- Ewa Szuminska
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The history of smart contracts.
What are smart contracts?
How and when can smart contracts be used?
What are the benefits and limitations of smart contracts?
Introduction to smart contracts
Contrary to what it may seem, smart contracts are not a terribly recent invention. The term smart contacts was first introduced by Nick Szabo – a recognized computer scientist, legal scholar, and (on top of it) a cryptographer renowned for his research into the areas of digital contracts as well as digital currencies – in the early ’90s. Szabo used the term smart contracts to refer to promises formulated in a digital form.
Historical background for smart contracts
As stated above, the term “smart contract” was first coined and introduced to the wider public by Nick Szabo. As Szabo, himself, writes about smart contracts:
“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.”
Comparing smart contracts to paper-based contacts, Szabo used quotation marks around the word “smart” and remarked on artificial intelligence on purpose as it is of importance in the context of smart contracts. Smart contracts may, indeed, be “smarter” than paper contracts because a smart contract executes certain pre-programmed steps in an automated manner. Hence, smart contracts offer a range of possibilities not offered by a traditional text-based contract. They ought not to, however, be viewed as intelligent tools which can deal with a contract’s more subjective requirements. In this sense, we could, for instance, see vending machines as a classic example of a smart contract. A purchaser satisfies the conditions of the “contract” by putting change into the machines, and the machines automatically execute contract conditions and deliver snacks to the purchaser.
Nowadays, smart contracts are also based on Ricardian Contracts. The concept was published in 1996 by Ian Grigg and Gary Howland as part of their work on the Ricardo payment system of assets transference. Grigg perceived Ricardian Contracts as a bridge between a traditional text-based contract and code in the form of a single document that “is a) a contract offered by an issuer to holders, b) for a valuable right held by holders, and managed by the issuer, c) easily readable by people (like a contract on paper), d) readable by programs (parsable like a database), e) digitally signed, f) carries the keys and server information, and g) allied with a unique and secure identifier.”
What are SMART CONTRACTS?
So what do smart contracts specifically refer to? The answer is simple. They are computer protocols digitally facilitating the verification, control, or execution of agreements when predetermined terms and conditions are met. In other words, a smart contract is a digital contract that works following a very simple predetermined principle of a statement that runs on blockchain platforms. A blockchain network is an advanced database technology allowing for transparency of information sharing within a business network. This smart contract logic basically allows for processing all information connected to a given transaction in a contract and a network of computers executes the actions when predetermined conditions are specifically met and verified. On top of it, a smart contract functions in an automated manner. Hence, middlemen are not required in order to realize a smart contract. Thus, contrary to a traditional text-based contract, a smart contract is a faster, more cost-effective, and more secure way to execute and manage an agreement. Smart contracts automate actions such as releasing funds to vendors, registering vehicles, notifying, or even issuing tickets. The blockchain network gets automatically updated when contracts execute agreements and the transactions are completed. This means that the transaction cannot be changed, and only people who have been given permission can see the results as well as can proceed with terminating smart contracts.
There can be as many conditions as needed in a smart contract. It all depends on what specific conditions satisfy both signing parties and what it takes to satisfactorily complete the task. During the process of smart contract development and agreeing upon the terms and conditions of a smart contract, the signing parties must necessarily establish how transactions and data connected to them ought to be represented on the smart contract blockchain, determine what is their “if/when A, the B” and decide on the framework for resolving disputes which may, as is the case of any legal agreement, arise. Therefore, not unlike in the case of traditional contracts, in smart contracts rules and penalties are also defined and obligations are automatically enforced and they can be implemented separately or together as the contract processes automatically what is included in it.
Putting it simply and to the point, smart contracts’ integral components are objects and each smart contract essentially consists of three objects included in it during the process of contract programming,. Smart contracts fundamentally consist of the signatories (parties involved using digital signatures), the subject of the agreement/contract, and, finally, the terms. Smart contracts are programmed by developers. However, more and more frequently companies utilizing blockchains for doing business offer templates, web interfaces, smart contract applications as well as a variety of other online tools and smart contract platforms in order to simplify the process of structuring smart contracts as well as smart contract programming.
Presumably, one of the biggest difficulties when discussing smart contracts is the fact that this particular term is used for describing two very different paradigms. The first of the two refers to smart contacts which are created and deployed but don’t contain any enforceable text-based contract underlying them. The signing parties may, for instance, have an oral agreement describing the business relationship they want to establish and then immediately reduce the agreement into executable code in the form of a specific smart contract. These smart contracts are referred to as “code-only smart contracts.” The second of the two paradigms refers to the use of smart contracts as “vehicles” that effectuate some conditions of more traditional text-based contracts. In this case, the text basis refers to the utilization of the smart contract to effectuate some conditions. These smart contracts are referred to as “ancillary smart contracts.”
How and when can smart contracts be used?
The questions should probably be where can’t smart contracts be used? Nowadays, smart contracts play a role in areas such as:
- government voting systems,
- healthcare sector,
- supply chains,
- financial services,
- mortgage systems,
- trading activities,
- property ownership,
- peer-to-peer transactions,
- product development,
- all kinds of records.
Some more prominent examples of smart contracts utilization include:
- Safeguarding the efficacy of medications.
One such example is the cooperation between Sonoco and IBM in the reduction of possible issues during the process of transportation of lifesaving medications. The way they are working to accomplish the goal is by increasing the transparency of the supply chain. Powered by IBM’s blockchain technology, i.e. Blockchain Transparent Supply, Pharma Portal was created. Pharma Portal is a blockchain platform that tracks temperature-controlled pharmaceuticals within the supply chain to provide reliable, and accurate data throughout the numerous stages of the supply chain.
- Increasing trust in retailer-supplier relationships.
Another example is the use of smart contracts by Home Depot. This particular retailer uses smart contracts on blockchain to quickly and efficiently resolve any arising disputes with their vendors. Smart contracts enable them to create increased visibility into the supply chain and real-time communication. Owing to this, they are able to build stronger relationships with their suppliers. This in turn, results in more time for doing critical work and innovation.
- Making international trade faster and more efficient.
International trade is yet another example of an area where smart contract implementation makes a lot of sense. For, example, by joining we.trade, the trade finance network convened by IBM Blockchain, businesses are encouraged to form networks creating a global ecosystem of trust for worldwide trade.
All the examples above would either be very challenging or impossible if they were subjected to the form of a traditional text-based contract.
What are the benefits and limitations of smart contracts?
As is the case with any other digital solutions, there are benefits and limitations to smart contracts. However, as also is the case with high-tech solutions, they are subject to constant development and efficiency increase.
One of the key attributes of smart contracts is their ability to automatically and relentlessly execute transactions without the need for human intervention. However, this automation, and the fact that smart contracts cannot easily be amended or terminated unless the parties incorporate such capabilities during the period of time when they create smart contracts, present some of the greatest challenges facing the widespread adoption of smart contracts.
For example, with a text-based contract, a party can easily excuse a breach simply by not enforcing the available penalties. We can easily imagine a situation in which a valued customer is late with their payment one month. A text-based contract gives a vendor space to make a decision that preserving the long-term relationship is of greater importance than the termination of the commercial relationship. In the case of reducing such commercial relationships to smart contracts, however, the option to make such decisions is very restricted. due to the underlying smart contract technology. Delayed payments result in the automatic extraction of late fees from customers’ accounts or the suspension of customers’ access to the provided services if that is what the contract code was written to do. The automated execution provided by smart contracts may, hence, not promote the manner in which many businesses operate nowadays and negatively impact how the contracting parties interact.
Supposedly, one of the biggest smart contract benefits of using smart contracts is the autonomy and savings they allow for. Smart contracts improve certain workflow processes by, for instance, aiming at erasing middlemen from the equation who would, in any other case, be required to confirm or authenticate the agreement. Hence, a smart contract automatically reduces the risk of manipulation by third parties. Obviously, this particular feature of smart contracts also results in a reduction in costs.
Another benefit of smart contracts is smart contracts security. Smart contracts provide unparalleled backup, as all documents are stored in smart contract infrastructure on a blockchain, duplicated numerous times, and, even in the case of data loss, originals of smart contracts can be restored at any given time which isn’t necessarily the case with text-based contracts.
Smart contracts are secure for another reason. They are encrypted which keeps all documents from being infiltrated. Blockchain transaction records are encrypted, which makes them very hard to hack. Moreover, because each record is connected to the previous and subsequent records on a distributed ledger, hackers would have to alter the entire chain to change a single record.
Yet another benefit of smart contracts is speed. In the case of smart contracts, tasks are automated by the utilization of computer protocols. This, in turn, saves hours in a variety of business processes.
Finally, there is accuracy. Obviously, using smart contracts eliminates errors that normally occur while filling in forms manually.
Once a condition is met, the contract is executed immediately. Because smart contracts are digital and automated, there’s no paperwork to process and no time spent reconciling errors that often result from manually filling in documents.
There are, however, still limitations to smart contracts. Amongst them, we can find drawbacks such as:
- Difficulties in changing processes in smart contracts as any code errors are frequently costly and time-consuming to correct.
- At present, there is no simple path to amend a smart contract, creating certain challenges for contracting parties. For example, in a traditional text-based contract, if the parties have mutually agreed to change the parameters of their business deal, or if there is a change in law, the parties quickly can draft an amendment to address that change, or simply alter their course of conduct. Smart contracts currently do not offer such flexibility. Indeed, given that blockchains are immutable, modifying a smart contract is far more complicated than modifying standard software code that does not reside on a blockchain. The result is that amending a smart contract may yield higher transaction costs than amending a text-based contract, and increases the margin of error that the parties will not accurately reflect the modifications they want to make.
Similar challenges exist with respect to terminating a smart contract. Assume a party discovers an error in an agreement that gives the counterparty more rights than intended, or concludes that fulfilling its stated obligations will be far more costly than it had expected. In a text-based contract, a party can engage in, or threaten, a so-called “efficient breach,” i.e., knowingly breaching a contract and paying the resulting damages if it determines that the cost to perform is greater than the damages it would owe. Moreover, by ceasing performance, or threatening to take that step, a party may bring the counterparty back to the table to negotiate an amicable resolution. Smart contracts do not yet offer analogous self-help remedies.
Projects are currently underway to create smart contracts that are terminable at any time and more easily amended. While in some ways this is antithetical to the immutable and automated nature of smart contracts, it reflects the fact that smart contracts only will gain commercial acceptance if they reflect the business reality of how contracting parties act.
- Possibility of loopholes since according to the concept of good faith, parties involved in signing a smart contract are meant to act fairly. Using smart contracts, though, makes it somewhat challenging to make sure the terms are executed fairly at all times.
- Third-party, i.e., even though smart contracts aim at eliminating third parties from the process, it is not possible to do it completely every single time. The change is in the roles these third parties assume in comparison to traditional contracts. Lawyers are a good example here. They are no longer necessary in the process of preparing smart contracts. They are, however, needed by developers to understand the terms to create codes for smart contracts.
- Smart contracts do not always use terms that are understood, hence there might arise issues with vague terms that smart contracts are not always able to handle.
Undoubtedly, smart contracts will be evolving with the passing of time. Many doubts surrounding smart contracts today, will not be an issue anymore as they become better, smarter, safer, more flexible, and whatnot. Smart contracts have considerable potential to revolutionize the reward and incentive-based structure shaping how parties contract in the foreseeable future.
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