[Note: below is chapter 2 to Great Chain of Numbers]

Since the release of the original genesis block in 2009, hobbyists and professional traders alike have been practicing trustless asset management – except there has been only one asset: bitcoin, and it has been traded on what until recently was essentially an unregulated securities exchange. The next evolutionary step is to begin using cryptographic ledgers to track, manage and exchange smart contracts and even smart property.

According to Nick Szabo, the lowest-hanging fruit in this segment is contracts that are 99.9% “dry” code – which is to say, those already formalized which can then be executed automatically via software code with extremely few manual exceptions. This would immediately encapsulate nearly all of the securities and financial instruments currently traded on electronic exchanges such as NASDAQ and Euronext (of which the NYSE is a component). This has a number of Christensen-disruptive qualities affecting middle management and potentially entire departments of individuals at financial institutions who neither write the code nor provide additional interpretive value to such contracts, and whose jobs (e.g., auditing, accounts reconciliation) could conceivably be made redundant by a decentralized cryptoledger.

Virtual, digitized assets and financial instruments may be easier to visualize since many people reading this already have experience receiving salaries via direct deposit, using 3rd party payment processors (e.g., PayPal, Alipay) and even online brokerages (e.g., E-Trade, Scottrade); but how could smart contracts interact and control physical property?

Through a modification appropriately called smart property.

Szabo was one of the first to describe a solution to this interaction conundrum, with what he called a “proplet.” He stated in the paper, “the goal of proplet design is to control physical objects with digital protocols.” In his view, the functionality of a proplet could be fulfilled with a microelectromechanical system (MEMS), a device that has microsensors with several capabilities including the ability to track ownership, determine precise location and provide robust security. Most modern-day smartphones and tablets, as well as some automobiles, include some type of MEMS (such as an accelerometer).

While ten or fifteen years ago it may have been a tall order to convince manufacturers to add “proplets” to their wares, the unintentional spread of MEMS-like devices has taken place through an organic push called the “Internet of Things” (IoT) (e.g., home automation). This is a term coined by Kevin Ashton in 2009 to refer to the ability to uniquely identify and tag any kind of object through an Internet-like structure. This can be done with existing technology such as RFID, NFC, barcodes, QR codes, and digital watermarking. As a consequence, many modern appliances such as refrigerators, thermostats, smoke detectors, doors, vacuums and even light-bulbs could be manufactured with IoT features built-in. According to BI Intelligence, by 2018 there will be 9 billion IoT-enabled devices; more than all smartphones, smart TVs, tablets, PCs and wearable computers combined. Yet keep in mind, just because something is automated such as WiFi enabled light bulbs or even doors, that this is not smart property. It may be automated or even autonomous but it is not “smart” in the sense that ownership and control can be reverted automatically to a different party via a smart contract.

If an object has not only IoT functionality, but also proplet-functionality, it can be managed by digital protocols which in turn can be managed by smart contracts. In fact, Szabo used a similar insight in an exchange: “Equipment and appliances that are not already titled, but have enough resale value to use as collateral, are good candidates to use the new peer-to-peer title registries and for building in proplets or something similar.”

The question of logistics – how to control a physical object remotely through a contract – is a common one that Szabo and others have considered. In one of his first publications on this topic, Szabo uses an example of a car lease and a smart lien protocol. A smart contract for a car lease may include a clause, such as a lien that revolves around a “time lock” (nTimeLock is the technical term used in Bitcoin). In such a contract, if a lessee fails to make a payment, the smart lien protocol is invoked, preventing the use of the vehicle and enabling a creditor (and repo firm) to retake control of the vehicle. Obviously there could be grace periods coded into such clauses and even operational exceptions, such as not revoking operation while a car is driving down a freeway.

Another example recently explained by Vitalik Buterin could be a museum pass. Using your phone’s NFC capability plus a feature like a “colored” coin or even bitcoin itself, assuming you own that token unit, you can sign a message attached to it with a private key. You can purchase a museum pass and then you can digitally sign the pass that allows admission into a museum. If you want to sell the museum pass you can transfer the virtual coin to someone else, they can sign the pass with their key (which is on their phone), and ownership is passed to them. Or, if Bob managed a rent-to-own store, he could include some kind of “proplet” to electronic merchandise that would facilitate the creditor-borrower ownership (e.g., failure to pay for a television, refrigerator, or even arcade machine results in service termination).

Despite this marginal progression through automation of pharmaceutical dispensaries, automation of factory work, self-driving vehicles, and voice recognition, there is a gulf between what can be done and whether or not it will be legally allowed.

However, according to Szabo,

“There isn’t any big technological barrier to this. It’s largely a matter of learning about the technology and being persuaded enough of its utility to make the relatively large capital investment for such hardware (as opposed to cryptocurrencies and the title registry itself which is just software). The biggest barrier will probably be synchronizing with or replacing existing titling systems. There’s no terribly difficult new technology required, but when it comes to property that is already registered (for example in the U.S. states register car titles), there has to be synchronization between the two registries, or else the states (in the case of cars) has to switch to using a block chain as the registry of record for their title systems. Alas there will probably be a lot of slow-moving bureaucracy and politics involved. Since title registries are already pretty good in the developed world there is probably an earlier market for these kinds of systems in less developed countries when it comes to existing kinds of property. In the developed world block chain titles will at first primarily be used for financial instruments or contracts (and of course, the first use of all has been to store and transfer titles to money itself). Also, equipment and appliances that aren’t already titled, but have enough resale value to use as collateral, are good candidates to use the new peer-to-peer title registries and for building in proplets or something similar.”

Let us explore the car example. What this would mean is that a state department of motor vehicles (DMV) would need to be convinced to use a computer system that is connected with the same cryptoledger or database that is being used to transfer automobile ownership. This could conceivably be done with existing technology. However, if the past five years of regulatory uncertainty and risks with cryptocurrency is any indication (e.g., anti-money laundering laws, Know Your Customer, Money Transmitter License, Money Service Business), it would seem unlikely that all departments like the DMV will quickly adopt this method and allow assets such as vehicles (or houses or securities) to simply trade hands without some kind of tax or oversight.

What happens to smart contracts if a cryptoledger one is using is abandoned by miners? For example, maintaining a single-use proof-of-work cryptoledger is not necessarily an optimal use of resources (discussed later in chapter 8). As noted above, you could potentially use the consensus-mining power of the Bitcoin network (or alts) to actually track and manage nearly every type of asset. The fact that it only tracks one is non-optimal in terms of assets per hash. But hypothetically, if Bob created a new cryptoledger for the DMV that is then solely used to allocate and track vehicles from a DMV registry, what happens if the underlying ledger loses all of its miners in a year or two? The ledger then no longer is usable for its purpose. And the vehicle titles are potentially forgeable and untrackable if miners abandon the network. The solution to this is that in all likelihood, the codebase for the smart contracts and DAO that utilize a cryptoledger will be portable due to its open-source nature. Thus you could create and encode additional copies of the smart contracts and place them on multiple ledgers for redundancy. That is to say, the developmental costs of duplicating and triplicating the smart contracts onto other ledgers are minimal. Either that or the ledger would be mined by the state, and electricity costs would be passed on to the general public as taxes.

There may be other opportunities for entrepreneurs to build tamper-proof and tamper-resistant containers with embedded smart property elements (NFC, MEMS), allowing users to track packages in near-real time. Or perhaps industrial design consultants can find new opportunities to assist companies wanting to affix proplets to their wares – a process which incidentally fulfills what Richard Brown jokingly stated last fall: on the blockchain, nobody knows you are a fridge.

Paper Meets Electricity

Smart contracts are coming of age in a period of paper-based controls designed to prevent error, fraud and abuse by delegating tasks to different, imperfect agents. For example, an auditor may split up functions in a warehouse in which delivery, sales, receipt of payment and accounting are assigned to different parties. According to Szabo, this segregation-style method is done as to require conspiracy by each party in order to accomplish fraud and abuse. Yet in a paper-less, digital era many of these functions are now redundant as they are provided by a decentralized cryptoledger that is immune to abuse (without a corresponding digital key); thus there is a need for smarter controls, not more stringent ones. Such controls would explicitly outline, by way of smart contract, the exact relationships, duties and responsibilities of each party to a transaction. This will transform traditional hierarchy and organizational structure within companies (both small and large), allowing the possibility for more horizontal, flatter firms. And typically, the flatter the organization, the fewer the transactional layers and delays between decision makers and information (e.g., removal of some information asymmetries).

With the advent of CRM, ERP and other advanced accounting, auditing and HR software that condense administrative overhead, these hierarchical and organizational changes have been taking place with increasing rapidity over the past 20 years. Yet they create new challenges in terms of trust. For example, mergers between accounting, investment, and consulting firms can create blurred lines of fiduciary responsibility and accountability. Szabo suggests that trust “will erode still further as accounting firms start taking advantage of the vast amount inside and marketing information.” Like clockwork, throughout each year there are numerous investigative reports detailing these types of insider cases, of people being allowed access to privileged information or to execute trade orders without authorization.

General Turdgison’s memorable quote regarding “Plan R” which (un)intentionally was used to bypass authorization protocols and the chain-of-command to unilaterally drop nuclear bombs against the Soviets sums up this conundrum: “the human element appears to have failed here, but we’d hate to condemn an entire program based on a single slip up.” Jokes aside, even if there is no intentional abuse by insiders, outside parties can still gain access to sensitive documents and information through social engineering as outfits like Lulz Security have demonstrated in a very public fashion. Perhaps in an era of Bitcoin or Ripple-based cryptoledger turnkey solutions, large enterprises could not only manage access to key documents (away from the prying eyes of Alice and Bob) but easily manage physical plants, campuses and even fleets of cars through the use of proplets. There will likely even be various profitable business opportunities for (attempted) key recovery consulting.

Slowly Evolving

More than twenty years ago, automobile manufactures created the precursors to the modern electronic data interchange (EDI) standard. EDI is a document standard that essentially turns paper-based business forms into electronic forms and thus acts as a common interface between two or more computer applications that enables them to understand what the documents mean. By using standardized markup, syntax and terminology (e.g., XML), organizations can quickly and cheaply send structured information to other compliant systems which allows closer integration. For example, a manufacturer can seamlessly send documents to vendors in its supply chain. Automobile and aerospace companies were some of the first firms to implement this technology as it allowed computer systems to automate what had otherwise been a manually intensive, error-prone, and sometimes – abused network of systems.

Over the years EDI has grown to digitally absorb dozens of forms such as: product and price catalogs, purchasing orders, inventory status updates, shipping orders, customs declarations and receipts. Consulting, accounting and law firms have followed suit, automating administration, billing and cost recovery systems into one standardized documentation and file format used by ECRS and LEDES software packages that have become industry standard in any enterprise of meaningful size. The supply chain industry and shipping industry are further fusing with technology through the power of cloud-based services. For example, in October 2013, Ingram Micro acquired Shipwire, a cloud logistics and supply chain management provider. That same month, Pacejet Logistics raised $4.5 million in an effort to connect logistics services with carriers like UPS via the cloud.

As a testament to Nick Szabo’s groundbreaking work, rather than rephrasing what he has written, I recommend that all readers interested in smart contracts read his seminal piece, Formalizing and Securing Relationships on Public Networks, which deals with many of these matters in considerable detail.

Though Szabo presents a holistic view of a trustless system, we should keep in mind that his view is a proposal – a visionary one, but one which will be tested by many hypothetical and real-world scenarios that will challenge the idea of trustless asset management in the coming years (and which will likely fill many volumes of writing). The influence of hackers – not of the blockchain itself, but of more vulnerable systems authorized to interact with it – is particularly illustrative. When Alice’s digital key on her smartphone or laptop is hacked by Bob and her smart contract-enabled car is sold and then fraudulently resold to numerous individuals, what recourse could she have? In an ideal scenario, the security of the car and her key would remain out of the reach of hackers, but as has been illustrated over the past five years, digital keys can be lost, stolen and extorted (e.g., the CryptoLocker virus, or unencrypted wallets being stolen from cloud storage).

In all likelihood, as Preston Byrne and another legal professional consulted on this manuscript think, market demand for consumer protection might discourage and even reverse decentralization, rather than promote it. As Byrne speculates, “there would likely be several centralised repositories tasked with verifying legal title and reversing fraud – whether those be corporate or government entities. Alice might, in this case, specify in advance which agency or court would have authority to make that decision (by possession and cold storage of the relevant private key) when title first lawfully passed to her; she might also have to pay a small one-off fee (assuming a competitive market for custodial services). Likewise, purchasers would want to be able to verify that any digital title they possessed was validly transferred and not subject to equities in favour of any third person. The blockchain would therefore need to be paired with other methods of title verification – which would likely be less expensive than the current title transfer systems in place in many jurisdictions (e.g. a state DMV). In the event Alice does not want to pay a small fee for a 3rd party, however, she could use an unregulated blockchain, but that ancient rule would apply – caveat emptor.”

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