Smart Liens

Nick Szabo

1994

Imagine that your government went bankrupt, leaving you with no jurisdiction which you and your neighbors were forced to abide by in order to live in that territory. Would chaos prevail, or a could a new, better arrangement take government’s place? Would it, in particular, still be possible enforce payment of debts and criminal liabilities?

Now imagine that your government is not yet bankrupt, but it might well become so if it doesn’t cut costs. One way of cutting costs is to improve the efficiency of that government function which is most vital to the economy, the enforcement of contracts. How can we reduce the burden of such enforcement on future taxpayers without jeopardizing productive free enterprise? Smart liens may be a powerful new way to accomplish these tasks.

First, let’s introduce the notion of a protection agency (PA), which while being part of the voluntary private sector, could take over many of the jurisdictional functions of government. PAs would be distinguish from governments by having overlapping territories, or even being non-territorial, allowing customers to choose from a wide variety of competitive PAs the PAs that best suite their purposes. Already we spend more on private security than government-funded police to protect against crime, so don’t think that PAs are far-fetched or dangerous. Their ability to enforce contracts and collect debts, rather than just protect against crime, would be greatly improved with the technique of smart liens, allowing PAs to relieve indebted governments and their taxpayers of these enforcement burdens.

How can debts be collected? No wise bank will lend to an agent (an agent can be a real person or a virtual person, aka a corporation) more than is covered by securely liened collateral plus some conservative function of its reputation for payment in full and on time. For all agents, both credit and liability are closely related, and limited.

The liability of agents are limited by that agent’s liens and by the ability to deter that agent by threatening punishment for violating contracts (ie, committing crimes as defined by the contract with the PA). The potential for other actions an agent might take that cause liability, such as damage to others’ persons or property, also need to be limited. More on that later.

Many agents, especially new entrants, may lack this reputation capital, and will thus need to be able to share their property with the bank via secure liens. A lien is, in a practical sense, a method of sharing a piece of property between the “owner of record” and a “lienholder,” instead of the property having strictly one owner. Liens are used in many large credit transactions, such as auto loans, mortgages, farm loans, etc. They are enforced by the jurisdiction specified in the contract; usually this enforcement is done by the government and subsidized by the taxpayers rather than paid for by the contracting parties. (In fact this usually is the case with contracts and property rights in general, the enforcement clause is an implicit government subsidy). One way to implement a lien without governments is via co-signing with your PA (as long as the PA has a good credit rating and the contractual right to take appropriate action against you). Another way is with what I call a “smart lien”. A smart lien is an electronic, cryptographic system whereby both parties need to identify themselves to the property for that property to function properly. For example, a smart lien on a piece of real estate would control the utilities (electric, water, etc.), shutting them off if either the lienholder or the owner so choose, or if the system is tampered with to try to disable the lien.

As is the case today, credit problems will usually be solved by artfully written, menacing dunning letters and dings to one’s credit rating long before the lien needs to be invoked. However, the lien needs to be enforceable to make these dunning letters credible over the long run.

If PAs bear ultimate responsibility for the criminal activities of their customers, or need to insure lack of defection or future payments on the part of customers, they may in turn ask for liens against their customers, either in with contractual terms allowing arrest of customers under certain conditions (e.g. if they commit acts specified as criminal by the PA contract) or (more likely for mobile world-traveling and virtual pseudonymous customers) smart liens against liquid assets such as bank accounts and investment portfolios. Smart liens over information, such as digital bearer securities, can be implemented via secret sharing (two or more keys required to unlock the encryption).

The “ultimate lien” would be a kind of cardiac anti-pacemaker controlled by the lienholder. PA customers would likely reject PAs with such an outrageous requirement, and it would be even more disgusting for a government to propose such a thing. However, one can imagine PA leaders themselves required to have ultimate liens, controlled by an N-out-of-M voting system of their customers and/or cross-contracted foreign PAs, as a hedge against their power. Ultimate liens do perhaps fly in the face of the moral imperative many see behind limiting government, the elimination of violence and threat of violence in the fabric of our society, but if implemented just against PA and government leaders they might still provide a great improvement over the current state of affairs.

Other important areas of liability include consumer liability and property damage (including pollution). There need to mechanisms so that, for example, pollution damage to others’ persons or property can be assessed, and liens should exist so that the polluter can be properly charged and the victims paid. Where pollution is quantifiable, as with SO2 emissions, markets can be set up to trade emission rights. The PAs would have liens in place to monitor their customer’s emissions and assess fees where emission rights have been exceeded.

Alas, there are some dangers where maximum damage could far surpass any liens. A good rule of thumb here is that if the risk is against a third party, and it cannot be liened or insured against, then PAs should not allow it to be taken. PAs that allow their customers to take such risks against non-PA parties would ruin their credit rating. One example of such a risk is building a nuclear plant for which no insurance company is willing to submit liability coverage. If a plant is safe, presumably one should be able to convince a good insurance company to cover its potential to damage others’ property.

Smart liens are one element of smart contracts. Smart contracts will replace, and even protect against, lawyers, politicians, and violent enforcement in many business and social interactions. They will also be used to design lucrative new free-market institutions. See my essay “Smart Contracts” for an introduction to smart contracts.