Yves here. One of the many ironies of the bezzle called Ethereum is that its promoter act as if it is something terribly novel. In fact, the problem of how to pay someone for goods who is in a completely different legal jurisdiction that you don’t know and therefore aren’t sure you can trust has been settled a long time ago because international commerce depends on it.
It’s called documentary letter of credit. You want to buy something from China, say a certain number of iron beams of a specific shape and length. You don’t know if you can trust the seller to provide what you want. He might ship 15 instead of 20 beams, or send beams that are off your spec. The seller does not want to ship anything across the ocean unless he is sure you have the money and won’t just walk off with his goods at the port of disembarkation without paying him.
The solution is a documentary letter of credit. The seller and buyer go to a bank. The bank guarantees payment provided the seller presents documents that attest that the shipment is what it says it is. There are typically quite a few documents (which party provides what document and what the document has to say is set forth in detail). The shipment will not be released to the buyer (as in title will not be transferred) and the seller will not be paid unless the documents match the LOC requirements exactly.
International LOCs are a mature, low margin business. I did an international trade study for Citibank in the early 1980s (it was looking for a way to “innovate” this very well settled, dull but paperwork intensive business way back then). It would have been normal for McKinsey to say, “No, there is a good reason there is no magic answer here.” We came up with a clever idea the client adored (it required entering into a different sort of relationship with some key transport companies). But the manager on our team was recovering from a nearly fatal ailment and was only scheduled to work on this project a month. The rest of us didn’t want to continue with an unknown team. So a second team came in, engage in a massive case of “not invented here” and proceeded to tear down our proposal. The immediate client team at Citi was furious because they regarded our work as more credible, but there was no way the higher-ups would go further if Mighty McKinsey had given a thumbs down.
By Clive, a bank IT professional and Japanophile
The ability to return interest rate policy to something vaguely approaching historic norms continues to elude central banks. Like the unfortunate perpetrator in an episode of Columbo, the economies subject to their ministrations keep showing up at inopportune moments and even if the central banks can talk their ways out of the last uncomfortable fact-set, there’s a succession of “just one more thing’s” one of which always gets them in the end.
Perhaps if they hadn’t colluded with governments in administering a double dose of high levels of household debts and falling real incomes, they’d be less culpable. But since the central banks were co-conspirators, it’s difficult to let them escape responsibility for their actions or lessen up on our insistence they confess that monetary policy alone cannot resurrect economies which have been suffocated through lack of demand.
And that’s before we’ve even started on the possibility that a 200-year growth cycle based on the apparently infinite availability of natural resources might not, after all, be limitless.
There’s plenty of incriminating evidence that zero, or close to zero, interest rate policies are enabling new speculative bubbles. Insipid consumer demand prevents a more generalised bubble in stock market valuations but so-called new economy start-ups are deemed innocent until proven guilty in terms of being susceptible to underlying economic fundamentals.
There is some much-needed scepticism. Microsoft’s purchase of LinkedIn for $26.2bn has been widely ridiculed. Justifiably so given the amount paid for a collection of validated email addresses and comically inflated career histories.
But Amazon moving into grocery delivery is another example of big corporations either sitting on cash piles they can’t sensible spend or else have access to funding at almost zero cost ploughing the money into implausible projects. In a sign that hope is still triumphant over history, Amazon’s investment hasn’t been seriously criticised. Grocery delivery is top heavy in terms of operational gearing (you burn through money maintaining infrastructure even if you don’t sell a single thing) and in mature markets there’s already saturation coverage. Amazon’s supply chain and logistical know-how are no better than anyone else’s – or, being generous, if it is, the difference is marginal – and it lacks any particular technological innovation compared to the established competition. It’s just hoping it has deeper pockets than anyone else. But throwing money into a hole and setting it alight isn’t a serious attempt at a strategy, it’s more like a cry for help.
At least these new-economy fantasies have some conventional, almost plausible, business models. Some others though are so far removed from any discernible legitimate method of generating earnings, never mind profits, they are proof positive that we’ve entered the economic Twilight Zone.
One such start-up is called Ethereum. Put simply, Ethereum is a trading platform supposedly (it isn’t, but this is what we’re supposed to believe) without a nation state, a legal system, or recourse to law enforcement.
Where two or more parties wish to conduct a business transaction, the agreement between the parties is transcribed into computer code. The code is the “law”. Settlement on performance of the contract is done in a virtual (crypto). Transactions on Ethereum (and similar platforms) are colloquially referred to as “Smart Contracts”. For a more comprehensive description of Blockchains, Cryptocurrencies and Smart Contracts, is an excellent overview. Written for an IT and legal audience, it does discuss the implications for both the law and technology in the vocabulary of the respective specialisms, but you can skip these sections without losing any of the main points.
While Naked Capitalism readers may well be scratching their heads and even rather cynical, all of this kind of thing is catnip to the global mega corporations, with IBM, Barclays, Goldman Sachs, Nasdaq, and the U.S. Commodity Futures Trading Commission rumoured to be interested. What is there not to like?
I could start by mentioning that stateless contracts, if they could ever exist, which they can’t, are by their very nature free from regulatory oversight and tax liabilities. But to the sorts of companies listed above, these are benefits not drawbacks so I won’t waste my breath making appeals to notions of a responsibility to society. And the mind-set of today’s transnational corporate elites is that it is the corporation which bestrides the state and not the other way round so ditto any pinko tree-hugging nonsense about undermining the institutions of government such as the rule of law and law enforcement.
Taken at face value, a Smart Contract has no risks arising from non-payment for performance. This is because the benefit paid as a result of performance to contract is made “up front” and held in the Ethereum platform’s escrow feature. Validation of performance is triggered by an agreed external input, supposedly neutral and not susceptible to tampering or influence. So whatever is described in the Smart Contract terms is either delivered or it isn’t and if it is delivered payment is automatically released to the beneficiary. Fine, but just so long as you’re willing to buy into the assumption that the Smart Contract exists only in the Ethereum vacuum.
Let’s rewind a little and consider why it is that we’ve been “limited” to “dumb” contracts, performed (or not performed, as the case may be) within the jurisdiction of a nation state, subject to laws ruled on in courts and enforced by the recourse to state intervention. Was this simply due to a constraint arising from the lack of technological innovation, a constraint which it is now possible to free ourselves from?
This seems unlikely. Stripping out the “smart” aspects of a Smart Contract, it is still a contract, albeit wrapped in a new-and-improved packaging of object-orientated programming and cheap, distributed computing power. Contracts are not new. And neither are their limitations. I’ll cover two here in the remainder of his article. There are many others, but hopefully readers will then understand why even with only these two pitfalls, it is not just desirable but an absolute necessity for a nation state to exist and for any contraction be encompassed within the jurisdiction of one. And furthermore, for whatever jurisdiction the contract is subject to, why that jurisdiction should offer as close to legal certainty as it is possible to have through its legal system and a fair and measured sanction of state-monopoly violence available as a penalty for non-performance.
One of the risks associated with doing business by means of contracts, be they traditional or smart ones, is how to resolve situations where the parties to a contract are bound to perform whatever is stipulated in the contract, but due to circumstances which weren’t envisaged when the parties agreed to abide by the contract, continuing performance of the contract results in perverse and unreasonable outcomes for one of the parties.
By their very nature, such situations are complex. Ordinarily, you shouldn’t be able to walk away from performing your part in a contract. That’s the whole point of a contract – it is like private law, you’re supposed to abide by it. If one or both of the parties didn’t want to be beholden to the contract they should not have agreed to it and there should be penalties for non-performance.
But these situations can and do arise. One of the two reasons covered in this article is that a contract has fallen because one of the parties who agreed to it was not permitted to enter into the contract. This was exactly what happened when the Morgan Guaranty Trust Company of New York (part of JP Morgan Chase) sold and interest rate swap to a county (Lothian Regional Council) in Scotland. It is worth noting that interest rate swaps are precisely the sort of contract which smart contract promoters foresee as being the most suitable for running statelessly as a Smart Contract. We’ll debunk the whole notion that you can pretend-away the state when you enter into a contract.
Unfortunately for Lothian county it turned out that UK counties were prohibited by statute from entering into this kind of interest rate swap deal. The contract contained the usual clauses for this type of interest rate swap covering early termination and the calculation of penalty fees. But these were useless for both the county and Morgan Guaranty because it wasn’t that the contract had been terminated early by Lothian; it was that the contract could have never legally existed in the first place.
So what happened when the music stopped and the UK Supreme Court (then known as The Law Lords) ruled that all interest rate swap contracts between counties and banks were voided?
Well, sometimes the banks were in the money and the counties had to eat losses and sometimes it was the other way round. In the case of Morgan Guaranty and Lothian county it was the county which had, for once, benefitted from the swap. Morgan Guaranty had continued to pay out on the contract right up until it had been voided and sought to recover its losses. But Lothian country had some of Morgan Guaranty’s money and wasn’t about to give it back. The county argued that it was entitled to sit on its gains right up until the point where the contracts were ruled as fallen.
You have to admire Lothian’s pluckiness. It refused to pay Morgan Guaranty a penny. As it had the money and Morgan Guaranty didn’t, the contract was voided and Morgan Guaranty couldn’t use any early termination clause and Lothian didn’t care in the least if it annoyed Morgan Guaranty, there didn’t seem much that Morgan Guaranty could do about it. How was Morgan Guaranty to respond?
Of course, Morgan Guaranty – bastion of free enterprise, master of cutthroat capitalism at its finest, first to tell anyone that a deal is a deal is a deal – went running to the state (the Scottish legal system in this instance) for help. It cited the principle of unjust enrichment.
To cut a long story short, Morgan Guaranty won. The case was not at all straightforward – the case was held before five judged instead of the usual three on account of both the byzantine points of law and the implications for what precedents their ruling would set. Unjust enrichment is always fact-specific and mired in legal complexity because if it is successfully proven the judgement ends up interfering in something that was never intended to be touched (the contract).
The legalese in judgement gives a hint to how gruesome the legal arguments are in a case of unjust enrichment and how important well-settled law is when a contract ends up going wrong. The jurisdiction which Morgan Guaranty and Lothian county’s contract was subject to (Scotland) was able to rely on case law dating back to 1696. To put that in context, this was nearly a century before America became a post-colonial independent nation and even started to develop its own laws. To make a definitive ruling in Morgan Guaranty vs. Lothian, the Scottish equivalent of the Supreme Court even had to go back to Roman contract law to establish basic principles of equity.
What we can learn from this in relation to Smart Contracts is that it took one the best and most accomplished and definitely amongst the more trustworthy legal systems in the world over three hundred years to provide legal certainty in relation to an important contractual principle. Smart Contract platforms such as Ethereum throw all that away. Worse, it’s not even discarded by accident, inadvertently. The proponents of Smart Contracts, unbelievably, actually see this as an advantage.
In an irony which one must assume is totally lost on the likes of Barclays and Goldman Sachs in their rush to investigate Ethereum and its ilk, it was recourse to a state, a legal system and the rule of law underpinned by effective enforcement that JP Morgan Chase so benefitted from in its tussle with Lothian county. Had Morgan Guaranty and Lothian written the same swap deal on the Ethereum platform, Morgan Guaranty would have had to – presumably – post increasing amounts of collateral into escrow as its position on the swap deteriorated. The fact that Lothian country officials were never permitted to enter into such a contract would not have mattered at all to the Ethereum algorithm.
Of course, had the roles been reversed and it was Lothian county which was sitting on the wrong side of the contract in terms of benefiting or losing money, it would have been prohibited from posting further collateral to support its loss-making position. But in the absence of a state to enforce the performance of the contract, what, exactly, would Morgan Guaranty have been able to do about it?
To further emphasise the point, Ethereum is barely out of diapers but has already found itself in a predicament caused by potential unjust enrichment. Bloomberg’s Matt Levine has ably covered the story in detail, but in essence, a legitimate feature of the Ethereum platform was exploited for financial gain in a way which complied with the letter of the platforms rules but hardly the spirit. No doubt that within the body of Ethereum users and rule makers, moves are afoot to decide and implement governing principles to cover what happened and start to figure out what the rights and wrongs of the various actors, technologies and enforcements involved are.
Don’t worry guys, you’ve only got another 300 years on the learning curve to go.
Unfair Terms (English Law) \ Unconscionability (U.S. Law)
It is sometimes helpful to think of contracts in terms of being “private law”. Within a nation state, individuals or groups can become a party to a contract. The contract is enforceable on the parties to it but the state can be invoked by a party to the contract to impose remedies for non-performance.
This has long sat uneasily for the society which forms the population of the state. One the one hand, the individual citizens of the state want to have the freedom to enter into private contracts. But then enforcement of a contract, potentially though violence, is too onerous a consequence to be left to the individuals to mete out or withhold according to their own judgements. So the individual citizens grant the state a monopoly on violence but the state doesn’t respond to individual notions of how that monopoly should be used. Rather, societies create the boundaries.
One boundary which has emerged through the pressure of society on the state is that, where a contract is drawn up between the parties to that contract, should the contract contain conditions which are so manifestly egregious or where the balance of power between the parties to the contract is so unequal as to render enforcement of the contract unjust, the party seeking redress for any non-performance of the contract cannot expect any intervention from the state or, perhaps more importantly, the state’s agencies of enforcement.
In many jurisdictions (I will concern us with only English and U.S. law here for the sake of simplicity but this concept is present in other nation states too) there are regulations which exclude or limit contractual terms or such limits are implied by common law. These are usually in play if clauses restrict liability, particularly negligence, of one party. The clause must pass a “reasonableness test”.
Another thing to add to the list of Things You See in Everyday Life that are More Important that you’d Think, this is a typical example of a term in a contract which is potentially “unfair” (in the English jurisdiction) or “unconscionable) (in the U.S.):
The notice was in the service area of a car dealership, which I visited with a friend while their car was in for a scheduled maintenance check. The “service due” message had appeared so the vehicle was booked in and the usual routine overhaul was performed.
Futurising but not too much, this is the kind of transaction which could be moved to a Smart Contract. The vehicle in question was fairly new so it had alerted the dealership and the owner to arrange a trip back to the mechanic. There was a standard checklist specified in the service schedule (oil change, brake pads, emissions control test, tyre inspection/replacement) and the vehicles on-board diagnostics recorded the completion of these items. It would be a small step to then have the on-board telematics forward this information to a Smart Contract platform such as Ethereum and have RFID tags verify any replacement parts had been fitted.
The dealership would want the customer to be bound by the terms in the notice above. And superficially, there isn’t anything too objectionable about it. What the dealership is telling the customer is if you leave valuables in the vehicle, don’t expect us to be responsible for them. If anything happens, we will not assume liability for your losses.
So that’s that, then? No. Despite what the notice says, the dealership is liable if it fails to act reasonably in respect of your property. If an employee of the dealership steals them – and the dealership has cause to be suspicious of that employee but had not acted on those suspicions – you could make a claim on both the employee for theft in a criminal court and against the dealership for negligence in a civil court. Similarly, if you left a $500 smartphone in the vehicle and the mechanic accidentally dropped it as she moved it out of the way, your claim would almost certainly fail. But if your smartphone videoed the mechanic deliberately kicking the phone around the service bay, the dealership would be liable for their employee’s conduct and your consequential losses. (These are just examples and are not implying anything is amiss with this particular dealership, I hasten to add)
This and other such “unfair” terms (only a court can rule on the fairness, or otherwise, of the terms) abound in contracts. Once you start looking, you’ll be amazed at how common they are. There’s nothing to stop a contract being drawn up with such terms and also nothing to stop one party trying to apply the terms. But once a party asks the state to step in and enforce the terms, nation states can and do set limits on what they are prepared to sanction.
Unless all parties to a Smart Contract are genuinely stateless – a domain which is impossible to create in practice – the common law of the state still places restrictions on what are valid contractual terms.
Readers will hopefully appreciate that I have tried to write this piece “straight” and taken the claims made for Smart Contract platforms such as Ethereum as their champions make them out to be.
But given the obvious limitations to the premise for a Smart Contract, as outlined above through the explanation of the principles of unjust enrichment and unfair terms, it has been demanding to achieve the levels of cognitive dissonance required to believe that the platforms themselves – and their admirers – are for real. At times, it has felt like it was more a job for our Richard Smith to highlight some cunning-but-ultimately-obvious scam. And yet this is not your typical New Zealand-based boiler room fraud or Carbon Trading shady dealing.
Richard Smith summed it up thusly:
The potential of libertarian paradises to terminate in a big fraud is always obvious and always stoutly denied by the fanboys (or shills).
In the case of Ethereum, is the user option to steal the money a bug or a feature? Ethereum and bitnation [another Smart Contract platform] seem in their more or less specialized ways to be quite close to a cyber version of the Freeman on the Land hoax. That word Sovereign again. People who want to opt out of taxes, states, citizenship.
All of which got me thinking about a different, but related conundrum. I’ve been banned (if only informally!) by my friends and family from walking alone in New Age district of Brighton (part of the City of Brighton and Hove, a coastal resort situated in East Sussex, England). The reason is that I am simply too much of a sucker to be safely left to my own devices. My crown chakra is a little dull? Oh, I can see why I need that £25 meditation charm then. And this £50 healing crystal will deep cleanse my aura will it? Oh, okay, I’ll take it.
My problem is, I really want to believe. That makes me all-too-readily an easy mark. This subject was covered in-depth in a rather good podcast by Cardiff Garcia in the FT Alphaville team whose guest explained the psychology of cons and how one of the prerequisites for executing a successful scam is that the scam-ee starts from a basis of wanting to believe in the hucksterism of the would-be scam-er.
If you are sufficiently self-aware, you can begin to know your own limitations and take steps to overcome them. It’s difficult. Trusting others to tell you the truth and then actually listening to them is one part. But first you also have to find people who are willing to speak the truth to power (or, if not power, to your own ego).
On the contrary, if you’re an omnipotent central banker, a self-appointed Master of the Universe investment genius, or a CEO who is not only paid tens or even hundreds of millions a year in compensation, it’s borderline impossible to not end up spending some of that money on a coterie of flunkies who’ll only ever tell you how great you are. Either that or your position simply attracts sycophants like moths to a flame.
Unfortunately, there’s no shortage of charlatans asking you to sell your cow for a handful of magic beans.
Of course, our elites are all smart enough not to fall for blatantly obvious scams or be lured into malinvestment, right? And in no way is executive compensation misaligned into pursuing short-term valuation ramping based on get-rich-quick schemes? Good, we’re all alright then.