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May 9, 2018

Code is Capital

New technologies might help integrate communities living under local, customary property law into the global economy.

When the Honduran police came to evict her in 2009 Mariana Catalina Izaguirre had lived in her lowly house for three decades. Unlike many of her neighbours in Tegucigalpa, the country’s capital, she even had an official title to the land on which it stood. But the records at the country’s Property Institute showed another person registered as its owner, too—and that person convinced a judge to sign an eviction order. By the time the legal confusion was finally sorted out, Ms Izaguirre’s house had been demolished.

—The Economist, “The Great Chain of Being Sure About Things”

When people live without credible property title, many complex transactions—taken for granted in an economist’s model of a free market—simply don’t occur. “Imagine a country where nobody can identify who owns what,” Hernando de Soto says, where “addresses cannot be easily verified, people cannot be made to pay their debts, resources cannot conveniently be turned into money, ownership cannot be divided into shares, descriptions of assets are not standardized and cannot be easily compared, and the rules that govern property vary from neighborhood to neighborhood or even from street to street” (de Soto 2000). De Soto estimates that some five billion people live with these limitations.

With billions of people affected, and an estimated $9.3 trillion in assets at stake, governments have made many attempts to extend property rights (de Soto 2000). However, these government programs generally fail because they don’t appreciate that local communities have already negotiated the obligations, rights, and norms among themselves (Miller and Stiegler 2004). Because the legal property records don’t match day-to-day experiences, the communities ignore formal titles, making the records irrelevant.

In Mariana’s case, the extralegal social contracts of the local community upheld her ownership, but she lacked clear legitimacy outside her community. Without external legitimacy, selling the property or using it as collateral for a loan would have been difficult. Miller and Stiegler call this the credibility of property rights transfer at a distance, defined as a stranger’s confidence that “they will acquire the goods specified in the contract” when they engage in “asset transfers and capital formation” (Miller and Stiegler 2004). Thus, a functional property system must fulfill two requirements: it must capture community-determined social contracts and also be credible to a larger audience.

Blockchain technology revolutionizes the credibility of property rights transfer at a distance. For the first time, transfers of property title can be recorded securely on a public, decentralized ledger without the use of a central authority. Furthermore, blockchain-based smart contracts can turn digital assets into capital by creating “abstractions built from widely tradable rights” (Miller and Stiegler 2004).

Double-Spending

Bitcoin gives us, for the first time, a way for one Internet user to transfer a unique piece of digital property to another Internet user, such that the transfer is guaranteed to be safe and secure, everyone knows that the transfer has taken place, and nobody can challenge the legitimacy of the transfer. The consequences of this breakthrough are hard to overstate.

—Marc Andreessen (2014)

Although digital currencies are what made them famous, blockchains disrupt a long-held assumption about digital assets in general—that central authorities are required. Physical objects are rivalrous, meaning that if one person is using the object, other people are naturally excluded. (In other words, if I eat an apple, no one else can eat that apple.) Digital assets, on the other hand, such an .mp3 of a song, can be copied, shared, and enjoyed simultaneously without any loss in fidelity. For digital cash, this presents a huge problem, known as double-spending—a unit of digital cash can be copied, and used to pay several people (Narayanan et al. 2016). What Bitcoin was able to do for the first time was to solve the double-spending problem without the use of a central authority.

Colored Coins

Building on the fact that bitcoin could not be double-spent, innovators added a layer to the bitcoin protocol to represent property title. These are known as colored coins. Simply put, a colored coin is a specific amount of bitcoin that has some significance beyond the coin itself. The architecture of Bitcoin allows a particular bitcoin amount to be traced through its entire history, even down to one hundred millionth of a single bitcoin. Thus, a user could imbue a coin, worth less than a cent in US dollars, with special meaning, and while it would look just like all other bitcoin in most ways, the coin  could be treated as a deed to a particular property right.

Colored coins are a practical way of reusing the existing Bitcoin blockchain for new purposes, and the legality of using these tokens is uncontroversial. As law professor Joshua Fairfield argues, “the law has long recognized the need to transfer property interests through the expedient of a symbol, deed, or token” (Fairfield 2015). However, the underlying Bitcoin blockchain is not well designed for this purpose. Tezos co-founder Arthur Breitman compares the use of Bitcoin protocol in this context to trying make a truck by bolting the four corners of a large wooden platform on the roofs of four cars and placing a shipping container on top (Breitman 2015).

Non-Fungible Tokens

Instead of reusing bitcoin, the Ethereum community created an open standard for issuing non-fungible tokens (NFT), called ERC-721.1 Introduced in 2017, the standard has been most notably used for Cryptokitties, virtual pets which can be bred to create additional Cryptokitties and bought and sold like baseball cards. Cryptokitties are a toy, but they are illustrative of more serious future endeavors. In the future, instead of representing a goofy cartoon cat, a non-fungible token might be associated with a more valuable asset, such as a company share, a concert ticket, or real property. New property title implementations for the ERC-721 standard, such as the extension described by Philip Saunders in his paper The Zone Protocol, may add additional value.

But even though the transfer of a digital asset is decentralized on a blockchain, the issuance of that digital asset as well as the interpretation of that digital asset may still be centralized. In the case of Cryptokitties, the images that are traded reside on a centralized website. If that website goes down or the company folds, the owner of a Cryptokitty will currently be left only with the ability to trade a ”meaningless 256-bit integer” (Duffy 2017).2

For real property, the issuance and the interpretation are even more critical, and most blockchain-based title implementations do not attempt to decentralize issuance and interpretation.3 Typically, issuance, transfer, interpretation, and offline enforcement are all handled by government. It’s important to note that colored coins or non-fungible tokens would only take over the secure transfer of the property title.

Turning Property into Capital

Putting the question of issuance temporarily aside, how can non-fungible tokens solve de Soto’s problem of capital? Miller and Stiegler explain that smart contracts that unfold over time—just as a mortgage does—can create capital.

They use the example of the covered call option:

Alice has an option when she has the right, but not the obligation, to engage in some action at some agreed price before some deadline. Alice has a call option when she has the right to buy some agreed asset, let us say stock, at some agreed price before the deadline. The option is a covered call option when Alice’s counterparty, Bob, escrows up front the stock Alice may decide to purchase. (Miller and Stiegler 2004, 75)

Miller and Stiegler represent Alice’s position as a seat at a game board—and that seat can itself be sold. Thus, the option of buying the stock for a given price can itself be turned into a right. Whereas the stock is a very literal kind of right, “this new right is somehow more abstract. In Wall Street terminology, the new right is a derivative of the more literal underlying rights. In de Soto’s terminology, if the literal instruments are physical assets, then abstract rights derived by contracts about these instruments are a step towards being capital” (Miller and Stiegler 2004).

With smart contracts, Alice can turn this new abstract right, this position of hers, into something that can be sold to someone else, allowing the digital representation to be commodified. Miller and Stiegler conclude that “De Soto’s capital, besides being an abstraction built from widely tradable rights, is also itself widely tradeable, enabling further abstractions—the creation of yet more forms of capital.”

The Problem of Centralized Issuance

As mentioned previously, colored coins and non-fungible tokens have assumed a central issuer such as the government. However, many problems with property title start at the issuance stage: disputes that are never resolved, formal title that doesn’t match the local social contracts, and properties that have several registered owners (as in the case of Mariana Catalina Izaguirre).

Is it possible for issuance to be decentralized? Miller and Stiegler explore an alternative solution to government issuance and interpretation: rating agencies. Similarly to bond-rating agencies, property title agencies would provide the market with “an estimate of the likelihood that transfer of a given title will actually be honored… Simply recording each village’s track record of honoring past title transfers, and assuming that the future will be like the recent past, is a low overhead procedure that is plausibly adequate. And it places each village in an iterated game with the system as a whole, providing it an incentive to treat these titles as legitimate claims, subjecting them to the local tradition’s means of enforcement. We can think of this as a credit report, not for an individual, but for a village and its system of local law” (2004).

However, the decentralization provided by title rating agencies may make it harder to access property title information. A centralized issuer that only allows a few forms of property may be able to reduce search costs and better deliver information to third parties (e.g. potential buyers and banks). However, this may be at the expense of extinguishing new and innovative forms of property rights. As Fairfield puts it,  “Choice raises information costs. It also increases satisfaction. The question is how to best balance the range of choice that increases individual satisfaction with the information costs increased by that range. This is an optimization exercise.” (Fairfield 2015, 846).  Yet in much of the world, the centralized issuer may not be functioning. This may make the choice between having decentralized property title, or having no property title at all.


Notes

  1. Non-fungibility simply means that the token can be identified uniquely and can’t be substituted with another token. ERC-721 can be contrasted with ERC-20, a fungible token standard.

  2. To solve this problem, the Cryptokitties team is currently working on an implementation in which the images would reside on IPFS, a peer-to-peer distributed file system which was used to bypass censorship in the Catalan independence referendum.

  3. Saunders’ Zone Protocol requires that the legal authority of a specific zone (for instance, a Special Economic Zone or SEZ), issue the property title.

Works Cited

Andreessen, Marc. “Why Bitcoin Matters.” The New York Times. January 21, 2014. Accessed April 28, 2018. https://dealbook.nytimes.com/2014/01/21/why-bitcoin-matters/.

Breitman, Arthur. “Making Sense of Colored Coins – Tezos – Medium.” Medium. August 17, 2015. Accessed April 23, 2018. https://medium.com/tezos/making-sense-of-colored-coins-c0a9e3459b1e.

de Soto, Hernando. The Mystery of Capital: Why Capitalism Triumphs in the West and Fails Everywhere Else. New York: Basic Books, 2000.

Duffy, James Martin. “How to Code Your Own CryptoKitties-Style Game on Ethereum.” Medium. December 04, 2017. Accessed April 28, 2018. https://medium.com/loom-network/how-to-code-your-own-cryptokitties-style-game-on-ethereum-7c8ac86a4eb3.

Fairfield, Joshua A. T. “Bitproperty.” 88 S. Cal. L. Rev. 805, 2015.

Flavelle, Mack. Medium. December 15, 2017. Accessed April 28, 2018. https://medium.com/cryptokitties/i-want-to-start-out-by-thanking-greg-for-writing-this-post-d306c7a4067f.

Miller, Mark S., and Marc Stiegler. “The Digital Path: Smart Contracts and the Third World.” In Markets, Information and Communication, 63-88. New York: Routledge, 2004.

Narayanan, Bonneau, Felten, Miller and Goldfeder. Bitcoin and Cryptocurrency Technologies. Princeton, NJ: Princeton University Press, 2016.

Saunders, Philip, The Zone Protocol (With Implementations) (April 12, 2018). Available at SSRN: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3161685

“The Great Chain of Being Sure about Things.” The Economist. October 31, 2015. Accessed April 23, 2018. https://www.economist.com/news/briefing/21677228-technology-behind-bitcoin-lets-people-who-do-not-know-or-trust-each-other-build-dependable.

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