In 1997, the concept of smart contracts by the father of smart contracts: Nick Szabo

What is “collateral”? What is the purpose of “collateral”? How does it sort out our existing relationships?

I think the formalization of contracts, in particular, realizes the blueprint for an idealized collateral for our relationship.

Many types of contractual clauses, such as collateral, bonds, property rights, etc., can be embedded in the hardware and software that enforces them, in such a way that the cost of default is high (and, if necessary, prohibitive) for those who do not abide by the agreement. As a typical living example, we can think of the primitive ancestor of intelligence as the humble vending machine. Since the money in the box is far less than the price paid by the saboteur, the machine collects the coin according to the displayed price after assessing the limited potential loss, forming the first science of computer design, limited automation, and transmission of changes and manufacturing through a simple mechanism. Vending machines are transport contracts: anyone with a coin can trade with the vendor. Lock boxes and other security mechanisms protect the stored coins and goods from tampering, enough to allow vending machines to be profitably deployed in a wide variety of areas.

Photo: Nick Szabo

Better than vending machines, smart contracts provide a digital way to control any asset of value, of any type. Smart contracts involve a dynamic, often active asset, and provide better observation and verification points where active measures must be accurate.

As another example, consider a hypothetical digital security system for a car. Smart contract design strategies suggest that collateral protocols continue to be refined so that they are more fully embedded in the terms of contracts that handle assets. Under the terms of the contract, these protocols would place cryptographic keys under full control of the person with the operational attributes who rightfully owns the property. In the simplest implementation, to prevent theft, the car could be rendered inoperable unless the rightful owner completes the correct challenge-response process.

If the car is used to secure the loan, this traditional approach will create a headache for creditors while achieving strong security – the debt collector will no longer be able to seize the car of the defaulter. To solve this problem, we can create a smart lien protocol: if the owner does not pay, the smart contract invokes the lien protocol, which hands control of the car keys to the bank. This protocol may be cheaper and more efficient than hiring debt collectors. Further refinements include the generation of provable lien cancellations, as well as account actions when the loan is paid, in distress, and in unexpected situations. For example, it would be rude to revoke the car when it is running on the 75 freeway.

In the process of continuous refinement, we went from a rough collateral system to specific contracts:

(1) selectively allows the owner to lock in and exclude third parties; (2) allows creditors to access the backdoor; (3a) the backdoor is opened only after a period of default and non-payment; and (3b) the backdoor is permanently closed after the final electronic payment is made.

A mature collateral system will behave differently for different contracts. Continuing with our example, if the contract for the car is a lease, the final payment will shut off the lessee’s access; a purchase of the debt will shut off the creditor’s access. Through successive redesigns, collateral systems get closer and closer to the essence of their contracts: managing the covered property, information, or collateral. Different contract terms, as well as technical differences in the nature of the property, lead to different agreements.

From "Regulating and Securing Relations in the Public Sphere" by Nick Szabo

Original text: http://szabo.best.vwh.net/smart_contracts_idea.html

Copyright (C) 1997 by Nick Szabo
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