Optimal Smart Contracts with Costly Verification

Abstract

We study optimal smart contract design for monitoring an exchange of an item performed offline. There are two parties, a seller and a buyer. Exchange happens off-chain, but the status update takes place on-chain. The exchange can be verified but with a cost. To guarantee self-enforcement of the smart contract, both parties make a deposit and the deposits must cover payments made in all possible final states. Both parties have an (opportunity) cost of making deposits. We discuss two classes of contract: In the first, the contract only interacts with the seller, while in the second, the contract can also interact with the buyer. In both cases, we derive optimal contracts specifying optimal deposits and verification policies.

Keywords: Smart Contracts, Deposit Design, Costly State Verification

JEL Classification: C72, D82, D86