When the Contract is not Smart Enough

Or Decentralized Arbitration

The main pillar of Decentralized Finance (or DeFi), is the absence of the intermediary and a central body. The two parties involved in the transaction are the only participants of the deal. But what happens when any of the parties are not completely satisfied, have been scammed, and want to open a dispute? The new economy has new challenges, but it doesn’t mean there are no solutions.

The DeFi transaction that happens between the two parties is possible thanks to the smart contracts that are running on the blockchain. The fact whether the transaction was borrowing or lending, or can be classified as a transfer of the security is very important for the financial regulators. If the security was traded, then it is the scope for regulation. Besides, as we have previously discussed, there are more challenges when it comes to the regulation of decentralized exchanges, such as anti-money laundering procedures, that are puzzling the financial watchdogs.

While regulators are figuring out how to protect market participants of the DeFi ecosystem, there are companies that already are offering mechanisms for dispute resolution.

The fact that blockchain gives power to people and the decentralized finance removes the central authority does not mean that there is no rule of law that should and can be applied to DeFi transactions.

What are the risks?

The smart contract is automatically executed when the conditions of the deal were met. It can’t be hacked or reversed. Also, it is impossible to honor the contract if the conditions were met. The smart contract is based on code, pure math, and technology, making it one of the most secure contracts between the two parties. However, it is not all-powerful as the conflicts still may arise, because we are all human, after all. One of the disputes may be purely objective, based on personal preferences.

The great news is, the decentralized online dispute resolution protocol exists, which can solve the disputes between the two parties.

What is Decentralized Justice?

Online Dispute Resolution (ODR) has originated some time ago. However, it did not gain substantial popularity. The subject has been revived, when blockchain technology gained mass adoption.

Decentralized Arbitration has managed to combine blockchain technology, game theory, and decentralized group intelligence in order to help fight fraud in cryptocurrency exchanges.

Kleros, the first decentralized arbitration service is helping to dispute virtually any transaction on the internet since 2018. Kleros has developed a Smart Contract called Kleros Governor to make decentralized decisions for any Smart Contract.

According to Kleros, the smart contract built on the blockchain is taking into account the most important pillars of the rule of law. For example, the decision-making logic is not kept secret, and anyone can learn what it is. Besides, the logic can’t change or vary depending on the dispute. The company runs the “virtual court”.

The Justice-as-Service that is provided by Decentralized Court can be used in various industries, however, it is especially useful for DeFi projects.

How does it work?

The decentralized arbitration begins when the two parties that had a contractual relationship via blockchain-based smart contract open a dispute. The decentralized network of users will make the ruling on this dispute.

Firstly, the users can register on the Kleros platform and “apply” to become the juror in a particular case. Users are motivated to participate in the arbitration with the utility token issued by Kleros called pinakion (PNK) with a current market capitalization of $112 million. The application is more like the self-selection that is completely automatic with a probability of being selected depending on the amount of PNK the user has put at stake for this case. The amount at stake is serving as insurance that the juror will vote honestly and coherently (like the majority).

If the juror was incoherent, he or she will lose part of their stake. Secondly, the amount of PNK at stake is serving as a Proof-of-Humanity and mitigates the possible Sybil Attack. Sybil Attack (named after Sybil Dorsett, a woman with Multiple Personalities Disorder) happens when a single person has created several accounts, nodes, or uses multiple computers in order to manipulate the blockchain.

Once the jurors were randomly selected, they examine the evidence and make voting. Jurors can’t change their vote and they do not see each other’s votes in order not to get influenced. The only way not to lose the stake is to vote honestly or cooperate like in the game theory. Once the ruling has been made, the coherent jurors are compensated for their work from the arbitration fees paid by one of the parties of the dispute.

Applications in DeFi Projects

The U.S. regulator SEC (Securities and Exchange Commission) did not approve any laws yet, however, several panel discussions have raised a concern that the Decentralized Exchanges must protect the users against unknown tokens and block such assets. Kleros helps DEXs to curate the list of tokens and become completely compliant in this regard.

Another challenge for the decentralized exchanges is to comply with anti-money laundering laws, hence know the origins of the funds. Oracles are capable to bring off-chain information (from the real world) into on-chain. The decentralized justice system can help here as well- it is capable of feeding data if the smart contract asks a question and acts as one of the parties. The users are providing answers, and if the answers are the same, then the oracle returns the answer given by the majority.

Before the regulation will be drafted and decentralized finance players have their playbook ready, they can prepare for the most obvious policy requirements and the decentralized justice will help them in it.

Decentralized finance is one of the industries that benefit greatly from the decentralized justice systems. However, if the blockchain technology will finally get mass adoption and will penetrate any type of contractual relationship- the marketplaces, the employment, freelancing, and so on, then the traditional dispute resolution frameworks will be not relevant and will be outdated. The dispute resolution will have to be fair, fast, and digital. Making the crowd decide fairly on the outcome of the dispute is the next step into the digital future.