Obsolete?

Photographer: Yuri Kadobnov/AFP/Getty Images

If You Can't Trust People, Try a Smart Contract

Elaine Ou is a blockchain engineer at Global Financial Access, a financial technology company in San Francisco. Previously she was a lecturer in the electrical and information engineering department at the University of Sydney.
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Trust is extremely valuable for markets and the economy. In its absence, though, technology might prove to be the next best thing.

Doing business would be really easy if people could all trust each other. In rural parts of Japan, for example, it’s common to see unattended produce stands where farmers leave fruits and vegetables for sale. Customers pay by leaving cash in a deposit box, and everything operates on the honor system.

In a low-trust society, someone would have to sit in the stall and write a bill of sale to transfer ownership of each item, and buyers would sign a bill of lading as proof of receipt. The produce stand would then need a business license, mandatory liability insurance, and regular health and safety inspections to make sure the vegetables aren’t covered in E. Coli. All of a sudden, buying a vegetable just got a lot more expensive.

One solution is to use a vending machine to automate all these costly functions. The machine could record transactions to avoid disputes. It could have a feedback site for customers to verify that it hasn’t caused any norovirus outbreaks, and to leave complaints if it has. If the produce presented a health threat, the machine could even shut itself down.

That’s the idea behind smart contracts -- a verifiable piece of software that enforces the obligations that might be described in a traditional contract. By automating the performance of contract terms, the software can lower transaction costs in a low-trust society. This makes it possible to create rules without worrying about how to enforce them. And if the software resides on multiple interconnected computers spread all over the world -- that is, on a blockchain -- nobody can tamper with it or shut it down.

Some of the potential uses for self-enforcing rules are pretty spooky. Back in the 1990s, for example, crypto-anarchist Jim Bell designed a system to crowdfund assassinations of government officials. It would collect anonymous donations earmarked for specific targets, then pay out automatically to whoever correctly predicted the date of the assassination -- a date that only the successful assassin would know ahead of time. (Bell also did a stint in federal prison for tax evasion.)

Others see more mundane opportunities, such as tax reporting. Ethereum founder Vitalik Buterin once described a smart contract that would govern a renter's relationship with a landlord: "If he shuts off his account paying the local government $6.60 land value tax per day, then he loses ownership and the contract automatically switches over so you are renting from the government instead.”

Automated reporting appeals to banks, which have seen the cost and complexity of regulatory compliance increase sharply since the financial crisis. Policy-analysis firm Federal Financial Analytics estimates that the six largest banks in the U.S. spent $70.2 billion on compliance in 2013, versus $34.7 billion in 2007. In the last six years, regulators have generated thousands of pages of Dodd-Frank rules that each participant interprets in a slightly different way.

In theory, all those rules could be encoded into software that would translate regulators' interpretation into specific lines of code. If banks used the same software, doing a transaction would be the same as reporting it and subjecting it to regulatory scrutiny -- the software simply wouldn’t allow trades that violated the rules to occur, or would route borderline cases to a human. Banks' need for compliance staff would be drastically reduced.

A recent white paper from the International Swaps and Derivatives Association shows how market infrastructure could be simplified. Here it is before smart contracts:

And here it is after:

With every transaction connected and automated on a blockchain, regulators' job would become a lot simpler. J. Christopher Giancarlo, a commissioner at the Commodity Futures Trading Commission, has gone so far as to speculate that the technology could have prevented the collapse of Lehman Brothers. It takes a bit of magical thinking to expect that smart contracts could replace billions of dollars' worth of infrastructure, but it’s easy to see why that might be an attractive goal.

To those who dream of self-sovereignty on the internet -- or of autonomous, self-governing companies -- this might seem like a bit of a letdown. Seeing banks and regulators appropriate subversive technology is like having your parents sign up for Facebook -- it feels like a violation of safe space. If it makes people better off, though, we might just have to live with it.

  1. Incidentally, Japan has vegetable vending machines.

  2. Kind of like how Uber deactivates driver accounts based on star ratings and cancellation rates.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Elaine Ou at elaine@globalfinancialaccess.com

To contact the editor responsible for this story:
Mark Whitehouse at mwhitehouse1@bloomberg.net