Can Smart Contracts Enhance Firm Efficiency in Emerging Markets?

Fandl, Kevin J. | May 1, 2020

Blockchain technology has the potential to eliminate one of the most significant barriers to economic growth through private business transactions in developing countries—lack of trust. In a typical developed country, individuals and firms conduct transactions within an institutional environment that offers security through the enforcement of agreements. Transparent and effective courts, while imperfect to be sure, enable parties to feel secure in their transactions even if their level of trust in the other party is low. This security, in turn, facilitates transactions far afield from high-trust relationships (e.g., immediate relatives), generating transactions based upon economic value rather than party trust alone. Developing countries often lack effective or transparent institutions and are frequently plagued with corruption that weakens substantially their level of security in economic transactions. Accordingly, individuals and firms in developing countries seek contracting parties whom they trust, knowing that it is trust that will ensure enforcement more than courts or law enforcement. Transactions in this type of environment are thus limited to known entities, such as relatives or colleagues who have a trust-relationship with the individual. As a result, potentially valuable transactions are avoided due to lack of trust, which, on a macro-level, limits the economic growth potential of the entire economy. Blockchain technology and smart contracts offer a solution to the trust problem prevalent in developing country contractual transactions. First, because blockchain uses an open architecture, all transactions are publicly accessible, immutable, and verifiable by anyone. This helps to eliminate corruption and fraud from the transaction. Second, because all smart contract transactions are recorded along a blockchain and cannot be modified ex post, a permanent and publicly accessible ledger is available to shed any doubt about payments or other transactions throughout the process. And third, because blockchain systems are automated, security in the enforcement mechanism is all but guaranteed. For instance, failure to deliver goods by a set time will automatically trigger a default clause that transmits payment of liquidated damages to the injured party without the intervention of a judge or arbitrator. Numerous problems with this approach exist. For instance, access to information about technology such as blockchain, especially among firms that would most directly benefit from it (e.g., informal firms), is highly limited for the moment. Second, smart contracts are in their infancy and work primarily with clearly stipulated terms that allow for no interpretation, which are not always common in contracts between firms. In this case, eliminating a neutral arbiter from the transaction also eliminates the possibility of reviewing the circumstances of a breach or other contract mishap. And third, though lack of trust in parties may be reduced through this technology, lack of trust in online financial transactions may be exacerbated. The use of electronic finance options in developing countries is far less common than in developed countries, making implementation of a completely online transmission system particularly challenging. Despite the evident weaknesses in applying smart contracts and blockchain technology to developing country firm transactions, there is great potential for at least small-scale application in certain markets where party trust levels are particularly low. In this paper, I will review literature on the development of smart contract technology and its application in relevant contexts. I will consider the potential impact that this technology could have if properly implemented in emerging markets. And I will offer a set of suggestions for policymakers to consider in educating firms and incentivizing their use of this technology. What follows is an introduction to the area of smart contracts as a substitute or at least a complement to legal institutions. I fully expect a robust literature to develop around this topic in the near future.