# Traditional Contracts vs Smart Contracts: First Principles<a id="sec-1"></a>

Traditional contracts and smart contracts both serve the purpose of enabling coordination in situations where people are engaging with entities that they can't necessarily trust.

Contracts enable this by moving the requirement of trusting all of the people involved in the coordination to an entity trusted by all parties to enforce the contract.

Traditional contracts are enforced by a trusted third party which inflicts consequences on those who break the contract, and smart contracts by a trusted third party which makes it literally impossible for people to break the contract.

The question is: in what scenarios does it make sense to use smart contracts instead of traditional contracts? Let's look at the implications of the difference enforcement mechanisms.

## Traditional Contracts<a id="sec-1-1"></a>

In the case of traditional contracts, enforcement is done by adding strong negative incentives for breaking the contract. Instead of coordinating with another entity using blind faith that they will uphold their end of the deal, you are relying on them acting rationally. You know that should they break the contract, something bad will happen to them, and so it doesn't make sense for them to break it. This relies on some assumptions:

- People are acting rationally. If this isn't the case, you're in trouble.
- The bad thing that will happen to them is worse than the thing which they stand to gain. If this isn't the case, you're in trouble.
- The third party will be capable of inflicting the bad thing on the person. If this isn't the case, you're in trouble.
- The third party will be willing to inflict the bag thing on the person (ie that the third party will decide actually enforce a contract as opposed to deciding they don't want to). If this isn't the case, you're in trouble.

Typically the government fills the role of the aformentioned third party. A major part of the government involves systems for properly inflicting bad things on people when they break contracts. Police, courts, supreme court, laws, etc. At the end of the day the thing which makes this entire enforcement system possible is the ability to use physical coercion should all else fail.

## Smart Contracts<a id="sec-1-2"></a>

Smart contracts have quite a different mechanism. Instead of applying negative incentives for breaking the contract, smart contract enforcement is done by making it literally impossible for any party to break the contract.

This has some nice benefits, namely:

- You don't need to worry about players acting rationally.
- You can engage agreements where the thing someone stands to gain by breaking the contract is greater than any negative incentive you could apply to that entity.
- You don't need to worry about the capability of the government to apply the negative incentive.

Additionally, unlike physical coercion which requires a centralized third party to host the military, it's possible for the third party to be a credibly neutral entity (for example a decentralized blockchain). When using a credibly neutral third party you don't need to worry about the third party deciding to not enforce a contract. They will always enforce it.

Another bonus of smart contracts is that you don't need to pay the cost of funding the entire enforcement system. You don't need a government or military! You do have to pay a fee to the third party but it is relatively tiny.

A limitation of smart contracts is that you are constrained by what you can put into a smart contract. Currently smart contracts have relatively little influence over the physical world, but this can shift over time.

## Implications<a id="sec-1-3"></a>

So what are the implications of the differences betweeen the underlying enforcement mechanisms?

They mainly become important in cases where the assumptions required for traditional contract enforcement are restrictive in some way.

Specific examples include:

- Traditional enforcement mechanisms creating barriers to entry and limiting competition
- Traditional enforcement mechanisms limiting the consolidation of responsibility
- Traditional enforcement mechanisms being inefficient for low stake contracts

### Barriers to Entry and Limited Competition in Finance<a id="sec-1-3-1"></a>

Because of the amount of responsibility that finance systems have (ie the extent to which people are dependent on them to behave properly), it's very important to make sure that contracts will be respected.

This translates to requiring businesses to go through a lot of work to make sure that contracts can be enforced to a satisfactory extent before you will trust them, which translates to large barriers to entry and a lack of competition in the space.

This lack of competition is unfortunate because it results in higher fees and less innovation for the end user.

When using smart contracts, you don't need to do any work to make sure that contracts can be enforced. It's impossible for them to be broken. This results in a system with low barriers to entry and more competition.

This competition is great because it results in lower fees and more innovation for the end user.

### Limited Consolidation of Responsibility in Finance<a id="sec-1-3-2"></a>

Because of the limits on the enforcability of traditional contracts, it's important to avoid systems which consolidate too much responsibility. Eventually the amount of value that the system controls becomes greater than the extent to which the government can control the system, at which point a breach of the contract becomes more likely and would have devestating effects.

Because of this, the government breaks up monopolies and prevents these systems from forming in the first place.

Unfortunately, this limits the benefits of economies of scale and network effects. You end up with a fragmented banking system where it is inefficient and expensive to send money from one person to another (i.e. the current system).

When using smart contracts, you don't need to worry about the consolidation of responsibility because there is no way for a system to breach whatever contracts it has made and the would be negative consequences of such a breach. You could have one smart contract which the entire financial system is dependent on and not need to worry about it being broken.

This is great because you get access to systems with greater economies of scale and network effects which means more value is created and passed on to the end user.

### Low Stake Contracts<a id="sec-1-3-3"></a>

Let's say you are playing a black jack online and everybody signs a traditional contract that they will not steal all of the money from the pot and run, but that the game doesn't literally restrict you from doing so. At any time somebody could click a button to take all of the money from the pot and exit the game.

Were somebody to click this button and steal $40 from the pot you could try and sue them in court, but it wouldn't make sense to do so given the cost of going through the traditional contract enforcement process.

In these cases smart contracts make a lot of sense because they are a lot more efficient in that they don't require anybody to go through an enforcement process because the contract cannot be broken (i.e. you modify the game to remove the button that takes all of the money out of the pot and exits the game).

## Where Does Blockchain Fit Into This?<a id="sec-1-4"></a>

Smart contracts are commonly associated with decentralized blockchain based smart contract platforms like ethereum.

That being said, you could build an ethereum like platform and deploy it in a centralized way whereby some party has the ability to make any modification at any time (you could imagine a government deploying such a platform for example).

The value that decentralized blockchains provide over these centralized platforms is that they are credibly neutral. You don't have to worry about the centralized party changing the rules on you in favor of one thing or another.

This is very powerful in that it is able to avoid many of the problems which go along with politics. It allows you to avoid situations where the government you are tied to makes some decision that you disagree with. Why compromise on decisions when you can build a system which allows you to participate only with those decisions that you agree with?

One way to think about it is that decentralized blockchains provide a credibly neutral foundation on top of which you can build more opinionated organizations which implement regulations according to their values. Why restrict yourself to the regulations of the country which you are born in when you can select and even construct your own perfect set of regulation?

A government hosted smart contract platform allows you to participate in complex coordination patterns while only relying on trusting the government to not compromise on your best interests. A decentralized smart contract platform allows you to participate in complex coordination patterns without needing to trust anybody (well, you do need to trust the blockchain consensus mechanism to be credibly neutral, a topic for another blog post).

## Bottomline<a id="sec-1-5"></a>

Smart contracts can be enforced more effectively and can thus enable some patterns of coordination which rely on more effective enforcement than traditional contracts can offer. That being said, they have some limitations and it doesn't make sense to use them for everything.

Decentralized blockchains are one possible foundation for smart contracts to exist on and offer the benefits of credible neutrality whereby you aren't bound by the decisions of any centralized party. That being said, they aren't currently as scalable as centralized solutions.

I'm excited to see what happens as decentralized blockchains become more scalable.