Martino, Edoardo D; Ringe, W.

Georg

Working Paper
The Social Cost of Blockchain: Externalities, Allocation of
Property Rights, and the Role of the Law

ILE Working Paper Series, No. 80

Provided in Cooperation with:

University of Hamburg, Institute of Law and Economics (ILE)

Suggested Citation: Martino, Edoardo D; Ringe, W. Georg (2024) : The Social Cost of Blockchain:
Externalities, Allocation of Property Rights, and the Role of the Law, ILE Working Paper Series, No.
80, University of Hamburg, Institute of Law and Economics (ILE), Hamburg

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 INSTITUTE OF LAW AND ECONOMICS
WORKING PAPER SERIES

THE SOCIAL COST OF BLOCKCHAIN

Externalities, Allocation of Property Rights, and the Role of the
Law

Edoardo D Martino
W. Georg Ringe

Working Paper 2024 No. 80

May 2024

Photo by UHH/RRZ/Mentz

NOTE: ILE working papers are circulated for discussion and comment purposes.
They have not been peer-reviewed.
© 2023 by the authors. All rights reserved.
 THE SOCIAL COST OF BLOCKCHAIN
Externalities, Allocation of Property Rights, and the Role of the Law

Edoardo D Martino†; W. Georg Ringe‡

ABSTRACT
In the past decade, the legal and economic literature on blockchain technology
and its applications has flourished. This new technology holds great promise for
enhancing the efficiency of contracting. Building on the classic Coase theorem,
blockchain as a decentralised mechanism of decision-making should be superior
to centralised regulation, possibly yielding substantial efficiency gains. Notably,
it also has the potential to improve the allocation of property rights and reduce
transaction costs.
However, many of these enthusiastic views about what blockchain technology
may bring are overblown. This article demonstrates that blockchain creates a
variety of new externalities, which cannot be addressed by the decentralised
actors using it. The most obvious of them is the environmental externality
stemming from the energy-intensive mining process. In addition, more
immediate externalities emerge, for example through the operational and legal
risks of being part of a blockchain transaction, which are particularly evident in
the crypto economy. Moreover, issues surrounding blockchain governance may
exacerbate these challenges.
In conclusion, we propose several regulatory strategies to mitigate these
shortcomings and harness the full potential of blockchain technology.

Keywords: blockchain technology, Coase theorem, social cost.

JEL Codes: K11; K22; K29

†
Assistant Professor of Law & Economics, University of Amsterdam (UvA), The Netherlands;
Associate Researcher, European Banking Institute (EBI), Frankfurt am Main, Germany.
‡
Professor of Law and Finance; Director of the Institute of Law & Economics, University of
Hamburg; Visiting Professor, University of Oxford.
Many thanks to Simon Gleeson, Gregory Lewkowicz, Bruno Meyerhof Salama, Eva Micheler,
and Thom Wetzer for their valuable comments and insights. A previous version of this paper
was presented at the ‘Center of Law, Economics, and Governance seminar’ at FGV Direito São
Paulo, ‘The Blockchain and Digital Assets Conference’ at HEC Paris, and a Business Law
Workshop at the University of Oxford. Helpful comments of participants are gratefully
acknowledged. The usual disclaimer applies.
 MARTINO & RINGE

I. INTRODUCTION

In the last 10 years or so, there has been an unprecedented surge in interest and
debate surrounding blockchain and distributed ledger technology (DLT) across
various sectors. This discourse involves diverse stakeholders, from tech
disruptors leveraging blockchain applications to traditional players adapting to
its disruptive potential. As regulators and academics grapple with the impacts
this emerging technology, questions regarding its regulatory framework have
become prominent.

The lively academic debate has evolved across several disciplines.1 This article
intends to contribute to the existing literature by adopting an interdisciplinary
perspective, focusing on the role of the law in addressing social costs arising
from blockchain activities. More specifically, this article unpacks the role of the
law when these activities generate negative effects on third parties or, in other
words, when these activities entail social costs.

We propose approaching the interaction between the law and blockchain

technology through the classic framework developed by Professor Ronald H.
Coase in 1960.2 Simply put, Coase posits that decentralised market-based
approaches can outperform centralised regulatory interventions (such as taxes
or regulation) under certain conditions.3 This simple yet elegant idea became

1
See Satoshi Nakamoto, ‘Bitcoin: A Peer-to-Peer Electronic Cash System’
<https://bitcoin.org/en/bitcoin-paper> accessed 22 March 2024. After the Bitcoin Whitepaper,
the technology took off and so did the policy debate and the academic literature. The latter has
developed along many different dimensions. Beyond the computer science and cryptography
literature, huge bodies of literature are developed in, among others, law, economics, finance,
management, accounting, environmental studies and so forth. For a broad overview of the
literature, see Anjee Gorkhali, Ling Li and Asim Shrestha, ‘Blockchain: A Literature Review’
(2020) 7 Journal of Management Analytics 321.
2
Ronald H Coase, ‘The Problem of Social Cost’ (1960) 3 Journal of Law and Economics 1.
3
Arguing against the so-called ‘Pigouvian approach’. Arthur Pigou, The Economics of Welfare
(MacMillan and Co 1920). The emphasis on the ‘centralized’ versus ‘decentralized’ feature of
different approaches to negative externalities is added and foreshadows the appeal of Coase’s
framework to discuss the interplay between the blockchain and the law.

2
 THE SOCIAL COST OF BLOCKCHAIN

known as the “Coase theorem.”4 Coase was awarded the Nobel Memorial Prize
in Economic Sciences in 1991 “for [Coase’s] discovery and clarification of the
significance of transaction costs and property rights for the institutional
structure and functioning of the economy.” The Coase theorem has since been
influential in the analysis of virtually any legal domain.5 Our paper seeks to
extend this analysis to blockchain technology, examining how well it aligns with
Coasean assumptions and the role of the law in maximising its potential.6

We argue in this paper that while blockchain technology holds promise in terms
of increasing the efficiency of entitlement allocation, it does not always adhere
to Coasean assumptions. Accordingly, we contend that the law plays an
indispensable role in enabling blockchain to realise its full potential in
entitlement allocation. Thus, we show that the potential of blockchain
technology in allocating entitlements efficiently can only be fully unleashed
with the support of formal legal institutions. In this regard, the law is not only a
tool to limit the possible abuses or misbehaviours of parties acting in the crypto
economy, but it also represents an essential and enabling feature of such an
economy.

The article is structured as follows: Part II establishes the connection between

blockchain technology and the Coase theorem; Part III re-evaluates the promise
of blockchain in terms of entitlement allocation; Part IV examines the social
costs inherent in the blockchain economy and explains why on-chain solutions
may fall short in addressing them; Part V, building on the analytical framework

4
Coase never formulated a theorem and was always very reluctant to do so. What is called the
“Coase theorem” was formulated by Stigler based on the seminal work of Coase 1960 (n 2). See
George J Stigler, The Theory of Price (4th edn, MacMillan and Co 1966) 113.
5
For a comprehensive survey, see Steven G Medema, ‘The Coase Theorem at Sixty’ (2020) 58
Journal of Economic Literature 1045.
6
Few limited and unsystematic attempts to use Coase for explaining the interplay between the
blockchain technology and the legal framework were already proposed. See Philipp Paech, ‘The
Governance of Blockchain Financial Networks’ (2017) 80 Modern Law Review 1073; Roee
Sarel, ‘Property Rights in Cryptocurrencies: A Law and Economics Perspective’ (2020) 22
North Carolina Journal of Law & Technology 389.

3
 MARTINO & RINGE

outlined in Part IV, discusses the pivotal role of the law in unlocking the full
potential of blockchain technology; and Part VI concludes.

II. COASE AND BLOCKCHAIN

The basic Coasean framework represents the idea blueprint to analyse the
economic functioning of blockchain technology and the role of the law therein.
In fact, blockchain aims to efficiently allocate entitlements through a
decentralised process. In the Coasean framework, this guarantees superior
outcomes compared to centralised public policies when it comes to handling
externalities. Crucially, this holds true only under the assumptions of very low
transaction costs and a clear initial allocation of property rights. As long as these
assumptions hold, market participants may exchange property rights, ensuring
that these entitlements are allocated to the party who values them the most,
thereby internalising the externalities. In this scenario, the law is almost
irrelevant, as it merely enforces agreements and provides for an initial allocation
of property rights.7 Specifically, legal arrangements are irrelevant for social
welfare and have only an allocative effect.

However, in his speech upon receiving his Nobel Prize, Coase highlighted that
the main legacy of the theorem would be to provide a framework for analysis in
a world where transaction costs are higher and where the solution to the problem
of social cost largely depends on the legal system.8 In this more refined scenario
depicting more realistically the modern economic system, the role of the law
can be enabling or essential.9

7
In such an idealised framework, any transfer is Pareto optimal. Thus, strictly speaking, the law
is not even relevant for enforcement. In this extreme scenario, the law should only avoid to
prevent the efficient transfer from happening.
8
Ronald H Coase, ‘The Institutional Structure of Production’ (12 September 1991)
<https://www.nobelprize.org/prizes/economic-sciences/1991/coase/lecture/> accessed 22
March 2024.
9
We borrow the terminology from professors Hansmann and Kraakman. Henry Hansmann and
Reinier Kraakman, ‘The Essential Role of Organizational Law’ (2000) 110 Yale LJ 387, 438.

4
 THE SOCIAL COST OF BLOCKCHAIN

The law may play an enabling role in lowering transaction costs and in clearly
allocating property rights.10 This means that pure market transactions would be
unable to allocate rights efficiently, either because transaction costs would be
prohibitive or because of uncertainty regarding the initial allocation of property
rights. In turn, this would result in social costs that private parties could not
internalize. Of note, the law can improve the ability of private parties to contract
around their entitlement, enabling them to reach efficient outcomes and
privately internalise potential social costs.

In contrast, if transaction costs are prohibitively high, the role of the law in
initially allocating property rights becomes essential, as parties would not
otherwise be able to contract around such an initial allocation. Therefore, the
law not only matters with regard to how wealth is allocated, but also in terms of
the amount of wealth that can be generated. In other terms, the law not only
determines how to split the pie, but it also dictates how big the pie is going to
be.11

Translating Coase’s reasoning and adapting it to the technological

characteristics of blockchain, we can analyse instances in which parties, thanks
to blockchain, can allocate entitlements efficiently. This directly follows from
the fact that the assumptions of the Coase theorem mimic the basic premises of
blockchain. The entitlements are exchanged at negligible transaction costs, and
property rights are clearly and perfectly allocated by design in a decentralised,
self-enforceable, and immutable ledger. This position, at least implicitly, is

10
Coase, ‘The Problem of Social Cost’ (n 4) 853. For a recent formal discussion of the matter,
see Carmine Guerriero, ‘Property Rights, Transaction Costs, and the Limits of the Market’
(2023) 24 Economics of Governance 143.
11
Francesco Parisi, ‘Coase Theorem’, New Palgrave Dictionary of Economics (Macmillan Ltd
2008) 859. For a broader discussion on the economic value of law, see Katharina Pistor, ‘The
Value of Law’ (2020) 49 Theory and Society 165.

5
 MARTINO & RINGE

supported by many proponents of the various blockchain technology

applications.12

Should this hold true in all instances, the law would be largely irrelevant, if not
detrimental. Instead, the code would be law, and such code could internalize
negative externalities.13

The original cypherpunk idea of an environment completely detached from, and

alternative to, the traditional legal system is fading, mainly courtesy of several
scandals to have emerged in recent years. Nonetheless, the opinion that the legal
system represents an impediment to the full deployment of blockchain’s
potential is still widespread.14 Consequently, according to this view,
blockchain-specific regulation should shield blockchain activities from the
interference of the legal system rather than addressing the specific social costs
generated by the crypto economy.15

12
Sece, for instance, Sinclair Davidson, Primavera De Filippi and Jason Potts, ‘Economics of
Blockchain’ [2016] Working Paper <https://ssrn.com/abstract=2744751> accessed 22 March
2024.
13
Borrowing from a famous expression from Lawrence Lessig, ‘Code Is Law. On Liberty in
Cyberspace’ (2000) 1 Harvard Magazine.
14
Among many possible examples, a paradigmatic one is offered in a statement by Sam
Bankman-Fried during a congressional hearing in 2021. Bankman-Fried stated that ‘an
appropriate policy framework for market regulation of crypto assets should remain market-
structure neutral and expressly allow non-intermediated markets’. See Committee on Financial
Services, ‘Digital Assets and the Future of Finance: Understanding the Challenges and Benefits
of Financial Innovation in the United States’ (House of Representatives 2021) Congressional
Hearings 117–63 107 <https://www.govinfo.gov/app/details/CHRG-117hhrg46302/CHRG-
117hhrg46302/summary> accessed 22 March 2024.
15
The latest example of this approach is offered by the debate around the liability regime
applicable to a Decentralised Autonomous Organization (DAO). Several court decisions are
sanctioning the unlimited liability of DAO token holders, categorizing these as unlimited
partnerships. See, for instance, United States District Court in Sarcuni v bZx DAO, No 22-cv-
0618 (S.D. Cal. March 27, 2023). Beyond the merit of the claim, these decisions are not seen as
a natural consequence of the ‘rule of law’ holding parties liable for their actions according to
applicable legislation. Rather, this is regarded as an undesirable side-effect of outdated legal
principles. For a wider discussion on this point and on the legal and economic aspects of DAO,
see Oscar Borgogno and Edoardo D Martino, ‘Decentralised Autonomous Organizations:
Targeting the Potential Beyond the Hype’ European Banking Institute Working Paper Series no
161/2024 <https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4692754> accessed 22 March
2024.

6
 THE SOCIAL COST OF BLOCKCHAIN

Our approach enables us to answer fundamental questions regarding the

understanding of the interplay between blockchain and legal institutions. First,
can blockchain technology function as a decentralised technology that allows
for the efficient allocation of entitlements? If, as this article shows, the answer
to this question is negative, and given the specific characteristics of blockchain
technology, two follow-up normative questions arise. First, what should the role
of the law be vis-à-vis blockchain? And, second, what legal tools are desirable
to achieve socially efficient results?

This marks an innovative step in the field, as the analysis in the current literature
too often does little more than reveal the authors’ priors. On the one hand, the
blockchain enthusiasts within the existing literature take for granted that
blockchain is a desirable innovation and focus on the legal and economic issues
that must be ironed out to unlock its full potential.16 On the other hand,
blockchain sceptics challenge the desirability of fully unleashing the potential
of blockchain technology, highlighting possible risks as well as at the substantial
legal and economic hurdles that could impede its widespread adoption.17
Sensible arguments have been presented from both perspectives. However, a
comprehensive law and economics framework for analysis of the issue is
absent.18

16
Among many others, see David Yermack, ‘Corporate Governance and Blockchains’ (2017)
21 Review of Finance 7. For a particularly sharp critique of the enthusiastic takes on Blockchain,
especially in its relationship with the legal system, see Edmund Schuster, ‘Cloud Crypto Land’
(2021) 84 The Modern Law Review 974.
17
Fatjon Kaja, Edoardo D Martino and Alessio M Pacces, ‘FinTech and the Law and Economics
of Disintermediation’ in Iris Chiu and Gudula Deipenbrock (eds), Routledge Handbook of
Financial Technology and Law (Routledge 2021).
18
Some authors have discussed specific aspects using a law and economics perspective. See,
for instance Massimiliano Vatiero, ‘Smart Contracts vs Incomplete Contracts: A Transaction
Cost Economics Viewpoint’ (2022) 46 Computer Law & Security Review 105710; Benito
Arruñada and Luis Garicano, ‘Blockchain: The Birth of Decentralized Governance’ (2018) 1608
Pompeu Fabra University, Economics and Business Working Paper Series
<https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3160070> accessed 22 March 2024.

7
 MARTINO & RINGE

III. THE PROMISES OF BLOCKCHAIN

Blockchain is a technical solution for managing data in a distributed

infrastructure without a central intermediary in a traceable and tamper-proof
manner. It promises to allow verification of transactions (for example, in
payment transactions with cryptocurrencies) trustingly and transparently
without the need for a central authority. In essence, blockchain technology
therefore aims to create an environment where strangers can safely interact
bearing minimal transaction costs.19 Crucially, the consensus-based record
validation that is inherent in the technology is able to eliminate the need for a
trusted intermediary which makes it particularly attractive for applications such
as the management of supply chains and related interactions.20 In addition, the
‘property’ of crypto-assets is immutably recorded on the ledger after the nodes
reach consensus.21 Beyond the technical details as to how blockchain works, it
is clear that the ultimate promise of the technology is to allow all parties to
transact freely at minimal transaction costs, exchanging entitlements until these
are allocated to whoever values them the most.22

In other words, blockchain – and the algorithmic consensus protocol proofing

the validity of the transaction happening there – would represent an institutional
setting that largely satisfies the assumptions on which the Coase theorem is

19
Davidson, De Filippi and Potts (n 12) 9.
20
Christoph G. Schmidt and Stephan M. Wagner, Blockchain and supply chain relations: A
transaction cost theory perspective’ (2019) 25 Journal of Purchasing and Supply Management
100552; Weifeng Chen, ‘A transaction cost perspective on blockchain governance in global
value chains’ (2022) 31 Strategic Change 75.
21
Assets that are cryptographically secured digital representations of value or contractual rights
that use some type of distributed ledger technology (DLT) and can be transferred, stored or
traded electronically. See, for instance, Financial Conduct Authority, ‘Cryptoassets: Our Work’
<https://www.fca.org.uk/firms/cryptoassets> accessed 22 March 2024. In this context, we use
here property in a non-technical way, indicating the possibility control the destiny of the crypto
assets encoded in the chain. On the more technical definition of property rights, properly
defined, in the blockchain see Sarel (n 6); Jason Grant Allen, ‘Cryptoassets in Private Law’ in
Iris HY Chiu and Gudula Deipenbrock (eds), Routledge Handbook of Financial Technology and
Law (Routledge 2021).
22
Some empirical evidence shows how blockchain decreases transaction cost in foreign
exchanges. See Thomas Kim, ‘On the Transaction Cost of Bitcoin’ (2017) 23 Finance Research
Letters 300.

8
 THE SOCIAL COST OF BLOCKCHAIN

built. Implicitly, or even explicitly, the most enthusiastic supporters of

blockchain argue that code is enough to ensure the efficiency and fairness of a
transaction. In other words, code is law.23

If these promises hold true, the role of the traditional legal system becomes
negligible, as there would be no need for institutions such as trusted
intermediaries that allocate property rights, record transactions in a centralised
ledger, or enforce promises. Everything, so its proponents argue, can be done
more efficiently on blockchain.

Notably, in a world where the assumptions of no transaction costs and clear

allocation of entitlements are satisfied, the law would have neither an essential
nor an enabling role. This contrasts with the off-chain world where the law
typically retains an enabling role. In blockchain, holding the assumptions, the
initial allocation of entitlements and the enforcement of transactions can be
better achieved using the technological design of the given blockchain itself.24

As noted above, the extreme claims of blockchain being a radical alternative to

traditional legal systems are fading. However, a recurrent argument posits that
traditional legal systems intrude in blockchain activities, generating unwanted
interactions and undermining the potential of the technology. In this regard, the
debate in the aftermath of the FTX collapse represents a telling case. Many
commentators, especially those active in the blockchain economy, claimed that
the FTX collapse could not be categorised as a ‘crypto failure’ as it was driven
by elements of residual financial centralisation.25 Accordingly, they claim, the
way to ‘save’ the crypto industry would be to go back to its roots, leveraging its

23
On the promises of the blockchain technology, see Samer Hassan and Primavera De Filippi,
‘The Expansion of Algorithmic Governance: From Code is Law to Law is Code’ Field Actions
Science Reports, Special Issue 17/2017, available at
<http://journals.openedition.org/factsreports/4518> accessed 22 March 2024.
24
Aaron Wright and Primavera De Filippi, ‘Decentralized Blockchain Technology and the Rise
of Lex Cryptographia’ [2015] Working Paper
<https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2580664> accessed 22 March 2024.
25
Illia Polosukhin, ‘Crypto Didn’t Fail FTX; People Did’ (CoinDesk, 22 November 2022)
<https://www.coindesk.com/layer2/2022/11/22/crypto-didnt-fail-ftx-people-did/> accessed 22
March 2024.

9
 MARTINO & RINGE

alternative nature compared to traditional finance. In addition, and differently

from the early cypherpunk claim, blockchain activities would have to be
sanctioned by law.26

The factual recognition of the role of residual centralisation in the FTX collapse
has some merit. By and large, FTX can be understood as a rather traditional
Ponzi construction.27 However, that of itself does not justify jumping to the
conclusion that ‘pure’ blockchain activities, fulfilling their promises and being
sanctioned by law, would have averted such a collapse. In fact, looking at the
matter through a Coasean lens, it remains unclear why the parties were unable
to contract around these social costs, thereby internalising them. One possible
and sensible interpretation is that ‘pure’ blockchain solutions, such as the use of
non-custodial wallets and decentralised exchanges, imply significant
transaction costs, preventing the given blockchain from achieving the efficient
allocation of entitlements.28

To gain a firmer grasp of this more nuanced approach, we focus on four

blockchain characteristics: decentralisation; self-enforceability; immutability;
and the need for minimal trust. These characteristics are essential to the creation
of a Coasean environment, where decentralised exchanges generate social
efficiency.

Immutability refers to the property of data stored on a blockchain that cannot be

changed or deleted once recorded and confirmed on the network. This is
supposed to ensure a clear and tamper-resistant allocation of property rights by

26
Mark Edwin Burge, ‘After FTX: Can the Original Bitcoin Use Case Be Saved?’ (2023) 72
University of Kansas Law Review 1.
27
Thomas Conlon, Shaen Corbet and Yang Hu, ‘The Collapse of the FTX Exchange: The End
of Cryptocurrency’s Age of Innocence’ [2023] The British Accounting Review 101277, 11. See
also Joshua Oliver, ‘What crypto (still) gets wrong’ Financial Times (London, 16 March 2024),
Life & Arts 1.
28
Sirio Aramonte, Wenqian Huang and Andreas Schrimpf, ‘DeFi Risks and the Decentralisation
Illusion’ [2021] BIS Quarterly Review 21, 26.

10
 THE SOCIAL COST OF BLOCKCHAIN

providing an unchangeable and trustable ledger of ownership and transactions.

To its supporters, this has the potential to reduce disputes, increase trust, and
simplify the management of property rights in various domains. The concept of
immutability is reinforced through decentralised consensus protocols, such as
Proof of Work (PoW) and Proof of Stake (PoS), adding another layer of security
and trust to the system. The other listed characteristics concern minimising
transaction costs: the lack of a needed central trusted party allows for costly
intermediaries, such as banks and other financial institutions, to be substituted.
The absence of pre-established trust among parties and the self-enforceability
of promises made in a blockchain decrease both ex-ante and ex-post transaction
costs.

However, Coase himself warned of possible Nirvana fallacies here.29 In his

speech upon being awarded his Nobel Prize, Coase discussed stock exchanges,
which are often seen as examples of near-perfect competition. Looking closely
at these marketplaces, one realises how there are several legal layers
determining various aspects such as what can be exchanged, who can participate
in the exchange, and the rules for clearing and settlement.30 Similarly,
blockchain, the consensus protocols, and the various applications characterising
the crypto economy also rely on several technological layers. In our analysis of
blockchain-specific social costs, we discuss four key layers outlined below.

1) The technological characteristics of blockchain, namely decentralisation,

self-enforcement, immutability, and the need for minimal trust, all of which are
key for the assumptions of the Coase theorem to hold.

29
Borrowing from a famous expression in Harold Demsetz, ‘Information and Efficiency:
Another Viewpoint’ (1969) 12 The Journal of Law and Economics 1. (‘The view that now
pervades much public policy economics implicitly presents the relevant choice as between an
ideal norm and an existing “imperfect” institutional arrangement. This nirvana approach differs
considerably from a comparative institution approach in which the relevant choice is between
alternative real institutional arrangements’).
30
Coase, ‘The Institutional Structure of Production’ (n 8).

11
 MARTINO & RINGE

2) The inherently transactional nature of blockchain: the economic activities

carried out in blockchain are, by design, transactional. The simplest illustration
thereof is investing in cryptocurrencies, such as Bitcoin, while acquiring/selling
non-fungible tokens (NFTs) or governance tokens, or entering into smart
contracts are other prevalent examples.

3) The objects of the transaction (e.g. crypto-assets), differentiating between

crypto-assets endogenously created within a blockchain (e.g. cryptocurrencies)
and crypto-assets that are exogeneous representations of a different entitlement
(e.g. a token representing a property right on real estate or a token representing
a voting right in a decentralised autonomous organisation (DAO)).

4) The key players needed for a blockchain, and the transactions therein, to
work. Specifically, these include: custodians and crypto exchanges; issuers of
derivative crypto tokens (in Ethereum and similar protocols); coders (of smart
contracts); significant miners; and core developers. This layer is crucial as it
starts to show how (new and old) intermediaries are necessary for a blockchain
to function as an allocative technology. Going back to our Coasean framework,
these intermediaries entail transaction costs, may cause ambiguity on the
allocation of property rights, and could generate externalities.

The next section aims to decompose the blockchain ecosystem, looking at the
various institutional components that make blockchain transactions possible.
Doing so allows us to critically review the extent to which blockchain represents
a Coasean environment.

IV. THE SOCIAL COST OF BLOCKCHAIN

Looking at the overall blockchain ecosystem, one quickly appreciates that the
promises of blockchain are far from being honoured.

First, it would be delusional to believe that blockchain provides the possibility

of writing perfectly state-contingent contracts through which parties can
privately address the problem of social cost. In other words, blockchain itself is

12
 THE SOCIAL COST OF BLOCKCHAIN

unable to reduce or even eliminate externalities. In reality, there are new

externalities created by this technology. To illustrate that point, blockchain,
specifically with its PoW consensus mechanism, can create a range of
environmental externalities primarily due to its energy-intensive nature. For
example, PoW blockchains require miners to solve complex cryptographic
puzzles through a trial-and-error process. This undertaking demands a
substantial amount of computational power, which, in turn, requires a
significant amount of energy. Moreover, miners use powerful hardware and
compete to be the first to solve puzzles and add a new block to the blockchain.
This competition drives up energy consumption as miners continually increase
their computational power to gain a competitive edge. Beyond pure energy
consumption, blockchain is also associated with the depletion of natural
resources, a high carbon footprint, and the creation of a significant amount of e-
waste as old hardware quickly becomes obsolete.

The alternative PoS validation methodology aims to cure the excessive

environmental externalities inherent to mining.31 However, it is also prone to
weaknesses, especially in terms of entitlement allocation. First, PoS protocols
are less resilient than PoW alternatives in terms of tamper-proofness of
validation.32 Second, and relatedly, validators with large ‘stakable’ holdings can
have a sizeable influence in transaction verification. This is yet another form of
residual power concentration in blockchain technology.33 Third, staking
holdings implies reducing the overall liquidity of the market. This is
contractually accounted for, with additional yields offered to those who are
willing to stake their tokens. However, in times of stress, illiquidity generates

31
For the differences between proof-of-work and proof-of-stake protocols, see Tuyet Duong
and others, ‘Twinscoin: A Cryptocurrency via Proof-of-Work and Proof-of-Stake’,
(Proceedings of the 2nd ACM Workshop on Blockchains, Cryptocurrencies, and Contracts,
2018).
32
Ulysse Pavloff, Yackolley Amoussou-Guenou and Sara Tucci-Piergiovanni, ‘Ethereum
Proof-of-Stake under Scrutiny’ (Proceedings of the 38th ACM/SIGAPP Symposium on Applied
Computing, 2023).
33
See on this below, text to n 51.

13
 MARTINO & RINGE

further systemic externalities which are not captured by inter partes

remuneration for staking.34

Decentralisation is another revealing example in this regard. If it is true that

decentralised consensus protocols allow the ledger to be distributed among
several different nodes throughout the world, it is also true that this does not
equate to the elimination of intermediaries and the related transaction costs.35
The blockchain-related concept of decentralisation concerns the computational
possibility of validating transactions in a peer-to-peer environment, obviating
the Byzantine general problem. The direct transposition of this concept into the
realm of law and economics is unwarranted and potentially generates the
problem of things being lost in translation.36

This ambiguity in the meaning of ‘decentralisation’ is evident if one considers

the ways in which transactions are validated. Under PoW validation, a certain
amount of computing power must be exercised by miners. As the main
blockchains currently used are designed as ‘computationally intensive’
protocols, the mining power tends to be concentrated in the hands of a few
powerful miners that can be effectively seen as ‘new’ intermediaries operating
between the transacting parties.37

Beyond validation, the vast majority of crypto-assets are not simply left in the
blockchain but are deposited in user-friendly wallets. The latter, not being part
of a blockchain, are easier to hack, which has been a consistent problem over

34
This is a well-known mechanism in finance. For a formalisation of the argument, see Arvind
Krishnamurthy, ‘Amplification Mechanisms in Liquidity Crises’ (2010) 2 American Economic
Journal: Macroeconomics 1.
35
Oliver (n 26).
36
Aramonte, Huang and Schrimpf (n 28). On the specific elements of residual centralization of
DeFI application, especially looking at Layer 2 and Layer 3 blockchain applications, see Katrin
Schuler, Ann Sofie Cloots and Fabian Schär, ‘On Defi and On-Chain CeFi: How (Not) to
Regulate Decentralized Finance’ Journal of Financial Regulation, forthcoming 2024 (available
at <https://doi.org/10.1093/jfr/fjad014>).
37
This phenomenon can also lead to a centralization of mining operations in regions with cheap
electricity, which may not always have sustainable or environmentally-friendly energy sources.
See Liana Badea and Mariana Claudia Mungiu-Pupӑzan, ‘The Economic and Environmental
Impact of Bitcoin’ (2021) 9 IEEE Access 48091.

14
 THE SOCIAL COST OF BLOCKCHAIN

the last decade, sometimes to a spectacular degree.38 Needless to say, crypto

wallets and crypto exchanges are picked by the holders of crypto-assets based
on their contractual conditions, as well as on the trust that crypto-asset holders
have in different wallets or exchanges.

Ultimately, consensus protocols are written by coders. The reliability, quality,

and honesty of code cannot be simply assumed, especially at a prospective stage
where the technology is being upscaled and where many users will be fully
ignorant in terms of cryptography and algorithms. This is the case even more
when considering strings of code that can run on ‘naked blockchain’, such as
smart contracts.39

There are numerous other such examples, and one could also consider other
problematic characteristics of blockchain. However, the gist of the argument
here is that blockchain, at least at its current stage of technological development,
merely changes the intermediaries involved, and the need to trust these new
intermediaries persists. This line of reasoning has been reinforced by the several
scandals in the blockchain ecosystem known collectively as the so-called
‘crypto winter.’40

Blockchain does not eliminate transaction costs nor does it get rid of
intermediaries. Instead, it reshuffles them, and often in a less transparent way.

38
In 2014, the largest crypto wallet and crypto exchange in the world, MtGox filed for
bankruptcy after it was hacked. See Matthew Beedham, ‘A Brief History of Mt. Gox, the $3B
Bitcoin Tragedy That Just Won’t End’ (The Next Web, 19 March 2019)
<https://thenextweb.com/news/a-brief-history-of-mt-gox-the-3b-bitcoin-tragedy-that-just-
wont-end> accessed 22 March 2024.
39
The DAO (Decentralised Autonomous Organization) was a smart contract running in
Ethereum. It raised finance through the issuance of DAO tokens, exchanged for ethers. The
DAO should have acter as a venture capital entity where the participants would have voted on
the projects to undertake. The DAO was hacked before the start of its operation. This event
generated an hard-fork where the community split between Ether and Ether Classic. See David
Siegel, ‘Understanding the DAO Attack’ (Coin Desk, 13 January 2023)
<https://www.coindesk.com/learn/understanding-the-dao-attack/> accessed 22 March 2024.
40
Douglas W Arner and others, ‘The Financialization of Crypto: Lessons from FTX and the
Crypto Winter of 2022-2023’ [2023] University of Hong Kong Faculty of Law Research Paper
No. 2023/19 <https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4372516> accessed 22
March 2024. See also Gary B Gorton and Jeffery Zhang, ‘Bank Runs During Crypto Winter’
Harvard Business Law Review, forthcoming.

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 MARTINO & RINGE

If transaction costs are shaken up, one could wonder whether blockchain is able
to privately internalise the social costs (externalities) it generates.

To be fair, we are not claiming that blockchain technology cannot solve certain
societal problems or improve existing market infrastructure, as some of its
critics have argued after the recent scandals.41 Rather, our point is that the initial
and continuing enthusiasm for blockchain as well as the current scepticism
toward it are both misplaced. We contend that blockchain can unleash its
potential as long as it is backed by the law and is intertwined with the law.
According to this view, code is not law nor does it represent an alternative to
legal norms. Instead, it is simply a way of entering into transactions. At the same
time, the law retains its enabling and essential role.

Decomposing the market structure and transaction phases elucidates this very
point.42 Indeed, markets should be understood as multi-layered infrastructures
allowing parties to transact. These are characterised by the price-formation
process, the settlement process, and settlement finality.43 In a textbook market
transaction, these three phases takes simultaneously place in the exchange of a
good against money. However, as the complexity increases, these three phases
become conceptually and practically distinct.

In the crypto world, naked blockchains and layer 1 protocols are settlement
technologies, whereby the settlement is probabilistic and regulated by the
consensus protocol. Meanwhile, layer 2 and layer 3 protocols aim to upscale
this settlement capability, operating as trading venues and facilitating the price-
formation process of various crypto-assets which are not native tokens.
However, distributed ledgers can technically perform only probabilistic

41
See, for instance, Hilary J Allen, ‘Regulating Fintech: A Harm Focused Approach’ (2024) 52
Computer Law & Security Review 105910. For an overview, see Joshua Ellul, ‘Blockchain Is
Dead! Long Live Blockchain!’ (2021) 4 (1) The Journal of The British Blockchain Association
1.
42
Special thanks to Simon Gleeson for pointing out this crucial example.
43
Johannes Rude Jensen and Omri Ross, ‘Settlement with Distributed Ledger Technology’,
(Proceedings of the Forty-First International Conference on Information Systems, India, 2020).

16
 THE SOCIAL COST OF BLOCKCHAIN

settlements of blockchain transactions. This does not allow for legal finality, nor
does it offer the chance to reverse the transaction in all of the instances in which
the law deems necessary (for instance, when the transaction is fraudulent or
concluded under duress).

As previously discussed, Coasean bargaining requires a clear initial allocation

of property rights and negligible transaction costs. Even assuming that
blockchain can actually facilitate price formation through crypto markets and
provide more efficient settlement capability through DLT consensus protocols,
it cannot provide legal finality, which is the key element in ensuring the clear
definition of property rights. Consequently, at the very least, the law should
provide legal finality to blockchain transactions and this not only means
sanctioning the legal validity of such transactions but also includes active
interference in the settlement phase where the transaction needs to be reversed
according to the law.

Conceptually, this is not significantly different from the role of the law in the
off-chain environment. What differs however are the sources of transaction
costs and the clarity of allocation of entitlements as well as the tools and
techniques that the law must use. This clearly runs counter the ideological
imperatives of the initial proponents of blockchain, in the liberal crypto-
anarchist and cypherpunk communities as well as in the more recent
restatements of these types of approach. However, analysis of the transaction
dynamics through a Coasean lens clearly highlights that external interferences
are still necessary to make sure that the social costs associated with blockchain
are efficiently addressed. Consensus protocols, in and of themselves, are unable
to provide an infrastructure that allows transacting parties to internalise
externalities privately through decentralised contracting and allocative
mechanisms.

We categorise externalities generated by blockchain activities according to the

different interactions such activities with third parties. The rationale behind this

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 MARTINO & RINGE

approach is that different types of interaction lead to inherently different

externalities and different failures of a blockchain to internalise such
externalities. Consequently, the role of the law to address these externalities also
differs, as detailed in Section V.

A way of conceptualising the different externalities created by blockchain is to

distinguish them according to the following categories:

a) Indirect interactions with the blockchain: Externalities can be generated

indirectly by the economic activities carried out in the given blockchain. The
simplest example thereof is the environmental externality generated by the
mining process, which is necessary to validate transactions.44 Also of relevance
here is the increase in systemic risk generated by the crypto economy and the
challenges this brings to monetary policy and financial stability.45 Finally, into
this category also fall all instances of money laundering and terrorism financing
courtesy of the anonymity of blockchain.46

b) Direct interactions with the blockchain: Externalities can be generated by

direct interactions between actors carrying out and facilitating crypto activities
and blockchain users. These can arise from different types of risk, including
operational or legal.

The easiest conceptualisation of this type of externalities is the risk of a bug or

a hack, not directly in the naked blockchain but in the layer 2 smart contracts

44
See, for instance, Moritz Wendl, My Hanh Doan and Remmer Sassen, ‘The Environmental
Impact of Cryptocurrencies Using Proof of Work and Proof of Stake Consensus Algorithms: A
Systematic Review’ (2023) 326 Journal of Environmental Management 116530.
45
See, respectively, Edoardo D Martino, ‘Monetary Sovereignty in the Digital Era. The Law &
Macroeconomics of Digital Private Money’ (2024) 52 Computer Law & Security Review
105909; Edoardo D Martino, ‘Regulating Stablecoins as Private Money between Liquidity and
Safety. The Case of the EU Market in Crypto Asset (MiCA) Regulation’ [2022] Amsterdam
Center for Law & Economics Working Paper 2022-07
<https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4203885> accessed 22 March 2024.
46
Lars Hornuf and others, ‘Cybercrime on the Ethereum Blockchain’ [2023] CESifo Working
Paper No. 10598 <https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4538046> accessed 22
March 2024.

18
 THE SOCIAL COST OF BLOCKCHAIN

(e.g. DAO), or with custodians, crypto exchanges, and so forth.47 Directly

hacking the blockchain is thought to be difficult, but not impossible if
malevolent nodes possess enough computational power.48 Parallel to the
externalities generated by operational risk, one may also think of the
externalities generated by legal risks related to the key players facilitating the
crypto economy. One key example here is the bankruptcy risk of wallets and
custodians.49 Another noteworthy issue is the legal nature of DAOs and the
liability status of their members.50

c) Interactions within the blockchain: Other adverse external effects may be

generated by interactions within the blockchain, meaning the mechanisms and
the actors designated to set and maintain a functioning protocol. This is
traditionally referred to as ‘blockchain governance’ and is – to this day – largely
based on informal interactions and decision-making of a small group of people,
namely significant miners and core developers. These individuals can impose
external effects on all users of the technology via changes in the protocol that
are compatible (soft forks) or incompatible (hard forks) with the previous
version of the protocol. Hard forks are particularly problematic in terms of
property entitlements as they generate two different and incompatible ledgers
with unclear effects for end-users.51

These three types of interaction of third parties with blockchain and with
blockchain participants are very different. However, there is a common thread

47
For a survey on the matter, see Ben Charoenwong and Mario Bernardi, ‘A Decade of
Cryptocurrency “Hacks”: 2011–2021’ [2021]
<https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3944435> accessed 22 March 2024.
48
Sarwar Sayeed and Hector Marco-Gisbert, ‘Assessing Blockchain Consensus and Security
Mechanisms against the 51% Attack’ (2019) 9 Applied Sciences 1788.
49
Matthias Haentjens, Tycho De Graaf and Ilya Kokorin, ‘The Failed Hopes of
Disintermediation: Crypto-Custodian Insolvency, Legal Risks and How to Avoid Them’ [2020]
Singapore Journal of Legal Studies 526.
50
Borgogno and Martino (n 15) 23.
51
To the best of our knowledge, this issue has received no attention in the literature. In the legal
realm, the issue is scrutinized only for tax purposes. See, for instance, Doris Stacey Gama,
‘Creating Something out of Nothing: Taxation of Cryptocurrency Hard Forks’ (2021) 31 Albany
Law Journal of Science and Technology 258.

19
 MARTINO & RINGE

linking all of them. At least at this stage of technological development, it is not

possible algorithmically to determine and regulate all possible courses of action
related to any given transaction. In other words, contracts are incomplete.52

In these settings, the concept of a contract is not used in its technical legal
meaning, but rather for its economic connotations, designating any sort of
implicit or explicit agreements on the allocation of assets and entitlements that
can be entered into and executed according to different modes. The economic
connotations of the concept of a contract are broader than the legal ones, and
legal contracts represent only a subset of what can be understood as contracts.53

This methodological refinement elucidates the role of the law in supporting

efficient blockchain transactions.54 Agreements on entitlement allocation and
their contingencies can be encoded and deployed in blockchain. But their
incompleteness invariably requires methods to ex-post complete contracts or, in
other words, to allocate residual control rights, at least at the stage of the legal
finality of the transaction.55 Therefore, if blockchain transactions are in some
respect incomplete, then the issue is what would it take to complete them
algorithmically, if that is possible at all. In other words, one should ascertain
whether encoding (almost) complete contracts can be done at transaction costs
close to zero.

In contrast, if the completeness of the contract cannot be achieved ex-ante

through algorithmic governance, the second problem to address here is who
holds the residual control rights according to the technological design of the
blockchain and its application. In the Coasean framework used for this analysis,

52
For a review of the most relevant theoretical contributions in the field, see Jean Tirole,
‘Incomplete Contracts: Where Do We Stand?’ (1999) 67 Econometrica 741.
53
For a more detailed analysis of this distinction, see David Martimort, ‘Contract Theory’, The
New Palgrave Dictionary of Economics (Palgrave Macmillan UK 2017)
<https://doi.org/10.1057/978-1-349-95121-5_2542-1> accessed 22 March 2024.
54
On incomplete contracting and the blockchain, see Vatiero (n 18).
55
Text to note 42.

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 THE SOCIAL COST OF BLOCKCHAIN

it implies that contract incompleteness and ex-post control allocation prevent

clear allocation of property rights.

If code or other features of blockchain technology allow parties to transact at no

transaction cost and with clearly allocated property rights, then the law should
sanction this and offer enforcement vis-à-vis third parties, ensuring the legal
finality of the transaction. However, where this is not possible by means of
technology, the law should take care of the allocation of entitlements to
approximate efficiency in blockchain.

V. THE LAW AS THE MISSING PIECE

The prevalence of the externalities associated with blockchain, as identified

above, underscores the necessity for regulatory intervention. While a
comprehensive analysis of what the ideal regulatory framework would be to
address each individual externality exceeds the scope of this contribution, it is
nevertheless essential to recognise that regulatory solutions may vary across
jurisdictions, thus precluding a uniform one-size-fits-all approach.

1. General Principles

Rather than prescribing specific regulations, we propose a set of regulatory

principles aimed at mitigating the externalities stemming from various
blockchain interactions.

It is important here to clarify that our objective is not to establish strict

regulation that would curb the use of blockchain technology by avoiding all
potential risks; nor do we advocate providing unconditional legal endorsement
of blockchain activities. Instead, our aim is to establish regulatory principles
that effectively manage the social costs associated with blockchain. In Coasean
terms, this entails leveraging the law’s enabling and essential functions to
internalise or at least minimise blockchain-generated externalities, thereby
enhancing social welfare.

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 MARTINO & RINGE

Broadly speaking, there are two main regulatory approaches to consider:

leveraging existing legal principles and rules; or drafting specific and new
norms tailored to blockchain activities. Both approaches have their advantages
and drawbacks.

Delegating existing legal principles and regulations to discipline blockchain

transactions has clear benefits. In particular, it economises on the political costs
of legislating. These costs can be sizeable, especially in some jurisdictions.
Moreover, this approach may reduce the risk of regulatory capture by the
industry which may attempt to lure lawmakers into inappropriately light
regimes.56

On the other hand, plainly applying existing legislation to new phenomena

implies potentially significant costs, as existing rules, for instance on securities
offerings and trading, may not align with the unique characteristics of
blockchain issuance and coin transactions. The existing legislation is largely
outdated, and expanding its scope to encompass new technological phenomena
may fail to recognise the unique points of the new technology. This means that
the existing regulation may be unable to curb blockchain-specific externalities
and, conversely, may reduce blockchain-specific efficiency gains, especially in
terms of transaction cost reduction.

For instance, the ongoing debate in the US regarding the classification of

cryptocurrencies as ‘securities’ exemplifies the challenges of applying outdated
legislation to blockchain transactions. Since the emergence of the first initial
coin offerings (ICOs), scholars, regulators, and the industry as a whole have
engaged in an intense and still ongoing debate about the doctrinal nature of
cryptocurrencies and whether they could be characterised as securities in line
with the long-established Howey test.57 This discussion does not advance our
understanding of the specific externalities, efficiency gains, and desirable

56
Text to note 14.
57
For an early contribution, see Scott D Hughes, ‘Cryptocurrency Regulations and Enforcement
in the US’ (2017) 45 Western State Law Review 1.

22
 THE SOCIAL COST OF BLOCKCHAIN

regulation related to cryptocurrencies though. Rather, it displays an obsession

of some legal scholars and practitioners with definitional questions and semantic
connotations. There is only one reason why the discussion still (and
exceptionally) remains relevant: due to political differences, the U.S. Congress
has proved itself unable to legislate on the matter, and, therefore, a pragmatic
extension of established legal principles has been the only viable legal response
to date. In fact, labelling cryptocurrencies as securities or commodities under
existing laws is crucial to assign regulatory and enforcement powers to different
agencies, such as the Securities and Exchange Commission (SEC) and the
Commodity Futures Trading Commission (CFTC). In the absence of specific
legislation, such designation becomes crucial to ensure that the industry is not
left completely unregulated.58

For these reasons, simply applying existing laws to blockchain transactions is

deemed desirable (i.e. a Coasean improvement) only if the functionally
equivalent off-chain transaction exhibits precisely the same externalities and the
same efficiency gains. Nonetheless, sticking with the existing legislation can be
considered a third-best solution only; the optimal (first-best) solution entails
internalising social costs via tailored codes, with the second-best being
blockchain-specific law, especially in cases where the political hurdles of
enacting new legislation are prohibitively high.

From a Coasean perspective, improving social welfare means that a transaction

should be organised on- or off-chain depending on the comparative advantages
that such organisational decisions provide at the margin.59 The direct
implication of this proposition is that there should be a level playing field for
the on- and off-chain options. Once this has been achieved, then private actors
can better determine, through contracts, where the transaction actually takes
place. Crucially, if the costs and benefits brought about by on- and off-chain

58
Chris Brummer, Yesha Yadav and David T Zaring, ‘Regulation by Enforcement’, Southern
California Law Review, forthcoming.
59
Ronald H Coase, ‘The Nature of the Firm’ (1937) 4 Economica 386, 396.

23
 MARTINO & RINGE

transactions are not identical, the risk is that the playing field remains level on
paper only. Instead, what we should aim for is a de facto level playing field.

2. Towards Blockchain-specific Regulation

When the externalities and the benefits of on- and off-chain transactions are not
identical, how can such a de facto level playing field be reached? Based on the
previous analysis, blockchain-specific law should complement blockchain
transactions by looking at two key dimensions: (1) the type of interactions with
third parties who are exposed to the social costs of blockchain, whether those
be indirect, direct, or within the blockchain; and (2) the level of technological
solution necessary to handle contract incompleteness in terms of transaction cost
reduction and the efficient allocation of property rights.

a) Indirect Interactions

In the case of indirect interactions with blockchain, when third parties cannot or
do not want to be part of crypto transactions, the law plays an essential role as
third-party effects are non-contractible, especially in all cases in which these
effects are systemic (such as environmental externalities and financial stability).
Having an essential role here means that the applicable law should mimic the
efficient allocation of entitlements should a market have existed. To do so, the
legislature has the typical Pigouvian measures at its disposal. Specifically, the
law can affect blockchain activity by impacting on prices (through taxes) or
quantity (through substantive requirements). From a regulatory perspective, this
implies the need to be able to identify those who are subject to such measures.
Typically, this is done through an authorisation regime.60 Clearly, authorisation
regimes increase transaction costs and have potentially anticompetitive effects

60
This approach is by and large adopted by the EU Regulation (EU) 2023/1114 of the European
Parliament and of the Council of 31 May 2023 on Markets in Crypto-Assets (MiCA) [2023] OJ
L150/40. For an introduction to the European regime, see Filippo Annunziata, ‘An Overview of
the Markets in Crypto-Assets Regulation (MiCAR)’ [2023] European Banking Institute
Working Paper Series n 158 < https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4660379>
accessed 22 March 2024.

24
 THE SOCIAL COST OF BLOCKCHAIN

as they can be understood as barriers to entry.61 On the other hand, such regimes
are widely considered a cost-effective way of handling this type of externalities
and represent a regulatory strategy widely employed in off-chain transactions.
This approach is in line with considering blockchain-specific regulation a
second-best solution.

Interestingly, to achieve this second-best solution and unleash the real potential
of blockchain application, in the presence of externalities caused by indirect
interaction with blockchain, it is necessary to identify blockchain users clearly,
which goes against the original promise, of anonymity for parties transacting in
a blockchain. In the same vein, some level of centralisation remains necessary
and unavoidable.

The key challenge for this type of essential regulation is that the regulator may
lack the relevant information to set the price and quantity efficiently. Indeed, in
the absence of externalities, the market could better elicit individuals’
preferences and reach efficient equilibria. However, this problem is not specific
to blockchain, and is common to all highly regulated industries. From a
technological perspective, this represents a residual category. As technology
evolves and blockchain adoption increases, externalities caused by indirect
interactions are likely to decrease as more parties will take part in blockchain
transactions. To the limit, this category should address only systemic
externalities as individual parties are structurally unable to account for those.

b) Direct Interactions

The second category of blockchain externalities relates to the direct interactions

among parties acting in the blockchain economy, where the parties could encode
their relationships. However, contractually encoding such relationships is not
always possible or cost-effective. In this case, the law shall have an enabling

61
Mukesh Eswaran, ‘Licensees as Entry Barriers’ [1994] Canadian Journal of Economics 673.

25
 MARTINO & RINGE

role. Encoding entitlements and efficiently transacting around them is

theoretically possible and the law should make it practically feasible.

To achieve this goal, the law should clearly define the entitlements, including
the responsibilities, of new blockchain intermediaries. These should be subject
to transparency and disclosure requirements, and to further substantive
requirements aimed at protecting weak parties. This approach is functionally
similar to existing securities regulation but, crucially, the specific requirements
do not need to be the same. On the contrary, these should be adjusted to the
specificities of blockchain transactions.

In this case, the key challenge in designing such regulatory requirements is in

balancing the risk of curbing innovation and excessively increasing transaction
costs via compliance requirements.

From a technological perspective, this category could become more and more
important as the technology and blockchain adoption evolve. One specific
aspect of this evolution worth mentioning here is asset tokenisation.62 Moreover,
if more asset classes can be transacted over blockchain, the realm of direct
interactions also increases.

c) Blockchain Governance

Finally, the last category of externalities to discuss are those generated by

interaction within the blockchain (a.k.a. blockchain governance). In this realm,
one can imagine many heterogeneous phenomena, ranging from informal and
off-chain governance up to fully on-chain and algorithmic governance. While
the former exists and is the main form of blockchain governance, for instance

62
For an introduction to the topic and its legal implications, see Rosa M Garcia-Teruel and
Héctor Simón-Moreno, ‘The Digital Tokenization of Property Rights. A Comparative
Perspective’ (2021) 41 Computer Law & Security Review 105543.

26
 THE SOCIAL COST OF BLOCKCHAIN

in the Bitcoin blockchain, the latter represents the holy grail for blockchain
proponents.63
Notwithstanding different technological specifications of blockchain
governance, the role of the law does not change. Blockchain governance sets
the rules of the game for all parties who want to transact over that particular
blockchain, including the consensus protocol and validation mechanism. This
set of rules constitutes the key market infrastructure, allowing parties to transact
around their entitlements.64 Consequently, those who have the ability to set and
update such infrastructure should be considered gatekeepers. Accordingly, the
law should clearly define the entitlements of such gatekeepers, in terms of rights
and responsibilities.65 The legal tools to do so would however differ. In the case
of informal and off-chain governance, ex-post strategies can be effective and set
the appropriate incentives. In the case of on-chain algorithmic governance, ex-
ante strategies, including authorisation, are preferable.
Here, the role of the law is similar to that of corporate and organisational law.
However, private enforcement through litigation should be complemented by a
strong system of public enforcement to avoid rational apathy among blockchain
users, especially in cases where judicial remedies may be practically unavailable
given the tamper-resistant nature of blockchain. Relatedly, blockchain protocols
should always encode a backdoor provision allowing tampering with the
blockchain in strict and typical cases provided by the law, mimicking cases in
which the law can declare a contract null and void because, for instance, it was
concluded under duress or violated mandatory legal norms.

63
See, for instance, Wessel Reijers and others, ‘Now the Code Runs Itself: On-Chain and off-
Chain Governance of Blockchain Technologies’ (2021) 40 Topoi 821.
64
Angela Walch, ‘The Bitcoin Blockchain as Financial Market Infrastructure: A Consideration
of Operational Risk’ (2015) 18 New York University Journal of Legislation & Public Policy
837.
65
Along this line of thought, some authors proposed to impose fiduciary duties on software
developers, see Angela Walch, ‘In Code(rs) We Trust: Software Developers as Fiduciaries in
Public Blockchains’ in Philipp Hacker and others (eds), Regulating Blockchain. Techno-Social
and Legal Challenges (Oxford University Press 2019).

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 MARTINO & RINGE

In summary, this section has proposed several regulatory principles to handle

the social costs of blockchain. By and large, these principles are not jurisdiction-
specific. However, the implementation of these principles may involve a
number of trade-offs, for instance in terms of authorisation requirements or
supervisory oversight. How to settle these trade-offs is not self-evident and
largely depends on the policy choices of individual legislators.66

VI. CONCLUSION

In conclusion, this article has delved into the intricate relationship between
blockchain technology and the social cost it generates, offering insights into the
regulatory challenges and potential solutions thereto. Through the lens of
Coase’s seminal framework, it has become evident that while blockchain
promises to transform economic activities and greatly lower their transaction
costs, it also presents inherent limitations and externalities that may necessitate
regulatory intervention.

Our analysis has revealed that blockchain technology, despite its

decentralisation and efficiency aims, does not inherently eliminate externalities
but rather redistributes them in novel ways. From environmental impacts to
operational risks and governance challenges, the social cost of blockchain
transactions are varied and complex. Moreover, the incomplete nature of
blockchain contracts underscores the indispensable role of the law in facilitating
efficient transactions and addressing externalities.

Moving forward, regulatory interventions must strike a delicate balance

between fostering innovation and safeguarding against adverse effects. The
proposed regulatory principles in this article provide a roadmap for

66
For a framework to approach the comparative aspect of blockchain regulation, see Edoardo
D Martino, ‘Cryptocurrencies and Stablecoin Regulation: A Framework for a Functional
Comparative Analysis’, in Edoardo D Martino, Hossein Nabilou and Alessio M Pacces (eds),
Research Handbook in Comparative Financial Regulation (Edward Elgar Publishing,
forthcoming).

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 THE SOCIAL COST OF BLOCKCHAIN

policymakers to navigate this complicated landscape, emphasising the

importance of tailored approaches that consider the unique characteristics of
blockchain interactions.

Furthermore, the article has underlined the need for ongoing dialogue and
collaboration among stakeholders to ensure that regulatory frameworks keep up
with technological advancements. As blockchain continues to permeate various
sectors of the economy, it is imperative that regulatory efforts remain adaptive
and responsive to emerging challenges and opportunities.

In essence, the law serves as the missing piece in unlocking the full potential of
blockchain technology while mitigating its social costs. By embracing a
pragmatic and nuanced approach to regulation, policymakers can foster an
environment conducive to innovation, efficiency, and social welfare in the
blockchain ecosystem.

29