Cryptocurrency, Decentralized Finance, and the

Evolution of Exchange: A Transaction Costs Approach

Abstract
We leverage a transaction costs narrative to provide a theoretically unified presentation of the
evolution of exchange, with the latest evolutionary frontier being cryptocurrency and decen-
tralized finance. We show that with each new development in the evolution of money, the new
form or medium of exchange must reduce transaction costs relative to relevant alternatives.
The development of blockchain and cryptocurrency reduced the cost of transfering currency
by removing the need for a trusted third party to intermediate funds while also providing the
benefit of anonymity/pseudonymity. Likewise, decentralized finance does not require a third
party to intermediate savings and investment and can provide contingent anonymity to bor-
rowers. While these innovations have attracted investment in the economically developed world,
they appear to have significantly reduced transaction costs for transactors who might other-
wise be defrauded of funds by corrupt governments that extort third parties responsible for
intermediating funds.

JEL Codes: E42, E51, G21

AIER Sound Money Project

∗
Department of Agribusiness and Applied Economics, North Dakota State Univer-
[email protected]
†
Department of Accounting, Economics, and Finance, SUNY Brockport. [email protected]

Electronic copy available at: https://ssrn.com/abstract=3891593

In the canonical presentation of money and its emergence, the adoption of media of exchange
across a network of exchange is supposed to reduce transaction costs: search costs, storage
costs, transportation costs, and costs owing to a lack of divisibility of the goods being ex-
changed (Menger 1871; 1885; 1892; Kiyotaki and Wright 1992). So long as adoption of a
commodity as a commonly accepted medium of exchange is expected to succeed in reducing
transaction costs sufficiently to allow economic actors to attain the resources required for
economic activity or survival, a commonly accepted medium of exchange will tend to be
adopted.
While ahistorical in its literal sense, Menger’s causal-genetic narrative of the evolution
of money is a valuable starting point for two reasons: (1) It recognizes the significance of
piecemeal changes guided by the discovery of profits. And (2) these profits are made possible
by falling transaction costs. Growing profits incentivize actors to continue the behavior that
generated the profit and sensing entrepreneurs to copy and develop the behavior of those
who are earning relatively higher profits (Bikchandi, et al, 1998).
The latest frontier in monetary evolution includes growing adoption of cryptocurrency
for exchange and, increasingly, for financing. Unique to digital money, both direct payments
and financial intermediation occur without requiring a trusted third party to intermediate
exchange. For a mature system of cryptocurrency and cryptofinance, the removal or repo-
sitioning of third parties that facilitate exchange and financial intermediation potentiates a
significant reduction of transaction costs.
In what follows, we leverage the transaction costs narrative to unify an account of the
evolution of monetary exchange and, subsequently, to analyze the past development of money
and consider current and future development of decentralized finance. In doing so, we con-
tribute to two literatures. First, our framework resolves tension with regard to the debate
between followers of the Mengerian story of monetary evolution and those who conceive of
money arising through local custom such as gift exchange. Second, and the focus of this ar-

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ticle, the framework integrates our understanding of the evolution of cryptocurrency within
the broader context of monetary evolution as illuminated by transaction cost economics.

2 Transaction Costs and the Evolution of Exchange

Over the past several decades, there has been a growing recognition that money serves to
reduce transaction costs and that the evolutionary trajectory of money is tied intimately
to the transaction costs that it reduces (Hicks 1935; Coase 1937; Alchian 1977; Selgin and
White 1987; Allen 1999; Baird 2000; Stenkula 2003). Evolutionary approaches consider the
significance of fixed costs that might inhibit adoption of a monetary system that lowers the
marginal cost of exchange (Hodgson 1992; Harwick 2018).
Enforcement costs very often prevent exchanges from occurring. For example, North
and Thomas (1973) have identified that production in early medieval Europe was largely
contained within the manor, which was a village or, at best, a small collection of villages
overseen by a lord “who was expected to defend the village and to administer the customary
law.” Without an overarching institution to enforce agreements, vulnerability to opportunism
associated with finite games – e.g., one time exchange between essentially anonymous actors
– necessarily prevents exchange and, more broadly, peaceful interaction with those outside
the community. That is, there might be a significant level of trade between villages within
a manor headed by a single sovereign, but trade between manors and certainly between
kingdoms was limited owing to low trust that accompanied low levels of familiarity between
citizens of distinct principalities.
Exchange institutions can be categorized by the level and type of transaction costs. The
marginal cost of exchange – that is, the costs incurred by making one exchange beyond the
cost of the good itself – is at its lowest when there exist no transaction costs, for example, of
finding a trading partner, agreeing to the terms of exchange, and enforcing those terms even
after the exchange is completed. In medieval society, along with many premodern societies

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organized traditionally, the organization of economic activity strictly within a given manor
approximated the game theoretic setting of no transaction costs and infinite play, albeit at
a limited scale. A high level of familiarity, along with small scale, enabled non-monetary
exchange, including taxes paid in kind.
While the search costs of in-kind barter are too high to feasibly organize economic pro-
vision at any scale, goods and services can be acquired through time separated exchange
when actors are familiar with one another and expect that exchange relations will continue
indefinitely. While money was not entirely absent in the medieval economy, it often was not
necessary, especially prior to the revival of trade in the 12th century. This meant that the do-
main of economic activity was typically limited to being between denizens of a given manner.
Enmeshed as they were in a network of personal loyalty ties, actors in the economy were ex-
posed to minimal risk of opportunism, and the stereotyping of economic production coherent
with demands of cooperating parties reduced or eliminated other transaction costs. Repeated
interaction with local actors eliminates search costs, limits transportation and storage costs,
and reduces difficulties that would otherwise arise from a lack of divisibility since producers
can plan for exchanges amongst one another. Further, the network of personal obligations
reduces the transaction costs of time separated exchange, namely the possibility neglect of
one’s obligations encourages like response. Since play occurs within an infinite game, actors
are better able to plan for lost future value that occur due to a failure to repay favors and
other previous time separated transactions. Since the manor was a network of overlapping
contracts, play in one game affected play in another. Even if an actor believed that defection
would generate greater gains than would future interaction with a particular trading partner,
this decision must also anticipate changing payoffs in other ongoing relationships. Failure to
discharge obligations might capitulate one’s ejection from the network of exchange.

Transaction Costs No Transaction Costs

Finite Always Defect Always Cooperate

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 Table 1: Equilibrium exchange strategies

As soon as we leave the manor and step into larger-scale impersonal networks, gains from
trade become less certain. Actors are essentially strangers to one another and lack normative
leverage. Absent any overarching institutions with the power to make binding obligations
from both actors, the actors essentially interact in anarchy and are at risk of falling to
violence or cunning from other parties (Buchanan 1975; Caton 2020). To minimize these
costs, exchange will more likely occur between parties that are familiar within one another,
in contexts with normative leverage, for example, extended kin networks (North 1990). This
moves interaction from finitely the finitely repeated game of an institutionless context to an
infinitely repeated game subject to the norms of kin and institutions made accessible by the
kinship network at relative low cost.
The four kinds of transaction costs identified with the emergence of money – costs from
search, storage, transportation, and divisibility – begin to impinge upon gains from trade
when not wholly contained within a given community. Here, the traditional Mengerian nar-
rative become increasingly relevant. Outside of a network of personalistic obligations, actors
face increasing uncertainty concerning with whom they can profitably trade. Development
of a money commodity plays an important role in reducing this uncertainty as it increases
the likelihood of finding a stranger who will be willing to trade. While money does not solve
all problems associated with trade outside of the manor, it is an integral part of the solu-
tion to the dilemmas arising from trade that stretches beyond a particular community and,
ultimately, that enables specialization and innovation.
With the transaction costs of in-kind exchange rising rapidly with scale, producers are
incentivized to incur the fixed costs that lead to monetary exchange. As Menger identi-
fies, those engaged in commercial activity will seek to acquire a marketable commodity for
exchange. Attributes that promote a commodity’s salability include storability, divisibility,
portability, and scarcity. Historically, precious metals were adopted as commodities that
efficiently facilitated exchange where barter relations proved too costly.

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2.1 Financial Intermediation

Robust financial markets, a hallmark of the modern capitalist economy, enable the transfer of
idle capital from capital owners to entrepreneurs. The development of one or a small number
of commodities that intermediate exchange significantly reduces the transaction costs of
lending. No longer must loans be in-kind. Instead, fungible wealth in the form of a monetary
commodity can be lent. Even with transaction costs reduced however, other barriers remain.
Compared to spot monetary exchange, intertemporal exchange outside a network of personal
obligations also raises questions of enforcement and expectations. Often a borrower will be
either unable or unwilling to repay his debt, a risk that must be recouped through higher
interest rates in order for the lender to lend (Figure 1). For example, imagine that 1 out
of 10 borrowers defaults in full on a loan with no means of repayment. For the lender, this
amounts to a loss of 10% of invested funds. Suppose that the investor will only invest if he
can earn a net rate of return r. In a world with a positive rate of default, a risk premium,
δ, is added to the rate of interest, r, to make equal the expected return with the return that
would be earned in a risk free world. This return would be equal to the interest rate if 100%
of borrowers repaid their debt:
.9(1 + r + δ) = 1 + r
.9 + .9r + .9δ = 1 + r
.9δ = .1(1 + r)
1+r
δ= 9

In a world where the risk of default is 10%, in order to incur no accounting loss, the lender
1
must charge a risk premium, δ, of 9
of the principal. We may generalize by representing the
risk of default as λ1 :
1

(1 − λ)(1 + r + δ) = (1 + r)
1+r
1 + r + δ = 1−λ
(1+r)−(1−λ)(1+r)
δ= 1−λ
(1+r)−(1−λ+r−rλ)
δ= 1−λ
λ+rλ
δ= 1−λ

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 λ
(1) δ= (1 + r)
1−λ

We present combinations of r, λ, and δ implied by this equation in Figure 1.

Figure 1: The color on the r-λ plane matches the δ value for a given coordinate pair r-δ;
contour lines on the same plane identify coordinates of a give δ value; lines projected on
the r-δ plane reflect the δ value of slices parallel to that plane at given intersection of the
λ-axis; the shaded region that parallels in the δ-λ plane represent the height of the slice of
the 3-dimensional surface that parallels the r-axis.
λ
δ= (1−λ) (1 + r)

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 Just as monetary exchange requires a saleable commodity that lowers transaction costs,
so too financial development requires efficient means of collecting relevant information about
a borrower and for enforcing the terms of a loan. Without a means of mitigating this risk,
lending cannot take off (Phelan 1995; Sanches 2011; Harwick and Caton 2020). As with barter
exchange, financial markets can only succeed where the lender expects that the borrower will
not abscond with funds. An established business that engages numerous clients and vendors,
for example – one with something to lose – will be a more dependable borrower than a
non-institutional party who experiences significantly fewer benefits from repayment and,
therefore, receives relatively greater value from absconding.
However, absconding is not the only cause for default. Honest default might occur if the
borrower is 1) undercollateralized and/or 2) his or her market of operation experiences a
negative demand or supply shock. Hodgson (2016) observes that financial development in
England following the Glorious Revolution immediately benefited the state and only over
several decades did this benefit expand to private borrowers. Part of the reason for this was
that wealth derived from land, the most significant source of collateral, was often constrained
by “entails [that] enforced primogeniture, ensuring that a landed estate passed from one
generation to another through the eldest son (2016, 86).” Although these were restricted by
court order in 1614, “these were replaced by voluntary and widespread ‘strict settlements’
that had similar effects” (2016, 86).
Financiers have historically had tenuous relationships with states. Although states do not
suffer from the problem of a lack of identifying information, pre-modern states do suffer from
an ability form a credible commitment. Growing autonomy of English parliament after the
Restoration in 1660 increased confidence of lenders in the states willingness and ability to
repay its debts, especially after the Glorious Revolution in 1688. Transaction costs that had
limited financial activity were greatly reduced both by the credibility of the English state
and the expanded scale of the market that it made possible, and English finance, both public
and private, experienced unprecedented growth over the next century (North and Weingast

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1989).
While we do not suggest that every country must follow precisely the path followed by
late and post-Stuart England in order to develop robust financial markets, the case does
suggest that the reduction of transaction costs is a key prerequisite. In turn, these financial
markets reduce transaction costs involved in transferring wealth from savers to entrepreneurs,
an important ingredient in economic growth.
Finally, the wave of financial innovation in the latter half of the twentieth century was
also driven by the reduction of transaction costs (Miller 1986). In most cases, these costs
were the result of regulations and taxes that increase the marginal cost of investment. In
particular, Regulation Q prevented payment of interest on checking accounts and capped
interest payments on savings deposit accounts. The initial interruption to the market by
this regulation was limited. In the decades following its implementation in 1933. But as
the rate of inflation began rising in the 1960s and 1970s, investors began seeking higher
returns to help offset this inflation. The euro-dollar market emerged as a means of providing
high interest bearing savings accounts. For account holders, these accounts acted much as a
standard deposit account. Their structure, however, was different. A multinational financial
firm could lend funds internally, allowing deposited dollars to support and benefit from
lending in European countries lacking a similar regulation (Friedman 1969; Rugman 1981;
Glasner 1989; Willmarth 2018). Legally, Regulation Q could not be applied to these accounts.
By avoiding the regulation, saved funds could flow to higher yielding investments while
maintaining a high level of liquidity for the account holder. Higher liquidity entails lower
transaction costs of converting the investment to cash for a given rate of return. As in the
English example, lower-cost intermediation ultimately translates to a higher level of resources
invested in productive activity.

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3 Cryptocurrency and Financial Intermediation

The transaction costs approach to the evolution of money helps to frame our understanding
of impediments to the development of cryptocurrency and decentralized finance, as well as
the potential impact of these technologies on economic organization. Just as we have provided
a sketch of the evolution of money and credit, we now move to the development of digital
money and decentralized finance.
Blockchain technology can serve to greatly reduce 1) the cost of transferring funds elec-
tronically and 2) the cost of lending funds. In the first case, either miners of cryptocurrency
are compensated for the service they provide, or a third party that supports the blockchain is
by some means compensated. For the latter case we observe, for example, Ripple attracting
funds through regular offerings of XRP, in addition to the charging of funds for transfer of
other assets recognized on the Ripple ledger. In either case the cost of performing large trans-
fers of currency can be significantly reduced. Public blockchains may also offer the additional
feature of anonymity. In the case of Bitcoin, for example, users are actually pseudonymous
since. Further, transaction records are public, but not necessarily linked to a persistent
real-world identity. Other cryptocurrencies like Zcash are truly anonymous and prevent the
history of a given unit of cryptocurrency from being monitored. While officials such as U.S.
Treasury Secretary Janet Yellen are concerned that this feature attracts those engaged in
nefarious activities, this feature also adds value for users living under governments where of-
ficials would otherwise be able to arbitrarily confiscate one’s wealth or prevent transactions
from being supported by the traditional financial sector. Whether an actor’s motives are
nefarious or noble, existing and potential impediments to transactions are being reduced.2
It is this reduction in transaction costs that allow struggling economies to grow and growing
economies to flourish.
Second, blockchain protocols that allow for financial intermediation can reduce transac-
2
It is possible that transaction costs are increased on some margins, but in order for a technology to be
widely adopted, it must lower costs on net.

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tion costs with regard to lending. And, as with transfer of cryptocurrency, these systems can
enable a modest degree of privacy. We have shown, and will review here, how decentralized
finance can be made incentive compatible (Harwick and Caton 2020). And further, we will
show that with the appropriate protocol, along with access by that protocol to information
from the traditional financial sector, blockchain technology can facilitate lending without
granting access of otherwise private information to a human third party.

3.1 Digital Money

While transferring money between users seems like an obvious application of computing
technology, the incentive to manipulate accounts contained in a digital ledger posed an ob-
stacle for many years following the widespread adoption of the internet. The problems is not
so simple as debiting one agent’s account and crediting another. The reader could accom-
plish this end in an excel spreadsheet or develop a program that systematically implements
transaction. Two problems obstructed the development of digital money: 1) anyone other
than the owner of an account must be prevented from transferring funds from that account
or granting another other user the right to transfer some defined amount of funds, and 2)
anyone with access to an account must be prevented from double promising funds from that
account. For decades these problems were thought to necessitate a trusted third party to
administer the ledger, and indeed such trusted ledger-operators arose early in the history of
the internet. But it was not until 2009, with the advent of Bitcoin, that a fully decentralized
practical solution was developed and implemented.
The first problem can be solved using cryptographic methods that are also used to sup-
port blockchain protocols. Accounts are made secure by preventing access unless a required
password is provided. To prevent hackers from gaining access to passwords in the event that
the one successfully hacks a password database, the passwords are hashed, meaning that they
are transformed algorithmically into an output of a fixed number of characters that appear
to be random. The transformation is irreversible, so the password can only be revealed by

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use of brute force methods. Since this is a costly means of revealing a password, a vigilant
user will almost surely be able to change his or her password before a hacker discovers it and
access their account.
The second problem generalizes to what is known as the Byzantine Generals problem, so-
called because of the difficulty of prioritizing signals coming from multiple sources. This prob-
lem is more difficult to prevent decentrally, particularly if users want to maintain anonymity.
Before the development of blockchain technology, financial firms solved this problem the
same way they solved the other: a trusted third-party ledger operator, whose priority over
other signals is “baked in” to institutional protocol. The user provides information that al-
lows an intermediary like PayPal to access and transfer funds to another user. Since double
promising funds would expose PayPal to both loss of consumer trust and legal liability, it
is not incentivized to abuse its control over the ledger. If a user wanted to transfer funds
directly without any 3rd party intermediary, he or she was required to trust the payee with
information enabling access to funds held by a financial institution.
One intermediate system for dealing with double-spending was the development of serial
numbers attached to digital currency. Transaction of a currency unit that has attached to it
a serial number can be tracked, thus enabling monitoring that could prevent double spending
(Narayanan, et al., 2016; Antonopoulos 2017). To be useful, this requires that the identity of
a double spender be linked to expenditure records, leaving no possibility of for anonymity.
Blockchain technology enables money transactions to include anonymity while requiring
no third party to oversee the transaction. In a sense, the blockchain is the third party. A
blockchain provides a public record of transaction that can only be modified if a minimum
level of consensus is reached among miners or a class of nodes with voting rights. By now,
those interested have likely read numerous descriptions concerning blockchains and money
transfers, so we will here concentrate on the reduction of the cost of money transfer as well
as costs associated with revealing one’s identity in the course of a financial transaction.
The expectation that blockchain will succeed in generating value – likely a consequence of

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its ability to reduce transaction costs – has attracted tremendous attention from investors. As
of July 14, 2021, total capitalization of cryptocurrency markets stood at $1.35 Trillion.3 To
put this in perspective, U.S. GDP was just less than $21 trillion in 2020. With good reason, a
tremendous amount of resources has been invested in blockchain and cryptocurrencies. Even
without anonymity, blockchain can greatly reduce the costs of money transfers by eliminating
the need for third party oversight of financial transactions.
The structure of blockchain transactions differs from traditional payments in that the
transaction costs (in terms of fees) are constant with the amount of value transferred. Thus,
while the Bitcoin blockchain does not provide an efficient means of making small transfers,
large transfers can be made at significantly lower proportional cost than in traditional finan-
cial systems. This daily average transfer fee is commonly less than $10. Similarly, XRP, the
native cryptocurrency on the Ripple blockchain, can typically be transferred for less than
one cent and often, the fee is a small fraction of that value.4 Transaction cost reductions
also occur in the form of time. Whereas traditional ACH money transfers can be measured
in hours and days, cryptocurrency transactions take only as long as is required to approve a
new block. On average the bitcoin blockchain adds a new block every 10 minutes. Lakkakula,
Bullock, and Wilson (2020) find that use of blockchain to track shipments and procure the
transfer of funds reduced time costs by 41% (See also Potts 2019; Schmidt and Wagner 2019).
Further, as we will see, the ability of blockchain to reduce transaction costs is not limited to
only direct exchange of money and goods.

3.2 Anonymity and Decentralized Finance

Anonymity is also a factor in certain transaction costs of exchange. Just as the development
of new financial instruments in the second half of the 20th century helped investors to
avoid certain regulatory and tax costs, anonymity and lack of a third party facilitator that
can be easily regulated by the state can help borrowers and lenders avoid similar costs.
3
https://coinmarketcap.com/
4
https://bitinfocharts.com/comparison/transactionfees-btc-xrp.html3y

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While this is often portrayed by government officials as an attractor for nefarious activity,
transactors in underdeveloped countries that suffer from unstable regimes of governance
stand to greatly benefit. Not coincidently, there has been an explosion of cryptocurrency
adoption and development in African countries. This has been preceded by adoption of
mobile money, for example M-PESA in Kenya, that has greatly reduced the transaction costs
for African vendors (Burns 2018). Likewise, exchanges supporting cryptocurrency transfers
are appearing across Africa. In particular, BitPesa combines the attractive feature of money
transfers supported by M-PESA with Bitcoin (Burns Forthcoming). Users can transfer their
locally denominated funds in the form of Bitcoin. While no medium is perfectly safe, the
costs of confiscating wealth in the form of cryptocurrency is much higher for state actors,
thereby providing greater security for vendors who might otherwise be extorted by state
actors.
The adoption of cryptocurrency in the developing world highlights the significance of
context for the transaction cost narrative. While a technological innovation might uniformly
reduce direct transactions costs such as transportation or storage costs, the legal institutions
governing exchange vary widely between regions, especially in the developing world, and
these can impose a variety of artifactual transaction costs. While the computing and internet
revolutions occurred largely in the developed world, lower-fixed-cost wireless communication
technologies have enabled the latest technological wave to profoundly impact areas that are
relatively impoverished and lack stable governance institutions. Thus, the transaction cost
story demands concern not simply for technical features of the transactions in question,
but also – importantly – for local circumstances and heterogeneities that similarly attracted
attention by those engaged in the convergence controversy (Romer 1993; 1994). We consider
this subject further in closing.
The transaction cost narrative of monetary evolution culminates in decentralized finance.
We begin with the basic question: how can funds be intermediated between anonymous
borrowers and lenders without the market unravelling?

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 Consider first the contrast to spot exchange of goods for cryptocurrency. If a user provides
cryptocurrency to a vendor for some good, there is little reason to be concerned about the
buyer’s identity. Buyers, on the other hand, will likely prefer to transact with a respectable
vendor, so there is little reason to worry about poor behavior on the seller’s part. The one-
time transaction is self-enforcing, meaning that the vendor is incentivized to provide the
good as identified in the exchange contract and the buyer need only to provide funds to
receive the good.
By contrast, consider now real-world financial transactions without cryptocurrency. In
our discussion of the early development of finance, we noted that the lender takes a significant
risk in placing trusted resources by the hands of the borrowers. Lenders attempt to offset
losses from default and reduce the likelihood of default. If the lender only offsets losses from
default by charging a risk premium, the level of lending will be severely constrained. A better
solution is to gather relevant information about the borrower ex ante that reduces the ex
post cost of enforcement of contract terms.
Harwick and Caton (2020) suggest that the lender invest resources in investigating the
borrower. If the lender has reason to think that the borrowers is likely to default, he might
simply deny a loan to the borrower in order to avoid this cost and limit the premium that
he charges to borrowers that he perceives as reliable (see Figure 1). The lender can make
such an evaluation by judging whether or not the borrower is affiliated with a commercial
network. In the modern era this appears in the form of a credit check. This system integrates
the borrower into a long-run, or infinitely repeated, game and reduces the transactions costs.
At a time when information was not so easily available, lending might be limited to
respectable businesses with a proven track record of performance and repayment of debts.
Similarly, a regional credit union could leverage local information and relationships when
making financial decisions. “The principal advantage small lending institutions have in pro-
viding credit to SMEs is in alleviating information asymmetries. . . ” that plagues intermedi-
ation by larger institutions. Credit unions can take advantage “of ‘soft’ information, as small

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institutions are better suited to relationship-based lending than large institutions” (Talbot,
et al. 2015, 116).
In both cases, lenders rely on institutional solutions to incentivize repayment. A borrower
risks his credit score in addition to any collateral offered to secure a given loan. In the case of
a loan with a credit union, the borrower also risks his local reputation. The entrepreneur and
his business operate within a nexus of a community and its formal and informal institutions.
Failure to repay a loan, particularly if due to negligence or intentional fraud, would earn
that entrepreneur a demerit that harms local relationships upon which the livelihood of
the entrepreneur depends. In both cases, incentive compatibility depends on the impact of
default or repayment upon the ability of the entrepreneur to bring current plans to fulfillment
in the approaching future. Availability of such information to a lender lowers the risks and
therefore the marginal cost of lending, and increases the total amount of lending.
The lack of connection to real-world identity hobbles decentralized finance at exactly this
point. The cost of accessing information about a pseudonymous borrower is prohibitively
high. Even if information is available about financial activity conducted by a pseudonymous
actor, if identity is alienable – that is, if nothing prevents the borrower from exiting the
network and rejoining with a clean slate – the lender has no recourse against opportunistic
borrowers. The risk of default is sufficient to prevent uncollateralized lending altogether. And
even with collateral, the level of collateral required to make repayment incentive compatible
is often greater than the value of the loan itself (Harwick and Caton 2020). Alienable identity
reduces interaction to finite play with positive and significant transaction costs.
Oracles present a solution to this dilemma. An oracle is a protocol that can securely
provide external information to a blockchain. For the purpose of decentralized finance, this
information may relay the creditworthiness of the borrower to the lender without simulta-
neously revealing the identity of that borrower so long as the loan is repaid, if the oracle is
backed by a mutually trusted party. Information can be drawn from the traditional financial
sector. This contingent anonymity allows decentralized financial applications to lower trans-

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action costs by providing only the information that is required to indicate the soundness of a
given loan. Whereas information and enforcement costs are essentially infinite in the case of
perfect anonymity, these costs are greatly reduced in the case of default since the oracle will
automatically reveal identifying information to the lender. Thus, the borrower cannot simply
start anew if he or she absconds with borrowed funds. Play moves from a finitely repeated
game to an infinitely repeated game since, with identity as collateral, the stake expands from
the borrower-lender relationship to any future interaction with members of and institutions
comprising the financial system by the borrower.
The result is that decentralized finance applications can simultaneously reduce costs
for borrowers who would like to maintain a private identity and centralization of control
over their funds will also reducing enforcement costs for lenders. As with the development of
mobile money and cryptocurrency applications in African countries, borrowers who otherwise
would face much risk owing to institutional uncertainty face a better chance of receiving a
loan and ensuring that such wealth is not seized by the domestic government. The reduction
of enforcement costs for the lender increases the likelihood of repayment.

4 The Future: Falling Transaction Costs, Monetary Sta-

bility, and Financial Exclusion

Coase (1937) argued that firms exist because they reduce the cost of accessing resources
as compared to accessing them in the market place. Innovations, he notes, may further
reduce the cost of organizing resources within a firm. Coase (1960) followed up on this
intuition, showing that positive transaction costs negatively impact economic efficiency. In
particular, clear definition and efficient enforcement of property decrease transaction costs
and improve the ability of entrepreneurs to form accurate expectations of future states of
the world. Blockchain technology in general, and cryptocurrency and decentralized finance
in particular, stand to improve economic performance on both of these margins.

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 As transaction costs fall, investments that were once strictly unprofitable become prof-
itable. This is true for every stage of economic evolution, including those recapitulated here.
But the developments of cryptocurrency, blockchain technology, and decentralized finance
are unique in how they affect transaction costs. The effects of previous innovations have
tended to be limited by the ability to accumulate and integrate new technology into a local
economy governed by an existing institutional framework. Cryptocurrency and decentralized
finance are emerging in a world where modern communication technologies that they require
have been adopted across much of the developing world.
Blockchain is an institutional technology (Berg et al., 2019) with diverse applications.
Even within the narrower confines of financial applications, blockchain technology can trans-
form existing institutions and provide substitutes for existing institutions. There is growing
interest for cryptocurrency to serve as commonly accepted media of exchange in developing
countries. For example, the President of El Salvador has signed into law a bill that makes
Bitcoin legal tender in the country.5 Use and ownership of cryptocurrency in many develop-
ing countries is on the rise.6 Whether due to direct adoption or the existence of competing
currencies, these developments bode well for countries that have suffered from monetary
mismanagement.
It is exactly these most impoverished areas that stand to gain most from the integra-
tion of blockchain and cryptocurrency with existing financial systems. The 1980s and 1990s
were a failure for national income convergence, a failure that brought into focus concern
on discrepancies in institutions, productive technology, and human capital between nations
(Mankiw et al., 1992). For a variety of reasons, the usual prescription of opening up a country
to foreign investment, and thus to the importation of technology and human capital (Romer
1994), was not always a politically feasible strategy. In particular, dysfunctional institutions
that failed to protect property rights of investors discouraged this sort of investment, and
5
https://www.newsamericasnow.com/latin-america-news-bitcoin-on-the-rise-thanks-to-mexico-and-el-
salvador/
6
https://www.statista.com/chart/18345/crypto-currency-adoption/

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there is no formulaic path to improving dysfunctional institutions (Acemoglu 2003). While
in hindsight one might develop a convincing narrative concerning why governing institutions
developed in the manner that they have, if there is a formula for good institutions, it is by
no means a simple one.7 Formal institutions depend upon informal institutions and informal
institutions are difficult to study since they often entail tacit knowledge.8 Even if an infor-
mal institution is well understood, replicating institutions as an end of policy suffers from
interminable incentive and knowledge problems (Coyne 2013).
The security provided by blockchain technology does not depend on the quality of local
institutions. Whether or not other countries adopt Bitcoin as legal tender as did El Salvador
has no bearing on the quantity of Bitcoin produced, nor would this substantively impact the
operation of the consensus algorithm. And while local governing institutions might affect
operations of a business that has taken out a loan in the form of cryptocurrency, corrupt
governments are not likely to be able to confiscate cryptocurrency lent with support of pro-
tocol. While countries like Kenya and Ethiopia have experienced sustained growth for more
than a decade now, it is not difficult to imagine that investment opportunities provided by
decentralized finance will be wind in the sails of countries whose economies struggled to de-
velop during the 20th century. According to the Statista report cited above (n5), over 30% of
Nigerians have owned Bitcoin and as have over 20% of residents of Vietnam and the Philip-
pines. While the extent of the crypto-revolution is not especially obvious in the developed
world, many in developing countries have been the beneficiaries of falling transaction costs.
The benefits of blockchain and cryptocurrency are no mystery to these groups.
In all, cryptocurrency and cryptofinance have the potential to usher in a period of inter-
national financial integration that could only be dreamed of a half-century ago. This new
technology is the latest iteration of cost reducing technologies and is poised to have the most
significant impact in areas that have traditionally suffered from financial exclusion. Much
7
Concerning the constraints of incentive structure on institutional evolution, see Grief (2006); North,
Wallis, and Weingast (2009); Acemoglu and Robinson (2012).
8
See Ostrom (2005) on “rules-in-use”, Searle (2005) on the relation between institutions and beliefs, and
Boettke, Coyne, and Leeson (2008) on role of local knowledge.

18
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remains to be said concerning the impact of blockchain more generally on economic devel-
opment and organization in the form of supply chain integration and the changing nature
of the firm, however, this is beyond the focus of the present article. We are seeing the first
hints of the impact that cryptocurrency and decentralized finance will have on economic or-
ganization. The transaction costs framework illuminates the significance of this development
and suggests a trajectory of future development.

19
Electronic copy available at: https://ssrn.com/abstract=3891593
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