The tech could lead to much better transparency, trust, and savings
Paper contracts can take weeks to travel around the globe, while digital documents are uncomfortably easy to forge. Is there a way to automate transactions to make them smoother, more efficient, and more secure for all parties?
Blockchain has become the IT buzzword in recent years, with hundreds of new companies rushing to create products and services based on the decentralized technology. Blockchain is a decentralized distributed ledger, or to simplify— it is a network of computers having an identical copy of the database and changing its state (records) by a common agreement based on pure mathematics. This means that there is no need for any central server or agent to trust. With the amount of attention blockchain-based companies have been receiving, ranging from wide news coverage to massive valuations, this has given rise to applications such as smart contracts – digital contracts with consensus terms that are self-enforcing and tamper-proof through automated execution. In the past few years, blockchain technology has been believed to potentially disrupt business and the financial services in a way similar to how the internet disrupted offline commerce.
Smart Contract Definition
A smart contract is a computer protocol intended to digitally facilitate, verify, or enforce the negotiation or performance of a contract. Smart contracts allow the performance of credible transactions without third parties. These transactions are trackable and irreversible. Smart contracts were first proposed by Nick Szabo in 1994.
Szabo’s first publication, “Smart Contracts: Building Blocks for Digital Free Markets” was published in Extropy #16, and then later reworked as “Formalizing and Securing Relationships on Public Networks.” These documents described how it would be possible to establish contract law and related business practices through the design of electronic commerce protocols, between strangers on the Internet. In 1996 Szabo described smart contracts as follows:
“New institutions, and new ways to formalize the relationships that make up these institutions, are now made possible by the digital revolution. I call these new contracts ‘smart’, because they are far more functional than their inanimate paper-based ancestors. No use of artificial intelligence is implied. A smart contract is a set of promises, specified in digital form, including protocols within which the parties perform on these promises.”
Proponents of smart contracts claim that many kinds of contractual clauses may be made partially or fully self-executing, self-enforcing, or both. The aim of smart contracts is to provide security that is superior to traditional contract law and to reduce other transaction costs associated with contracting. Various cryptocurrencies have implemented types of smart contracts.
Smart contracts can have different flavours, mainly if the contract is on public blockchain, private or hybrid or between interchains. This predominantly affects the execution and enforceability part of a smart contract. Smart contacts are also currently the subject of a standard being discussed at ISO/TC 307.
When a contract is developed, it is encrypted and deployed on to the blockchain, hashed and shared with thousands of computers which will then verify it to ensure trustworthiness. Although it is publicly available, its encryption prevents anyone from accessing the contents of the contract, even an abnormally smart hacker.
With the use of smart contracts, parties to an agreement have no need for a lawyer to draft the rules, guidelines, conditions and penalties. These are all programmed into the system in the form of a computer code and will execute themselves based on predetermined conditions.
What are the benefits of smart contracts?
Smart contracts are appealing for a variety of reasons:
- Autonomy: There is no need to rely on third parties, which could be biased or not have your interests at heart.
- Trust: Your documents are encrypted on a shared ledger, and all parties can have access to them.
- Redundancy: Documents are duplicated many times over on the blockchain, and can’t ever be “lost”.
- Safety: Documents are encrypted, making them near-impenetrable by hackers.
- Speed: These contracts automatically self-execute, saving you precious time.
- Savings: Smart contracts save you money by taking out the middleman.
- Precision: Smart contracts execute the exact code provided, ensuring zero errors.
- Transparency: For organizations like governments, they could add another level of transparency to dealings.
What are the risks associated with Smart Contracts?
Smart contract technology is still in its early stages. Business and technology leaders who want to stay current on implications of smart contracts should track both technology and business developments surrounding smart contracts.
Smart contracts can encode complex business, financial, and legal arrangements on the blockchain, and this does create a risk associated with the one-to-one mapping of these arrangements from the physical to the digital framework. Additionally, cyber risks increase as smart contracts rely on “oracles” (data from outside entities) to trigger contract execution. Smart contracts apply consistently to all participant nodes across the network; they should be capable of exception handling that adheres to business and legal arrangements and complies with regulations. Like other software code, smart contracts require robust testing and adequate controls to mitigate potential risks to blockchain-based business processes.
In 2016, the Decentralized Autonomous Organization (DAO) announced that a hacker had exploited a vulnerability in Ethereum, a blockchain platform utilized by the group. The total loss to the DAO was reported at $150 million. The flaw was not in the blockchain platform itself, but rather in the smart contract. The hacker was able to trigger a recursive send vulnerability where the act of sending funds triggered another “send funds” request. Etherium had done exactly what it was supposed to do, but a loophole in the smart contract code exposed the organization to a hack. It was reported that the DAO lost $60 million in just the first 12 hours.
Smart contract code can be hacked and assets could be diverted and there is a constant battle to address this risk, but in essence, it is no different from other cybersecurity risks that are being addressed in an increasingly digitized world.
Smart Contracts are being adopted
Smart contracts represent a next step in the progression of blockchains from a financial transaction protocol to an all-purpose utility. Technology leaders envision many applications for blockchain-based smart contracts, from validating loan eligibility to executing transfer pricing agreements between subsidiaries.
It is becoming difficult for the ordinary person to avoid the blockchain buzz, and many multinational companies have already jumped onto the blockchain bandwagon and are working on their own projects to stay ahead of the competition.
According to Accenture research published at the start of 2017, investment banks alone could save up to $12 billion per year by adopting blockchain and smart contracts, effectively a program code that automatically performs some actions when predefined conditions occur. Gartner has estimated that by 2022, so-called ratified unbundled (i.e. defined impact) smart contracts will be in use by more than 25% of global organizations.
Blockchain and smart contracts enable companies to create ecosystems that support their business processes by being more efficient through automation, and trust what the technology brings to these processes.
The transparency and immutability of blockchain means businesses and their customers could ensure that their transactions and agreements are verifiable. This encourages compliance and accountability among parties.
Businesses can gain much from adopting blockchain, but with any technology adoption that would significantly change an organization’s ways of working careful planning and strategy needs to be adhered to.