
currency (and payments system) to work without the need for a trusted central
authority by using a distributed, cryptographically secure, and economically
incentivised consensus engine. While a lot of attention has been paid to
cryptocurrencies, such as Bitcoin and Ethereum, in this chapter we argue that
the true innovation is not cryptocurrencies per se, but rather the underlying
technology that operationalises cryptocurrencies, namely blockchain. We
argue that the blockchain is not merely a productivity enhancing technology
in a Schumpeterian sense, but that it is an institutional innovation following
Oliver Williamson’s worldview.
An economic analysis of distributed ledger technology needs to start by
carefully considering just what sort of technology it really is. While it can
certainly be understood as (just) a new general purpose information and com-
putation technology, it is better understood as a new institutional technology
for economic coordination and social record keeping. The true significance of
this new technology is not as the next in a line of transformative information
technologies, each of which powers a productivity revolution: e.g. transistors,
computers, the internet, and eventually blockchains. Rather it is best under-
stood as the emergence of a new mechanism of economic coordination; gov-
ernments, firms, markets, relational contracting, and eventually blockchains.
In this chapter we set out the argument for distributed ledger technology as
being an institutional technology and frame our understanding of that tech-
nology in Oliver Williamson’s transaction cost economics framework. This
chapter draws heavily on Davidson, De Filippi, and Potts (2018), and Berg,
Davidson, and Potts (2019a). In particular, we use Williamson’s framework
to explain why (some) transactions are likely to occur on blockchains, rather
than in firms or on markets. Furthermore we argue that many transactions that

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currently do not occur are likely to occur in future, on blockchains, because the
current transaction cost threshold is too high.

2. PRODUCTION COSTS, TRANSACTION COSTS,

AND DISTRIBUTED LEDGER TECHNOLOGY

The adoption and use of distributed ledger technology can be examined using
economic theory. There are two distinct (yet commensurable) approaches to
the meaning of technological change; the neoclassical approach and the new
institutional/evolutionary approach. In the neoclassical production-function
based approach, technological change is a change in factor productivity (see
Solow 1956; Swan 1956 and the resultant literature). In the new institutional/
evolutionary approach, technologies also include “social technologies”, or
institutions and organisations, as rules for coordinating people, and so
institutional change is also a technological change. In the social technology
approach, technological change is a change in institutional efficiency (see, for
example, North 1990).
In the standard neoclassical model, blockchain technology can be described
as being a general purpose technology. Its adoption drives economic growth
by improving the productive efficiency of economic operations. This is both
an intuitive and popular understanding of the rationale for the adoption of this
new technology. Technological change in any general-purpose technology –
say electricity, computers, or blockchains – is factor augmenting. Blockchain
innovations increase total factor productivity by their effect on marginal factor
productivity. They do so by reducing the production costs associated with any
endeavour to produce a particular output.
There is another way that economising can occur; economising not on
production costs, but on transaction costs. Transaction costs are the costs of
coordinating economic activity. This idea was first explained by Nobel laure-
ate Ronald Coase (1937). The basic insight of this line of inquiry (now known
as new institutional economics) was to ask why do some transactions occur in
firms (hierarchies) rather than in markets? Another way of asking this question
is in terms of the make or buy decision. Why do firms sometimes make all the
component parts of their product and why do they sometimes buy some of the
component parts of their product? The answer being that some transactions
costs (due to uncertainty and asset specificity) are high in markets compared
with within the firm, while other transactions costs are low in markets com-
pared with within the firm (Williamson 1979, 1985). When market transaction
costs are high, transactions occur (if at all) within firms. That answer earned
Oliver Williamson the economics Nobel prize in 2009. Transaction costs
thus determine the efficiency of different governance institutions (firms
or markets). The basic insight that transaction cost economics can bring to

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 Institutional cryptoeconomics 3

blockchain is to ask the same, but now extended, question: why might some
transactions occur on blockchains, rather than in firms or markets?

3. WILLIAMSON AND THE TECHNOLOGY OF

TRUST

Ronald Coase’s 1937 paper “The Nature of the Firm” launched the field of
institutional economics by nominating transaction costs as the answer to why
firms emerge in “a specialised market economy”. In a later 1960 paper, Coase
made the same point in relation to law. The 1937 paper contrasts the firm and
the market, a reading of his 1960 paper can be seen as a contrast between
the market and government. Social nuisance can be managed by doing
nothing, markets (i.e. trade), integration (i.e. the establishment of a firm), or
government intervention. In each case, he identified that there are costs to
employing market mechanisms and some of those costs can be ameliorated
by supplanting the market mechanism with hierarchical organisations – gov-
ernments and firms. What Coase, however, did not well explain is when and
why a substitution away from markets to hierarchy would occur. If markets
were less efficient than hierarchical organisations in some circumstances,
which circumstances? That question was left to Oliver Williamson. If Coase
moved the attention of economists from understanding the costs of production
to understanding the costs of exchange, then Williamson directed attention to
the costs of contracting.
Standard economic theory has a very simple contracting process that can
be described as a sophisticated form of barter or retail economics. Consumers
know what they want to buy, sellers know what they have available for sale,
and then trade occurs. There is no ongoing relationship between buyers and
sellers. Each exchange is simple and short-lived. In a retail sale, the execution
of the contract and the release of payment occur simultaneously. But retail
sales are only a small part of the modern economy. Many economic relation-
ships occur over time where the execution of the contract and the payment
do not occur simultaneously. Employment contracts and supply contracts are
obvious examples where execution and payment diverge. These are long-term
contracts – a promise for work later in exchange for payment later. Any pur-
chase agreement that involves after-sales service is a long-term contract too.
Williamson divides the transaction costs associated with long term contract-
ing into ex ante costs – these costs consist of drafting, negotiating, and safe-
guarding the agreement – and ex post costs – the costs of enforcing the terms
of the contractual promise. If courts of law could easily and cheaply resolve
disputes then buyers and sellers would only ever worry about the ex ante costs
of their contract. When courts do not resolve disputes cheaply and easily, then
ex post contractual costs become important. Here Williamson identifies “mala-

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4 The economics of blockchain and cryptocurrency

daption” costs as being a problem. These are costs that occur when, over time,
what was agreed to and what should have been agreed to given actual events
deviate from each other. Even if both parties with hindsight would rather the
contract had different conditions, renegotiation – haggling – to overcome mal-
adaptive activity has costs. Then there are the setup costs of dispute resolution
mechanisms and finally the bonding costs necessary to secure the agreement.
Making the situation all the more complicated Williamson suggests the ex ante
and ex post costs are interdependent and must be addressed simultaneously.
At the heart of Williamson’s model are two behavioural assumptions that
underpin the contracting process: bounded rationality and opportunism.
Bounded rationality is a recognition of the fact that there are limits to human
cognition. Williamson argues that bounded rationality can be manifest in two
ways. First, there are limits to the human brain’s computation power. Second,
people may be unable to express in language the precise nature of the transac-
tion they are contemplating. When these limitations are combined with uncer-
tainty – that is, the inability to accurately and completely forecast the future
– bounded rationality implies that many contracts describing or establishing
exchanges are incomplete. That is, the contracts do not spell out the entirety of
an agreement. It is virtually impossible to write a contract with all the possible
contingencies spelled out. What happens to the terms of a contract if there
is a natural disaster? Or a revolution? Or a medical pandemic? Even if both
parties would prefer to respond to such events in a mutually beneficial way, the
absence of these contingencies in a contract (the contract’s incompleteness)
might make doing so impossible, or require the renegotiation of the contract.
Williamson’s second behavioural constraint is opportunism. Not only
are humans boundedly rational, they are also opportunistic, which he
describes as “self-seeking with guile”. In standard economic theory people
are self-interested and even selfish. But they would not lie, steal, or cheat.
Williamson suggests opportunism goes beyond self-interest and includes, “the
incomplete or distorted disclosure of information, especially to calculated
efforts to mislead, distort, disguise, obfuscate, or otherwise confuse”.
In the absence of bounded rationality and opportunism, contracting is
a trivial task. Even if the only constraint was bounded rationality, individuals
could introduce a “general clause” into their contract promising to make each
other whole in the event of an unexpected deviation from their contract. But
the combination of these two behavioural assumptions creates problems. Once
Williamson adds a third constraint – asset specificity – it becomes clear how
deeply governance, that is, the rules and relationships under which economic
activity is coordinated, is embedded in economic choices.
The notion of asset specificity recognises that mainstream economics makes
strong homogeneity assumptions in its analysis. Assets, however, are often
not homogeneous and cannot be cheaply and easily transferred from one use

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 Institutional cryptoeconomics 5

to another without significant loss of value. The gains from specialisation that
Adam Smith identified means that when firms invest they tend to invest in
particular processes and relationships – investments that cannot be quickly
adapted to alternative processes and uses. For Williamson, this means that
very often specific investments are tied to specific exchanges – equipment
purchased by one firm to satisfy the demands of another firm along the supply
chain. In turn this means that ongoing relationships are valuable. Williamson
identifies four types of asset specificity; site specificity, physical asset speci-
ficity, human capital specificity, and dedicated assets. In the blockchain space
it is the latter two types of specificity that are likely to be decisive.
These constraints – bounded rationality, opportunism and asset specificity
– shape the choices available to economic actors when they come to establish
contractual exchange with each other.

Source:  Adapted from Williamson (1985); Berg, Davidson, and Potts (2019a).

Figure 1.1 Williamson’s contracting processes

Figure 1.1 illustrates the menu of alternatives faced by parties to a potential

contract. The short term contracting process – Williamson calls that “competi-
tion” – more or less corresponds to the standard economic theory of trading or
exchange. If market participants could write a comprehensive contract between
themselves – that is, one that sets out all the contingencies that could possibly
arise and how each party would act following those events – then this is an
opportunity for planning. In this situation maladaption costs never occur and
all the ex post contractual problems do not arise. The only contracting work
required is figuring out what to do, ex ante. These situations are, unsurpris-
ingly, rare. Promise recognises that the costs of writing such a comprehensive
complete contract are prohibitive, but that nonetheless, market participants
can credibly commit to acting in good faith. In the absence of a real threat of
opportunistic behaviour, the counterparties can promise to make each other
whole in the event of unforeseen (that is, uncontracted) occurrences. This
contractual state could still see maladaption costs being incurred, but given
the absence of opportunism, haggling is easy and the contract is easily reset.
But opportunism is rarely absent. The final alternative is what Williamson

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calls “governance”. This is a situation where market transactions (short term

contracts) are subsumed by hierarchies. For Williamson, governance is the
contractual mechanism that manages bounded rationality and opportunism
while dealing with asset specificity. Governance is better read as hierarchy:
the organisations, such as firms and governments, which suppress opportunis-
tic behaviour through ranked authority.
Faced with this menu of choices, it is clear that planning and promises are
rarely viable contracting options. Both bounded rationality and opportunism
are part of the human condition. Williamson sees bounded rationality being
based on the fact that the mind is a scare resource and we lack the precision in
language to agree on exactly what we wish. There seems to be an opportunity
here – bounded rationality seems to be a technical problem that might have
a technical solution. If the mind is a scarce resource then it could be augmented
by artificial intelligence and prediction markets. But bounded rationality
cannot be completely eliminated as it must include uncertainty. The future
is inherently unknown. George Shackle called radical uncertainty “unknowl-
edge” – our inability to firmly predict (and thus plan) which makes the act of
choosing among alternative actions meaningful.
Planning is viable in a world without bounded rationality and uncertainty.
Promise is viable in a world without opportunism. So everywhere we see spot
market exchanges in markets and governance in hierarchical organisations.
Williamson makes the argument that if the parties to a contract can promise
to engage in cooperative behaviour, and the contracts are self-enforcing, then
promises are an efficient mechanism for facilitating trade. So what does it
mean to now have a technology of “trust”?
Distributed ledger technology has been described as being “trustless” (Swan
2015). The proof of work consensus mechanism that Satoshi Nakamoto built
into the original blockchain protocol had this very feature in mind. So-called
“miners” are required to consume (expensive) electricity on (expensive) com-
puters to solve a cryptographic puzzle for the right to create a new block (i.e.
add new information to the blockchain). In return, successful miners earn a fee
paid in newly minted Bitcoin. Precise details vary from blockchain to block-
chain but the principles on proof of work blockchains are more or less similar.
Miners have a clear economic incentive to maintain the integrity of a block-
chain. Berg, Davidson, and Potts (2019a, 2019b) have shown how a proof of
work blockchain can be analysed in a Williamson (1985) framework. Although
Williamson (1993) argued that trust and an absence of opportunism was not
quite the same thing – and we agree – nonetheless, suppression of opportunism
does go some way (perhaps even a long way) to creating a trustworthy trading
environment.
In addition to proof of work protocols, smart contracts also reduce opportun-
ism. The promise of smart contracts is precisely that they are self-enforcing.

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 Institutional cryptoeconomics 7

A smart contract will execute regardless of the presence of opportunism. As

Nick Szabo wrote in 1994, the objectives of smart contract design are not only
to minimise the need for trusted intermediaries but also to lower “fraud loss,
arbitration and enforcement costs, and other transaction costs”. Note that this
does not prevent ex ante opportunism – most dramatically, a contract designer
might conduct fraudulent behaviour while designing the contract – but the
smart contracts suggest that ex post opportunism, the cost of enforcing the
terms of a contract, might decline.
Distributed ledger technology suppresses (some but not all) opportunism
costs. Under the twin conditions of asset specificity and bounded rationality,
this implies that some exchanges that are currently managed through our exist-
ing suite of hierarchical orders such as firms and governments that suppress
opportunism could now occur at a lower cost. Governance is costly, not least
because governors, like managers and bureaucrats, are subject to the same
behavioural constraints as everyone else. Likewise, transactions that cannot
occur on the spot market due to asset specificity but cannot cover the costs of
hierarchy might now be able to occur. Either way, using digital ledger tech-
nology to suppress ex post opportunism could facilitate an increase in trade at
both the extensive and intensive margin. The transaction cost analysis we have
provided here suggests that in an economy characterised by the use of distrib-
uted ledger technology, we can expect more exchanges to be managed through
promise rather than hierarchy. See Berg, Davidson, and Potts, Chapter 9 in this
volume, for more discussion on trust and distributed ledger technology.

4. INSTITUTIONAL CRYPTOECONOMICS

In the Williamson (1985) operationalisation of Coasian transactions cost anal-

ysis, a hierarchical organisation is a method for controlling opportunism in the
presence of bounded rationality and asset specificity. This protection against
opportunism gives rise to the transaction cost efficiency of hierarchies and
relational contracting over markets.
The valuable prospect of distributed ledger technology, when operational-
ised with smart contracts, is precisely to minimise opportunism. Spot market
transactions that are currently priced out of market exchange, but not suffi-
ciently valuable to be incorporated into hierarchies, can now become viable.
We have already seen some of this economic activity occurring in the so-called
sharing economy. It is very likely that more activity will occur in that space
in future. This is revolutionary because it undermines the strong case for the
economic efficiency of hierarchies (which exploits incomplete contracts) and
relational contracting (which requires trust between parties) over markets. To
the extent that opportunism is minimised, distributed ledger technology can
provide a competitive advantage to traditional organisational hierarchies and

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relational contracts. In the late 1980s and early 1990s Thomas Malone made
similar predictions to those we make here (Malone 1987; Malone, Yates, and
Benjamin 1987, 1989; Malone and Rockart 1991). His argument was that
information and communications technology would result in markets displac-
ing hierarchy. Clearly that has not happened to the extent that he had expected.
Berg, Davidson, and Potts (2019b) explain that what Malone’s analysis was
missing was the suppression of opportunism that is provided by distributed
ledger technology.
In the Coasian view, a firm is a “nexus of contracts”, but specifically a nexus
of incomplete contracts (Jensen and Meckling 1976; Williamson 1985; Hart
1989; Hart and Moore 1990). Yet distributed ledger technology implies a par-
ticular class of an economic system made of complete contracts. Smart con-
tracts could be effective ways to load significant numbers of low probability
state-contingencies into contracts. To the extent that these could function like
open source libraries insertable into machine-readable contracts, the complex-
ity cost of writing contracts could scale linearly, and so lower transaction costs.
Distributed ledger technology allows a greater number of complete contracts
to be written and transacted.
That distributed ledger technology is fundamentally an institutional rather
than a technological innovation is not mere semantics. This distinction
matters because it focuses attention on what is actually changing in the
creative-destruction space. What is changing is the technology of economic
coordination and governance. And that means that the relevant margin of
analysis is with substitute mechanisms of economic coordination and govern-
ance. To unpack the relevant margins of governance efficiency that distributed
ledger technology has over firms, markets, networks, relational contracting,
and governments, consider the underlying problem of the economics of effi-
cient governance.
In the new institutional economic analysis, organisational form is largely
shaped by the need to control opportunism (Williamson 1985: 64–67).
Opportunism has a proximate and an ultimate cause. The proximate cause is
the conjoint pay-offs to idiosyncratic investment (asset specificity), a normal
part of all economic production that requires coordination of joint inputs. But
the ultimate cause of opportunism arises because of the intent and ability of
agents to exploit trust. With full rationality, complete information and costless
transactions, all agents can engage in comprehensive contracting, so there is no
need for trust. But if information is imperfect, if transactions are not costless
(i.e. conditions of bounded rationality), then trust operates at the economic
margin of contracting. In this view, distributed ledger technology is a new
mechanism to control opportunism by eliminating the need for trust by using
crypto-enforced execution of agreed contracts through consensus and trans-
parency. Opportunism is eliminated (or, if not entirely eliminated, massively

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 Institutional cryptoeconomics 9

reduced) with distributed autonomous organisations. This extends the domain

of the market and shrinks the domain of organisations.
If the Williamson model of firms and markets is correct, and effective,
cooperative economic activity and investment is stymied by both threats
and engagement of opportunism, then distributed ledger technology has the
potential to be a revolutionary institutional innovation (see Berg, Davidson,
and Potts 2019a, 2019b, and Chapter 9 this volume). If governance exists for
reasons other than opportunism, however, then distributed ledger technologies
may well be a source of productivity growth, but not the institutional revo-
lution argued here. As use cases for distributed ledger technologies come to
market, it will become clearer whether our institutional innovation optimism
is justified.
Alchian and Demsetz (1972) suggest another possible avenue whereby
a governance revolution may unfold at the margin of the economic efficiency
of organisations versus markets. They proposed an alternative transaction
cost theory of the firm that emphasised monitoring costs in team production.
When production is more efficient with shared inputs than non-shared ones, it
may be more efficient to establish sets of agreements that characterise firms
as the team use of inputs plus the centralised position of some party in the
contractual arrangements of all other inputs, than to govern these transactions
using markets. The Alchian and Demsetz model argues for the efficiency of
centralised monitoring – the productivity of inputs and rewarding outputs
is a centralised problem in the absence of markets. What distributed ledger
technology introduces, however, is a new prospect of distributed monitoring,
undermining the main argument for the comparative efficiency of the firm
in the context of the generalised efficiency of production with shared inputs.
The arguments made by Thomas Malone and his various co-authors in the
late 1980s and 1990s apply here. Distributed ledger technology can facilitate
cooperation and coordination in a structure that is neither strictly a market nor
strictly a hierarchy. Berg, Davidson, and Potts (2019a) refer to this as being
a V-form organisation (also see Berg, Davidson, and Potts, Chapter 9 this
volume). In essence, distributed ledger technology is not simply a “trustless”
technology, it is a self-monitoring technology too. In this, as-yet hypothetical,
organisational structure, the monitoring function currently performed by
management is replaced by the operation of smart contracts that execute, or
not as the case may be, in a mechanistic manner. Task A is either performed
to contractual specification and the smart contract executes, or Task A has not
been performed. A lot of management monitoring that effectively reduces to
auditing and compliance would become redundant.
Both the Williamson model of the firm (opportunism) and the Alchian and
Demsetz model of the firm (monitoring) furnish theoretical reasons to expect
that distributed ledger technology may erode the margin of the comparative

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10 The economics of blockchain and cryptocurrency

efficiency of firms. If correct, then new institutional economics furnishes an

analytic framework to consider how the mass adoption of this new technology
might shape the evolution of, as Williamson (1985) framed it, the “economic
institutions of capitalism”.

5. CONCLUSION

Cryptographically secured distributed ledger technology is one of the most

innovative new technologies of the 21st century. While still closely associated
with cryptocurrencies, such as Bitcoin, the underlying technology is widely
seen as a new general-purpose information technology whose disruptive
effect already extends beyond digital money to a broad range of economic and
government activities that rely on consensus of a database of transactions or
records. Yet it is so much more than that. Distributed ledger technology adds
an additional category to the suite of Williamson’s (1985) “economic institu-
tions of capitalism” – namely, markets, hierarchies and relational contracting
– with a new type of economic order. We are very likely to observe a new
form of business organisation emerging in the coming years that suppresses
opportunism at important margins and self-monitors.
One way to think about the long run effect of distributed ledger technology
is that the innovation is neither a source of productivity growth in an insti-
tutionally unchanged economy, nor revolution in which distributed ledger
technology, as governing institutions, replaces firms and markets, but rather
is an evolution of the basic institutions of capitalism, as a new variation that
competes with the existing institutional species. An economy with distributed
ledger technology is institutionally more varied and complex than an economy
without it. From the new institutional economics (i.e. transactions cost) per-
spective, the relevant analytic criterion is comparative institutional efficiency
(Williamson 1979, 1991; North 1990; Ostrom 1990, 2005). The most efficient
institution to coordinate economic activity – cf. markets, hierarchies, relational
contracting, blockchains – is the one that achieves the desired outcome at
lowest transactions costs.
So there are two frontiers on which the extant order of market capitalism
might evolve through the innovation of blockchain technologies. First, the
substitution (reallocation) of economic governance from firms, markets, and
relational contracts into blockchains; as, for instance, when on-chain voting
for capital allocation in a DAO (decentralised autonomous organisation) that is
running a fund replaces committee-based decision-making by a board. Second,
the integration of economic governance into activities not currently within
the modern institutional economy because the transaction cost threshold is
currently too high; as, for instance, when that same DAO is able to integrate
continuous real-time subcontracting of asset allocation advice and implement

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 Institutional cryptoeconomics 11

those strategies and pay contractors. One could imagine a similar dynamic
in the production of media content – where a DAO could replace editorial
decision making, as a substitution of governance, or a blockchain platform
enabling non-fungible tokens (NFTs) could enable producers of media content
to directly sell to a market with all administrative infrastructure related to prop-
erty rights, permissions, royalties and payments coded into the token. Indeed, it
may well be that the long run most significant economic impact of distributed
ledger technology accrues through this latter pathway, as effective economic
institutions are adopted into domains that previously had relatively high cost
or poor governance.
These new governance capabilities have the potential to offer far greater
improvements to total factor productivity and economic welfare than the
mere technological innovations typically considered, such as efficiency gains
in payments settlements, for example. Economic analysis is at risk of funda-
mentally misunderstanding the long-run consequences of distributed ledger
technology unless it clearly grasps that this is a technology that revolutionises
governance – it is an institutional technology more like “the invention of the
joint stock company” than “the invention of the internet”. Distributed ledger
technology is not just a new information and communications technology, but
more fundamentally supports a new mode of governance that competes with
other economic institutions of capitalism, namely firms, markets, networks,
relational contracting, and governments.

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