SMART CONTRACTS AND THE COST OF INFLEXIBILITY.

Author:Sklaroff, Jeremy M.
Position::COMMENT
 
FREE EXCERPT

"Smart contracts" are decentralized agreements built in computer code and stored on a blockchain. Proponents imagine a future where commerce takes place exclusively using smart contracts, avoiding the high costs of contract drafting, judicial intervention, opportunistic behavior, and the inherent ambiguities of written language.

These decentralized code-only contracts are part of a decades-long quest to eliminate supposed inefficiencies in traditional written agreements. Electronic data interchange (EDI), a contracting technology from the 1970s, was designed with the same goal and garnered similar fanfare. Commentators at the time imagined a revolution in the way firms transacted and a full shift away from anything resembling a paper contract. Ultimately EDI failed to achieve these goals--it empowered, rather than circumvented, human decisionmakers along with their "inefficient" way of forming agreements. In doing so, EDI successfully reduced some transaction costs while preserving efficient forms of contractual flexibility.

Smart contracts are indeed more technologically sophisticated than EDI. Smart contract scripting languages offer a broader range of operations and greater scalability. Smart contracts are capable of seamlessly integrating with the operational and financial systems at the core of modern firms, whereas EDI transactions occurred in very early digital environments that required human intermediaries. Proponents of the smart contract revolution, therefore, do not describe the technology as a way to merely enhance human activity; they argue it can replace every stage of agreement formation and performance. From a purely technical standpoint, they might be right.

However, shifting away from human-language contracts creates new inefficiencies. These stem from three features of smart contracts: automation, which requires that every agreement be formed from fully-defined terms; decentralization, which conditions performance on verification by third parties; and anonymity, which eliminates the use of commercial context to give meaning to agreement terms. As a result, it is extremely costly to form smart contracts in a volatile environment or whenever there's a level of uncertainty surrounding the agreement.

On the other hand, semantic contracts are flexible. They enable parties to use performance standards, generally-defined contract terms, to create an enforceable agreement without requiring complete knowledge of what might happen in the future. Standards also allow parties to responsively incorporate commercial customs into their agreement, circumventing the need for explicit but redundant negotiation. And once their agreement is formed and executed, the parties are nonetheless free to dynamically shape their relationship through informal modifications or by selectively enforcing breaches. These two forms of flexibility--linguistic ambiguity, and enforcement discretion--create important efficiencies in the contracting process. By eliminating this flexibility, smart contracting will impose costs that are more severe and intractable than the ones it seeks to solve.

INTRODUCTION 265 I. LEX CRYPTOGRAPHIA? 267 A. The Rise of Bitcoin 268 B. How to Lease a Car from an Anarchist 271 II. FLEXIBILITY AND SEMANTIC CONTRACTS 279 A. Contracting Through Uncertainty 279 B. Avoiding Redundant Negotiation 282 C. Enforcement Flexibility 284 III. FLEXIBILITY AND ELECTRONIC DATA INTERCHANGE 286 A. The Vanguard of Electronic Contracting (in 1969) 287 B. Business Processes as Computer Code 288 C. Computer Code as Human Decisionmaking 289 IV. INFLEXIBILITY IN SMART CONTRACTS 291 A. Precision, Decentralization, and Anonymity Create Unique Costs 291 B. Smart Contracts Cannot Create a Transaction-Costless Environment 296 C. Open-Source Development is Efficient in Some Contexts But Not in Contract Creation 298 D. Blockchain-Based Dispute Resolution is Radically Uncertain Without Offering Any Advantage Over Traditional Contract Litigation 300 CONCLUSION 302 INTRODUCTION

Technology promises to replace slow and imprecise paper institutions with efficient, digitized counterparts. (1) Contract law is a frequent target of these hopes. (2) Though contracts ostensibly provide relief from the inefficiencies of public law, creating stable and predictable rules with which parties can privately order their affairs, many claim that contract law is broken, and sorely in need of a "killer app."

Such criticisms come from the academy and from practitioners alike. Scholars criticize the inconsistency of judicial contract interpretation and the unpredictability of remedies in cases of breach. (3) Even more severe criticisms come from commerce and industry, the private parties for whom contracts are explicitly supposed to be efficiency-enhancing. They view contract drafting as being dominated by arbitrary complexity, empowering lawyers to sap businesses of time and money. (4) Some of the most ferocious criticism comes from technology entrepreneurship, where time and money are both especially rare commodities, compared to more mature industries that have perhaps accepted the inevitability of complex contractual arrangements. (5)

With criticism concentrated in technology-forward industries, it's no surprise that technology is proposed as an answer. Indeed, the desire to redesign human affairs according to digital rules--motivated by a desire for transparency and efficiency, and an ideological distrust for human institutions--accompanies each era's major technological developments. (6) The creation of elementary mainframe computers in the early Seventies inspired visions of governments and societies structured entirely around data flows and statistical modeling. (7) It also hinted at revolutions in the internal organization of the firm, and in the ways that firms could interact externally. Developments in processing power and speed allowed firms to distribute computers throughout the business, creating information systems that were granular, accurate, and fast, driving new kinds of management decisionmaking. (8) The maturation of the Internet transformed both the nature of commerce and the nature of society. But at each stage, the ultimate effect of disruptive technology is both more limited, and more unpredictable, than evangelists initially declare. (9) The Internet has allowed for unprecedented access to knowledge and information, but also has enabled corporate concentration, government surveillance, and new types of control over consumers. (10)

This Comment analyzes smart contracts, a recent development in the quest to replace traditional contract law. (11) Smart contracts enable firms to transact without the need for law or courts. They can autonomously negotiate with other parties (or other parties' smart contracts), and then attach directly to the parties' information systems so that goods or payment promised by the contract are automatically delivered. According to the technology's more extreme advocates, smart contracts will revolutionize the way firms transact and may fundamentally transform our social and legal institutions. However, even if the technology is robust enough to enable such a change, its tangible effects on firms' interactions will be more nuanced than evangelists claim. In some instances, it will make transactions more expensive and inefficient than the traditional legal contracts it aims to replace.

This Comment proceeds as follows. In Part I, I explain the technology underlying smart contracts, trace its evolution from Bitcoin, and describe a sample smart contract in use today. In Part II, I analyze the importance of flexibility in the contracting process as a way to manage transaction costs. I focus on standards--roughly-defined contract terms that guide parties' behavior without precision--and on informal contract governance, which helps mitigate incentives for bad-faith litigation or other abusive behavior. In Part III, I compare smart contracts to electronic data interchange (EDI), an older contracting technology whose proponents also imagined would transform the fundamental nature of contracting. I argue that EDI's features actually enabled--and encouraged--parties to rely on flexibility and informal dispute resolution in their contracting process, whereas smart contracts make such flexibility impossible. Finally, in Part IV, I identify what exactly makes smart contracts so inflexible, and then anticipate some possible responses.

  1. LEX CRYPTOGRAPHIA?

    Today, a new technology dominates conversations about the future of social and commercial organization. Broadly labeled "decentralized ledger technology" (DLT), the term spans a group of cryptographic tools and protocols to exchange, verify, and secure data without the need for centralized intermediaries. (12) So-called "trustless exchange" is motivated by the same goals as technologies that came before--autonomy from inefficient and corruptible institutions, an insistence on the primacy and desirability of private social ordering, and frustration with the law and lawyers. (13) And as with those earlier technologies, DLT has attracted a curious mix of sophisticated global corporations and shadowy activists, placing IBM, Maersk, and JP Morgan alongside cryptoanarchists, cypherpunks, and black market drug kingpins. (14)

    1. The Rise of Bitcoin

      What unites these seemingly disparate groups is more than an interest in using DLT for information storage and exchange. DLT's earliest but most successful application to date is Bitcoin--a "cryptocurrency" built using DLT protocols to enable participants to create, store, and exchange money itself. (15) Bitcoin's market capitalization has soared in the past year, reaching about $2oB in late 2016, and was the world's best performing currency during 2015. (16) Bitcoin can be used as payment for hundreds of thousands of firms and service providers, including Microsoft, Dell, Overstock.com, and even the Chicago...

To continue reading

FREE SIGN UP