Smart Impact Bonds

Impact bonds are an economic mechanism to finance the delivery of products and services in a way that incentivises the achievement of pre-defined outcomes. Here we introduce the concept of Smart Impact Bonds, which are implemented using blockchain and other Web3 technologies.

We believe the economic mechanisms implemented through current forms of impact bond instruments are very well-suited to bridge into the crypto-economic mechanisms of blockchain technologies, which use a combination of applied cryptography (maths) and game-theoretic economic mechanisms (behaviours) to achieve outcomes in ways that can be scaled through decentralised networks.

This holds enormous potential to provide a new set of tools and mechanisms for forming and allocating impact capital to achieve greater social, environmental and economic impacts, pursuant to the global goals for sustainable development.

Impact Bonds

Impact Bonds are typically structured as innovative financing mechanisms that require multiple parties to be coordinated, incentivized and held accountable through contractual agreements.

In a game-theoretic sense, the parties are set up to play adversarial roles that keep the actors honest. This is achieved through a system of incentives and penalties that are adjudicated by trusted parties. Financial incentives are used to promote the participants to be good actors. Legally enforceable penalties are put in place as disincentives for bad actors or poor performance. Performance conditions are established for payments to be triggered and these mechanisms must be trust-worthy. Triggers typically rely on predefined measures being met, based on verifiable evidence, which usually requires acceptable quality data that is independent audited.

All the participants in an Impact Bond must estimate their individual risks ex-ante and they have limited control over the external sources of risk that could compromise their performance. These instruments are vulnerable to many potential points of failure and vectors of security compromise.

Impact Bonds are therefore highly reliant on intermediaries to negotiate the rules of engagement, to monitor compliance, measure and validate outcomes and enforce contractual terms. This requires considerable professional expertise, time and skills to negotiate, manage and execute.

For these reasons, most impact bonds to-date have had to be large-enough to provide some economies of scale, but not too big to cause massive financial losses or opportunity costs, if they fail. Most development/social impact bonds have therefore been implemented as safe-fail pilot projects, which offset the high costs to operate against institutional learning and research outcomes.

In thinking about future technology-enabled impact bond mechanisms, we would like to learn from previous experiences of implementing traditional Impact Bonds.

Blockchain technologies and the decentralised web

(If this is already familiar to you, feel free to skip this section)

Blockchain describes a combination of information, financial, economic and governance technologies. As an information technology, a generic blockchain processes and stores information within permanent, non-repudiable transaction records. Copies of these records are typically distributed across multiple independent compute nodes in a decentralized network. Records are transparently (and usually publicly) shared amongst many actors who can, without permission, view, query or write to the ledger.

Logical operations encode how each transaction gets executed when new information is written into the record. This happens during deterministic state transitions during which consensus must be reached amongst a threshold number of participating nodes. Various algorithmic consensus mechanisms exist to operationalise this process.

A blockchain that can compute more sophisticated logic, as well as respond to input messages, is described as offering smart contract capabilities.

Smart contracts are used to programme applications, such as escrow payments and even more complex instruments, such as token curation and prediction markets.

As an economic technology, a blockchain is hard-coded to provide both incentives and disincentives for participants in the system to act in coordinated and performant ways.

Participant must identify and authenticate themselves to exercise their rights on the network, using cryptographic key signatures. The blockchain protocol determines the scope of rights that can be exercised by each participant. It encodes economic incentives and disincentives for participants to correctly exercise their rights and responsibilities. This happens automatically, without any value-judgement or human interference. No participant needs to be trusted.

The economic costs of attacking a blockchain system are far higher than the economic costs of protecting the system. This enables otherwise-adversarial actors to participate in the same game, as the rules are hard-coded for everyone and (in theory) get executed without the need for trusted third parties.

Internet of agreements

Aside from blockchain technology providing these capabilities, users of the technology must still come to an agreement on how they will configure blockchain applications in which they would be willing to participate. This is where the new field of crypto-economic mechanism design is relevant. This applies a useful game-theoretic principle that, without value-judgement, sees every participant as an adversary in the system (game).

Crypto-economic mechanisms are designed and optimised so that no one adversary has less disincentive to attack the system than incentives to protect the system, which encourages them to play an honest game. Achieving optimal mechanism design is both art and science. This also requires experience over time, to learn and update the mechanism. Decisions about changing a live mechanism require governance mechanisms. Disputes arising from unexpected outcomes of a mechanism need effective dispute-resolution mechanisms.

Cryptographic tokens

Cryptographic tokens are core to all these systems. Tokens encode digital rights to perform operations, access services, secure ownership, use assets, hold membership, or participate in decisions. A lot of research and development is ongoing in the fields of crypto-economic mechanism design, decentralised governance mechanisms and automated dispute resolution.

Changing the game

It is becoming evident that blockchain and Web3 (decentralised internet) technologies and standards are game-changing. Blockchain networks have been proven to provide a highly secure and scalable mechanism for recording data and value-transfers. Many innovative solutions are being built and tested to deploy crypto-economic mechanisms for all kinds of known and novel use-cases. This is disrupting many business models and processes that have traditionally relied on trusted intermediaries.

Blockchain for Impact — the ixo Protocol

The ixo Protocol uses emerging Web3 standards to enable high-definition impact data to be collected in a new data format that we call Verifiable Impact Claims.

The data collected in this way resolves to and is authenticated against universally unique identifiers, which are referenced on a blockchain public key infrastructure. The data is high-fidelity, as each claim is cryptographically hashed and signed.

Impact Claims are submitted to the ixo Network to be evaluated through an efficient, incentivised mechanism. Evaluations are typically assisted by software agents that work as smart oracles, pulling in triangulation data from external references, to algorithmically predict whether a claim is true. Over time, this is optimised through machine-learning and predictive analytics.

This process is executed through a purpose-built blockchain that validates each claim and establishes crypto-economic Proof of Impact. By transforming raw data into verified impact data, with proof of impact, this becomes a valuable digital asset. Each impact asset is now represented as a cryptographic token that can be traded for capital or other assets and used to trigger impact bond payments.

Value-transfers in this system are programmed into a blockchain smart contract system that we describe as Decentralised Impact Exchanges (DIX). These exchanges can be thought of as a type of self-executing multi-signature escrow contract.

Taking this a step further, decentralised impact exchanges can be configured to execute value-transfers within an impact bond mechanism, to pay out service providers, evaluation agents and investors. Each value-transfer is a state-transition in the smart contract, triggered by signed message inputs. Each signed message is generated from a proof of impact that is relevant to the specific exchange.

This provides a highly secure, trustless and scalable control system for executing Impact Bonds. We refer to these as Smart Impact Bonds.

The crypto-economic design of Smart Impact Bonds includes token staking and bonding mechanisms for all the participants. Remember that we start with the principle that all participants are adversaries and then apply game-theoretic analysis to establish the parameters that will optimise the outcomes for everyone and quickly penalise bad actors, without the need for trusted intermediaries.

Financing and other applications can be built into Smart Impact Bonds — including, for instance, crowd-funding, decentralised governance, project curation and automated dispute-resolution.

Smart Impact Bonds

Smart Impact Bonds hold great potential to decentralise and greatly scale how impact gets delivered, evaluated and financed. For this potential to be realised, we need to bridge the traditional mechanisms for financing, incentivising, evaluating, regulating, governing, securing and legally enforcing impact bonds from (low-definition) analogue to the (high-definition) digital mechanisms that are offered by Web3 and blockchain technologies.

Designing new open standards for tokenised impact bonds

On 7–8th June, the ixo Foundation and UBS Optimus Foundation will co-host a design workshop in Zurich to take the first steps towards designing smart impact bond mechanisms, using blockchain and web3 technologies. This is a collaborative effort that we hope will bring together some of the smartest minds and people who are already working on innovative impact bond applications.