Smart Contracts and Blockchains:
The Contract Centre Explains...
Traditional Contract vs. Smart Contract
Let’s first remind ourselves of the characteristics of a typical “dumb contract”. For example, in a rental contract, two or more parties undertake mutual obligations (one party pays a sum to the other party, provided that the other party transfers rights to use the car for a specific period). They may agree on certain conditions, e.g. an additional higher amount if the car is returned late or if maximum mileage is exceeded. Just a few years ago, if you wanted to rent a car, you would call the rental company a week in advance to make the reservation; take your place in a mile-long queue at their sole rental office in a 20 km radius; fill out an endless form (on each occasion); at the end of the rental complete another form with details of return time, mileage and fuel consumption (the accuracy of which may later be contested by the rental company). The human administrative involvement was high. No one would call that a smart way of doing things today.
So what would a smart version of such a contract look like? You make the contract using an App on your smartphone, specifying the rental period, accepting the rates and agreeing on the other contract terms. The rental company immediately receives confirmation of your identity and has access to all necessary personal data and payment security. You go to the nearest convenient location, just 2 km away. The car is released to you through an exchange of protocols between your phone and the on-board computer when you approach the car and at a press of a button, you’re on your way. Use of the car can be restricted or disabled if you breach any material obligations, for example driving at excessive speed or attempting to take the car to another country. At the end of the rental period, the car automatically transmits the usage data to the rental company and the payment is automatically transferred (including any adjustments for late return, additional mileage etc.). The human administrative involvement is low and the scope for dispute is minimal. The major rental companies are moving in this direction (though are not quite there yet).
What makes this contract smart is that it automatically performs a part or all of what the parties have agreed (here, adjustments to amounts due and payments) without the need of further intervention of the parties. The smart contract is implemented through program code stored on a blockchain or a similar platform for security (see below). The interconnectivity of data promised by the Internet of Things, People and Services will progressively increase the range of transactions which could be based on various forms of “smart contracts”.
The main advantages are speed, elimination of errors and vastly reduced transaction costs.
There is one more potential advantage. In a conventional contract, if there has been a breach, the non-breaching party is forced to take a proactive enforcement step (e.g. to call a bank guarantee or go to court) which may be very negatively viewed by the other party. Alternatively, he might abandon his own rights (leading to frustration) precisely because he is worried about the other party’s potential reaction. However, if the relevant part of the contract is self-executing (e.g. imposition of a financial penalty) then the emotional friction is eliminated (because the relevant consequences and automatic implementation were decided when the contract was entered into, not at the time of the breach).
Blockchain
Traditional large or complex financing transactions almost always involve banks or other financial institutions in some capacity. The reasons include perceived expertise and trust compared to dealing only with the other commercial party (a bank can prepare the contracts, act as a depositary, administer payment transfers and issue bank guarantees etc.). However, if you could be certain that the other party’s contract obligations would be automatically performed, without the necessity of involving a bank, the transaction costs would be lower.
A blockchain consists of blocks of transactions linked together in a chronological chain. The blockchain is stored in a decentralized database. You can trust the information contained in the blockchain because each transaction is verified and accepted before it is added as a block in the chain and the history of the transactions in the blockchain is transparent across the network. Blockchains are used to enable peer-to-peer transactions without involving a bank, e.g. to record transactions using virtual currencies such as Bitcoin or Ether.
The same blockchain principle can be applied to record any data, for example ownership of property.
Limitations of smart contracting
Computers and computer programs generally operate in a binary world (0 or 1, black or white). However, grey areas abound in the real commercial contracting world. For example:
Let’s first remind ourselves of the characteristics of a typical “dumb contract”. For example, in a rental contract, two or more parties undertake mutual obligations (one party pays a sum to the other party, provided that the other party transfers rights to use the car for a specific period). They may agree on certain conditions, e.g. an additional higher amount if the car is returned late or if maximum mileage is exceeded. Just a few years ago, if you wanted to rent a car, you would call the rental company a week in advance to make the reservation; take your place in a mile-long queue at their sole rental office in a 20 km radius; fill out an endless form (on each occasion); at the end of the rental complete another form with details of return time, mileage and fuel consumption (the accuracy of which may later be contested by the rental company). The human administrative involvement was high. No one would call that a smart way of doing things today.
So what would a smart version of such a contract look like? You make the contract using an App on your smartphone, specifying the rental period, accepting the rates and agreeing on the other contract terms. The rental company immediately receives confirmation of your identity and has access to all necessary personal data and payment security. You go to the nearest convenient location, just 2 km away. The car is released to you through an exchange of protocols between your phone and the on-board computer when you approach the car and at a press of a button, you’re on your way. Use of the car can be restricted or disabled if you breach any material obligations, for example driving at excessive speed or attempting to take the car to another country. At the end of the rental period, the car automatically transmits the usage data to the rental company and the payment is automatically transferred (including any adjustments for late return, additional mileage etc.). The human administrative involvement is low and the scope for dispute is minimal. The major rental companies are moving in this direction (though are not quite there yet).
What makes this contract smart is that it automatically performs a part or all of what the parties have agreed (here, adjustments to amounts due and payments) without the need of further intervention of the parties. The smart contract is implemented through program code stored on a blockchain or a similar platform for security (see below). The interconnectivity of data promised by the Internet of Things, People and Services will progressively increase the range of transactions which could be based on various forms of “smart contracts”.
The main advantages are speed, elimination of errors and vastly reduced transaction costs.
There is one more potential advantage. In a conventional contract, if there has been a breach, the non-breaching party is forced to take a proactive enforcement step (e.g. to call a bank guarantee or go to court) which may be very negatively viewed by the other party. Alternatively, he might abandon his own rights (leading to frustration) precisely because he is worried about the other party’s potential reaction. However, if the relevant part of the contract is self-executing (e.g. imposition of a financial penalty) then the emotional friction is eliminated (because the relevant consequences and automatic implementation were decided when the contract was entered into, not at the time of the breach).
Blockchain
Traditional large or complex financing transactions almost always involve banks or other financial institutions in some capacity. The reasons include perceived expertise and trust compared to dealing only with the other commercial party (a bank can prepare the contracts, act as a depositary, administer payment transfers and issue bank guarantees etc.). However, if you could be certain that the other party’s contract obligations would be automatically performed, without the necessity of involving a bank, the transaction costs would be lower.
A blockchain consists of blocks of transactions linked together in a chronological chain. The blockchain is stored in a decentralized database. You can trust the information contained in the blockchain because each transaction is verified and accepted before it is added as a block in the chain and the history of the transactions in the blockchain is transparent across the network. Blockchains are used to enable peer-to-peer transactions without involving a bank, e.g. to record transactions using virtual currencies such as Bitcoin or Ether.
The same blockchain principle can be applied to record any data, for example ownership of property.
Limitations of smart contracting
Computers and computer programs generally operate in a binary world (0 or 1, black or white). However, grey areas abound in the real commercial contracting world. For example:
- A contract may need to be amended because an unanticipated event has occurred.
- The parties have a commercial relationship which may extend beyond the literal terms of the contract, e.g. they may wish to reach a settlement which is different from the solution originally agreed upon.
- Legally relevant concepts may be strongly fact-specific, such as “force majeure”, “good faith”, “reasonable efforts” or “material default”. An algorithm is unlikely to be able to interpret those concepts in a manner that is always acceptable to all parties to the contract. Disputes may arise which have to be decided or mediated by third parties. Therefore, one or more of the parties may not want a "self-executing" mechanism to apply.