Are Smart Contracts the Future of Fraud Prevention?

Tuesday, November 7, 2017

This is the first in a series of three articles about blockchain-enabled “smart contracts” and their ability to address retail fraud. In the first article, we describe evolving solutions to the problem of retail fraud and introduce smart contracts. We also provide background on a case study, the online platform OpenBazaar and its multi-signature escrow approach to addressing fraud.

Evolving Approaches to Retail Fraud

Retail markets require confidence to function. All parties must believe they are likely protected from fraud. The emergence of electronic commerce posed new challenges in addressing fraud by both buyers and sellers. Retailers no longer know buyers personally, and online fraudsters can conceal their identity and launch large-scale attacks.

The resulting fraud is often low in value but adds up to large losses for the industry. Ex post enforcement of these cases by legal systems is often infeasible: even if law enforcement could pursue these cases, legal costs would often exceed the value of the fraud. In 2015, online merchants reported an average of 156 successful cases of fraud per month with a mean value of $113. While such fraud is quite costly in sum (over $17,000 per month), virtually no merchants would choose to take individual cases to court.

Continued growth of electronic commerce has been enabled in part by private approaches to fraud enforcement and prevention. Ex post private enforcement resolves disputes between buyers and sellers through moderation by a private entity. PayPal, for example, operates its own dispute-resolution system. PayPal can tailor its private system specifically to the needs of retail transactions on its platform, making it far more efficient than courts at resolving such disputes. Large online retailers and payment platforms also employ ex ante mitigation of fraud, using data they gather to decline the transactions most likely to be fraudulent or flag them for increased scrutiny.

The advent of blockchain technology and cryptocurrencies such as Bitcoin and Ethereum, which allow transactions between individuals without intermediaries, has created new challenges in combatting fraud. Parties are more difficult to identify than in traditional e-commerce, making ex post enforcement of fraud more difficult. There is also no large entity like PayPal with the resources and incentives to both moderate cases and mitigate fraud through data analytics. The decentralized nature of blockchain technology therefore requires a novel solution to the problem of fraud.

Enter Smart Contracts

The next step in the evolution of approaches to fraud appears to be smart contracts. Raskin (2017) defines smart contracts as “agreements whose execution is automated. This automatic execution is often effected through a computer running code that has translated legal prose into an executable program.” If the algorithm determines that certain conditions have been met, it automatically executes the terms stipulated in the contract. Smart contracts allow parties to pre-commit to the terms being executed, without relying on a central authority such as the court system to enforce them.

For example, I could agree to a smart contract with a local library stating that if I do not return a book by a certain date (and the library scans a book as it is returned), the cost of the book will automatically be sent from my Bitcoin wallet to the library. In contrast, under a traditional contract, the library would send me a bill, which I could choose to not pay—in violation of the contract. In the extreme case, the library would resort to legal means to force me to pay.

This traditional method of legal enforcement relies on the credible threat of enforcement by a central authority. If a court orders me to pay and I do not, I will be punished further, will have the funds seized, and could ultimately be imprisoned. The smart contract acts as a substitute to this coercive power, allowing parties initiating a contract to pre-commit to executing its terms. I have pre-committed to the charge of the book in the event I do not return it on time. In effect, the pre-commitment device inherent in a smart contract has substituted for the centralized authority of the legal system.

To fully avoid relying on the credible threat of enforcement by a central authority, smart contracts rely on the irreversibility of transactions and “pseudonymity” of cryptocurrencies such as Bitcoin. Substituting a credit card for a Bitcoin wallet in the above example, I could still petition to have the charge reversed. And, aware of the library’s identity, I could still in theory sue them to get my money back. While smart contracts could exist before blockchains, this new technology vastly increases their significance.

To make parties willing to pre-commit to the execution of a smart contract, they must have confidence that the facts leading to automatic execution will be correctly judged. Raskin (2017) explains that blockchain technology coupled with the smart contract seeks to provide this assurance:

The implications for the smart contract are that terms of the contract and the state of facts relating to the performance of the contract can be programmed into a decentralized blockchain that cannot be overridden by any individual malicious or mistaken node. If millions of computers verified that “Murray paid Reuben $100 on March 2 at 4 p.m.” and these computers are disinterested and do not make computational mistakes, then one can assume with an exceptionally large degree of certainty that Murray did, in fact, pay Reuben $100 on March 2nd at 4 p.m.

Case Study: OpenBazaar and Multi-Signature Escrow

The online platform OpenBazaar provides a unique case study on the early use of smart contracts to prevent fraud. OpenBazaar is an open source, peer-to-peer marketplace that uses smart contracts based on blockchain technology. It allows buyers and sellers to transact online without a middleman or gatekeeper. Launched in 2016, the project uses cryptocurrency and cryptography to facilitate fully peer-to-peer commerce.

Given the lack of censorship, concerns abound that OpenBazaar could become “the next Silk Road,” a haven for the sale of drugs and other black market items. However, the virtually all of products currently listed are not illicit, though this may change when the platform’s developers incorporate functionality with dark net browser Tor in its next version.

OpenBazaar’s smart-contract-based system is known as “multi-signature escrow.” When a buyer and seller on OpenBazaar enter a transaction, they mutually agree on a third party who will settle any potential disputes (these arbitrators are selected via a free market on the OpenBazaar platform). Next, the buyer’s funds are transferred to escrow, at which time the seller sends the item. If the buyer receives the item and there are no disputes, the funds are released to the seller. In the event of a dispute, the third party moderates and either sides with the buyer (returning the funds in escrow) or the seller (releasing the funds).

By providing commitment devices for buyers and sellers to not engage in fraud, the multi-signature escrow system uses smart contracts to substitute for central authority, either public or private, in making the enforcement of contract terms credible. If a moderation system is reliable and accurate, buyers and sellers should not have incentives to commit the types of fraud most feasible on OpenBazaar’s platform. This underscores the importance of the moderation system in a multi-signature escrow approach.

In the next article in this series, we will compare the smart-contract-based system employed by OpenBazaar to other methods to address fraud. OpenBazaar’s system has some desirable qualities but also poses several challenges.

 

 

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Max Gulker, PhD

Max Gulker joined AIER in 2015. His primary research areas are applied microeconomics and industrial organization. Max previously worked as an economist for Keystone Strategy, supporting expert testimony for antitrust and intellectual property litigation in high tech industries. Prior to that, he worked on financial litigation matters with NERA Economic Consulting. Max holds a PhD in economics from Stanford University and a BA in economics from the University of Michigan. Follow @maxgAIER.