The past decade has ushered in a new era of transacting business virtually on decentralized networks known as blockchains. Blockchains started as the underpinning of virtual currencies, most notably Bitcoin, and have evolved to serve other purposes, such as allowing for the execution of smart contracts. Understanding smart contracts and the enhanced utility they offer is critical for succeeding in different industries in the ever-evolving business marketplace that is steadily moving towards decentralized, virtual networks.
What is a Smart Contract?
You've probably heard the term "smart contract" used before, but what exactly does that mean? A smart contract is basically computer code stored on a blockchain that implements itself when certain predetermined conditions are met. They are typically used to automate the execution of all or part of an agreement or automate a workflow by triggering subsequent actions when conditions are met.
Using smart contracts allows anonymous parties to carry out transactions and agreements without the need for an intermediary, legal system, or external enforcement mechanism, and thus, cutting out any fees owed to these third parties while promoting frictionless transactions.
Quick History of Smart Contracts
Nick Szabo, a graduate student at the University of Washington, first conceived of the idea of smart contracts in 1994. This revolutionary idea came ten years before the invention of bitcoin and its accompanying blockchain technology that would allow smart contracts to venture beyond the realm of theoretical concepts.
Szabo explained that he used the word "smart" because these contracts could execute pre-programmed steps that paper contracts could not. He also warned that using the term "smart contracts" did not imply the use of artificial intelligence; these contracts could not analyze and determine a contract's more subjective requirements.
Szabo offered a non-technical analogy to convey the functionality of smart contracts, comparing it to a vending machine. Once a party has met the conditions of the "contract," like inserting money into a vending machine, the contract is automatically executed as a machine would dispense a snack.
How does a Smart Contract Work?
Smart contracts work on input parameters and execution steps that are specific and objective. If "x" occurs, then execute step "y." One can execute various actions, including distributing funds to parties, registering a vehicle, or issuing a ticket.
However, before the contract is executed and added to specific blockchains, payment of a transaction fee for the contract is required. For example, on the Ethereum blockchain, smart contracts are executed on the Ethereum Virtual Machine, and the payment for the transaction is known as "gas." As the complexity of the agreement to be executed increases, the gas required to execute the contract rises as well.
Once the transaction fee is paid, the transaction is linked to the blockchain. This means the transaction is wholly finalized and cannot be changed, and only the parties granted permission can see the results.
Why Should I use Smart Contracts?
There are several reasons why implementing smart contracts for your business is worth the upfront investment of money and time into a smart contracts system:
- Accuracy: Smart contracts ensure that all vital contractual terms are recorded in explicit detail, avoiding problems that arise when someone forgets to insert certain information when filling out a template agreement.
- Efficiency: Using smart contracts starts to pay dividends when time spent executing similar agreements is significantly cut down because their digital and autonomous nature substantially reduces the time spent filing out paperwork and fixing clerical errors.
- Trust and Transparency: The parties to a smart contract can rest assured after executing an agreement because encrypted transaction records are shared with participants, and all terms are fully visible and accessible.
- Security: Smart contracts utilize the highest level of data encryption currently available on the market, the same standard cryptocurrencies, like Bitcoin, use to secure their highly valuable blockchains. This makes smart contracts one of the most secure digital items.
- Savings: Third-party intermediaries that charge high fees and delay transactions are cut out of the equation when smart contracts are used.
- Guaranteed Outcomes: Potentially the most attractive feature, smart contracts could offer a way to substantially reduce or completely eliminate the need for litigation and courts. This is because when parties commit to using self-executing contracts, they bind themselves to the rules and determinations of the underlying code, rather than exposing themselves to interpretations med by parties outside of the contractual relationship.
Are smart contracts the future of contracts?
Smart contracts might reach higher adoption rates in different markets, but overall, people should expect their prevalence to increase in the coming years. Smart contracts are increasingly being used in digital consumer transactions for digital art and other things recorded as non-fungible tokens ("NFTs"). Besides that, there are signs that you may be able to buy or sell your house using a smart contract soon.
The Republics of Georgia, Sweden, Dubai, and Brazil have launched pilot programs to move real estate title records to blockchains to increase electronic sales. Cook County, Illinois and South Burlington, Virginia have implemented similar programs to test the feasibility of moving their real estate records to blockchains.
However, these ambitious ideas will not become practical until local laws are changed to require real property records to be recorded on blockchains, including all liens, like bank loans and judgments. Overall, smart contracts will not suddenly take over everyday consumer transactions. Instead, it will be a gradual shift similar to how consumers have started buying things digitally on Amazon instead of in-person from traditional brick-and-mortar retailers.
Are Smart Contracts Secure?
As with all new technologies, smart contracts have their weaknesses and vulnerabilities. A couple of high-profile heists have been pulled off by exploiting smart contract coding holes. In 2017, $150 million Ethereum was stolen from an organization named Parity Technologies due to a critical vulnerability in their smart contracts. In August 2021, one of the biggest cryptocurrency heists occurred when hackers stole $613 million from Poly Network by attacking a hole in their digital contracts.
Smart contract security hinges on the planning, design, and development processes that occur before the first line of code is written. Secure smart contracts will implement contract code in compliance with the best practices leading organizations use, periodically perform security audits and penetration testing, and run automated security scans.
Advising with cybersecurity experts to implement these safeguards can ensure that your smart contracts will be safer from external attacks and save you from a financially dangerous heist. Another emerging safeguard is smart contract failure insurance that companies like Bridge Mutual are starting to offer.
Ultimately, smart contracts will be the most secure when a knowledgeable programmer designs and implements the contract, so heavily consider working with one if you are handling complex and expensive transactions on blockchains.
What industries work best with smart contracts?
There are several industries where widespread smart contract adoption would reap the most benefits. For example, various governments worldwide have tested smart contract pilot programs to help eliminate burdensome manual paper filing associated with dated real estate transactions. Smart contracts could also help ensure the security of sensitive patient data in the healthcare industry while ensuring the information's accuracy to avoid erroneous diagnoses. Also, smart contracts could automate several time-consuming tasks in the accounting and finance industry involving number crunching.
Other industries that may benefit from smart contracts include:
- Venture Capital
- Supply Chain
- Transport & Logistics
- Travel & Tourism
Limitations of Smart Contracts
Presently, there are several practical limitations of smart contracts preventing them from reaching mainstream use.
Lack of Ability to Change
First, amending or terminating a contract is significantly harder, or in some cases impossible, than doing the same with text-based contracts. Parties can quickly draft an amendment to a text-based contract when a law changes or an unexpected event occurs. However, given that blockchains, where smart contracts reside, cannot be changed, modifying a smart contract is far more complicated. This drawback potentially yields higher transaction costs as opposed to using traditional contracts.
Few Remedies for Breach
Furthermore, smart contracts have issues with allowing parties to elect for self-help remedies when a contract is breached.
Limitations on Negotiations
The objectivity and automation inherent in smart contracts can foil how parties actually negotiate contracts. For instance, a party may decide it is beneficial to leave a provision more ambiguous so to later argue that the provision should be interpreted in their favor if or when an issue arises. Smart contracts do not allow for the same level of ambiguity. Smart contracts demand exact parameters. Consequently, parties may elect for text-based contracts for complex agreements due to high transaction costs associated with negotiating those contracts.
As previously discussed, smart contracts also present the added risk that the contract can be hacked and financially exploited. Parties may find added insurance in knowing a text-based contract cannot lead them to financial ruin.
Another technical problem occurs when provisions are inserted into a smart contract requiring the smart contract to receive information from off-chain resources, data from resources not on the blockchain itself. For example, a crop insurance smart contract is programmed to transfer money to an insured party if the temperature falls below 32 degrees. In this case, a significant problem arises because smart contracts cannot pull data from off-chain resources. Rather, that information must be entered into the smart contract.
Oracles, which are trusted third-party information sources, can cure this problem by inputting this information at predetermined times; however, adding a third party to the smart contract process presents the residual problem of diluting the decentralized experience of smart contracts.
Smart contracts present a digital alternative to paper-based contracts, yielding significant benefits in reducing transaction costs, enhancing process efficiency, and ensuring the security of information. Adopting smart contracts might make more sense in some industries than others.
Nevertheless, widespread adoption of smart contracts will be a slow, incremental process. Therefore, your real estate agent will not be asking you to execute one any time soon. If you do decide to go forward with pursuing smart contract automation for your business, be sure to do sufficient research on exactly how to do so. Consult the necessary legal and technical experts to ensure the final code produced reflects your desired expectations and is safe from devastating external attacks.
Questions about Smart Contracts?
Our experienced attorneys here at Newburn Law can help answer any questions you might have about smart contracts and how to implement them into your business.
Contact us today to learn more.