Optimal Smart Contracts with Costly Verification

We study optimal smart contract design for monitoring an exchange of an item performed offline. There are two parties, a seller and a buyer. Exchange happens off-chain, but the status update takes place on-chain. The exchange can be verified but with a cost. To guarantee self-enforcement of the smart contract, both parties make a deposit, and the deposits must cover payments made in all possible final states. Both parties have an (opportunity) cost of making deposits. We discuss two classes of contract: In the first, the mechanism only interacts with the seller, while in the second, the mechanism can also interact with the buyer. In both cases, we derive optimal contracts specifying optimal deposits and verification policies. The gains from trade of the first contract are dominated by the second contract, on the whole domain of parameters. However, the first type of contract has the advantage of less communication and, therefore, more flexibility.