When the average person thinks of contracts, 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 who wrote it. And they would be right. This is how it worked before the rise of smart contracts.
A smart contract, in its simplest form, is a string of code allowing transactions to be made without requiring a third party. Basically, a digital vending machine.
But smart contracts are only as strong as the system they’re built upon. This is where blockchain technology steps into the mix, ushering in a whole new array of use cases still being realized.
Already, smart contracts, with the help of blockchain technology, have revolutionized the way deals are made, executed, and enforced. In fact, this tech tag team has infiltrated nearly every industry imaginable, and the best is yet to come.
It has been said that blockchain technology will be the stepping stone to an entirely new internet, and you can be sure that smart contracts will play a key role in this process.
So, what are contracts, anyway? The answer may seem obvious, but there are actually a number of characteristics by which a legal contract must abide.
A contract begins with an offer and acceptance. Two or more competent parties must reach mutual assent, wherein the parties involved agree upon a legally enforceable exchange.
Contracts are used in some way, shape, or form in nearly every aspect of our lives. From beginning a new job, buying a car, accessing the internet, to more complex interactions such as trading energy, communicating between banks, or even interactions between governments.
With so much on the line, however, things can get messy – and fast.
Anyone who has ever used social media or downloaded an application may be able to attest to this. By signing the ‘terms and conditions,’ you have entered into a contract with the entity providing this service. And as we all know, these terms and conditions can give power and privilege to the service provider that is often overlooked, misrepresented, or even omitted intentionally. And acting on this betrayal is not always as easy as it should be.
Knowing how quickly things can go wrong in these events is important. Drafting, enforcing, and executing these contracts is a highly bureaucratic process requiring time, money, and manpower, and if one party is lacking any of these resources, the chance for foul play increases substantially.
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 the terms – and it’s all based on a few simple lines of code.
Smart contracts have the potential to level the playing field, removing the cost, time, and bureaucracy from the process of drafting and enforcing the agreed upon terms. Where traditional contracts use natural (or legal) language to communicate and execute terms and conditions, smart contracts are built on computer code.
“If this happens, do that. If it does not happen, do this instead”
The idea comes from Nick Szabo, a computer scientist and cryptographer, who made the famous vending machine comparison. But the real breakthrough came only recently.
The integration of smart contracts and blockchain technology changed the way contracts could be accessed, stored, and utilized.
A blockchain is, in essence, 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 famous by bitcoin, 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 currency, 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.
However, no where are these applications more important than in the Internet of Things (IoT). With billions of devices connected, and some of our most critical real-world infrastructure dependent on 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.
How are smart contracts being used?
You may have heard that the middle-men will soon be out of the job, but 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 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, 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 amount 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 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 contract 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 becoming 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 cons….
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 on 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 contract 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 be 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.
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. As new eyes set their sights on the possibilities, it is safe to say that we’re only getting started.