Can blockchain solve supply chain disputes?

A small glitch can create ripples like a domino effect in the supply chain, but smart contracts offer a quick and fair way to share responsibilities

Featured faculty: Ko Chiu-yu
Written by Putro Harnowo

The fuss and feathers around bitcoin and cryptocurrency sometimes obscure the basic technology behind them. Indeed, blockchain, as the fundamental technology, has the potential to revolutionise industries beyond finance.

Blockchain is a distributed, encrypted digital ledger or record that everyone can see and agree on through computers. Its unique feature has opened a new mechanism called a smart contract, a self-executing agreement implemented as code on a blockchain that automatically performs actions without a middleman. Once deployed, this contract has a unique and immutable address that prevents unauthorised changes.

Leveraging this technology, a new study by Ko Chiu-yu, Associate Professor at the Department of Decisions, Operations and Technology at the Chinese University of Hong Kong (CUHK) Business School, examines how smart contracts can be utilised to solve disputes in the supply chain.

“Supply chains involve multi-tiered arrangements with numerous bilateral contracts. When disruption arises, figuring out who should bear the loss can be complicated,” says Professor Ko. “Smart contracts can automatically manage, track, and settle these losses fairly, especially when an action of a party initiates sequences of unanticipated damages that affect others.”

For instance, when a supplier fails to ship a component on schedule to an electronic assembler, the assembler would face compensation demands from the distributors for delayed delivery. A question then emerges: When actions of a party affect another party’s agreements with a third party, how should the liability be shared between the initiator and other parties for the damage?

In a study titled Sharing sequentially triggered losses: Automated conflict resolution through smart contracts, Professor Ko and his collaborators propose “the fixed-fraction rules” to fairly share responsibilities among parties in a supply chain. Each liability is split between the party that initiated the problem and the other parties that caused further damages later in the sequence.

Professor Ko compares it to a choose-your-own-adventure game with a dial. One end shows 0, which means the first party is responsible for all the costs, and the other end shows 1, which means everyone only pays for their own mistakes. The easy middle ground is to split the costs fairly between the initiator and the next party affected, using simple fairness principles like “let’s all chip in equally so nobody gets the short end” to keep the peace.

“Smart contracts can automatically manage, track, and settle losses fairly, especially when an action of a party initiates sequences of unanticipated damages that affect others.”

Professor Ko Chiu-yu

How can blockchain help?

Along with Jens Gudmundsson and Jens Leth Hougaard of the University of Copenhagen, Professor Ko takes a step-by-step approach in creating the fixed-fraction rules. They began by defining core allocation principles to balance fairness and incentives, making liabilities shared among each party based on a fixed fraction of the total loss.

A party is only aware of the agreements it participates in, so each party is only responsible for the loss associated with its own purview. Therefore, the initiator shall cover the rest of the loss since they could have done something to avoid the damage. For the loss incurred by several connected parties, the liabilities are shared equally among the initiator and the other parties. With these rules, the initiator is incentivised to avoid starting the chain of loss while also acknowledged for their limited control over further damage.

“The fixed-fraction rules operate on a similar principle to a common term in the supply chain called fixed share rate contracts, where the costs, risks, or liabilities arising from issues like delays, defects, or product recalls are shared among the involved parties based on predetermined fixed fractions,” says Professor Ko. “These terms have been shown to incentivise improved product quality.”

In ensuring fairness, the researchers further set out four principles. First, if losses occur in two different cases, the system can simply add up each party’s responsibility from both cases to get the total loss. Second, if the system combines two separate losses into one, the way of sharing the liabilities should stay fair and consistent. Third, if the number of parties involved changes, the responsibility shares also adjust accordingly. Lastly, parties not involved in causing any loss shouldn’t be responsible for anything.

To illustrate, the researchers extend the model to a scenario represented by a loss tree below, where any party can initiate the chain of loss. When B fails to meet its agreement with E, a total loss of US$19 occurs, which is calculated from a direct link with E and indirect links with F and G. According to the fixed-fraction rules using a benchmark middle-ground split, B pays US$14 to cover the full loss with E plus half of the losses with F and G (each taking an equal half as the balanced default for shared accountability). Accordingly, E cover the remaining US$5.

This approach ensures the initiator bears primary responsibility without overburdening downstream parties, maintaining incentives for prevention across the chain. Meanwhile, A, C, and D aren’t affected.

The fixed-fraction rules can be implemented in smart contracts by storing the agreements in a loss tree. Involved parties shall make deposits to cover potential losses, and with a set of functions, the blockchain can automatically compute and distribute liabilities in case of damage. If everything goes well, the deposits will be returned to conclude the deal.

The future of smart contracts

Supply chain is not the only one with an interwoven network. Given its ability to address the chain of loss, Professor Ko believes that fixed-fraction rules can be applied in other industries, such as automating cost-sharing in loan defaults, handling group claims after disasters in insurance, sharing penalties for construction delays in real estate, and many more.

However, there is a limit on how the rules can work, since their success depends on reliable data sources and integration with their supporting ecosystem. In many countries, the legal framework for smart contracts is also still evolving, and there is no uniformity in regulation about blockchain worldwide.

“Complex and high-value disputes will likely be settled through courts, as it takes time and effort to verify evidence and examine the terms stated in the contracts,” says Professor Ko. “Therefore, automatic conflict resolution works best for clear-cut, data-driven disputes with less room to argue, and facts can be verified automatically.”

With that being said, smart contracts will work best to settle smaller disputes, such as in delivery delays verified by sensors or tracking systems, e-commerce issues confirmed by delivery logs, and licensing or intellectual property breaches tracked through secure digital records.

In the era of AI, Professor Ko anticipates technologies to enhance smart contracts to be more adaptive by using predictive analytics to detect patterns and prevent disputes. Natural language processing would also be able to interpret ambiguous terms, and automated verification may validate data and trigger more accurate settlements.

“By combining AI-driven analysis with smart contracts for complex cases, and monitoring regulatory compliance in real time, technologies can improve efficiency, especially in sectors such as public services, e-commerce, and insurance,” he adds.