Smart Contracts and Blockchains: Steroid for Collusion?

• Citation: Vol. 28 No. 1
• Publication year: 2018
• Author: By Ai Deng
• topic: Antitrust and Competition,Contracts,Intellectual Property,Technology

SMART CONTRACTS AND BLOCKCHAINS: STEROID FOR COLLUSION?

By Ai Deng¹

I. WHAT IS A SMART CONTRACT?

It is late afternoon. Our stomachs are calling. We walk up to a vending machine. We stare at the selection for a minute, swipe a card or insert some cash, and make our choice. The machine (usually) gets us the snack we want and also figures out how much change to give back. It is such a routine part of life that most of us probably don't realize that we and the vendor just engaged in a transaction that is based essentially on a smart contract. Smart contracts are those that self-execute as soon as certain contractual terms are met.

The idea is not new. Every time we set up an automatic recurring bank transfer or payment, we effectively create a smart contract with the financial institution. Of course, a smart contract can do a lot more. For example, given the inevitability of smart vehicles in the not-so-distant future, it is easy to imagine a smart insurance contract where sensors on the vehicle detect who is at fault in an accident, insurance rates are adjusted accordingly, and an insurance payment is made automatically—all with minimal human involvement.²

The idea of "smart contracts" was conceptualized by computer scientist Nick Szabo in 1994:³

A smart contract is a computerized transaction protocol that executes the terms of a contract. The general objectives of smart contract design are to satisfy common contractual conditions (such as payment terms, liens, confidentiality, and even enforcement), minimize exceptions both malicious and accidental, and minimize the need for trusted intermediaries. Related economic goals include lowering fraud loss, arbitration and enforcement costs, and other transaction costs.

As indicated by the quote from Szabo, in its simplest form, a smart contract is written as a machine-readable computer program. For example, on the popular smart contract platform Ethereum, smart contracts are created using a particular programming language called Solidity.

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II. WHAT IS A BLOCKCHAIN, AND WHY DO WE NEED IT FOR A SMART CONTRACT?

We began by asking whether smart contracts and blockchains might be a catalyst for collusion. To answer that question, we must first understand blockchains. One can think of a blockchain as a particular type of information management system or, more specifically, a ledger system. It is also the technology that underpins the much-talked-about Bitcoin and other cryptocurrencies. A blockchain has three key characteristics: distributed, trustless, and consensus. Let's use a simple example to build an understanding of how a blockchain works.⁴

Imagine that you have just signed a contract to rent an apartment. As is typically done today, both you and the building management would keep an identical copy of the contract. The idea is that neither party can unilaterally modify any of the terms without revealing a discrepancy. You don't have to trust your landlord, nor does your landlord have to trust you. Obviously, both parties are free to make additional copies of the contract. You may decide to ask one or more friends or family members to keep a copy because you are concerned about theft or simply about the possibility of losing your copy. Your landlord may do the same. When a contract is "distributed" in this way, neither party has an incentive to manipulate the agreement. You have created an environment that works for both parties without necessarily trusting each other.⁵ This is exactly what the blockchain enables us to do. One can think of a block in the blockchain as a collection of these contracts. The blocks are distributed in an analogous way.

There is, however, more to worry about. Suppose you have a pet dog that has a history of destroying your important documents, or that some of your friends may want to mess with you by changing terms (say, your monthly rent amount) in their copies. Your landlord may have a similar concern. At least one way to get around such a problem is to rely on consensus. That is, we are going to believe the version that is consistent with at least 51% of the copies. This is how blockchain works as well, that is, the "truth" on a blockchain is based on consensus.⁶ For this reason, the so-called decentralized consensus is a fundamental feature of a blockchain.

Where does the "chain" part of the blockchain come from? Let's consider the perspective of the landlord for a moment. The landlord may want to track the property you are renting over time. He or she may have rented the same apartment to someone else before you. The "chain" simply refers to the sequence of transactions or blocks of transactions that are recorded in the system. The current block is always linked to the previous block. This allows one to track back all the way to the origin of a transaction, or the ownership history of a property. And thanks to the ingenuity of a design feature of the blockchain, people have little incentive, and for practical purposes are unable, to change the information in a block.⁷ This is known as the "immutability" of the blockchain. And because the blockchain is immutable, the transactions are also "auditable." The relevance of this auditable feature will become clear when we discuss cartels and blockchains in the next section. Finally, it should be clear that although we use a rental contract as our example, any transaction or any information can be recorded on a blockchain.

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Now that we have...