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Smart Contracts: Reducing Risks in Economic Exchange with No-Party Trust?

  • Helen EENMAA-DIMITRIEVA and Maria José SCHMIDT-KESSEN

Abstract

Our study on smart contracts, self-executing agreements based on blockchain technology, can be placed in the field of inquiry within law and economics of contracts which explores new modes of contract enforcement as sources of market creation. We lay the foundations by characterising contract enforcement and trust mechanisms underlying contracts. Considering that trust reduces risks in economic exchange, we explain how the particular trust mechanism underlying smart contracts’ enforcement (no-party trust) provides opportunities for creating new markets and changing existing ones. We explore, among other things, whether using smart contracts could be a path to increasing the autonomy of consumers and offering a solution for democratising trade.

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Helen Eenmaa-Dimitrieva (JSD Yale Law School) is a Postdoctoral Researcher in Information Technology Law at the University of Tartu. Maria José Schmidt-Kessen (PhD European University Institute) is an Assistant Professor at the Copenhagen Business School. The authors are grateful to Roger Brownsword for an e-discussion which inspired them to write this paper and to Karen Yeung, Giovanni Sartor, and Hans Micklitz for drawing attention to the philosophical foundations of their work. They would equally like to thank the organisers and audiences of the conference on “Blockchain, Public Trust, Law and Governance” at the University of Groningen in 2018 and the inaugural conference “Constitutional Challenges in the Algorithmic Society” of the IACL Research Group on Algorithmic State, Society and Market – Constitutional Dimensions in Florence in 2019. They acknowledge the generosity of the European University Institute that provided them with an excellent research and teaching environment, as well as the Dora Plus programme (funded by the European Regional Development Fund) that supported their research.

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1 It is reasonable to ask whether trust is necessary for economic exchange at all. For example, some could suggest that we should rather talk about the reliability of relationships or control gained over exchanges by various means. For studies showing that trust is essential for economic exchange and increases the efficiency of exchange due to the fact that it reduces the expectation of opportunistic behaviour, which in turn lowers transaction costs, see K Arrow, The Limits of Organization (Norton 1974); P Bromiley and L Cummings, “Transaction costs in organizations with trust” in R Bies et al (eds), Research on Negotiation in Organizations (JAI Press 1995); G John, “An empirical investigation of some antecedents of opportunism in a marketing channel” (1984) 21 Journal of Marketing Research 278; J Barney and M Hansen, “Trustworthiness as a source of competitive advantage” (1995) 15 Strategic Management Journal 175. We would like to bracket this debate for now by recognising that it is possible to characterise the mechanisms underlying economic exchanges with a variety of concepts. Reliance on the broad conception of trust in this paper helps us to convey a comparative understanding of various contracts, including SCs.

2 For an overview of various underlying technologies upon which one could build SCs, see L Scholz, “Algorithmic Contracts” (2017) 20 Stanford Technology Law Review 128; H Surden, “Computable Contracts” (2012) 46 UC Davis Law Review 629.

3 As a tool for preserving the integrity of data, blockchain has been around for decades already. It is not suitable as a solution for achieving the much-desired confidentiality of information (not just data) or its verifiability. After all, whether something recorded on the blockchain corresponds to the actual facts in the world (ie whether it is true or not) is not only a matter of verifying whether a piece of data has been recorded in a particular database. It also concerns the real-world circumstances connected to the information that the data is meant to confer (the particulars about the people, items, information or values involved). See eg A Buldas et al “Time-stamping with binary linking schemes” (1998) 1462 Lecture Notes in Computer Science 486; A Buldas et al, “Optimally Efficient Accountable Time-Stamping” (2000) 1751 Lecture Notes in Computer Science 293.

4 See eg H Eenmaa-Dimitrieva and MJ Schmidt-Kessen, “Creating Markets in No-Trust Environments: The Law and Economics of Smart Contracts” (2018) 35 Computer Law & Security Review 69; Scholz, supra, note 2, pp 145–148.

5 A Savin, “Blockchain, Digital Transformation and the Law: What Can We Learn from the Recent Deals?” presented at CBS Maritime Law Seminar Series on 22 March 2018.

6 Scholz, supra, note 2, pp 145–148.

7 While the automated enforcement of SCs can be essentially independent of external influence or control, the parties may choose to involve external information sources known as oracles in the process of execution, or separate the execution process into several stages with varying levels of parties’ involvement. The level of external control in a particular SC depends on the content of the contract.

8 Eenmaa-Dimitrieva and Schmidt-Kessen, supra, note 4.

9 R Mayer et al, “An integrative model of organizational trust” (1995) 20 Academy of Management Review 709; J Colquitt and J Rodell, “Justice, Trust, and Trustworthiness: A Longitudinal Analysis Integrating Three Theoretical Perspectives” (2011) 54(6) Academy of Management Journal 1183.

10 Colquitt and Rodell, supra, note 9.

11 G Sartor, Privacy, Reputation, and Trust: Some Implications for Data Protection EUI working paper LAW No 2006/4.

12 A Greif, “Contract Enforceability and Economic Institutions in Early Trade: The Maghribi Traders’ Coalition” (1993) 83 American Economic Review 525; L Guiso et al, “Cultural Biases in Economic Exchange?” (2009) 124(3) The Quarterly Journal of Economics 1095.

13 B McEvily et al, “Can Groups Be Trusted? An Experimental Study of Collective Trust” in R Bachmann and A Zaheer (eds), The Handbook of Trust Research (Edward Elgar 2006); L Guiso et al, “The Role of Social Capital in Financial Development” (2004) 94 American Economic Review 526.

14 A similar idea has been defended by several authors. Eg Sartor, supra, note 11; Memmo, D et al, “Trust, Reliance, Good Faith and the Law” in Nixon, P and Terzis, S (eds), Trust Management (Springer 2003) pp 150164.

15 Kenneth Arrow, for example, notes that the trust relationship between a patient and her doctor derives from the fact that society imposes a certain code of conduct on doctors (eg that the doctor is using her knowledge to the best advantage of the patient, and that the doctor is not seeking to maximise her income with the patient) that gives the patient trust in the doctor independently from the person of the doctor. See K Arrow, “Uncertainty and Medical Care” (1963) 53(5) American Economic Review 941 at p 965.

16 P Dasgupta, “Trust as a Commodity” in D Gambetta (ed), Trust: Making and Breaking Cooperative Relations (Blackwell 1988) p 49.

17 ibid.

18 ibid.

19 Sartor, supra, note 11.

20 L Zucker, “Production of Trust: Institutional Sources of Economic Structure: 1840 to 1920” in LL Cummings and B Staw (eds), Research in Organizational Behavior (JAI Press 1986) p 55.

21 On this point, see also C Catalini and J Gans, “Some Simple Economics of the Blockchain” MIT Sloan Research Paper No 5191-16 (21 September 2017) <papers.ssrn.com/sol3/papers.cfm?abstract_id=2874598> (last accessed 26 June 2019).

22 R Posner, “The Right of Privacy” (1977) 12(3) Georgia Law Review 393 at 408; see also Arrow, supra, note 15. We thank our reviewer for making the point that the reverse can be true, too: information duties imposed under contract law obliging parties to reveal information are a means to mimic or even foster trust. While literature on the imposition of information duties in EU contract law rather stresses the function of information duties as either a tool of market regulation to cure information asymmetries between parties or to enhance private autonomy (eg D Kästle-Lamparter, “Section 4: Pre-contractual Information Duties” in N Jansen and R Zimmermann (eds), Commentaries on European Contract Law (Oxford University Press 2018) pp 383, 402–403) they could, of course, ultimately lead to more trust between parties. Nonetheless, trust always has a definitional element of uncertainty about how other people will behave; therefore perfect information would probably do away with trust altogether. As put by Gambetta, “For trust to be relevant, there must be the possibility of exit, betrayal, defection”: see D Gambetta, “Can We Trust Trust?” in D Gambetta (ed), Trust: Making and Breaking Cooperative Relations (Blackwell 1988) pp 213, 218–219.

23 Dasgupta, supra, note 16; A Dixit, “Governance Institutions and Economic Activity” (2009) 99 American Economic Review 5.

24 An alternative would be to set up a company/firm.

25 The concept of second and third-party institutions and governance are discussed in Dixit, supra, note 23.

26 We use the concepts of peer-to-peer and Leviathan trust to cover the same idea or institutional phenomenon as discussed in the widely circulated draft paper by K Werbach, “Trustless Trust”, on file with the authors, p 4.

27 We engage to a certain extent with these questions in Eenmaa-Dimitrieva and Schmidt-Kessen, supra, note 4.

28 Dixit, supra, note 23. Dixit refers here also to R Benabou and J Tirole, “Intrinsic and Extrinsic Motivation” (2003) 70(3) Review of Economic Studies 489.

29 Dixit, supra, note 23, pp 11–12.

30 ibid.

31 This term is coined by Werbach based on Elinor Ostrom’s conceptual work: see Werbach, supra, note 26, p 4; Dixit, supra, note 23, p 13.

32 Werbach, supra, note 26, p 16.

33 Important foundational works for relational contract theory within the area of law are S Macaulay, “Non-Contractual Relations in Business: A Preliminary Study” (1963) 28 American Sociological Review 55; I Macneil, “Relational Contract: What We Do and Do Not Know” (1985) 4 Wisconsin Law Review 483.

34 Dixit, supra, note 23, pp 14–15.

35 Werbach, supra, note 26, p 6.

36 We thank Karen Yeung for drawing attention to our label.

37 This is the basic game theoretical explanation found in any law and economics textbook for why contract law exists, eg R Cooter and T Ulen, Law and Economics (6th edn, Pearson 2012) p 284.

38 On chargeback mechanisms used by online intermediaries, see Y Guo, “To Sell or Not to Sell Exploring Sellers’ Trust and Risk of Chargeback Fraud in Cross-border Electronic Commerce” (2018) 28 Information Systems Journal 359.

39 Eenmaa-Dimitrieva and Schmidt-Kessen, supra, note 4.

40 J Bacon et al, “Blockchain Demystified” (2017) Queen Mary School of Law Legal Studies Research Paper No 268/2017, 5 <ssrn.com/abstract=3091218> (last accessed 26 June 2019).

41 See Werbach, supra, note 26; K Werbach, “Trust, But Verify: Why the Blockchain Needs the Law” (2018) 33(2) Berkeley Technology Law Journal 487 <ssrn.com/abstract=2844409> (last accessed 30 July 2019).

42 Public Key Infrastructure (PKI) is one of the possible authentication mechanisms based on cryptography and is used both for the Bitcoin and the Ethereum blockchain. For a more detailed explanation of PKI see, eg, Bacon et al, supra, note 40.

43 There is a lot of research showing that at least of the Bitcoin blockchain, PKI does not provide any meaningful level of anonymity. See S Meiklejohn et al, “An Empirical Analysis of Anonymity in Zcash” (2018), <smeiklej.com/files/usenix18.pdf> (last accessed 26 June 2019).

44 M Raskin, “The Law and Legality of Smart Contracts” (2017) 1 Georgetown Law and Technology Review 305 at 309–310 <papers.ssrn.com/sol3/papers.cfm?abstract_id=2959166> (last accessed 26 June 2019).

45 Raskin, supra, note 44, p 311.

46 Node usually refers to a single computer in a network of computers. In the case of blockchains, the node is a computer that stores a copy of the blockchain. In public blockchains any node can participate in the consensus mechanism. See, eg, P De Filippi and A Wright, Blockchain and the Law: The Rule of Code (Harvard University Press 2018) p 36.

47 J Bonneau et al, “SoK: Research Perspectives and Challenges for Bitcoin and Cryptocurrencies” (2015) 2015 IEEE Symposium on Security and Privacy (IEEE 2015).

48 ibid.

49 ibid.

50 ibid.

51 Bacon et al, supra, note 40, pp 6–7.

52 Ibid. See also De Filippi and Wright, supra, note 46, p 36.

53 For Ethereum, for example, all transactions that have occurred so far are available on various websites, eg Etherscan, <etherscan.io/txs> (last accessed 26 June 2019).

54 This is at least the case for the two main examples of public blockchains, Ethereum and Bitcoin. The open source software of bitcoin is called Bitcoin Core (see <github.com/bitcoin/bitcoin> (last accessed 26 June 2019)). Ethereum is developed through an open-source process, while the ultimate decisions about changes to the protocol are taken by the Ethereum Foundation, and by the Ethereum founder Vitalik Buterin: see N Tomaino, “The Governance of Blockchains” (2017), <thecontrol.co/the-governance-of-blockchains-5ba17a4f5da6> (last accessed 26 June 2019).

55 Bacon et al, supra, note 40, pp 21–22.

56 The classic argument for using open source software is that it is more secure, since it allows anyone to inspect the source code of a program and understand how it functions. As a Reddit blogger put it in an easily understandable way: “It’s not that open source software is necessarily better engineered… it is that without the source code it is impossible to see what a program does. So open source software is seen as more secure as it is the only kind of software that can be checked for security at all without needing to blindly trust someone… everything not open-source can’t be checked and by this has to be seen as insecure”: see J Lynch, “Why is Open Source Software More Secure”? (2015) <www.infoworld.com/article/2985242/why-is-open-source-software-more-secure.html> (last accessed 26 June 2019)). For a more comprehensive argument on why software should be open source and how copyright helps to support the open source software movement, see J Boyle, Enclosing the Commons of the Mind (Yale University Press 2008) ch 7.

57 Bacon et al, supra, note 40, pp 11–12.

58 As De Filippi and Wright explain, just as the Internet was envisioned by some activists as a space free of government intervention, so was the creation of the idea of SCs by cypherpunk Nick Szabo. De Filippi and Wright, supra, note 46, pp 7, 73.

59 For a more detailed discussion on the distinction between public and private blockchains in general see, eg, Eenmaa-Dimitrieva and Schmidt-Kessen, supra, note 4.

60 Bacon et al, supra, note 40.

61 For studies on such technologies through the lens of transaction cost economics see eg Catalini and Gans, supra, note 21; S Davidson et al, “Blockchains and the Economic Institutions of Capitalism” (2018) 14(4) Journal of Institutional Economics 639; A Nicita and M Vatiero, “Blockchain and incomplete rights. Whither challenges for rules and organisations” Presentation at the Annual Conference of the Italian Law and Economics Society 2017, Rome, 16–17 December 2017.

62 This theory goes back, for example, to the works of Ronald Coase and Oliver Williamson.

63 We thank Roger Brownsword for asking this question.

64 The reminder that markets are not always a good thing by definition is discussed in an enlightening way by L Herzog, Inventing the Market: Smith, Hegel, and Political Theory (Oxford University Press 2013). The same point is made by Gambetta, supra, note 22, p 214.

65 De Filippi and A Wright, supra, note 46, p 66.

66 To an extent, illegal behaviour can already be observed in relation to SCs on Ethereum that allow for gambling, see M Bartoletti and L Pompianu, “An Empirical Analysis of Smart Contracts: Platforms, Applications and Patterns” (2017) manuscript <arxiv.org/pdf/1703.06322.pdf> (last accessed 26 June 2019). The authors provide empirical evidence that the second most frequent type of SC on the public Ethereum relates to games, including games of chance, which, since unlicensed, would be illegal in many jurisdictions.

67 Due to the fact that a cartel usually involves an agreement between firms to keep prices artificially high to reap off higher profits jointly, any of the participating firms has an incentive to lower prices in contravention of the cartel, because it would immediately attract most demand in the market.

68 Lianos, for example, envisages an SC between cartel members that distributes funds among cartel members, and could include an escrow function that would prevent the paying out of funds to a cartel member that has deviated from the cartelised price: I Lianos, “Blockchain Competition” in Philipp Hacker et al (eds), Regulating Blockchain: Political and Legal Challenges (Oxford University Press forthcoming), available at SSRN <ssrn.com/abstract=3257307> (last accessed 26 June 2019) p 66.

69 ibid.

70 See OECD, Blockchain Technology and Competition Policy, 8 June 2018, p 2.

71 See, for a similar analysis and conclusion in respect of unilateral anti-competitive behaviour, T Schrepel, “Is Blockchain the Death of Antitrust Law: The Blockchain Antitrust Paradox” (2018) Georgetown Law Technology Review <papers.ssrn.com/sol3/papers.cfm?abstract_id=3193576> (last accessed 26 June 2019) p 27.

72 Kiffer et al show, for example, that on the most popular public blockchain for SCs, Ethereum, more than 60% of contracts have never been interacted with. In addition, all SCs on Ethereum are created by a very small number of users. See Kiffer et al, “Analyzing Ethereum’s Contract Topology IMC” 18, 31 October–2 November 2018, Boston, MA, USA, <mislove.org/publications/Ethereum-IMC.pdf> (last accessed 26 June 2019).

73 This point is also made, for example, by M Finck, “Blockchains and Data Protection in the European Union”, Max Planck Institute for Innovation & Competition Research Paper No 18-01, <papers.ssrn.com/sol3/papers.cfm?abstract_id=3080322> (last accessed 26 June 2019).

74 The massive exploitative use of user data has recently led the German competition authority to impose restrictive measures on how Facebook can use user data, see <www.bundeskartellamt.de/SharedDocs/Meldung/EN/Pressemitteilungen/2019/07_02_2019_Facebook.html> (last accessed 26 June 2019). Others worries concern the use of user data on online marketplaces that could allow for personal pricing, thereby discriminating between various users based on their behaviour and personal attributes. This could lead to a reduction in market trust and could harm consumers. See, eg OECD, Personalised Pricing in the Digital Era, report of 20 November 2018, <one.oecd.org/document/DAF/COMP(2018)13/en/pdf> (last accessed 26 June 2019).

75 Catalini and Gans, supra, note 21. This would also further the objective of data sovereignty for consumers and citizens, see Finck, supra, note 73.

76 See also Finck, supra, note 73, pp 8–9.

77 Catalini and Gans, supra, note 21.

78 ibid.

79 See for example the information duties for an online seller in Art 6 of the E-Commerce Directive 2000/31.

80 Luca explains, for example, that while first generation online marketplaces such as Amazon or eBay showed very little information of buyer and seller to each other, second generation platforms include much more comprehensive user profiles, eg including pictures, and personal biographies (eg Uber or Airbnb). This is not necessarily a good thing, since discrimination on second-generation platforms has become a quite pervasive, and researched, problem. See M Luca, “Designing Online Marketplaces: Trust and Reputation Mechanisms” (2017) 17 Innovation Policy and the Economy 77.

81 Information duties in e-commerce were set up for the purpose of fostering trust in e-commerce, and so is the setting up of personal profiles on online platforms: see Luca, supra, note 80.

82 Whether privacy is ultimately enhanced would always depend on how the blockchain system is designed. This point is stressed, for example, by Finck, supra, note 73, p 9. An example of a privacy-enhancing blockchain system in described in G Zyskind et al, “Decentralizing Privacy: Using Blockchain to Protect Personal Data” (2015) IEEE Security and Privacy Workshops, <ieeexplore.ieee.org/document/7163223/>, (last accessed 26 June 2019).

83 See Datawallet Whitepaper, <datawallet.com/pdf/datawallet_whitepaper.pdf> (last accessed 1 August 2019). For further details on their ongoing work for more transparent and fair data exchange with the help of blockchain based SCs, see A Norta et al, “A Privacy-Protecting Data-Exchange Wallet with Ownership- and Monetization Capabilities” (2018) International Joint Conference on Neural Networks Proceedings (IJCNN 2018), pp 1–8.

84 The description of the scenario stems from an exchange with Roger Brownsword.

85 See OECD, supra, note 70; Catalini and Gans, supra, note 21.

87 See, however, for a critical assessment of such a possibility from a copyright law perspective, B Bodó et al, “Blockchain and Smart Contracts: The Missing Link in Copyright Licensing?” (2018) 26(4) International Journal of Law and Information Technology 311.

88 See Mediachain, <www.mediachain.io/> (last accessed 26 June 2019).

89 See Entropia Universe DeepToken 2018 Whitepaper <deeptoken.io/docs/V6_MindArk_Whitepaper_SINGLES.pdf> (last accessed 26 June 2019). The long-term goal of this project is to create a global intellectual property exchange for IP in digital assets.

90 A report by Berklee suggests that between 20 to 50% of music payments do not make it to their rightful owners. See Berklee, Transparency and Payment Flows in the Music Industry (2015), available at <www.berklee.edu/sites/default/files/Fair%20Music%20-%20Transparency%20and%20Payment%20Flows%20in%20the%20Music%20Industry.pdf> (last accessed 30 July 2019).

91 M Giancaspro, “Is a ‘Smart Contract’ Really a Smart Idea? Insights from a Legal Perspective” (2017) 33 Computer Law and Security Review 830; E Mik, “Smart Contracts: Terminology, Technical Limitations and Real World Complexity” (2017) 9 Law, Innovation and Technology 269 at 293.

92 Mik, supra, note 91, p 281.

93 Deloitte’s 2018 Global Blockchain Survey shows, for example, that 39% of more than 1000 respondent companies will invest more than $5 million in the area of blockchain technology. This alone would amount to at least $1.95 billion. See <www2.deloitte.com/content/dam/Deloitte/cz/Documents/financial-services/cz-2018-deloitte-global-blockchain-survey.pdf> (last accessed 30 July 2019).

94 A Glassdoor Report from 2018 shows that job openings requiring blockchain skills increased by 300% from 2017 to 2018 and pay 61.8% than the US median salary. See <www.glassdoor.com/research/rise-in-bitcoin-jobs/> (last accessed 26 June 2019).

* Helen Eenmaa-Dimitrieva (JSD Yale Law School) is a Postdoctoral Researcher in Information Technology Law at the University of Tartu. Maria José Schmidt-Kessen (PhD European University Institute) is an Assistant Professor at the Copenhagen Business School. The authors are grateful to Roger Brownsword for an e-discussion which inspired them to write this paper and to Karen Yeung, Giovanni Sartor, and Hans Micklitz for drawing attention to the philosophical foundations of their work. They would equally like to thank the organisers and audiences of the conference on “Blockchain, Public Trust, Law and Governance” at the University of Groningen in 2018 and the inaugural conference “Constitutional Challenges in the Algorithmic Society” of the IACL Research Group on Algorithmic State, Society and Market – Constitutional Dimensions in Florence in 2019. They acknowledge the generosity of the European University Institute that provided them with an excellent research and teaching environment, as well as the Dora Plus programme (funded by the European Regional Development Fund) that supported their research.

Smart Contracts: Reducing Risks in Economic Exchange with No-Party Trust?

  • Helen EENMAA-DIMITRIEVA and Maria José SCHMIDT-KESSEN

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