Understanding Smart Contracts

Bitcoin​ has a new avatar. 

Even as scandals have tarnished its reputation, Bitcoin is re-emerging in finance circles as a vehicle for smart contracts. 

Blockchain, the technology behind Bitcoin, underpins its network. Instead of relying on a centralized authority to validate a contract between two counterparties, blockchain relies on digital code to confirm transactions. Numerous industries and organizations are using this concept to implement smart contracts and streamline transactions. 

Nick Szabo, who first proposed smart contracts back in 1994, defined them as computerized transaction protocols that execute terms of a contract. He wanted to extend the functionality of electronic transaction methods, such as POS, to the digital realm. Such technologies already exist but they still require a physical interface for the actual transaction to take place. As an example, consider the checkout counter at a supermarket where the payment is through an electronic interface but product delivery requires a physical interface.  

In his paper, Szabo also proposed the execution of a contract for synthetic assets, such as derivatives and bonds. “These new securities are formed by combining securities (such as bonds) and derivatives (options and futures) in a wide variety of ways. Very complex term structures for payments can now be built into standardized contracts and traded with low transaction costs, due to computerized analysis of these complex term structures,” he wrote. In simple words, he was referring to the sale and purchase of derivatives with complex terms.  
Many of Szabo's predictions in the paper have already come true. For example, derivatives trading is mostly conducted through computer networks using complex term structures. 

But Szabo's vision went beyond online transactions. 

In the paper, he also envisaged extending smart contracts to property agreements and physical products, such as cars. As an example, algorithms could revoke owner access to digital car keys, if the said owner failed to make a loan payment.

Several protocols have already been developed to implement Szabo's vision. For example, multi-signature protocols ensure that a contract can be executed only after both parties have agreed to its terms and signed it using their digital keys. Similarly, “Oracle” automates loan transactions by making automatic deposits to a borrower’s bank account once their loan has been approved. 

As with most new technology, smart contracts come with a number of advantages and disadvantages. Digitization of transactions has the potential to reduce costs. They can also cut legal red tape and, consequently, time associated with each transaction. Thus, securing a transaction can take micro-seconds instead of hours through smart contracts. 

There are still a number of problems associated with execution and implementation of smart contracts in the public sphere. For example, transferring or providing access to physical products through smart contracts requires inserting a digital chip in such products. This is something that hasn't happened yet. 

Then, there are the legal problems associated with implementing smart contracts in highly-regulated industries, such as the financial services industry. For example, Know Your Customer is a mandatory requirement in this industry to prevent money laundering. With their decentralized processing, smart contracts obviate the need for customer credentials. This could prove to be problematic in the future. It would also be difficult to resolve disputes for smart contracts. Since algorithms are responsible for the contract, it becomes difficult to prove its validity and accountability in a court of law.

That said, the wide applications of smart contracts across industries has ensured that they have received an enthusiastic reception across industries. SWIFT has already released a paper exploring the use of smart contracts-type technology in their network. The United States Postal Service released a paper last month to investigate the use of smart contracts for money transfer within its network.