Catallaxy: the origins of Bitcoin, innovation and spontaneous order

The term Catallaxy describes the process by which order emerges from the seeming chaos of countless individual interactions between participants in a complex system. This spontaneous human coordination is the result of the individual action of the system’s participants, but the resulting order is not shaped consciously by human design.

Catallaxy is perhaps the most powerful concept in economics, because it allows us to understand, and be amazed by, the imperceptible unstoppable forces that shape our civilization. It explains how and why technological innovation, free markets and Bitcoin come to exist.

The Catallaxy should be embraced by businesses and organizations that wish to survive the black swans of modernity. More importantly: understanding emergent order is an exercise in self-awareness. Embracing the forces that shape the systems our lives depend upon is the key to becoming a sovereign individual in the coming information age.

Truly disruptive innovation emerges only out of Catallaxy. Antifragile systems are born when Catallaxy is left unbound, which is why they are desirable. Understanding Catallaxy empowers one to identify, and foster, the conditions that yield the most innovation.

The term Catallaxy itself is derived from the Greek verb Katallato, which means not only “to exchange” but also “to admit into the community” and “to turn a foe into a friend”. The term catallactics is defined as “the science of exchange”, because it studies economics by looking at the primary evidence: individual transactions.

This concept was popularized by the philosophers Friedrich Hayek and Ludwig von Mises, pioneers of the Austrian School of Economics. Disruptors of the economic establishment in their time, they had a radical new understanding of how the world worked and needed a new word for it.

Indeed, the mainstream term “economy” was invented by Aristotle and original meant “the art of household management”, in reference to the ancient Greek elites that would expertly manage their income, slaves, properties and business dealings. Thus, the term “economy” implies that there is, or ought to be, some guiding force and that there is some shared objective that all participants should aspire to pursue, and that the economy can (and should) be managed.

According to this worldview, the economy is mechanic: you should tweak it here and there and attempt to control the engine and process to create the best outcome possible. This was the premise which, engrained in the institutions of authority, had dramatic consequences which Hayek and Mises vowed to oppose: the rise of economic central planning.

When I gave a presentation on this subject in Vancouver, I walked outside of the Airbnb I rented and found a coffee shop within 10 meters that served me a small (double-shot) latté for 4.31$ The information contained in the availability and price of this beverage is beyond human imagination, because it is the abstraction of the millions of individual actions of every single participant in the supply chains that resulted in this coffee. As such, no urban or economic planner could have designed a better coffee market outcome: my breakfast transaction was exactly as it was meant to be.

To Hayek and Mises, the economy is to be thought of as organic: a complex and intricate balance, built naturally from the ground up. The information required for people to make decisions, simply put, is completely decentralized and truly only relevant on a peer-to-peer basis. It is a grassroots, bottom-up iterative process.

Catallaxy is the equivalent of the Cosmos, the spontaneous order of the universe, applied to economics. Only out of chaos and disorder can the true equilibrium be discovered.

The concept of emergent order is a generalization of what Catallaxy represents for the particular field of economics. Many examples of emergent order include:

• Languages and dialects
• Common law
• Free markets
• Pre-fiat currencies
• The internet
• Memes and culture
• Evolution through natural selection

These are all open dynamic network effects. They emerge as a result of participant’s action, but spontaneously without any overarching human design. They exist because participants collectively maintain them for their benefit and because they produce the best possible outcomes. They emerge and mutate without any identifiable conductor.

Bitcoin: applied catallaxy

Bitcoin, for example, is better understood using the conceptual lense of the Catallaxy: participants in Bitcoin spontaneously form a decentralized monetary and financial ecosystem, collectively choosing Bitcoin as a medium of exchange and store of value. Bitcoin is quintessentially antifragile and an irrefutable demonstration of spontaneous order in action.

Bitcoin emerged from seemingly out of nowhere: a black swan event that could never have been predicted. But it was the cumulation of an iterative process where ideologically-motivated individuals continuously innovated on each other’s work, guided by the foundational organizational principles of open-source software and cypherpunk ideology. It was a truly unpredictable disruptive innovation.

There is nothing magical about Bitcoin’s technology, although it is extremely state-of-the-art. It is the human participants, which collectively assume individual portions of risk and expense, that bring utility to the Bitcoin network because it is in their self-interest to do so. The requirement to follow the rules of the Bitcoin protocol in order to participate in its network ensures the alignment of incentives between self-interested anonymous participants, resulting in Bitcoin maintaining its decentralization. This is Satoshi’s true genius.

In peer-to-peer networks, peers (nodes) produce and consume resources at the same time. In Bitcoin, an enormous workload and set of responsibilities rests on the peers which do the work because it allows them to benefit directly from the network. The incentive for nodes is self-validation, making sure that their transactions are on the correct version of the blockchain and that the miners are following the rules, while the incentive for miners is the reward paid by all participants.

The participants converge spontaneously around the longest valid chain because it is in everybody’s best interest to do so. As we have seen, the ecosystem also converges around the same consensus rules and rule change activation processes, and when it does not, part of the system leaves, resulting in the participants being in stronger consensus. This should not be used as a maxim to encourage splitting the Bitcoin network when a faction disagrees. Money is the strongest network effect: if you’re on the wrong network, you die. Because the value of a cryptocurrency is derived from its network effect, the possibility of losing most (if not all) value weighs heavily choosing one blockchain over another.

While the possibility of exit is possible, the associated costs and risks of breaking consensus are enormous. This keeps the Bitcoin network adaptable and antifragile, but ultimately extremely reliable as a foundational institution of the information age.

The Bitcoin ecosystem emerges so naturally that it sometimes it feels like a living organism. It’s ability to immunize itself from internal and external attacks of all sorts extends beyond the protocol: the community, aligned by spontaneous agreement on core principles of self-sovereignty, privacy and decentralization, adopts norms and informal institutions against social attacks over time.

The constant addition of blocks and cumulation of proof-of-work, as well as the purchasing power of bitcoins, are measurable proofs that participants in this spontaneous order derive value and utility.

Satoshi’s achievement is not only in design: he bootstrapped the network by himself, following the very principles he coded in Bitcoin. He released the first implementation of Bitcoin in the wild, naked and unsecured. He built a community of ideologically-driven early contributors that maintained Bitcoin’s ability to evolve, which quickly surpassed him in technical skill.

Satoshi inspired others to collaborate through sheer persuasion and skill, logic and mathematics, profound wisdom. He was idolized and followed by early entrepreneurs building key institutions (e.g. exchanges) allowing dynamic market feedback loops from participants with skin in the game. He provided all the ingredients for extremely fast-paced disruptive innovation, and disappeared leaving the project in the hands of the world’s smartest and most dedicated pioneers.

Origins of innovation

Innovation cannot be designed. It happens in the trenches. To find the frontline of innovation, look for mass graves. Look where the rate of failure is the highest and the fastest. Innovation happens at the edges, on the frontier. Look where the participants have skin in the game and where the will pay a high price for their mistakes.

Charles Darwin, in The origin of species (1859), outlines the concept of evolution through natural selection, validating that natural ecosystems emerge spontaneously through countless imperceptible deadly mistakes that remove the least adapted DNA from the system. He writes:

“From the war of nature, from famine and death, the most exalted object which we are capable of conceiving, namely, the production of the higher animals, directly follows. There is grandeur in this view of life, with its several powers, having been originally breathed by the Creator into a few forms or into one; and that, whilst this planet has gone cycling on according to the fixed law of gravity, from so simple a beginning endless forms most beautiful and most wonderful have been, and are being evolved.”

Thankfully, unlike our DNA, individuals and companies can modify their business plans and wealth management strategies. Today’s innovators can fail without risking their life, but feel enough pain to still be strongly incentivized.

Innovation is a central property of systems which makes them antifragile (thus survive over time), and antifragile systems by their exposure to volatility foster necessity, which drives innovation.

Innovation must happen at the edges, because it is where the negative externalities are the lowest for other participants in the system. The failure of entrepreneurs shouldn’t be fatal and cause harm to others. This is why large corporations acquire startups, and why altcoins and second-layer protocols complement Bitcoin’s blockchain. This is why innovation, in decentralized networks, happens on the higher layers where innovation is not only permissionless, but forgiving.

Antifragility is defined by Nassim Taleb as:

“a convex response to a stressor or source of harm (for some range of variation), leading to a positive sensitivity to increase in volatility (or variability, stress, dispersion of outcomes, or uncertainty, what is grouped under the designation “disorder cluster”). Likewise fragility is defined as a concave sensitivity to stressors, leading to a negative sensitivity to increase in volatility”

Considering the unfathomable disruptions that the information age has yet to deliver, having the systems we rely upon be antifragile is not a strategy of optimization: it’s survival.

Innovation, just like evolution, happens where the iterative development cycles are fastest. This is true for the “agile/lean” startup models that many Bitcoin businesses and open-source projects follow. Information signals and feedback loops that are meaningful, such as consumer adoption, revenue generation, market valuation, number of contributors, provide part of the answer on how innovation occurs.

Open competition, permissionless innovation, and widely distributed information need to provide a constant threat. Nothing spurs necessity for an entrepreneur like incoming bankruptcy from competition. For the greediest and largest players, there needs to exist a possibility of taking over the entire market share and obtaining near-monopoly status. Smaller firms must be able to challenge larger market participants if they are to justify the expense of required resources.

Market signals must be meaningful and dynamic in addition to being from those with skin in the game. For example, ICO projects that receive all the funding upfront are unlikely to yield any innovation whatsoever, since they are completely removed from any stressor that would cause the necessity to innovate. Their value is derived mainly from marketing and network effect bootstrapping strategies rather than actual utility. Subsidies remove critical information from the decision making process: market feedback.

Innovation happens where participants have skin in the game. There must be strong symmetry between decision-making and its consequences. For example, think of industry participants and lobbyist/consultants that create organizations to collect and distribute government subsidies. Since the decision makers allocating resources don’t have skin in the game, they lead to misallocation of resources and market failures with not only no mechanism for feedback and adjustment other than the central planners’ judgement, but no incentive to obtain feedback in the first place. The incentives transform the optimal strategy for entrepreneurs away from innovation into the realm of rent-seeking.

The Chinese philosopher Zhuang Zhou, like Hayek and Mises, argued against the mainstream intellectual movement (confucianism). He wrote in 300 BC:

“there has been such a thing as letting mankind alone; there has never been such a thing as governing mankind with success. Good order results spontaneously when things are let alone”

The best human planners could never reproduce the magnificent equilibrium of nature’s ecosystems (at least not at scale). So how could economists and politicians do it for the production and allocation of wealth?

In order to create an optimal equilibrium, one would need to “reverse-engineer” all the individual interactions that compose it. To do this, one would have to have not only all the information available to the participants, but also an intimate knowledge of all that makes them unique as a human beings. Only an omniscient being could recreate the optimal equilibrium, and not even he could do better than just letting humans act on their own.

To make matters worse, artificial state intervention in the Catallaxy often disrupts the equilibrium in imperceptible ways that produce negative outcomes, regardless of the motivations. These are “unseen” effects, as 19th century French economist Frederic Bastiat explains:

“In the economic sphere an act, a habit, an institution, a law produces not only one effect, but a series of effects. Of these effects, the first alone is immediate; it appears simultaneously with its cause; it is seen. The other effects emerge only subsequently; they are not seen; we are fortunate if we foresee them (…) it almost always happens that when the immediate consequence is favorable, the later consequences are disastrous, and vice versa. Whence it follows that the bad economist pursues a small present good that will be followed by a great evil to come, while the good economist pursues a great good to come, at the risk of a small present evil.”

To find sources of innovation, go see practitioners, startups and entrepreneurs, tinkerers, hackers, fanatical early adopters, hobbyists, traders, meetup organizers, passionate educators, open-source project developers, inventors. Go see those with skin in the game and that not only positive react to, but significantly contribute to, market-based feedback loops. Innovators don’t need to be scalable at first, because they are in a process of innovation. To foster innovation, identify the market-validated winners and amplify them with resources so they can scale.

If you’re not the wave, be the surfer

There is a wave coming, and better to be on a surfboard than swim against the current. The surfer can never tell the wave where to go: the best it can do is stay afloat and use the wave’s momentum. Those who can feel the wave and anticipate its underlying trend will go the farthest. The wave always reaches the shore, but this is not true for the surfer.

Bitcoin is not just a wave: it’s a tsunami.

Acknowledgements.

This essay was inspired by recent podcasts/articles by Nassim N. Taleb @nntaleb and @econtalker, as wall as numerous contributors and commentators in the Bitcoin ecosystem. The image used is “Wanderer above the sea fog”