This article explores the effects of changing exposure to world trade and relative factor abundance on the institutional and economic development of a paradigmatic Spanish-American frontier colony, Paraguay. The problem is conceptualized within a neoinstitutionalist staples model in which – during the long sixteenth-century trade expansion – the colonial state delegated the provision of defence onto individuals who financed it by restricting indigenous labour mobility and extracting the resulting monopsony rents. Despite the encomienda's stated intentions, its inefficient incentive system actually contributed to the decline in indigenous population and provincial security shortcomings. As trade contracted and defence needs rose during the seventeenth-century crisis the crown commuted the labour services of Jesuit mission Indians for contributions to defence and payments in kind and money. The mestizo peasantry remained free, but was increasingly burdened with military obligations as well.