Blockchain Disruption and Smart Contracts

paper by William Cong and Zhiguo He

discussion by Andreas Park

2018 American Economic Association Meeting in Philadelphia

Research question:

How do
blockchain-registered
smart contracts
affect economic interactions?

Basic Setup

  • suppliers post prices via smart contracts
  • customers arrive and transact/place order
  • blockchain verifiers confirm delivery and record transaction
  1. smart contract: delivery-contingent payment => trust for unknown entrant
  2. blockchain: observing competitors activities => collusion easier 

Results

Economic Insights/Mechanism

  1. blockchain = escrow/trusted party
  2. blockchain changes information environment

Model Mechanism Review (simplified):
no blockchain = benchmark

  1. no verification => no entry
  2. incumbents play a la Green & Porter (ECTA 1984)
    • dynamic game with imperfect monitoring
    • tacit collusion on price-gauging
    • deviations from price-gauging get punished
    • sometimes punishment unnecessary/inefficient
      •  A had no customers not because B cheated
      • but because there were no customers

Model with Blockchain and smart contract

Idea

  • supplier is unknown/new
  • may not deliver a product
    • => pay for nothing
  • if consumers believe that new entrant may be unreliable:
    • => no entry.

Role of blockchain: escrow account that releases payment upon delivery confirmation

Model Mechanism Review (simplified):

with blockchain

  1. with verification => entry happens (if entrant is competitive)
  2. activities/transactions are recorded on/visible through the blockchain and they are visible to suppliers
    • improved monitoring
      • more tacit collusion
      • no inefficient punishments

Welfare Results (simplified):
with blockchain

  1. entry => average quality higher
  2. 2 incumbents only: tacit  collusion space expands
  3. 2 incumbents + entrant: when collusion possible
    • any collusion equilibrium has surplus < any eq. from traditional world
    • exist equilibria with surplus >,=,< any eq. from traditional world

Comment: What is the right benchmark?

But: there are other established market solutions!

  • intermediaries or escrows
  • e.g., marketplaces as certifiers such as Amazon, Apple's App store

 

Currently:

  • w/o blockchain = no verification 
  • w blockchain = verification

Why not:

  • intermediary verifies vs.
  • blockchain verifies

Why important?

  • getting info from outside on the blockchain is a hard problem
  • requires essentially trusted third party

Comment: is entry vs collusion the key trade-off when thinking about blockchain-registered smart contracts?

  • Main message: blockchain presents trade-off
    • verification => trust => entry (good)
    • visible activities => better monitoring => more collusion (bad).
  • Applicability and assessment of surplus trade-offs depend on choice of benchmark.
  • Delivery verification can obtain with intermediaries 
    • => Key feature of blockchain is non-intermediated decentralized interaction

Comment 1: Key question reg. smart contracts in this setting is/should be the trade-off that non-intermediated decentralized interactions bring.

Model Ingredient Review (simplified): product market

q_A,q_B,q_C
qA,qB,qCq_A,q_B,q_C

what are the buyers' decision rules?

what's the role of qualities? why needed?

how do I interpret this in finance?

for most of the paper: truthful verification

Model Ingredient Review (simplified): verifiers

  • Four items of interest:
    • the truth: w
    • the info about w: x
    • the vote on w: y
    • the bias in the vote
  • Q: How do we interpret a bias?
    • ​​For price quotes that are fed by an oracle?
    • For UPS delivery information?

Comment 2 (part 1): the main results in the paper don't use the verifier and instead assume perfect revelation. 

Review of model extensions

  • imperfect consensus may still lead to entry (unless bias is large) 
  • privately observed quality can be included
  • only these two extensions exploit the lengthy consensus modelling and the qualities

Comment 2 (part 2): These results have an appendix-like/robustness-check feel. Why not simplify the model and shift all the complex material to an online appendix? 

Broader Thoughts

  • Collusion (or accusation thereof) is a genuine concern
    • highlighted in Bank of Canada's Jasper II experiment.
  • In practice, tacit collusion is difficult to establish, in particular with many players
    • competitors have an interest to be able to plausibly deny collusion
    • => can they take active steps to create plausible deniability?
      • state channels, multi-IDs, or Zk-snarks?
  • Paper does talk about the design: permissioned vs. public (Sec 4.3 vs 4.4), regulatory nodes, who sees what (Sec 5.1), but the discussion is dispersed throughout the paper.

Comment 3: Does the paper address a question on blockchain design question? If so, organize the paper as such.

Conclusion

  • Blockchain:
    • decentralized ledger that allows peer-to-peer transfers of value
  • smart contracts on blockchain
    • automated execution of contracts with verifiable parameters
  • This paper:
    • smart contracts expand the contracting space relative to world without any verification
    • blockchains change the information environment and affect behavior 
      • follows Yermack (2016) and Malinova & Park (2016).

Summary Main Comments

  1. Welfare/surplus results depend on benchmark
    • IMO,more suitable benchmark would be setting with intermediary
    • should bring out trade-off from core blockchain feature (= enabling non-intermediated transactions)
  2. Many model ingredients aren't used except for results with appendix-feel
  3. If there is a market design question, need to bring it out clearer.

Congrats on getting into the
Review of Financial Studies!

Shorter AEA Discussion of Cong and He

By Andreas Park

Shorter AEA Discussion of Cong and He

My discussion of Cong and He "Blockchain Disruption and Smart Contracts" at the 2018 AEA meeting.

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