Smart Contracts Provide an Alternative to Legal Enforcement

Tuesday, November 14, 2017

This is the second in a series of three articles about blockchain-enabled “smart contracts” and their ability to address retail fraud. In this article, we continue our case study on the online platform OpenBazaar and the smart-contract approach to mitigating fraud, known as multisignature escrow. We provide a framework to evaluate this approach and compare it to public and private ex post enforcement of traditional contracts. The first article in the series is available here.

Three Methods of Dispute Resolution

Ex post Legal Enforcement

Most people typically think of contracts as being enforced by the legal system. If one party to a contract feels another party has breached its terms, they can file litigation, with all that implies: attorneys, negotiation, the prospect of settlement, and in some cases trial. There are set rules for each stage of a case, governed for instance by U.S. civil procedure, but each stage is fully handled by human beings rather than computer algorithm. At the heart of the assumed enforceability of legal verdicts is the coercive power of the state: if a party does not abide by the court’s verdict, there is a credible threat of greater punishment and in theory imprisonment.

Ex post Private Enforcement

Online payment platforms such as PayPal decide many contractual disputes between buyers and sellers privately. For example, a buyer may open a dispute against a seller of a physical good for two reasons: “Item Not Received” or “Significantly Not as Described.” The issue is classified as a “dispute,” and the parties are first encouraged to resolve the matter between themselves. The negotiation process allows the parties to communicate, but is more algorithmic than the legal process described above: the dispute is closed automatically after 20 days if neither party has escalated it to a “claim.” A seller has 10 days to respond to a claim with requested information such as records about when an item was shipped, at which point “PayPal will work to evaluate the information provided and determine the outcome of the claim.”

The system also handles cases where sellers believe that buyers have fraudulently initiated a chargeback with their credit card company. The private enforcement mechanism allows PayPal to incentivize sellers who follow best practices for preventing fraudulent chargebacks—for instance, by using parcel carriers who provide full documentation of shipment and receipt.

PayPal often has control of the disputed funds in such claims and can release them to the winner. Instead of deriving authority from the state’s coercive power, PayPal derives authority from its gatekeeping power. Noncompliant buyers and sellers face the credible threat of being banned from the site, which for some online sellers could be a matter of life and death. It is noteworthy, however, that buyers and sellers must provide PayPal enough information as an intermediary that cases of fraud could in theory be litigated in the court system if the parties chose (though this method would often not be cost-effective).

Multisignature Escrow

The multisignature-escrow method of addressing fraud was not originated by OpenBazaar, but the platform provides an early test of its efficacy. The approach combines decentralized moderation with the commitment mechanism of smart contracts. When a buyer and seller enter a transaction, the buyer places their funds in a special Bitcoin wallet that requires two of three signatures (the third being an independent moderator) for the funds to be released. As OpenBazaar notes, there are five possible outcomes:

  • The buyer and seller are both satisfied and release funds to the seller
  • The seller cannot deliver and the buyer is unhappy. They mutually agree to release funds back to the buyer
  • In a dispute, the moderator finds in favor of the buyer, the buyer signs and funds are released to the buyer
  • In a dispute, the moderator finds in favor of the seller, the buyer signs and funds are released to the seller
  • The moderator finds neither or both parties at fault, and joins with either party to release funds in a split

OpenBazaar provides a decentralized marketplace for moderators, which buyers and sellers select and agree on prior to a transaction. Moderators list a percentage fee they charge should cases go to a dispute, and can provide information about their experience and philosophy or list incentives such as the use of certain shipping providers (as in the case of PayPal above). Note that this feature is not essential to the multisignature-escrow approach: a retail platform using multisignature escrow could provide adjudication centrally, or it could be provided by a separate for-profit firm.

Due to the anonymity made possible by OpenBazaar, a buyer or seller could not bring such a dispute to the court system even if they wished. It is the commitment device of smart contracts that substitutes for the public and private sources of central authority. Buyers and sellers must abide by moderators’ decisions because they have pre-committed to those decisions’ being executed without their direct consent.

Comparing Dispute Resolution Methods

This section provides a comparison of several attributes of the three methods described above. The table below summarizes this comparison. For many of the attributes listed, the methods become increasingly decentralized as one moves from left (ex post legal) to right (multisignature escrow). Decentralization appears to be favorable along many of the dimensions we discuss below, though it poses special challenges for some attributes.

Source of Authority

To ensure enforcement, a traditional contract relies on the credible threat of action by some central authority. Parties who do not abide by legal decisions potentially face several sanctions that ultimately end in the state’s power to imprison someone who violates a court order. In contrast, private firms such as PayPal have no authority over physical freedom, but do have authority over their own property, in this case access to the platform itself. Losing parties in a claim, particularly sellers, risk being banned from the platform, which may greatly impact future revenues. However, PayPal as an intermediary possesses enough information about each party that they could be subpoenaed in a court case (though for low-value claims, this threat is mostly theoretical).

PayPal also has the authority in most cases to automatically transfer the funds in a dispute to their rightful owner. In practice, this is likely all that is necessary to resolve many disputes between buyers and sellers. The multisignature-escrow approach performs the same function without an intermediary by using smart contracts to create a commitment from each party. With OpenBazaar, there is no central intermediary to move funds, make a credible threat to ban a party from the platform or even know the identity of each party. The potential of smart contracts to substitute for a central authority by simply forcing parties to commit to resolutions before the transaction begins is striking.

Application of Common Rules

While there are different jurisdictions, types of cases and institutions such as small-claims court, all court cases in the United States are essentially in the same legal system. This means that the procedures applied have not been adapted specifically to retail disputes, let alone disputes on one platform. PayPal can adjudicate disputes on its own platform far more inexpensively and efficiently than the courts because cases do not have to go through the same procedural hurdles or red tape. On OpenBazaar, each third party moderator in the marketplace could have his or her own pre-stated rules or knowledge. Moderating a dispute about product quality might be significantly different for vintage baseball cards, flower seeds or cigars. In a free marketplace, one might find moderators tailored to each.

Scope for Penalizing Fraud

In the court system, a judge or jury can assign more severe punishments to a convicted fraudster than merely returning funds to the rightful party. These can include civil damages, fines, and jail time. A private platform such as PayPal has far less scope to punish fraud than the legal system, but can still assign punishments greater than the value of the fraud itself by restricting future access to the platform. In contrast to both of these systems, multisignature escrow is restricted by its algorithm to only return funds to their rightful owner.

There are certainly many merits to keeping disputes out of the court system, but restricting punishments also dulls disincentives to commit fraud. A potential fraudster may think the probability of the case being brought to court is very low, but the risk of severe punishment might still act as a deterrent. To be effective, the probability of being caught in the multisignature-escrow system must be high—in other words, the moderation system must work well.

Specialization of Third Party

Some third party arbitrators may have more knowledge about retail fraud or specific products in question than others, allowing for a degree of specialization. A judge or jury is selected centrally by the court, with no specialization. In the case of PayPal, the third party is provided by the platform itself, and is therefore specialized to some degree in the resolution of online retail disputes. On OpenBazaar, the third party moderator is selected by agreement of the specific buyer and seller, who can look for moderator attributes tailored specifically to the product or service being sold.

Reversibility of Fraud

Any system that seeks to resolve retail fraud must make the defrauded party as whole as possible. The legal system can order the fraudulent party to return any funds, but this process could be time-consuming and costly. The ensuing transfer would not be automatic, instead relying on the court’s coercive power to make the guilty party comply. Returning funds is likely much easier under PayPal’s system, where those running the platform can automatically make the necessary balance transfers. Smart contracts play a similar role in the multisignature-escrow approach. If a moderator judges that a buyer has committed fraud, the money held in escrow is released to the seller pending signatures from the seller and moderator.

Scope for Appeal

The lack of opportunity for appeal distinguishes multisignature escrow from the other two approaches. Under both legal and private ex post enforcement, losing parties have an opportunity for appeal that is ultimately decided by the court or private entity. Due to the irreversibility of Bitcoin transactions, there is no scope for a losing party to appeal under multisignature escrow. Such a process would involve a more complex smart contract, with a second escrow account requiring two signatures to release funds after appeal. This process is feasible, but to our knowledge has not been implemented. The lack of appeal in OpenBazaar’s method of dispute resolution makes the platform more appropriate for lower-value transactions, which limit the risk to an honest party of an incorrect decision.

Cost to Defrauded Party

Even if funds are fully returned, the victim of fraud still incurs costs under all three approaches. Ex post legal enforcement involves significant costs including legal fees, time until judgment and compliance with bureaucratic hurdles in the system. Private enforcement and multisignature escrow both likely involve lower costs for fraud victims since the dispute processes are streamlined according to the specific nature of online retail disputes.

Deadline to Detect Fraud

Not all fraudulent transactions are immediately detectable. Suppose, for instance, that a seller knowingly sends a buyer a laptop computer with a bad part, which only becomes clear after months of use. The ex post legal approach depends on the statute of limitations governing the transaction. Under PayPal’s private enforcement system, claims must be filed within 180 days. OpenBazaar does not specify a window, leaving it open to the parties to choose. Decentralized rule making has benefits, as parties could tailor the length of the window to the nature of the product being sold, making it longer for a laptop computer than for a comic book.

Scalability

U.S. courts and PayPal’s private dispute resolution system both handle a large number of cases. Would OpenBazaar’s decentralized multisignature-escrow approach be able to grow along with the platform if the number of transactions dramatically increased?

We have discussed reasons why the court system is poorly matched to low-value online retail disputes, but this is not a scaling issue per se. The court system is large and operates by standard, centralized rules. The cost of litigating a retail-fraud case is likely higher than under the other two approaches, but that cost likely does not rise very much with the number of total cases decided by a court.

Given the large number of transactions processed by PayPal, it is not surprising that its dispute resolution system appears built to be scalable. It involves many similar cases, handled with standardized procedures in a centralized manner.

It is not entirely obvious whether OpenBazaar’s multisignature-escrow system would be scalable along with the platform. Multiple issues might arise. First, as transactions increased, the system would require an ever-larger number of third party moderators (or time spent by existing moderators) offering their services on the site. It is possible that such increased demand for moderator services would result in higher fees that would make the decentralized platform inefficient relative to existing centralized retail platforms such as eBay and payment platforms such as PayPal. Note that this is not an intrinsic problem with the multisignature-escrow system, but relates more to the decentralized approach to providing third party moderators. Second, and potentially more problematic for multisignature escrow, would be the appearance of larger-scale fraud as the platform grew. We will discuss the potential efficacy of multisignature escrow in preventing different types of fraud in the next article in this series.

Third Party Incentive Issues

Third parties judging retail disputes have their own incentives, which go beyond deciding the case in the most disinterested and accurate manner. These incentive-alignment issues appear to increase in scope as the selection process becomes more decentralized.

In the court system, judges may have incentives to appease the politicians who appoint them, and both judges and juries will have personal biases. But if judges are assigned on a system-wide basis with limited control by parties to the dispute, these biases will be largely random.

PayPal is a profit-maximizing corporation. On the one hand, it seeks to maintain good relationships with large sellers who generate high fees, and might be incentivized to resolve disputes in their favor. On the other hand, PayPal may wish to appear friendly to consumers, and may be incentivized to side with buyers. Whether either of these incentives is problematic depends on both competitive issues and PayPal’s organizational structure (i.e., to whom in the organization the moderators report).

In any multisignature-escrow system, there is potential scope for collusion between one side and the third-party moderator. OpenBazaar solves this in part by only letting each party communicate to both other parties together, but in cases of repeat fraud where a buyer or seller encountered the same moderator, tacit collusion might be possible.

OpenBazaar’s selection system, where buyers and sellers agree on the potential moderator for each transaction, is potentially rife with incentive problems. Suppose a seller has market power, for instance because they are selling an extremely rare item. This seller might be able to dictate the selection of the moderator, allowing them to pick someone known to be seller-friendly. Asymmetric information also creates issues: if one party to the transaction has made many more purchases or sales on the site than the other, they might have relevant and nonpublic information about the chosen moderator. Finally, the ability to repeatedly select the same moderator makes the type of collusion discussed above easier. These issues, however, are likely problematic only in higher-value transactions. The types of cheating discussed here may not be worth the effort if little is to be gained.

In the third and final article in this series, we will build on the analysis above to evaluate the efficacy of the smart-contract-based multisignature-escrow system in addressing or preventing fraud. We will also propose some changes and additions to the system that might address potential shortcomings.

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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.