Long before blockchain was cool, Nobel Prize-winning economist Oliver Hart was into contracts. As far back as 1976, the doctor of economics from Princeton University had been exploring how corporations use contracts to interact, and what happens when things go wrong.
Over the years, Hart became fascinated by what he describes as the “fuzzy” areas of these agreements, where the anticipated potential outcomes break down, and arbitrators, or even judges are required to make sense of the chaos. The concept is called “contract incompleteness,” and in the age of blockchain, it is on the verge of exploding into more more mainstream circles.
While contract incompleteness may be an unavoidable side effect of the complexities of life, Hart believed his work could help empty the courts of cases based solely on contractual confusion.
By June 2016, Hart and fellow economist Bengt Holmström of the Massachusetts Institute of Technology were just months away from winning the Nobel Prize for their work in “residual rights control,” a term they coined to describe who has control over an agreement when all anticipated eventualities break down. Then, modern technology finally caught up with him.
A distributed autonomous organization called The DAO, powered by little more than self-executing code called a smart contract, had dramatically imploded. A contract with a bit too much fuzziness was made to execute an order its authors never intended, sending $60 million worth of the ethereum cryptocurrency to a hacker’s wallet.
While a simple tweak to the underlying agreement could have prevented the loss, the ethereum blockchain was designed to be immutable, no one had residual rights of control, and there was no single authority to charge back such illicit gains. The resulting wave of financial destruction culminated in the contentious separation of ethereum into two competing blockchains.
The original blockchain with the hacked funds still in the hacker’s wallet, now called ethereum classic, is currently valued at $1.6 billion. The other blockchain, where the users agreed to return the illicit gains to their original owners, simply called ethereum, is now valued at $42.7 billion.
From the ashes of The DAO collapse, a boutique industry of smart contract consulting firms emerged to help ensure smart contracts are as airtight as possible before they go live. And as of today, Hart officially joined one of those consulting startups, blockchain economics, governance and design firm Prysm Group, as its first senior adviser.
“Instead of just looking at the contract itself, what’s written there, it’s also useful to think about what procedures are put in place for dealing with what isn’t there,” said Hart, who will be paid for his work with Prysm Group on a case-by-case basis. “How you communicate with the other party, how you might resolve disputes.”
At his new position Hart will review incentive structures designed by the Prysm Group team to help ensure the client’s desired outcome is achieved. While this is the first time the Harvard professor has worked directly with a blockchain startup, his expertise in the field of contract incompleteness has previously resulted in his serving as an expert witness in cases involving the Department of Justice and Uber.
The key to Hart’s work lies in the incentive structures put in place around the agreement. On the most basic level, he believes that changing ownership of an asset is the simplest way to ensure the peaceful resolution of a contract dispute. So, at the most extreme level, if two companies are in a dispute, one company buying the other guarantees the ownership of residual rights of control.
But with a distributed ledger like a blockchain, capable of hosting assets such as currency and securities without a central authority, the kinds of ownership can be much more nuanced, and the incentive structures can be reimagined to align interests across a wide range of agreements.
Prysm Group cofounder Cathy Barrera breaks down those agreements into two categories, both of which she expects Hart will consult on. The first kind of incentive occurs at the protocol level and includes things like how miners are rewarded by public blockchains similar to bitcoin and ethereum for the computing power they contribute to auditing the blockchain.
For example, bitcoin miners are rewarded 12.5 bitcoins for every block they successfully audit, and the reward gets cut in half periodically. As the number of bitcoins offered decreases, the price of bitcoin is expected to increase, helping offset the change. Or at least that’s the hope. But any number of incentives could have been put in place, including a complete pre-mine of all the tokens, which would in turn either be sold to investors or given away to people based on criteria including whether or not they own a stake in another cryptocurrency.
The second incentive structure Hart is expected to consult on occurs in applications built on top of the blockchain. Specifically, Barrera says her company is already helping design smart contracts for startups looking to incentivize participants to help secure a system, contribute data or write original content.
“Depending on the context that you’re trying to apply blockchain, the smart contracts can be designed in a more targeted way,” said Barrera, who has a Ph.D. in economics and studied contract incompleteness at Harvard under Professor Hart. “Or they might be more difficult to design and you have to incorporate more variables to try to get at that specific behavior that the participant is engaging in.”
Joining Hart as a Prysm Group senior advisor is former Microsoft chief economist Preston McAfee, who described his role as largely focused on helping technology and industrial firms reimagine the way markets are designed. “In any situation where a public ledger with nuanced permissioning is valuable, blockchain can be a superior alternative to a trusted third party,” McAfee told Forbes. “Or even a complement to a trusted third party, but only if it is implemented in a self-enforcing way.”
For Hart’s part, he breaks down the kinds of criteria he’ll be analyzing into how verifiable the data that feeds into a smart contract is and how much human input is required for the payment of a completed contract. “Blockchain can be very helpful in automating certain things,” said Hart. “Incentives are at the heart of all this. But also governance, how these things are organized.”
Barerra declined to share the names of her clients but says Prysm Group is already generating revenue and has no plans to raise venture capital. On a broader scale, Hart describes the business opportunity surrounding such smart contract consulting firms as being carved out of the costs resulting from nearly every case in the courts involving a contract.
“Almost all legal disputes have to do with contract incompleteness,” said Hart. “I don’t know how to quantify the costs of all that, but I think just casual empiricism suggests that those costs are pretty big, and if people could write better contracts or get themselves on the same page so they can agree on what was meant to happen, those costs will be reduced.”
In part, Preston Byrne, a lawyer and fellow of the Adam Smith Institute, agrees with Hart. The former chief operating officer of blockchain law startup Monax argues that much of the value of moving contracts to a blockchain lies in eliminating overhead costs associated with managing the original documents. In the future, Byrne believes, the “digital originals” of agreements tracked on a blockchain could take legal precedence over their paper analog. But he also argues that the promise of this process is limited.
“I don’t think moving contracts to a chain will reduce disputes,” he said. “It will simply help get to a mathematically certain set of facts, which will either be used to automate a business process or to prove a chain of events with a high degree of certainty in the event of a later dispute.”
Further skepticism can be found within Hart’s own Nobel laureate community. Previous winners, such as economists Paul Krugman, Joseph Stiglitz and Robert Shiller, have expressed strong doubts about cryptocurrency, and even Hart’s own faith in the technology is limited. Hart says he doesn’t own any cryptocurrencies and is worried that “bitcoin might be a bubble.”
“Like many economists, I’m a bit skeptical, to say the least,” Hart said. “To the extent that I think blockchain and bitcoin can be separated, I think I’m more enthusiastic about blockchain.” On the flipside to Hart’s skepticism though, Nobel laureate Myron Scholes earlier this year became an advisor to the Saga Foundation, a group working to build a new cryptocurrency.
As with many of Hart’s Nobel laureate contemporaries, his work tends to skew to the esoteric. But at the core of the research is a single principle: Instead of contract authors trying to write all possible contingencies into an agreement, they should struggle to find a common view of the world prior to doing business together.
This, Hart argues, isn’t achieved through overly complicated incentive schemes. Rather, the secret to his contract creation strategy is that “you also have to build a relationship with the other person,” he said.
“I’m not arrogant enough to say I’m going to solve that problem, but I think this work can help.”