When someone buys an apartment, begins a new job, or ask for credit, it´s always mandatory to create a contract between the two or more parties involved in the exchange. This contract specifies and records the terms of the transaction and the required actions of each part. Alone, a standard contract has no power to enforce the terms that it defines. Instead, a legal or governmental third-party oversees the execution of a standard contract, ensuring that each party carries out their end of the agreement. If the terms are not met, the parties must rely on the intermediary to rectify the situation and enforce the contract.
Thanks to recent advancements in distributed ledger technology, lawyers, notaries or other intermediaries are no longer required to oversee contracts. Using smart contracts, people can execute and enforce contracts without middlemen.
What Are Smart Contracts?
A smart contract defines the terms of a transaction via computer code, and also verifies, executes, and enforces the transaction without the need of a trusted intermediary.
To explain smart contracts with an example; it could be compared with the full transaction process executed by vending machines. The machine verifies the payment, executes the transaction, and deploys the product. There is no need for a cashier, a lawyer, or a government agency. Like vending machines, smart contracts fulfill an agreement without middlemen. The parties simply agree on their terms, put a cryptocurrency coin into the program, and then, the smart contract executes the desired digital exchange.
A Smart Contract Application Example
In the case of a seller who agrees to send 100 products to a buyer, for the price of 1 bitcoin per item, by a specific date, this agreement is written into an encrypted smart contract and put into blockchain. Smart contracts need a secure digital infrastructure that can support intermediary free transactions. Distributed ledgers as Blockchain are platforms that enable users to securely transact without the need of trusted intermediaries.
In the case where the buyer doesn’t receive the goods by the specified date, the cryptocurrency will not be released and both parties will be notified of the contract breach without any need for human intervention or supervision.
In terms of the analogy, if smart contracts represent the software that executes a vending machine transaction, a distributed ledger represents the hardware of the vending machine itself.
Benefits of Smart Contracts
Time-saving – Smart contracts use blockchain software to automate processes through a series of triggered actions that can save time and energy. Eliminating the need for third parties, banks and middlemen also enables smart contracts to dramatically speed up traditional processes.
Cost-effective – Cutting out costly factors like legal payments and transaction fees.
Safe & secure – Although documents are publicly available, the information is encrypted, anonymous, and resistant to hacking. Documents are also duplicated many times on the blockchain so are virtually impossible to lose. Moreover, by extracting third party involvement, smart contracts also eliminate the risk of both human error and external manipulation.
Easy – Smart contracts make complex transactions easy. While smart contracts can be used for simple transactions, they can also define and complete intricate, multiparty exchanges with precise timelines. Additionally, multiple smart contracts can be used in tandem to execute even more elaborate exchanges.
Drawbacks of Smart Contracts
Although smart contracts are helpful for small businesses, there are a few inconveniences to mention:
Human Error – The person creating the contract via computer code could make a mistake that affects the whole chain. Although every bug can be fixed eventually, it’s a problem nonetheless.
Automatism – One of the main advantages of smart contracts is actually a disadvantage as well. What if something happens? Comprehension is not part of any technology, and human interaction is, sometimes, better than automatic processes, even if it takes more time.
Legal Enforceability – Since smart contracts are pretty new, they aren’t recognized in many parts of the world as legally binding. This means with some transactions that, by law, require the presence of a lawyer (for example, real estate closings in several US states) can’t be dealt with through smart contracts. This might change quite soon, though. In fact, the state of Arizona has already acknowledged smart contracts as valid legal documents.
Currency – Cryptocurrencies themselves are difficult to use for most people and volatile in price.
The Future of Smart Contracts
Lawyers will transition from writing traditional contracts to producing standardized smart contract templates, similar to the standardized contracts available on LegalZoom. Other industries such as merchant acquirers, credit companies, and accountants, may also employ smart contracts for tasks such as real-time auditing and risk assessments. Smart contracts are merging into a hybrid of paper and digital content, where contracts are verified via blockchain and substantiated by physical copy.
One example includes professional services firm EY, which has launched a smart contract and blockchain platform for the insurance sector with a focus on global shipping. This includes the ability to create and maintain asset data from multiple parties, to link data to policy contracts, and to receive and act upon information that results in a pricing or business change. Insurance giant AXA has also launched self-executing contracts covering flight delays for consumers.
Where You Can Process Smart Contracts on Blockchains
Bitcoin: Bitcoin is great for processing Bitcoin transactions, but has limited ability for processing documents.
Side Chains: This is another name for blockchains that run adjacent to Bitcoin and offer more scope for processing contracts.
NXT: NXT is a public blockchain platform that contains a limited selection of templates for smart contracts. You have to use what is given; you’re unable to code your own.
Ethereum: Ethereum is a public blockchain platform and the most advanced for coding and processing smart contracts. You can code whatever you wish but would have to pay for computing power with “ETH” tokens. Although there are many end-user driven smart contract companies and enterprise-driven smart contract companies, they both have one thing in common – most of them are building their products on top of the Ethereum blockchain, due to its superior processing capabilities.
Blockchains might let us move assets around the globe securely and instantaneously, but they will never play much of a role in the real world without legal agreements and supporting legislation to govern all these new kinds of transactions. Blockchain-based legal contracts may make sense in theory, but they still face a range of practical issues. Businesses often want to keep their contracts private, however, blockchains are designed to be transparent. As to the potential of smart contracts itself, there’s no end to the range of industries it can impact, from healthcare, to automobiles, to real estate, and law. The list goes on and on. It will be interesting to watch how this develops in the future.