When Do Smart Contracts and IoT Improve Efficiency? Automated Execution vs. Increased Information

Abstract

Smart contracts existed before blockchain technology, but blockchains have been a key reason for their recent popularity and their emerging use in areas such as Decentralized Finance (DeFi). Smart contracts critically depend on digital inputs that inform them whether their triggering conditions have occurred, typically provided by connected sensors (such as ``IoT'') that supply certified signals to the blockchain. If there is a dispute, evidence from these sensors can be shown to a court or an arbitrator, making the corresponding states ``verifiable.'' The two technologies are thus intricately linked but have distinct functionality. We develop a model that distinguishes the impact of smart contracts and connected sensors. We show that connected sensors and smart contracts have different implications for contracting outcomes and efficiency, and depending on the setting, can substitute for or complement each other. Specifically, smart contracts restrict the strategy space by allowing the contracting parties to commit not to hold-up each other; this typically increases the contracting region where trade occurs and thus increases efficiency, but for certain parameter values it surprisingly can decrease social welfare. Connected sensors expand the state space over which the contract can be specified by creating finer partitions of the verifiable states of nature. This typically leads to more efficient trades when they occur. Finally, when applied together, smart contracts and connected sensors enable all efficient trades, including certain trades that neither technology can enable individually. The preferred combination for deployment is determined by the tradeoff between efficiency gains and technology cost.