How Smart are Smart Contracts?

Smart contracts have nothing to do with AI or machine learning, so perhaps the term is a bit of a misnomer. But the implications and use cases for hard coded logic in contracts and transactions are plenty.

Smart contracts are compelling blockchain applications poised to reform the landscape of contracts & contract law.

The idea of smart contracts is not new — it dates back to the 17th century when Gottfried Leibniz worked to create legal logic that could be resolved by machinery. We’ve come a long way since then, especially since the proliferation of trustless blockchain technology that takes the place of the centralized and trusted third party.

With smart contracts, blockchain tokens not only represent data about an object (such as the geographic borders of property), but they also embed the rules and actionable procedures that define how the object exchanges between parties. Smart contracts reinvent how legal contracts, business offerings, and other formal arrangements are both created and enforced.

Smart contracts reinvent how legal contracts, business offerings, and other formal arrangements are both created and enforced.

Consider a payment contract, where the release of funds occurs after the verified completion of specific actions: the data representing money deposited in an escrow account, the rules that mandate which steps must be completed before payment is forwarded, the trigger that monitors those actions’ completion and their deadlines, and the code that electronically transfers funds from escrow to the recipient’s account — all exist digitally within the smart contract.

Evangelists of smart contracts promote their groundbreaking benefits, including:

the elimination of middlemen such as brokers and lawyers

unambiguous interpretation of what contract terms mean

a resultant reduction in litigation

immediate execution of obligations once their triggering criteria have been met

Is a future for business, built on digital contracts, really imminent? A more in-depth look at smart contracts highlights both their potential as well some fundamental challenges to circumvent.

How are smart contracts created?

All blockchain tokens have some degree of logic embedded within them; smart contracts are a particular set of logic. To create a token on the Ethereum blockchain, for example, embedded logic is required to:

initialize the total amount of assets available

provide for transferring value from one party to another

alert the entities that are participating in the maintenance of the digital ledger

Blockchain functionality can be built using a variety of well-established software development languages, including C++, JavaScript, and Python. Furthermore, specific programming languages have been tailored to smart contracts. Combining elements of C++ and JavaScript, Solidity is a dominant computational contract language affiliated with Ethereum, the go-to platform for smart contracts. Solidity allows the developer to focus more on describing the obligations within the contracts, then compiles the description into lower-level code that runs more efficiently on an “Ethereum Virtual Machine.”

Use Cases

The potentials extend far beyond the transferring digital assets from one wallet to another. Smart contracts address a variety of multi-party arrangements that can be captured digitally. Let’s look at just a few interesting real-world examples, though there are many more:

Real estate property sale often is cited as an example of complex and time-consuming contract work. By embedding all information and signature requirements in the property token — proof of identity/assets/credit, inspections, mortgage, escrow, etc. — all parties have transparency into the steps that have been completed or remain.

Media licensing agreements pay royalties when music, movies or other intellectual property are re-played. A variety of media-use information feeds can trigger a media-license smart contract to calculate the amount owed based on the nature or distribution channel of the performance, and transfer value to its creator. Changing the payment scale calculations from agreement to agreement is simple. Further, wrapping the digital media within a blockchain token and secure ledger creates irrefutable proof of who originally filed as the creator of the intellectual property. In a more advanced architecture, the smart contract supports the creation of derivative works, such as books compiled from lecture materials published under a Creative Commons license.

Finally, imagine dynamic auto insurance whose cost and coverage is based on the mileage driven in the car and even its speed relative to the speed limit. In exchange for lower insurance rates, car owners volunteer to have their autos’ monitoring systems report driving behavior, via IoT, to the insurer — this is already in customer pilots at a number of insurance providers. The distributed blockchain ledger stores the auto performance data reliably and discretely, so that both insurer and insured can review it at any time (while third parties might be able to view aggregate, anonymized versions of the data). Meanwhile, third parties like other drivers in a collision and their insurers can file a claim electronically and receive payment through the smart contract.

Caveats

Smart contract formats are easy to design for a variety of situations… in principle. Challenges arise, however, when one considers how sophisticated and robust they can be, when deployed at scale in the real world.

First, existing smart contract platforms including Ethereum may not be able to support high-volume activity across smart contract applications. Recently, Ethereum was clocked at processing just 12 transactions per second.

The blog Freedom to Tinker sums up an insightful article by Karen Levy (a Cornell faculty member) about more fundamental limitations of smart contracts. She calls them “neither smart nor contracts.” Among her assertions are that smart contracts:

Must be designed optimally from the outset, because the blockchain paradigm makes their contents immutable. Neither corrections or extensions can be introduced after their creation. In contrast, legal documents explicitly or implicitly offer leeway to interpret and refine the agreements as new circumstances arise.

Have a hard time capturing all the contextual information that would be needed to adjudicate real-world arrangement like a lawsuit between a landlord and tenant. Judgements of reasonable efforts come into play in such situations.

Levy prefers to refer to smart contracts simply as “mechanisms.” Andrew Gidden has coined the term “PETS,” or programmatically-executed transactions. Both are thinking of these smart contracts as virtual bots that act precisely as they are coded to behave, but with the added benefits of immutability, transparency, anonymity, and security that comes with blockchain design.

Also consider that smart contracts are susceptible to highly-disruptive hacking because they intermingle financial value (currency or representation of real assets), terms of performance, and new and unfamiliar software. One Ethereum-based application, known as the DAO, achieved infamy for having business decision-making rights embedded in its smart contract. Then, a vulnerability in its code was exploited to attempt to shift Ether funds worth US$50 million to inappropriate accounts. This action was prevented only by the entire Ethereum codebase was forked permanently into two variations — the “before DAO” (Ethereum Classic) and “after DAO” (Ethereum) versions — to allow funds to be returned to their rightful owners.

The Future

Smart contracts have real potential to reinvent how industries digitally tailor their offerings and increase transactional efficiency. They have the greatest chance for lasting adoption when the applications align with blockchain’s inherent strengths. That is, smart contracts ideally:

Define agreements using straightforward descriptions of what must occur. Numerical calculations of value combined with “if-then” triggers of action work well.

Look for customization opportunities, where relatively few, isolated parameters, such as geographic jurisdiction or frequency of use, can be factored into tailoring the terms and behavior of the smart contract.

Leverage the blockchain’s distributed ledger to introduce information transparency as a replacement for good intentions and trust.

Expect to see this digitization and tokenization of contracts grow beyond the world of cryptocurrency as we progress into the million token future.