Smart Contracts are Here and They’re Getting Smarter
In a recent podcast interview, Max Galka, CEO of Elementus.io (a “search engine for non-private blockchain”) explained the fundamentals of blockchain-based smart contracts using a travel insurance policy as an example.
In that scenario, a person taking out a travel insurance policy would instantly have the potential payout amount put into escrow by the insurer. If the plane left on time the money would revert to the insurance company, but if it was delayed, money would be transferred to the policyholder.
Departure and arrival times presumably would be defined in the policy in terms of plane pushback, wheels up, and the permission to de-board. Since these conditions are factual and not subject to interpretation, no lawyers or other parties are needed to determine whether on-time departure and arrival was achieved.
This may not be the best example, since policyholders might try to game the system, perhaps by actually trying to delay the plane. And insurance companies don’t have sufficient capital to hold in reserve at all times to cover every one of their possible obligations.
But the illustration makes the point about how smart contracts are self-executing. And they’re about to enter the mainstream of our lives in many scenarios similar to that illustration.
What’s Smart about Smart Contracts?
First, a note about terminology. In today’s IT world, the term “smart contract” is broadly applied to refer to the placement of nearly any program or decentralized application (DApp) on the blockchain.
For our purposes, though, we’re going to explore the concept in the context of smart legal contracts, contracts in the traditional sense of the word – agreements between parties that take the form of programs placed on the blockchain where the provisions are monitored and executed.
In this context, the concept of smart contracts emerged well before the advent of blockchain technology. The person who coined the phrase was a computer scientist, Nick Szabo, who likened the concept to the mechanical technology behind a vending machine.
Mechanisms in the vending machine verify that the purchaser has deposited sufficient money, verify that they’ve made a valid selection, and determine whether change is due. Only then does it deliver the product. No human being acts as an intermediary to verify the transaction – to the chagrin of someone who sees their Milky Way get hopelessly wedged so it can’t fall down the chute!
What does Blockchain Have to Do with it?
Yes, vending machines are pretty smart and they can manage one type of simple transaction. However, they’re not infallible and they certainly can’t manage a contractual home purchase transaction, for example.
In contrast, blockchain is perfectly suited to manage the consecutive “if/when … then” aspects of more complex contractual agreements as they monitor and verify steps of compliance and then authorize subsequent steps.
That’s because blockchain can manage many types of data supporting the contract and can keep that data secure so the underlying contract can’t be subsequently altered. The terms of the contract, including responsibilities of parties and executable actions, are programmed into actionable code.
There’s no middle party, no second-guessing, no varying interpretations, no delays. The contracts on the blockchain are “smart” because they’re self-executing.
The Future of Smart Contracts
We already have smart contracts – most typically in transactions with niche companies that are already in the cryptocurrency or blockchain space.
Smart contracts will very soon be far more mainstream as people increasingly understand and gain confidence in blockchain technology.
It’s curious that so many detractors impulsively say they’ll never place these kinds of legal agreements in a blockchain environment because blockchain isn’t 100% secure. They’re ignoring the fact that the IT infrastructure at the average bank, brokerage house, or savings and loan is hackable and fallible too.
What kinds of transactions and contractual agreements can be managed through smart contracts? Pretty much any financial transaction – loans, insurance, investments, renting, wagering, and purchases – can and will be secured and policed on blockchain systems in the future.
The Future of Smart Contracts
But can smart contracts be used to enforce non-monetary agreements? Those might be harder to structure, and as a result we’ll see more and more agreements that include a financial element.
Take the case of written, non-financial agreements between two companies, for example regarding swapped services or an understanding that one party will receive preferential service levels. It’s more difficult to craft a smart contract that automatically guarantees satisfaction to the injured party when no financial penalties are on the line.
Disputes stemming from these kinds of contractual arrangements currently might require an attorney or a session in small claims courts. However, in the future these kinds of service contracts will include some type of financial guarantee – a deposit, for example, can easily transform this agreement into one that can be policed, managed and enforced through a smart contract.
Before smart contracts are more widely used, there are two primary concerns and downsides that will have to be addressed.
First, to place a contract onto the blockchain, all of the necessary legalese has to be written into computer code. Lawyers are not typically coders and coders are not typically lawyers. This requires an element of trust and expertise so the parties can be confident that the code within the smart contract truly reflects the legal intent.
Second, a blockchain-based smart contract is “written in stone.” The blockchain is decentralized, and usually that works for the good. But it also means that there’s no central authority or referee who can step in if one party feels aggrieved or even conned.
Those issues will be resolved over time. On the first matter, as more and more smart contracts are drawn up, they’ll serve as templates for similar agreements. And for more complex legal matters, we’ll see the emergence of a new specialty that bridges the gap between traditional and coded legal drafting.
Regarding the issue of fraud, no doubt the legal profession will attempt to try to step in to serve in some capacity as a legal recourse. More likely, though, the IT community will design a decentralized way to adjudicate these cases.
More and more aspects of our lives are being automated – cars, trucks, automated grocery checkouts … and these functions certainly have the potential to make things run faster, cheaper, and safer. But like truck drivers and grocery checkout clerks, you can now add certain legal contract specialists to the list of soon-to-be-displaced workers that will need to reinvent themselves in the future.