Smart Contracts and the Cost of Inflexibility
42 Pages Posted: 6 Sep 2017 Last revised: 18 Nov 2017
Date Written: September 18, 2017
“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 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 decision-makers 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 broad range of operations and greater scalability. Firms’ operational and financial infrastructures are digital. Smart contracts can directly interact with these systems, whereas EDI was ultimately reliant on human intermediaries. Proponents of the smart contract revolution do not describe the technology as a way to 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, the shift 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 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.
Keywords: smart contracts, blockchain, contract law, EDI
JEL Classification: K12, D86, D23
Suggested Citation: Suggested Citation