Rights and Obligations are the 2 most fundamental building blocks of trade and finance. Contracts exist to protect rights and enforce obligations. Trade consists of trading one right or obligation for another.
They are also fundamental in understanding how Financial Systems, Blockchains and Smart Contracts work, yet most people haven’t really thought too much about what they actually work.
I believe it is vital to understand and think about these basic concepts to be able to successfully understand Bitcoin, Ethereum and eventually replace the traditional financial instruments and systems that are all based on this.
This article is a quick introduction rights and obligations and how to think about them in financial applications, in particular when writing Smart Contracts.
Possession is nine-tenths of the law
We have all heard the above expression and it is the easiest kind of right to understand. If I have a dollar in my hand it’s mine.
No one has a right to take it out of my hand and I have a right to use it for what I want.
Trade without obligation
Trade is easy in person. I buy a kilo of fresh smoked cheese from my local cheese maker here in Managua by handing him a 100 Cordoba bank note and he gives me cheese.
He could take off running with my money or I could take off with the cheese before payment, but it is unlikely.
How about buying something on-line or over the phone? This is a bit harder in a cash based society unless you do cash-on-delivery. Such as the the delivery guy who exchanges the Pizza for cash.
An Obligation is the opposite of a Right. It requires me to do something at some future date. For an Obligation to be worth something, the buyer has to trust that I will follow through on my Obligation.
Some people think credit and obligations are new, but as David Grabber says in Debt: The first 5,000 years. It has probably been around longer than money and may be one of the things that allowed us to grow our civilizations.
A simple modern form of obligation is paying with a credit card. Your obligation is written right on the slip you sign “I the card holder promise to pay …”.
A check is an obligation I write to a 3rd party, who now has the right to cash it in his bank and my bank has to take the funds out of my bank account.
Obligations vs Rights
In most kind of modern trade and finance Obligations are the exact opposite of Rights. Credits vs Debits. Lender vs Borrower. Buyer vs Seller.
If you exchange an Obligation for a Right or another Obligation you basically have a contract.
A rental contract has 2 parties the tenant and the landlord. The landlord has the obligation to let the tenant live in his house and the tenant has the obligation to pay monthly rent.
Rights and Obligations in Currencies
Back in the day when currency meant a gold or a silver coin, currency was a right based on possession. Also known as a bearer right.
There was also no obligation involved as the value was in the metal in your hand. This is what is known as intrinsic value.
Modern cash has no intrinsic value. It is still a bearer right, but the value is an obligation from the issuer, most often a central bank. You can see it written in small print on most bank notes.
Wherever there is an Obligation there is a counter-party risk. In reality the value of a $100 bill is not that the US government will give you $100 worth of gold (they removed that right a long time ago).
The real value of a $100 bill is that the consensus of people around the world is willing to accept the $100 bill at face value and provide you something in exchange for it.
The risk as the right holder is that you have to trust the issuer not to screw up this fact. The primary obligation of the Federal Reserve or any Central Bank is (in theory) to maintain a stable currency and economy.
As we can see in Venezuela, Argentina and Zimbabwe and increasingly the Euro zone, when people start loosing trust the value of these rights go down.
Fractional reserve banking and bank runs
When you deposit money in your bank account. You no longer have possession of this money. You exchange this possession for a right to access it whenever you want. This is an obligation on the bank.
Once you have deposited this money the bank owes it to you, they have a right to issue some multiple of that as loans or as investments in the financial markets.
You can see this on the banks balance sheet in the liabilities column. Liabilities is an accounting term meaning obligations.
Cash is not that relevant in rich countries today. Transactions are often performed electronically through a bunch of intermediaries exchanging rights and obligations through electronic payment systems.
The vast majority of money that you have in your bank account and in use for buying stuff on Amazon is not even issued by the central bank. It is actually created by your bank through the “fractional reserve banking” method I explained above. This is why the failure of one or two banks can sometimes bring the whole financial system down.
Bitcoin and Rights
Bitcoin is a financial system without obligations. There is no issuer. In this respect it is like gold or silver.
The basic Right in bitcoin is the “transaction output”. The value you own in bitcoin is held on the global ledger as outputs owned by your bitcoin address. You can transfer money to someone else by signing an output and creating a new output to another address.
We can also see through the basic right of the output, that the value of it is intrinsic to it. No output has special rights or restrictions. Each output has the right to transfer to someone else unhindered.
In other words the value of bitcoin the currency is based on the fact that I need it to be able to use the Bitcoin network.
While strictly speaking there is never a counter-party or issuer in Bitcoin as a physical entity. You could talk about the bitcoin network itself being a Decentralized Anonymous Organization (DAO) with the issuers obligations.
Problems with a system without obligations
So many parts of what makes the world go around are about obligations. In traditional money systems networks of trusted third parties help to ensure the trust in these obligations.
In Bitcoin we have a system that doesn’t at it’s basic level support obligations. This is also true in 100% cash based economies.
This may be one of the reasons that Bitcoin hasn’t really succeeded in e-commerce for example. You need some sort of contract that obliges the seller to deliver what you ordered.
Granted this can be built into the e-commerce layer itself through rating systems, such as those found in both e-bay and all the notorious drug market places.
But the traditional payment systems when they work actually win against Bitcoin here. They themselves are built on layers and layers of obligations and rights. It is pretty easy to build trust into the system, through obligation enforcement systems such as Charge Backs.
Ethereum a blockchain with contracts and therefore also obligations
Ethereum is a new kind of Blockchain that also at it’s lowest level only consists of rights.
I have the Right to transfer any amount of Eth (the currency of Ethereum) that is in my account to anyone else or create Smart Contracts with it.
The Smart Contracts allows us to build obligations and contracts directly onto the blockchain.
For basic value transfer it can easily be argued that Bitcoin is better. However the Smart Contract part allows us to create obligations.
Exchanges of Obligations for Obligations or simply Obligations for Rights.
Smart Contracts essentially allow you to promise away part of your right and put it under control of code that can give rights to others.
See From Contract to Smart Contract for more on how this works.
Rights holders interact with Smart Contracts by sending special signed function call transactions onto the network. The Smart contracts themselves checks if the sender has the rights and performs the obligation requested.
Smart Contracts with external obligations
Any right being promised that requires someone to do something outside the Ethereum system has a counter-party risk. It is the same kind of counter-party risk as found in traditional financial instruments, only without fewer institutions to help enforce them.
An example of counter-party risk from the Digix crowd sale
As an example we have the Digix crowd sale, which sold more than $7M worth of Digix Tokens. The great guys at Ether.Camp did a fantastic technical analysis of the Smart Contract and it’s transactions.
This kind of analysis would be very difficult to do in the traditional IPO as you need to investigate all the different systems and parties needed to make it work.
The obligation that the issuer DigixGlobal Private Limited of Singapore has is:
There will be a initial lifetime supply of 2,000,000 DigixDAO tokens. A holder of 1 token will receive a pro rated 1 / 2,000,000 of transaction fees collected by DigixDAO every quarter. There will be an automatic crowdsale project proposal submitted to current token holders for a new round every 2 years that may increase the lifetime supply. This is put in place to ensure the sustainability of DigixDAO if more funds are needed. Additional crowdsales will only occur with majority consensus since it involves token dilution. Current holders will be eligible to purchase more tokens prior to releasing to the general public with a special multiplier.
So as much as possible of this part is enforced by the Smart Contract itself.
The external obligation involves the “Transaction fees collected by DigixDAO”. DigixGlobal Ltd is obliged to do this and also implied promote the system so transactions are created.
This is not bad and is not hidden. Part of buying into the token sale is making a bet that DigixGlobal can do that. The risk in investing is that they can’t.
If there are any legal disagreements about that obligation and the performance of it, it can be taken to the courts of Singapore and disputed there.
The importance of isolating the external Obligation
The great thing about Ethereum Smart Contracts is that we can separate the rights and obligations very clearly. The Rights are generally specified clearly in the Smart Contract itself.
Internally managed obligations such as voting, transferring etc can itself be handled with no systemic risk through the contract.
A well written Smart Contract with external obligations has as small an external obligation as possible. The external obligations should be documented very clearly in a human readable contract enforceable in a court of law or other external dispute resolution system.
This has to be written clearly, the people behind it should not hide who they are and there should be a clear path for dispute resolution.
I am positive we will see more and more trusted third parties and intermediaries just like in the traditional financial system. My hope is that these will also base their services on transparency and as much as possible on smart contracts.
The next article will cover counter-party risks and how they apply in block chains.