Smart Contracts Are Having Their Moment: Named in the 1990s, they took 15 years to arrive

Saturday, October 28, 2017 - 12:42

Consider a situation where a product is covered under manifold patents held by multiple third-party patent holders. Imagine the time and costs of, among others, monitoring sales and royalty payments. Now imagine a technology that could (1) ensure that every time a sale is made, royalty payments are made to all patent holders in an eye blink; and (2) eliminate the need for an audit because the transaction history is readily secured and transparent. Such “smart contracts” have the potential to eliminate frictions (or transaction costs) common with traditional contracts. But would that also eliminate or materially reduce the role of contract lawyers?

The term “smart contract” was first coined in the early 1990s by Nick Szabo, a computer scientist and legal scholar, to describe an automated contractual relationship. The concept, however, would remain elusive and obscure until about 15 years later, when the right technology – the blockchain – came along.

Created by pseudonymous developer Satoshi Nakamoto, blockchain underpins bitcoin (and other cryptocurrencies) as a distributed ledger that stores, time-stamps, encrypts and verifies every bit of data and could bring Szabo’s concept into reality. The ledger is not under any single entity’s control but is distributed across a network of computers and operates by consensus; all parties can confirm in real time the status of a transaction. If an attempt is made to change any data in a block already added to the chain, it is rejected by the network of computers (i.e., the chain cannot be broken as the blockchain is immutable). Trust rests in the record itself.

Given the enormous potential, it is not surprising that new blockchains far afield from cryptocurrencies are emerging, particularly where trust in the veracity of records and verifiability of transactions are warranted. Insurance, real estate and health care are examples of industries well suited to benefit from blockchain adoption. In law, immutable transaction records could change the way evidence is used in courtrooms.  

An algorithmic smart contract is essentially self-executing code that enables the transfer of complex assets with automated exchange of rights. Business rules and arrangements can be encoded in software that execute themselves automatically under predetermined circumstances, and nothing outside the code can alter the rules of the transaction. Economic theory could provide clarity and guidance for such rules and arrangements, in particular providing an understanding of the potential pitfalls when designing contracts – Oliver Hart and Bengt Holmström were awarded the Nobel Prize in Economics in 2016 for such research.

The proliferation of smart contracts could diminish demand for lawyers to the extent that they are part of the friction within the transaction process. But it is also possible that demand for lawyers could increase in other ways. Indeed, the prediction that smart contracts will diminish the role of the lawyer may be overblown, and yet another example of the “lump of labor” fallacy. This fallacy is the incorrect notion that only a finite amount of work exists, and when automation is introduced, the amount of work is reduced. The historical economic evidence, however, shows that the rise of new technology has generally ended up creating more jobs than it destroys, because automation increases the demand for humans to do the other tasks around it and shifts the work mix toward new types of services.

Whether economic history regarding the lump of labor fallacy repeats itself in this instance, the best contingency is to be smart about the economic impact of the blockchain. Gaining a better understanding of the economics of contract theory couldn’t hurt.


William Choi, a Managing Director at AlixPartners LLP, specializes in finance, antitrust, securities, intellectual property and assessment of class-wide damages. He has testified on economic damages and quantitative methods, and he assists clients on matters related to competition and data analysis. Choi has a Ph.D. in economics from Duke University and can be reached at wchoi@alixpartners.com.