- Yannis Bakos, Associate Professor, Stern School of Business, New York University
- Hanna Halaburda, Associate Professor, Stern School of Business, New York University
This blog article is derived from the authors’ paper titled Blockchains, Smart Contracts and Connected Sensors: Substitutes or Complements?, a project of the Economics of Digital Services (EODS) initiative led by Penn’s Center for Technology, Innovation and Competition (CTIC) and The Warren Center for Network & Data Services. CTIC and The Warren Center are grateful to the John S. and James L. Knight Foundation for its generous support of the EODS initiative.
Blockchain-based smart contracts have been in the spotlight because of the increasing attention on blockchains. They were popularized with the initial release of Ethereum in 2015, as the ability to offer “Turing complete” smart contracts (essentially, smart contracts that can implement any computer algorithm) was a central design goal. Since then, smart contracts have been at the forefront of blockchain applications, such as enabling certain types of coins in ICOs (initial coin offerings) or providing functionality for NFTs (non-fungible tokens).
This has brought attention to the potential economic role of smart contracts, with frequent claims that they will improve economic efficiency while also affecting firm boundaries and supporting new business models—for instance, blockchain-based smart contracts could transform interactions between firms by providing an alternative to the legal system. An early example was the creation of DAOs (decentralized autonomous organizations), which are organizations based on rules encoded in smart contracts rather than legally sanctioned authority. More recently, we are seeing this idea demonstrated by the use of smart contracts in enabling DeFi (decentralized finance).
The idea of smart contracts is often attributed to Nick Szabo’s 1996 proposal for a “smart lien” on a car, which would automatically “return control of the car keys to the bank” if the borrower fails to make payments and thus “might be much cheaper and more effective than a repo man.” More recent examples include using real-time transaction data to provide automated sales or inventory financing or taking automatic actions when a transported good is subjected to unfavorable conditions. This is one of the capabilities of TradeLens, the blockchain-enabled digital shipping platform by Maersk and IBM Blockchain Solutions, which can trigger automatic shipment for the replacement of fruit that has not been properly refrigerated in transit.
The main value of these applications of smart contracts comes from efficiencies resulting from their automated algorithmic execution—if certain states of the world occur (such as failure to pay on a car loan), corresponding actions take place automatically (e.g., the car is disabled and its location communicated to the bank so that it can be repossessed). For this to work, however, smart contracts critically depend on digital inputs that allow them to trigger the corresponding actions. Many of these inputs may already exist in digital form, such as digital notification of a delivery, a trade execution, or a missed payment, but some of the most promising applications of smart contracts rely on new sources of digital information. In the smart lien example, the smart contract not only needs to be informed of the failure to make payments but also connected sensors would be needed that can disable the car and communicate its location to the bank.
The impact of smart contracts thus is closely linked to the availability of connected sensors (like those that are part of IoT—the “Internet of Things”) and of blockchain “oracles” that can provide smart contracts with information from the outside world. When such connected sensors are developed and adopted, they provide important functionality even without smart contracts—the bank could disable the car and initiate repossession without a smart contract. This leads to the questions before us: : How much value is created from smart contracts and how much from the connected sensors? Do we need blockchains as platforms for smart contracts?
Our analysis shows that introducing smart contracts and connected sensors in a business setting changes the strategic interaction between the parties to an agreement or a contract. This is not just an incremental quantitative change in the value of certain parameters, such as a reduction in the cost of writing a contract or obtaining certain information, but rather a qualitative change in the structure of the interaction that is different for each of these technologies—in the language of game theory, the structure of the game changes.
Blockchains play a key role
Smart contracts such as limit brokerage orders and vending machines have existed for a long time without blockchains. , The increasing prevalence of blockchain technologies, however, broadens the scope and applicability of smart contracts. Blockchains provide an infrastructure for the recording and execution of smart contracts and play a key role in three main aspects:
First, blockchain technology can assure the irreversibility of actions executed by smart contracts such as a payment upon delivery. Before blockchains, the value of smart contracts came from automation rather than commitment. For instance, automated payment with a credit card may offer convenience, but it can be reversed by the credit card network if it is challenged as unauthorized or fraudulent. Without irreversibility, smart contracts do not address concerns of reneging on agreements.
Different types of blockchain platforms provide different levels of assurance against reversing a transaction. In permissioned blockchains a payment can be reversed by agreement of a large enough number of validators, but such reversals are very rare and would likely require an extraordinary level of effort and supporting evidence. As long as the blockchain operator and validators can be trusted not to compromise the platform, parties to a smart contract are well protected. Similarly, in well-functioning permissionless blockchains, transactions are also practically irreversible. Reversal would require either a successful attack or a level of coordination among miners similar to what is involved in protocol changes, either of which would be infeasible for typical transacting parties.
Second, blockchain technology guarantees that information provided from sensors and oracles has not been tampered with after it is recorded on the blockchain. Modern sensors can use digital signatures to assure the integrity of their data and can be designed to prevent or at least detect tampering with their operation. Blockchain “oracles” can relay to smart contracts information from connected sensors but can also provide data from external data sources; these oracles can authenticate and query these sources, usually via APIs from trusted websites, and then provide the relevant information to smart contracts. The capabilities of connected sensors are continuously increasing as their hardware, software, and connectivity improve. This, combined with the authentication and integrity protection provided by digital signatures and recording on the blockchain, can allow us to reliably identify the occurrence of states of the world at an increased level of detail, and then use smart contracts to trigger appropriate corresponding actions.
Third, there is substantial recent growth in decentralized business models based on short-term interactions among anonymous or pseudonymous parties that are typically implemented on permissionless blockchains such as Ethereum. In such interactions the mechanisms traditionally used to enforce agreements in business settings, such as the court system or alternatives like reputation or relational contracts, are not feasible, and the cost of enforcing agreements, which is a key parameter in our analysis, is practically infinite. As a result, smart contracts and trusted oracles or sensors that can provide the necessary digital inputs are key in enabling these business models. For example, decentralized finance (DeFi) depends on transactions among parties that do not know or trust each other and is made possible only because all aspects of such transactions can be implemented by smart contracts that obtain information from trusted sources—trust is in the technology rather than in the institutions.
Findings from an economic model for smart contracts and connected sensors
We modeled a simple supply chain setting with two parties to a potential trade for transportation where a costly action by the transporting party, such as proper refrigeration of fruit being transformed, can improve the quality of the delivered goods. Payment is due upon delivery, but there is the possibility that the receiving party could renege on payment. In this setting, we analyzed the implications of automated and irreversible execution made possible by smart contracts, the implication of more granular states that can be identified and verified by connected sensors, and how they each affect the scope and efficiency of contracting.
A smart contract can trigger irreversible payment upon delivery. This could be achieved via direct blockchain verification, such as a digital token representing proof of delivery; via an appropriately verified sensor reading, such as scanning a tamper proof tag on a shipping container; or via a blockchain oracle such as a system that obtains verified information from port authority or customs records and provides a corresponding indication of delivery on the blockchain.
A connected sensor can determine and communicate on the blockchain whether proper refrigeration was provided during transportation. This could be accomplished, for instance, by sensors that indicate whether transport temperature was kept in the appropriate range, that can detect tampering with either the container or the sensors, and that can communicate their readings to the blockchain either directly or via a trusted oracle. Implementing this type of sensor makes refrigeration during transport verifiable, as the readings of the sensors can be provided to a third party such as a court or an arbitrator. This kind of sensor also allows the contracted payment upon delivery to be contingent on whether proper refrigeration was provided.
Our analysis shows that the cost of contract enforcement (e.g., the cost of legal action or arbitration) is a key parameter in our setting. This cost can be substantial―in our setting involving international transportation, it would likely be prohibitively expensive to resolve disputes in court. Arbitration might be cheaper, but it is still expensive. Even if the losing party must reimburse the arbitration costs of the winning party, the uncertainty of resolution, delay of over a year in settling the dispute, and uncertainty in being able to collect any award may be costly. Similarly, in settings with short-term interactions among anonymous participants, such as blockchain-based decentralized business platforms like dApps or DeFi, participants do not know or trust each other. Thus, they cannot rely on the legal system or arbitration mechanisms for enforcement, making the cost of enforcing agreements practically infinite.
We show that when the cost of contract enforcement is low compared to the potential gains from trade, the ability of smart contracts to prevent reneging adds little value, as the contractual terms can be enforced at a low cost with alternative solutions. Connected sensors making relevant states verifiable are beneficial as long as their cost is lower than the resulting efficiency gain from enabling a higher value equilibrium outcome.
When the cost of contract enforcement is comparable to the potential gains from trade, there will be no trading without either smart contracts to reduce the enforcement cost or connected sensors to increase the value generated at equilibrium. Depending on their implementation cost, both smart contracts and connected sensors can add value but may act as substitutes in the sense that depending on the parameter values, it will be efficient to employ one but not both.
When the cost of contract enforcement is high compared to the potential gains from trade, there will be no trade without smart contracts, and in that case connected sensors can further increase the value created and should be adopted if their cost is less than that increase. Connected sensors and smart contracts may act as complements in the sense that they create value only if the two technologies can be implemented together.
We show that under conditions that depend on the parameters of the setting, it can be individually and socially optimal to implement only smart contracts (based on the currently available data), only connected sensors (providing additional verifiable information), or both sensors and smart contracts (i.e., where synergies exist between them). Furthermore, we show that the incentives to adopt these two technologies may differ for different economic agents and may not be aligned with social optimality. Our results also demonstrate that smart contracts may “democratize” certain business areas by providing alternatives to other mechanisms to operate in environments with high enforcement costs such as relational contracting, reputation, or bonding, all of which tend to favor established or large participants.
Discussion and policy implications
Connected sensors and smart contracts have different impacts on contracting outcomes. Connected sensors increase verifiable information and thus expand the strategy space by allowing payoffs to depend on new actions and outcomes. This can lead to more efficient trades but typically does not achieve full efficiency, especially in settings where enforcement costs are high. By contrast, smart contracts automate execution and thus restrict the strategy space by eliminating actions like reneging or hold-up, which allows for commitments that previously would have been too expensive to enforce; this typically increases efficiency. When applied together, smart contracts and connected sensors enable all efficient trades, including certain trades that neither technology can enable individually.
Predictions of the increasing prevalence of smart contracts often fail to make this distinction and incorrectly attribute the benefit from the digital inputs that provide information to the smart contracts that use them, which can promote inefficient implementation of technology in practice.
Technological progress in connected devices has meant that the Internet of Things also includes connected “actuators” that allow the triggering of actions such as remotely disabling the car in Szabo’s smart lien example. Like sensors, the result of such actuators is to enable or facilitate new actions and therefore extend the strategy space of the contracting parties. Thus, they have similar implications, and our analysis of connected sensors can be thought of as also encompassing connected actuators.
A key factor driving our results is the cost of enforcing an agreement when one of the parties reneges, something frequently not considered in the contracting literature.
When the cost of legal action is high, repeated relationships (i.e., relational contracts) and reputation can also prevent reneging on contractual obligations and thus can mitigate the cost of contract enforcement. Reliance on these mechanisms, however, creates barriers to entry for new market participants. An important premise of smart contracts has been that they would “democratize the marketplace,” countering the advantage that established large players enjoy even if they do not offer a better product. In our analysis, we examined whether smart contracts indeed allow for this premise to be realized. Wefound that while smart contracts can help address enforcement costs, in many cases the ability to deliver on this premise depends on the simultaneous deployment of appropriate connected sensors.
Our findings can guide investment decisions in smart contracts and connected sensors by investors and platforms or policy and subsidization decisions by governments. They also illustrate the key role of smart contracts in enabling the emerging blockchain-based decentralized business models such as DeFi.
We also found there can be divergence between private and social incentives to invest in smart contracts and sensors, which raises the question of whether this could justify regulatory intervention or subsidizing smart contracts or smart sensors. In addition, there could be externalities that should be taken into account—for instance when development and deployment of certain connected sensors enables derivative applications.
Another policy concern is that smart contracts can be used to enforce illegal agreements, where recourse to the legal system is not available as traditional contracts would not be enforceable; in such cases the high enforcement cost may prevent certain activities of negative social value, which would be socially desirable. Examples might include trading in restricted items or reaching agreements for anticompetitive behavior, possibly with the identities of the responsible agents masked to avoid legal consequences.
Finally, smart contracts and connected sensors may be able to help with implementing international treaties, such as limits to greenhouse gas emissions, where trust among participants and ability to monitor compliance and enforce agreements are major challenges.