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The Future is Looking a Little Smarter with Smart Contracts

DANicholsonLawMay 21, 2018, 8:19:57 PM

A lot of the discussion around Bitcoin (BTC) revolves around the virtual currency and its value, but that is only one aspect of the technology. One of the more exciting features of cryptocurrency will be the future of Smart Contracts, an innovation that has the potential to disrupt and innovate finance, business and law.

To discuss the future of Smart Contracts it is important to start with the concept behind it: the distributed ledger (see: blockchain or tangle). A whole article could be written on how distributed ledger technology works, but to keep things simple let's focus on blockchain as the first developed data structure and the one used by the popular Bitcoin.

Simply stated, blockchain is a program code technique that creates a secure, decentralized ledger (think database) of transactions and information. A blockchain can be public, like Bitcoin, or it can be private, like those that are developed by businesses for internal transactions and information sharing. Businesses already maintain detailed ledgers of their economic transactions, and these sources of information are centralized as the business controls what is recorded or removed on the ledger. Blockchain technology decentralizes that information by requiring multiple validations by independent sources before accepting a transaction as completed. Every time you send a Bitcoin to a friend the transaction is validated by multiple “nodes,” who must all agree that the transaction has occurred in order to have the transaction recorded on the public ledger (the transaction executes). This technique is why blockchain is so secure: if a party attempts to corrupt that transaction the other nodes wouldn't recognize it and it would not be added to the ledger. You also have a complete record of where you Bitcoin has been and who has used it.

Why is this desirable? As technology and business becomes more complicated, so do our economic exchanges. We live in a global marketplace and we rely heavily on third-parties to facilitate a lot of the business we conduct (think governments and banks). These third parties often charge fees, can cause costly delays, have little or no transparency in their practice, and maintain their own transaction records that are often isolated from the other parties. Distributed ledger technology allows parties to create a secure and decentralized public ledger that allows the participants to monitor each and every transaction without a third-party to validate or facilitate the exchange. As one expert put it: “We can create a decentralized database that has the same efficiency of a monopoly without actually creating that central authority.

Smart contracts are essentially digitally coded option contracts that are facilitated by this same distributed ledger technology and share the same benefits. A smart contract is only smart in that it can automatically perform actions when pre-determined conditions are satisfied (think like a logic puzzle, “if X, then Y”). Smart contracts ultimately reduce risk because of their characteristics: computer coding (the 1’s and 0’s) reduces the risk of contract ambiguities; most information (for example, how many Bitcoin a party possesses) can be uploaded and then validated by the blockchain reducing the risk of uncertainty; the contract performs automatically, reducing the risk of a breach and the amount of resources spent to accomplish execution; and the parties have economic certainty as the transaction is saved forever on the ledger and cannot be altered by either party. By reducing risk and creating economic certainty the smart contract will save the parties time and money.

Let’s consider how this would hypothetically work: I intend to sell you an object, a very important and very generic object. This object is subject to the loans I took to purchase it, subject to licensing by the government and is required by law to have a publicly recorded deed which lists out every previous owner of the object. Traditionally before purchasing this object you would conduct your due diligence by hiring a third party to confirm what liens are attached to this object and that it is indeed the object I purport to be selling you by confirming the previous owners of the object. This third party checks over the title, making sure there are no mistakes that will cause you litigation later on and agrees to insure you from any mistakes they may make. You would need to confirm with the government that the item is registered correctly and would perform a visual inspection. This is costing you a lot time and money and can take months to complete.

In a smart contract world all this data is stored on the public blockchain. You review the data concerning this object, all of the previous transactions and owners are recorded and the title in my name is already digitized. You confirm that the object has a lien on it and check the registration with the government and everything looks good. We write up a smart contract: when you send me the agreed upon price the title is automatically transferred to you, the lien is automatically paid off from the proceeds of the sale, and the whole transaction is recorded and secured by the blockchain. Let's take this one step further. Let's suppose that generic object is connected to the internet of things (as most of our objects will be in the future) and can only be accessed by someone possessing the digital key that I currently have on my cell phone. I upload the key's code to the blockchain, and it automatically transfers with the title. Amazingly, this whole process was accomplished with just our cell phones and a visual inspection.

Some experts believe that smart contracts are over-hyped in the public and media. Lawyers are having a hard time figuring out whether smart contracts will have them replaced by robots. As with all new concepts and technology it is important to realize what limitations we have, but to also understand the furthest extent of possibilities. Smart contracts will not replace lawyers, because although the possibility for a breach of contract is more limited, it is still possible. In general, the more complicated the contract, the more exposure that needs to be accounted for. Smart contracts also require input. Recall that each node in the data structure needs to record the exact same data or else the transaction is not recorded. If the input required is outside the blockchain, then it will be difficult to ensure that every node gets the exact same green light. Trusted third-parties (think lawyers and inspectors) may be necessary to validate and confirm that outside conditions have been completed in order for the smart contract to execute.

One of my favorite example of all this is the future of construction projects and building maintenance. As any construction lawyer will tell you a construction project can be a massive legal and financial undertaking. Just coming to an agreement can be expensive in both human and financial resources, but enforcing those agreements is another story. Traditionally we mitigate the potential legal fallout of complex agreements with insurance, which is costly. To make matters worse every business involved in the project uses a different operating system, a different communication system, and a different database system. Keeping everyone on the same page is an issue. The old system is bulky and causes delays. Exposure and delays cost everyone money.

To improve this the general contractor sets up an internal blockchain to store all the data on the project and to facilitate smart contracts for its sub-contractors. Every piece of information, from the government permits to the completion and inspection of project milestones are stored electronically and accessible by everyone. The general contractor may create a series of smart contracts with its subcontractors which stipulate that payments will be dispersed upon certain project milestones or other conditions (think "three months after project completion," or "upon verification that wall passes inspection"). The general contractor will then hire a third-party inspector to validate that these project milestones are completed and input the data into the blockchain. When the nodes get the green light, the contracts begin to execute. Smart contracts can be just as complicated as traditional agreements, but with more certainty and less exposure, ultimately keeping costs down, and minimizing risk.

These smart contracts are not just limited to the job site. They can be utilized for purchasing project supplies directly from the manufacturer to cut costs. The smart contract can be written in a manner that accounts for quality right before it ships (confirmed by a third party), or liability, transferring it from the manufacturer to shipper and finally to the contractor, while the materials are transported to the job site. In building maintenance everything connected to the internet of things can become a data point. Light bulbs could be required to check in every hour to confirm they are working properly. Smart contracts can then be written to automatically purchase, ship and hire maintenance workers to replace any light bulbs that fail to check in.

In my opinion the future of smart contracting is really unlimited despite the push back from commentators and experts. The only limitation on its application is the technology behind it. As the technology improves so will our capacity to automate more of our transactions while minimizing exposure. I don't see it replacing lawyers altogether or see it wiping out all contractual risk with the click of a button, but I can see a future where lawyers play less of a drafting role and more of an arbitrator role. I also see a lot of potential for cryptocurrencies that facilitate smart contracting, it may provide that fundamental value that many traders are looking for. Feel free to message me or comment below with any questions or concerns, how do you feel about the future of smart contracts?

This article is not intended to be legal or trading advice and is for informational purposes only. If you would like to discuss this or any other topic further feel free to comment or message me. For further information on how smart contracts work this video will provide a basic crash course.