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 It works because states dont care. Once (if) they do there wont be proxy merchants anymore. I think circular econ is actually not that difficult to achieve. Only fiat money you need is for taxes. I think if you charge customers in bitcoin+fiat it might be a good start. Having that functionality  in wallet would be awesome. 
 Again - states have cared about the drug business for more than 40 years, yet everyone who wants to get some does. Even in states where enforcement is strict and effective, it still works.

Go to Orchard Towers in Singapore, prostitution supplemented by cocaine. Yes, they have death penalty for cocaine in Singapore.

The mistake here is to believe that this is not a solved problem. State can try to enforce something, but that creates counter pressure, because going around that limitation is a valuable service, so you'll have providers who specialize and compete on figuring out the way around.

Also, I would leave a hellish dystopia well before they could even try this, but that's another topic.

It's impossible to ban bitcoin, it can be only more or less costly to transact with it. 
 Ok, fair points 👍