Blockchain and the Future of Optimal Financing Contracts

Blockchain technology makes it possible to create immutable smart contracts that are based on reliable and timestamped records of transactions. These new features imply that contracts for raising external financing could now depend on when, and not just on whether, positive cash flows occur. Such flexibility is bound to become increasingly important in a dynamic moral hazard environment where entrepreneurs can learn from data and make effort choices more and more frequently. This paper develops a theoretical model of contract design in the new blockchain environment, and shows that the optimal contract is a relatively simple and dynamically adjusting splitting rule. Under this type of smart contract, external financing would be as cheap as internal funds and more accessible to agents with no internal funds. In contrast, traditional debt and equity would likely become more expensive, as there would be more frequent effort decisions and learning. Furthermore, debt would become inferior to equity in this new environment, as the blockchain eliminates the need for costly verification, and as more frequent decision making magnifies the negative features of debt contracts