Smart Contracts: Behind the Scenes!

Beginner’s Guide / 17.11.2019

One of the “killer applications” of blockchain technology is smart contracts. Smart contracts are essentially normal contracts that enforce themselves according to the agreed terms and conditions are written in the code. What makes this a “killer app” is that it removes the middleman for services, just as Bitcoin removes the middleman for asset transfers. With smart contracts, intermediary services such as brokers and agents are made redundant, instead of becoming a more expensive opportunity cost to using smart contracts. On the customer-facing side, there will be little change to how transactions are conducted. However, behind the scenes, the intricacies are more complex.

What is a Contract?

Let us first take a step back and understand what a contract is and how it is actually formed. Contracts need to have certain key elements that allow it to be enforceable in the courts. There must be an offer and an acceptance in the simplest contracts, including an agreement from both parties that the contract will have legal force. The agreement in question is of legal nature (among other considerations). This is the traditional view of contracts.

However, it is important to note that the advent of the internet really pushed this definition to its limits with clickwrap contracts (in which a user must agree to the contract). The EU’s General Data Protection Regulation (GDPR) itself is an ode to this fact – that contract law needed to be updated for the internet age because large companies were taking advantage of the loop-holes and fine print. In the case of clickwrap, the internet allows people to sign up for hundreds of services a day, and people are expected to read all the terms and conditions for each service. But this is infeasible, as Time magazine calculated that it would take 76 days every year to read all of one’s privacy policies. Users face a zero-sum choice: to accept the clickwrap contract or not use the service.

Enter: Smart Contracts

Enter smart contracts, paving the middle way. As defined by Nick Szabo, their creator, smart contracts are a set of promises, specified in digital form, including protocols within which the parties perform on these promises. In the above example, this allows the user to negotiate with the company and decide what a fair agreement would be for both parties (e.g., the user only allows the company to monetize certain data and activity and MUST share a percentage of this revenue). As long as the preconditions are coded into the smart contract, then it is possible to have a contract that negotiates with the user at the point of sale.

Smart contract processing can be broken down into 6 key steps:

1) Identify the agreement between the parties;
2) Set the conditions of the agreement;
3) Code the business logic into software;
4) Encrypt the agreement for immutability;
5) Run the smart contract for compliance and verification;
6) Update other nodes of the new contract.

It is currently a lengthy process, but its aspects will be automated as the cryptocurrency space develops. In fact, this is one of the current challenges of smart contracts: complexity. Smart contract development is currently only reserved for programmers and not for the layman entrepreneur. Furthermore, security is a key challenge to overcome, especially on a large scale with millions of dollars running through the code, not to mention questions about privacy, data ownership, and jurisdictional governance brought into question by smart contracts.

Smart contracts are set to transform the operations landscape across industries, lowering the cost of transactions while improving speed and security. But there are still many discussions to have and details to consider regarding the regulatory side of smart-contract implementation.

Patrick is a third culture kid born to Brazilian parents, who enjoys reading, writing and thinking. He believes we need to be relentlessly improving models for investing in good ideas and moving them from the lab to the market, which naturally draws him to the cryptocurrency and blockchain space.