What are smart contracts?
When a person thinks of a contract they might think of stacks of paper, hundreds of signatures, negotiations and loopholes, and leering legal eyes. A time consuming, inefficient, and error prone process that no one understands besides the person (usually a lawyer) leading it.
A Smart Contract is a string of code allowing transactions to be made without a third party. With the help of blockchain technology, Smart Contracts have already revolutionized the way deals are made, executed, and enforced, and the utility of the pair is predicted to be the stepping stone to an entirely new Internet.
So what are Smart Contracts, how are they being used, and how will they change the world as we know it?
What are (not) Smart Contracts?
Founded on an offer and acceptance, contracts are legally enforceable instruments that govern agreements and activities between two or more parties. Traditional contracts are used in some way, shape, or form in nearly every aspect of our lives (even when we don’t know it). From buying a car and accessing the Internet to the trading of energy, communications between banks, and the interactions between governments, contracts exist to keep agreements intact.
A simple example of a traditional contract would be a home rental agreement. This agreement will outline a set of rules with which both the landlord and tenant must comply. On the most basic level, a landlord is looking to ensure rent is paid on time, while the tenant is looking to secure their space in the home. In some cases, the tenant may fail to pay, or the landlord may look to terminate the contract early. In these scenarios, the process to resolve the issue can be costly and time consuming, involving lawyers or even law enforcement officials.
In the digital world, too, the use of social media is governed by a contract between users and services. By signing the ‘terms and conditions’ with Facebook, Snapchat and Uber you have entered into a contract with those entities providing their services.
The problems with traditional contracts
Traditional contracts fall short on even the most basic of agreements. Returning to the previous example of renting a house, if the terms and conditions of the agreement are not met, the tenant and landlord could be forced to enter a lengthy and expensive dispute. A Smart Contract, on the other hand, would allow the execution and enforcement of the terms and conditions within the contract without involving third parties. An industry standard Smart Contract could save the landlord time in drafting the contract, receiving rental payments, and even enforcing the contract, while the tenant could ensure that they remain able to occupy the space, and receive their deposit when the terms and conditions are met and the contract is terminated.
Smart Contracts have the potential to level the uneven playing field that exists as a byproduct of the traditional contract, removing the cost, time, and bureaucracy from the process of drafting and enforcing the agreed upon terms.
What are Smart Contracts?
Smart Contracts, like traditional contracts, declare an obligation between two parties. The difference, however, is that Smart Contracts then verify and execute the agreed-upon terms automatically, ensuring the parties involved cannot deny the terms and no third parties can interfere with them – and it’s all constructed by virtue of a few simple lines of code. "If this happens, do that. If it does not happen, do this instead," — a basic protocol which will allow the contract to execute a set of terms designated by the creator of the Smart Contract.
Where traditional contracts use natural (or legal) language to communicate and execute terms and conditions, Smart Contracts are built on computer code. The idea came from Nick Szabo, a computer scientist and cryptographer, who theorized that digitally facilitated contracts could provide far greater security and certainty for agreements than what the traditional contract law supported. While Szabo coined the term, "Smart Contract" more 25 years ago they didn’t become a practical reality until the integration of Smart Contracts with blockchain technology, which changed the way contracts could be accessed, stored, and utilized.
A blockchain is a digital, cryptographically-secured distributed ledger. Information is stored and distributed throughout a network, as opposed to a single location, making it less vulnerable to attack. Records are public and easily verifiable by anyone, while maintaining the privacy of its users. Data is stored on blocks, each block containing a timestamp and a link to the previous block, which means the information cannot be altered or removed without doing the same for the following blocks within the chain, ensuring the immutability of the ledger.
While blockchain technology was made mainstream famous by Bitcoin and its founder, Satoshi Nakamoto, it was Vitalik Buterin who really took the idea to the next level. Buterin’s brainchild, Ethereum, was created as a Smart Contract platform, allowing participants to develop their own programs on the Ethereum blockchain utilizing a built-in coding language.
Where Bitcoin’s blockchain could only operate with a single cryptocurrency, the Ethereum blockchain unlocked a new realm of possibilities, from proof-of-ownership and the exchange of digital assets to the creation of tokens and cryptocurrencies used in the execution of numerous Smart Contract protocols.
How are Smart Contracts being used?
These technologies are poised to do a lot more than just cut your lawyer out of the mix. Entire industries will be upended – and it’s already begun. Entrepreneurs, coders, and techies have come together with a vision to support the idea that transparent, verifiable, automated, and self-enforcing contracts may have some value. Surprising, right?
The biggest sector already being transformed thanks to these breakthroughs is banking. While big banks have remained fickle on Bitcoin, it is clear that their love for blockchain technology and Smart Contracts is growing.
A study by the Cambridge Centre for Alternative Finance has found that within the next two years over 20 percent of banks plan to integrate blockchain technology into their operations, with over 40 percent suggesting that the tech will be implemented within the decade.
In the past, traditional contracts ruled the industry. Stacks of paper, convoluted language, escrows, and long waits were the norm. Where even a simple wire transfer between banks may have taken days, Smart Contracts allow these transfers to be executed in seconds. But that’s only the tip of the iceberg.
The mortgage business is notoriously time consuming, costly, and inefficient. Verification of the huge amounts of financial and property data by all parties involved requires trusted professionals spending days looking over documents, continued communication, lengthy loan approvals processes, and more. But with Smart Contracts and the proper digital infrastructure, electronic versions of these documents could be shared, agreed upon, and fulfilled in a short amount of time and for little cost, without the risk of third party error. Capgemini Counseling estimates an average savings for customers of $480-960 per loan, while saving banks up to $3-11 billion per year.
Settlement and clearing is another area where both the customer and bank stand to benefit immensely. The Depository Trust & Clearing corporation alone processed over $1.5 quadrillion worth of securities, accounting for 345 million separate transactions. Utilizing secure, automated Smart Contracts, the potential for savings is unfathomable.
Another concept in testing are ‘smart bonds,’ based on Smart Contracts. The idea is that a preset list of rules will be determined, and then the bond will automatically ‘execute’ or pay out in intervals. Nick Szabo noted: "bonds are a good example of a financial instrument suited to Smart Contracts because they could be backed by other assets that exist on the blockchain, if the bond issuer itself fails to make a payment"
While the use cases of Smart Contracts and blockchain in banking are numerous, perhaps more fascinating are the technologies’ applications in the energy sector.
The oil industry is among the largest industries in the world, and its supermajors are scrambling to adopt blockchain technology and Smart Contracts. BP and Royal Dutch Shell have already created a consortium of oil and technology companies in order to create an entirely new oil trading platform. As another industry which is largely dependent on paper contracts and slow, bureaucratic exchanges, this consortium of oil majors hopes to streamline the processes, reducing costs for customers, and increasing profits for the corporations.
Patrick Arnaud, Managing Director for Trade & Commodity Finance, ING, a member of BP and Shell’s consortium, said: "The commodity finance industry is hampered by nature by inefficiencies and outdated procedures. By applying blockchain technology, we expect that we can eliminate a lot of these, making the overall process faster and more cost effective and the tests we have been able to carry out have proved this."
Another application of the technology in the oil and gas industry is in supply chain management. Oil and gas is a global undertaking, where inventories are transported, held, and processed through multiple channels all over the world. Any failure within the supply chain could result in lost revenue. Production falls, cargo is lost, and deadlines are missed, resulting in billions in lost revenue. With the Internet of Things, Smart Contracts and blockchain technology, every drop of oil can be tracked and monitored from the moment it is pumped from the ground to point it is refined into gasoline, ushering in a new era of transparency in oil markets.
While most Smart Contracts developments are centered around cost savings, one of the most important and overlooked applications of the technology is in critical infrastructure management.
Using smart sensor networks and blockchain technology, oil and gas pipelines, refineries, or even nuclear plants can be monitored and shut down the second there is an issue. This could be key in preventing the catastrophic oil spills or nuclear meltdowns that we’ve seen in recent years.
In addition to preventing environmental disaster, this technology could add a layer of protection to our vulnerable energy grids. In recent years, cyberattacks on energy infrastructure has become an increasing threat. With greater automation, and a secure data stream, would-be attackers lose one of the biggest tools in their arsenal: social engineering.
But Smart Contracts are not without their problems…
Smart Contracts still have a long way to go, from legal challenges and the risk of monopolies, to security concerns and development costs.
A growing concern in the crypto-community is the idea that the space is becoming more centralized and that some of the biggest blockchain companies could end up controlling too much of the underlying infrastructure.
As entire industries fall, first movers have a clear advantage over potential competitors. This is already happening with companies like Ripple, or even Blockstream Inc. Both are making significant moves to build infrastructure which could result in a dependence on that infrastructure in the near future, opening up the opportunity for data exploitation, costs, or even discrimination. While there is no evidence of any of this occurring yet, the need for competition in the space is clear.
Another giant hurdle for Smart Contracts is in the very industry it has the biggest potential to disrupt: law. Smart Contracts still face a number of legal issues. A Smart Contracts in a legal dispute may fall apart very quickly. In many jurisdictions, contracts must be entered by a qualified person in natural language which must contain certain conditions, ensuring all parties are protected. Additionally, any changes in law, be it sanctions or otherwise, have the potential to render a contract useless.
Security is also a concern moving forward. While infinitely more secure than a simple piece of paper, human error or bad actors in the creation process could create critical security vulnerabilities as some of our most important infrastructure becomes dependent on the technology.
Additionally, the cost of developing and maintaining blockchains on this level could be astronomical. The Bitcoin blockchain alone uses as much energy as medium sized countries, and writing the code, verifying the code, and correcting any issues that arise will require a tremendous amount of manpower.
In light of these issues, however, it is still fair to say that the technology is more than promising.
A new era of legal efficiency
Smart Contracts are designed to save time, money, and avoid some of the biggest issues threatening efficiency. By removing as much of the human factor as possible, Smart Contracts have the potential to usher in a new era of efficiency. Smart Contracts are already disrupting the world’s biggest industries and show no sign of slowing.
Blockchain technology may be the star of the show, but Smart Contracts are vital to its success, and while many challenges still remain, it is important to remember that the technology is still in its infancy. With billions of devices connected, and some of our most critical real-world infrastructure dependent on the secure, seamless transfer and storage of data, the old way of doing things simply won’t cut it. This is where Smart Contracts and blockchain technology will truly shine and as new eyes set their sights on the possibilities, it is safe to say that we’re only just getting started.