Blockchain and transparency in trade[1]
This is a journal article to be published in the Institute for the Integration of Latin America and the Caribbean (INTAL) of the Inter-American Development Bank (IDB) Integration & Trade Journal. Issue: Blockchain technology and the future of the economy.
Jørgen Svennevik Notland
Student Msc. Informatics & Business development.
Norwegian University of Science and Technology (NTNU)
Jorgen.notland (at)protonmail.ch
+47 90080822
January-February 2019
Abstract
Can Blockchain smart-contracts enable trust in supply chains and prevent moral hazard and cheating in symbiosis with conventional contracts?
Abstract
Introduction
Blockchain Data Integrity & Reliability
Supply chain
Smart Contracts
Ricardian Contracts & Agency theory
Introduction
Dubbed “Operation Car Wash”, the largest corruption scandal in the history of Latin America and the Caribbean is often understood to have shattered public trust in government and non-governmental institutions and enterprises, as more than 9.5 billion dollars were laundered through numerous government institutions and private enterprises. The 2017 Edelman Trust Barometer revealed that trust in institutions, including Non Governmental Organizations (NGOs) and corporations declined globally to trust levels similar to those of the 2008 financial crisis. 85% of respondents indicated that they do not trust the system, with only 52% of the respondents indicating that they trust businesses (Edelman 2017).[2] These developments pose a great economic, as well as social and political risks, as is evident since trust levels between firms has been shown to be a central part of trade relationships (Kannan & Tan 2006).[3] When a party in a transaction has been paid to provide a goods or service, the paying customer expects the goods or service provider to perform a particular action. The social and political dimensions of this mistrust is also evident in the emerging anti-establishment movements that are sweeping the region and challenging what they believe to be an untrustworthy system.
It is within this context that the question of how public institutions and private corporations can regain trust in supply chain trade and contracting arises.This paper argues that blockchain does indeed provide the solution to this problem, as it provides a trustworthy system whose integrity is assured using mathematics, code and decentralized verification of transactions. Thus, parties that have different sets of interests are likely to be less concerned when the existing systems and processes — which arguably have failed to earn their trust — gets replaced by blockchain implementations. By being self-administered, self-executing and administrator-free, blockchain offers a new innovative and trustworthy alternative. Instead of a system involving a central authority that can control and corrupt the system, trust is no longer exclusively placed in individuals and central institutions, but rather distributed across the population; central authorities are replaced by communities of peers in the form of peer-to-peer networks. With no single entity has the capability to take unilateral action on behalf of the community, thereby establishing a democratised system in which corporations can no longer defy the community and break the rules of the system, thereby increasing the trustability of the system itself (Sun et al 2016).[4]
This case will be made by first generally account for blockchain’s data integrity and reliability, and argue that while it is not a perfect technology, it nevertheless gives us the technology to solve critical issues related to transparency, accountability and authenticity. Having done so, we will then specifically look at how blockchain’s transparent and accessible supply chain enables us to create a more efficient, trustworthy and accountable alternative to the existing supply chains. Having done so, we will look at how through the lens of agency theory(Eisenhardt 1989) combining legal contracts and smart contracts in Ricardian contracts using existing jurisdictions (Grigg 2004)[5] offer increased transparency in contractual agent-principal relationships by placing financial transactions and reputation on distributed and open Blockchain ledgers.
Blockchain Data Integrity & Reliability
Blockchain (technology) is the new, groundbreaking open-source technology, which was initially released as the underlying technology for Bitcoin, the world’s first decentralized global digital currency (Nakamoto 2008).[6] Essentially, Blockchain is an immutable and transparent distributed database, a ledger which achieves global and immutable consensus by all participants. This means that the data recorded on a Blockchain ledger is nearly impossible and very costly to edit (Hua & Notland 2017).[7][h][i][j][k]
The International Organization for Standardization (ISO) mandates the standards for current record management, with ISO 15489 (2001) stating that:
A reliable record is one whose contents can be trusted as a full and accurate representation of the transactions, activities or facts to which they attest and can be depended upon in the course of subsequent transactions or activities.[8]
What is more, ISO 15489 acknowledges that a record recorded at the time or soon after an incident or a transaction by an individual that has direct knowledge of facts or by an instrument used to conduct the transaction is more reliable. Records must be protected from unauthorized tampering and must serve as the primary source of information about documented actions while providing access to all metadata and records (ISO 2001).[9]
Even though we cannot fully trust a third-party recording data onto a Blockchain[l] ledger (Lemieux 2016),[10] we can trust the data stored on it to be authentic. Maintaining the authenticity and integrity of records is the core quality of Blockchain technology (Hua & Notland 2017).[m][n][11] Thus, while blockchain’s ability to maintain authentic records depends on how secure the system is (Lemieux 2016),[12] its ability to prove authenticity is considered a major opportunity[o] Blockchain technology promises to deliver;. while not being 100% secure from all attacks, it is one of the most[p] secure protocols ever designed (Nakamoto 2008).[13]
Being a technology that ensures a trust, security and transparency, Blockchain has the potential to rectify the aforementioned problems regarding transparency in trade. An example is a blockchain implementation that registers all transactions of goods on a Blockchain ledger, as well as the parties involved, date of transaction, price, location, state, and quality of the product, as well as other information that is relevant to management of the supply chain.
The Blockchain ledger’s public availability[q] means that it will be possible to track every step in the supply chain of every product. In a supply chain that has implemented Blockchain tracing, all actors can trace a product back to the raw materials used to produce it. Full transparency, as well as being decentralized, having immutable ledgers and being cryptographically secure makes them nearly impenetrable for attackers or “hackers” to seize control of[r] the Blockchain and the data stored there and manipulate it.
Supply chain
A supply chain contains all of the links that are involved[s] when manufacturing and distributing goods. In today’s world, a supply chain can potentially involve hundreds of stages and dozens of geographical locations, such as the supply chain of Apple Computers, which includes over 1.6 million people in 20 countries (Apple 2016).[14] The scale of these supply chains makes it very difficult to track events happening within it, and investigate incidents. Since data is lost and obscured in every step of the supply chain, the further down in the chain an incident occurs, the harder it is to obtain any information about it (Cecere 2014).[15]
Buyers and sellers need to have a reliable system for verifying and validating[t] the true value of a product or service purchased. The endemic lack of transparency in supply chains effectively results in consumers paying a price for a service or a product, which is often an inaccurate reflection of what the true cost and impact of production is. There is for example no standard way to track the environmental impact of goods with supply chains that are not fully integrated and shares all relevant information with all actors in the chain (the vast majority of goods). Blockchain can help overcome this issue by establishing standards based on open Blockchain ledgers for sharing trusted information with all actors. To enable adoption of Blockchain standards, an industry leader might be needed to spearhead the initiative[u].
Despite numerous cases of actors in a traditional supply chain being involved in illicit/illegal activities,it is often the case that nobody is held accountable since investigations are hard to conduct. This includes illegal activities such as unregulated sweatshops, counterfeiting, detecting and tracking contaminated food sources. A notable example is the mining of coltan ore in Africa. The ore is needed for the extraction of tantalum, a metal used in mobile phones and other consumer electronics. Despite reportedly committing human rights abuses for several years in a row (Sutherland 2011),[16] mining operations are still prevalent.
Developing broad and clear communication lines in the supply chain is important (Mohr and Spekman, 1994[17]; Frankel et al., 2002)[18] to breed sharing of information and creating a shared understanding[v] (Stank et al., 1999[19]; Ireland and Bruce, 2000[20]). Instead of single points of contact there ought to be developed broad interfaces between organizations in order to overcome potential lack of internal communication and to foster culture that supports an innovative mindset (Barratt and Green, 2001).[21] Centralisation[w][x] is a point of weakness that should ideally be avoided, such as in scenarios where a relationship is jeopardised[y][z] due to the departure of an individual who has previously functioned as the point of contact.(Frankel et al., 2002).[22]
Sharing information within the scope of a supply chain poses certain challenges:
* Confidentiality of information
* Issues regarding incentives
* Reliability of information technology
* Cost of information technology
* Accuracy of information
* Development of capabilities that allows firms to utilize the shared information effectively
(Lee and Oakes 1996)[23] (Khurana et. al 2011)[24] (Lee and Whang 2000)[25]
Several scholars have highlighted the basic need of information sharing if supply chains are to increase their performance (Stank et al., 1999; Lambert[26] & Cooper, 2000[27]; Lau & Lee, 2000[28]). Mason-Jones and Towill (1997)[29] argue that “information enrichment”, or the instantaneous sharing of data from the marketplace with all actors in the supply chain is not only desirable, but obligatory. In a process integration scenario where the goal is reaching a “seamless” supply chain where all “players” act and think as one, “information enrichment” needs be achieved first (Towill, 1997)[30].
Concerns about information privacy constitute an obstacle to interpersonal sharing of information in supply chains,specifically the question of what information can be shared with third parties. To foster interpersonal information exchange in the supply chain, a trusted network where individuals can share information should be built (Razavi & Iverson, 2006).[31]
Blockchain can enable distributed commerce systems that communicates with existing systems and technologies in the economy, as it is distributed and cannot be imbalanced or owned by a single government or vendor. Partners that have shared economic incentives can execute upon agreed terms and validate activities. Events, transactions, and provenance of any item is can be recorded on a Blockchain ledger and are tamper-proof. Transactions and movement of goods, sensitive data across firms and containers can be tracked, traced and monitored. This can bridge trust gaps for cross-border movements because actors can digitally verify the identity of companies, goods and people involved. Government processes can be integrated across countries using Blockchain solutions for secure sharing of relevant data.
Therefore, if implemented correctly, Blockchain technology can increase transparency in supply chains. This is possible using its decentralized ledger that can track and record movement of goods through supply chains from beginning to end. Tracking goods using Blockchain technology enables the capability to directly validate an item’s provenance and authenticity. Every actor using the same Blockchain ledger has a complete and constantly updated copy of the ledger at his disposal. This enables organizations to use Blockchain ledgers for reliable real-time monitoring of supply chains.
As a result, the Blockchain ledger can provide customers with the information about the provenance of suppliers product, and information such as how it has been transported, what it is made of and if the workers downstream in the supply chain are poorly treated sweatshop workers or well compensated employees. In a Blockchain enabled supply chain buyers might require suppliers to be active on the blockchain because the buyer is running a brand based on guaranteed slavery-free supply chains and needs to prove it to the customers. Thus, utilizing Blockchain technology for tracking of a firm’s internal operations could prove that a supplier fulfils standards that are expected from suppliers upstream in the supply chain.
Therefore, ,in a future scenario, having implemented Blockchain technology might yield a competitive advantage as consumers are becoming more aware of the provenance of products and conditions that it has been produced in. If Blockchain is adopted by the majority of supply chain actors in the same fashion as food labeled as organic or Genetically Modified Organism (GMO), customers have the option to disregard all suppliers that are not Blockchain enabled;the comparatively lack of transparency might lead customers to suspect that the corporation has something to hide with regards to the provenance of the product, or working conditions.
Latin America is a very active region in coffee production and trading with Brazil being number one, Colombia the third, and Honduras the sixth largest coffee exporters globally (International Coffee Organization 2017)[32]. Coffee production is fragmented and mostly grown in developing and remote regions. Prices are unstable and many coffee-growing regions are threatened by climate change (Inbound logistics 2017),[33]while there are also several documented abuses by human rights organizations of laborers across the region (DANWATCH 2016).[34] South American and Caribbean coffee supply chains are therefore ripe for reform. All farmers, other businesses, experts, academics, organizations and forums participating ought to identify key areas where Blockchain technology can improve the coffee supply chain and offer new innovative solutions.
When a food source is contaminated, the source of the contamination must be found as soon as possible to avoid further food poisoning among the population. For example in Mexico there was an outbreak of multistate Salmonella infections linked to imported Maradol Papayas. The Mexican Centers for Disease Control and Prevention spent more than two months to identify the source of the outbreak and from May 17, 2017 to October 4, 2017 220 people where infected.[35]
Health crisis’ like this can be solved through open Blockchain ledgers such as Ethereum’s that can create shared data repositories for the entire vertical of supply chains which can be accessed to instantly to identify the source of the such outbreak. To solve this challenge Driscoll’s, Golden State Foods, Kroger, Dole, McCormick and Company, Tyson Foods, McLane Company, Nestlé, Unilever, Walmart and IBM has partnered up in a consortium (Coindesk 2017).[36] In the words of Brigid McDermott, IBM’s vice-president for blockchain business development, the blockchain food safety program is valuable as it “provides transparency into the food system” and enables you to “quickly, effectively, surgically deal with that problem”.
Smart Contracts
A smart contract is a transparent piece of computer code which among other things can transfer assets automatically or on-demand in between owners who control the contract using a 20-word long code proving ownership called a “private key”. A smart contract executes on a network of computers running a Blockchain protocol such as Ethereum. In a smart contract, the terms of the contract are defined by computer code as a set of instructions (Blockchain Technologies 2016)[37]. According to security and Bitcoin expert, Andreas M. Antonopoulos, a smart-contract on an open Blockchain has the capabilities of being open, borderless, censorship-resistant and neutral. A smart contract has the capability to facilitate, execute and enforce the performance of negotiation of a contract and transferring of assets. The entire lifecycle of a smart contract is automated and can provide valuable as a complement to a legal legal contract (Walport, 2016)[38]. By granting legal authority to a smart contract using a Ricardian Contract, a smart contract can be a substitute to a legal contract facilitating transactions in accordance to the code deployed in the smart contract This combination is explained in the next section.
An experiment conducted by Wells Fargo & co, Brighann Cotton and the Commonwealth Bank of Australia showed what benefits smart contracts can deliver. While trading cotton, port staff scanned an ID connected to the cotton shipment upon arrival at the destination port. In doing so, they verified that the goods had arrived and update the smart contract which automatically transfers ownership of the goods while authorizing the release of a payment which is instantly settled (Cadman, 2016).[39]
The underlying TCP/IP running the internet has enabled anyone in the world with a computer/smartphone and a connection to the internet to freely share information with each other. More specifically, the information flows freely and anyone can share (upload, copy) or consume (download, copy) any digital content such as text or images. This phenomenon is referred to as “the internet of information”, where information is instantly accessible to all users once it is published.
In a Blockchain based system, transactions occur almost instantaneously and are settled immediately on the Blockchain. This is known as “the internet of value”, where any business, organization or person can instantaneously transfer value such as stocks, custody of cargo or ownership of property directly to each other using smart contracts
Thus, while monetary transactions between banks and countries takes several business days (Commonwealth Bank 2016),[40] and settlement of a contract between two firms in the supply chain in the shipping industry happens every 30. days (Kavussanos & Visvikis 2006).[41] On the other hand, Blockchain technology and smart contracts can reduce these time scales to an instance, thereby saving money and increasing accountability and transparency of the transaction at the same time.
Ricardian Contracts & Agency theory
The principal-agent problem in agency theory is where people or entities called “agents” can make decisions and/or do actions on behalf of, or impact the people or entity called “principal”. This branch of scholarship often studies contractual agreement where for example a principal hires an agent for transporting precious cargo. Also in stakeholder relationships employees acts as agents whereas shareholders are principals. When agents are motivated to act in their own best interest and those interests are contrary to those of the related principal’s interests moral hazard occurs (Eisenhardt 1989).[42] In his 2017 paper on disrupting governance with Blockchains and smart contracts, Shermin acknowledges among other subjects that further research must focus on agency theory and principal-agent problems (Shermin 2017).[43]
Ricardian contracts enable strict separation between issuance and execution of contracts by forging a connection between existing legislation and the digital world. Ricardian contracts are thus a combinations of smart-contracts and conventional human-readable legal contracts. Rules and conditions that are part of a Ricardian contracts are integrated in both contracts.This is achieved using a smart-contract controlled by the acting parties in the contract which is defined by the legislation in the legal contract (Grigg 2004).[44]
Because smart-contracts are borderless and jurisdiction-agnostic, several jurisdictions including domestic and local jurisdictions can collaborate on cross-jurisdiction Ricardian contracts. This empowers Ricardian contracts to facilitate transparent transactions across borders and interconnect jurisdictions. This can help mend contract fraud as seen in the car wash scandal as legal documents and transactions can be immutably and transparently stored on Blockchain ledgers using smart-contracts.
World Bank Chief Economist for the regions of Latin America and the Caribbean, Augusto de la Torre, announced in the publication “The Trade Challenge for Latin America and the Caribbean” that:
What we have learned so far is that it is not enough to have global trade or to receive foreign direct investment. There is more to be done to take full advantage of that trade and investment.
The world bank urges the regions to find ways they can improve its human and physical capital in addition to business development and technological capacity. It wants labor and capital to find their way into the most productive sectors (World Bank 2015).[45]
Opportunistic behavior in agent-principal relationships in the automotive repair industry has been proven to increase when there is information asymmetry between the agent and the principal (Wolinsky 1993).[46] In online interactions reputation systems has been shown to be the best way to earn trust between both buyers and sellers. Information about reputation can measure how much a community trusts an agent or principal. When reputation is greater an agent or principal is deemed more trustworthy Prisco argues that more is on the line for the agent or principal and they behave more honestly (Prisco 2015).[47]
Ricardian contracts with embedded reputation mechanisms (Dennis & Owen)[48] based on legal court rulings, reviews and truthful completion of contracts from agents and suppliers in the past saved on Blockchain ledger’s trusted data store can lower requirements for relationship-specificity IT investments. Agents and principals can trust information such as financial transactions and reputation without investing in traditional closed and centralized mechanisms of coordination financial transactions and due diligence. The reduction in cost and transactional risk can make more coordination possible between agents and principals. This can result in transitional economies of scale with fewer and more long-term relationships (Clemons et al., 1993).[49]
Increasing trusted behaviour between agents and principals in Latin America and Caribbean supply chain, businesses and governments using Blockchain Ricardian contracts and can thus increase trust for foreign investors, domestic business, government organizations and foreign traders. For example can drive benefits and growth to small to medium sized enterprises such as coffee farmers in Latin American and Caribbean by increasing trust in supply chain, principal-agent relationships and geographically displaced investors.
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[1]I wish to thank Jakob S. Notland, Emil S. Emami, Roger Sørheim and Sveim Grimholt for reading through and providing valuable feedback on this paper.
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“Will the future consist of a costless transaction base, a truly open market for trading, and a borderless economy that allows all equal access?
https://www.researchgate.net/publication/4085229_The_Ricardian_contract#pf2
