We already have smartphones, smart TVs, smart homes and even smart cities. Are we ready for smart contracts?
The notion of a ‘Smart Contract’ was put forward by Nick Szabo, a cryptographer, in his White Paper published in Extropy magazine in 1995. He proposed the idea of a smart contract in the form of computer programme codes which self-execute and self-enforce the terms agreed between the contracting parties.
BASICS OF SMART CONTRACTS
Smart contracts are NOT traditional legal contracts. It is made up of computer codes with computer programmed protocols that emulate the logic of terms and conditions of a legal contract. In short, smart contracts are the transformation of natural language in paper into mathematical language in computer.
Smart contracts, being computer codes and protocols, can be ‘written’ to conduct self-verification, self-execution and self-enforcement.
Smart contracts aim to provide security superior to traditional contracts and hence reduce transaction costs associated with traditional contracting.
Nick Szabo described traditional contracts as being ‘wet codes’ while smart contracts are ‘dry codes’. Wet codes are ‘codes’ running in the human mind. It is subjective, based on human experience, cultural background and language differences. It is capable of being flexible and caters to situations dependent on human circumstances. In legal terms, we call it ‘force majeure’ – events beyond the control of the contracting parties.
The enforcement of contracts based on wet codes are jurisdictional; it is a lengthy and cumbersome process and the legal costs in enforcement can be expensive. Security is low, as it is dependent on a single or a few intermediaries who are deemed as ‘trusted’ third parties.
Computer codes are ‘dry codes’ which are rigid. It is purely boolen logic and mathematic equations. While codes behave without favour or prejudice, it lacks in humanity to adjust itself to human circumstances. On the other hand, it is extremely speedy in execution regardless of financial, political and jurisdictional borders. There is no heavy legal cost involved in computer self-execution.
Security in smart contracts is not naturally inherent. A smart contract saved in a party’s mainframe computer or server is just as vulnerable as a traditional paper contract. It is open to hacking since it is a centralized data and management system. We see this in many famous data security breaches this year like the Dropbox, Oracles, Linkedin and US Internal Revenue Service. On September 22, 2016, Yahoo announced that a hacker had stolen information from a minimum of 500 million accounts in late 2014.
The answer that gives effect to a secured smart contract is ‘blockchain’. Smart contracts in blockchains are distributed to many personal computers across the globe, where every personal computer has an identical copy of the same contract, encrypted. It is called a peer-to-peer trust system. Only the relevant party with the right key will be able to open the readable copy.
ADVANTAGES OF SMART CONTRACTS
Smart contracts have been programmed with instructions to self-execute and self-enforce. When a certain condition is met, the next step will follow, and so on and so forth. Hence, the outcome is predictable. This also means that the contracting parties will be able to bypass intermediary third parties who used to be entrusted to execute the contract. This may result in fewer disputes between the parties. The contracting cost involved will correspondingly reduce.
The execution is fast, as it is automated and does not rely on performance of intermediary third parties. Traditionally, the execution and enforcement of contracts rely on a single party for verification. For example, a developer is responsible to verify the current legal ownership to a property. A lawyer is responsible to confirm the identity of the previous owner who has passed ownership to the current owner. Trustworthiness of a single party could be undermined by human error. Hence, the more verifying parties (decentralized trust system) could increase the accuracy and trustworthiness of the information.
Smart contracts on blockchain are designed based on a distributed peer-to-peer trust model. The ledger of ownership trail of the property is distributed throughout hundreds or thousands of personal computers all around the world where everyone will have an identical copy of the same document encrypted and who (with a reward system in place) will be in a position to verify the information (in encrypted form).
Once an entry is made to a blockchain, it cannot be altered. It is immutable. Once one makes a wrong entry into the blockchain, the entry cannot be undone. One can only add a new entry to record the new correct entry. Every entry has a digital trail. Hence, blockchain promotes total transparency.