Smart contracts and their potential applications

Smart contracts are on everyone's lips when it comes to blockchain. They seem to add additional value and functions to the applications, but what are they if they are not formulated and printed out contracts? What makes them so special and more diverse compared to classical contracts? In which scenarios can they be helpful and what are their limitations, if there are any?

The essence of smart contracts

The origin of the smart contract does not lie in blockchain technology but in traditional information technology. Blockchain, nevertheless, enables the full potential of a smart contract.1 Essentially, smart contracts leverage all the aspects of a traditional contract with the difference that they are not physical and instead embedded in code. Traditional contracts consist of an agreement between at least two parties and the determined conditions of this agreement. Based on the named contractual elements all parties can insist on their claims and, in the event of a dispute, present the contract as evidence to justify their claims and rights. To do so the contract is represented through a piece of paper signed by the relevant parties.

A smart contract, on the other hand, is intangible. Similar to the traditional contract it incorporates the agreement between the contracting parties and the conditions of the contract. The agreement, nevertheless, is not written as text on paper but is embedded in executable computer code. This code is largely composed of if-then clauses that represent the terms, rights, conditions, obligations, and consequences of the contract. Thus, during the lifecycle of the contract, certain actions can be executed automatically if linked conditions, acting as a trigger, are fulfilled. Since the contract is both defined and executed by code, according to Swan2 this minimizes needed trust between contractual parties and eliminates the need for intermediaries. A simple example is a vending machine. If a product has been selected and enough money has been deposited, the selected snack will be issued alongside the change.3

Smart contracts have been in place since 1995 and exist much longer than blockchain does. In 1995 Nick Szabo, a computer scientist and expert in the field of cryptography, came up with the concept and defined it as “a set of promises, including protocols within which the parties perform on the other promises".4 His initial expectation was that traditional contract law could be improved and revolutionized by applying cryptographic procedures, suitable protocols and logic through algorithms. Due to the lack of a platform, suitable to facilitate intermediary-less, peer-to-peer transactions, Szabo was not able to effectively implement and use them. Thirteen years later, evoked by the development and rise of the Bitcoin, the blockchain emerged and thus created a platform enabling the effective use of smart contracts.

Smart contracts and blockchain technology

Blockchain technology first evolved in 2008 and was developed by Satoshi Nakamoto in the form of the cryptocurrency Bitcoin. Today, however, the potential of blockchain expanded from solely cryptocurrencies to an array of industries, markets, and functions. To a large extent, these use cases are driven by the application of smart contracts.

The decentralized nature of blockchain and the irreversibility of records in this system create a suitable environment for the application of smart contracts.3 Nakamoto5 describes the blockchain as an intermediary-less, peer-to-peer network of anonymous actors. Smart contracts can be implemented in this environment and, as a result of which, are able to facilitate, e.g., trades between two peers. While writing and storing the smart contracts manually afterwards the execution is solely in the hands of the network and the creator himself has no possibility to make changes. As a result, only the program code is responsible for the execution of the contract and, if pre-defined rules are met, can move digital assets and execute other actions automatically.

However, if errors occur in the code, they cannot be changed afterwards. This was the case with a specific Ethereum blockchain. Ether worth several million euros could be stolen due to a coding error in a smart contract and the only solution to fix it was to conduct a hard fork on the blockchain.6 Furthermore, a distinction must be made between the virtual execution of a smart contract, the real world and the legal system in place. Despite the saying “code is law” only the actions to be executed are stored on the blockchain itself. These procedures, nevertheless, are not necessarily valid and representative of a binding contract in the real world.7 Therefore, a smart contract may be considered accurate but not necessarily as evidence in litigation to enforce a legal claim.

Opportunities of applying smart contracts

Despite possible problems of coding errors smart contracts in combination with blockchain technology incorporate a huge potential for the applicants. The following four major advantages can be identified: (1) dependability, (2) security, (3) efficiency, and (4) independence.8

Dependability:

Traditional contracts and many legal acts are subject to a wide range of interpretations, which may lead to ambiguity and protracted litigation. By contrast, smart contracts negate the scope for interpretation of the contract almost completely, since the if-then clauses lead to unambiguous conclusions. The purely technical nature of smart contracts also protects against human error during their execution. However, programming errors may still occur as described above.8

Security:

The advantages of blockchain resulting from the use of cryptographic procedures are also transferable to smart contracts. Thus, subsequent manipulation of the contract’s content and associated transactions is prohibited. Like manipulation, the loss or deliberate deletion of contract documents is counteracted, as these are stored directly in the blockchain and are thus registered by the entire network.8

Efficiency:

To assess the efficiency of smart contracts, the resources needed to draft a contract manually have to be compared to those needed to program a smart contract. While a traditional contract, to a certain extent, has to be drafted individually smart contracts can be used in multiple cases. Thus smart contracts offer substantial cost- and time-saving potentials. The improvements can further be expanded by automating manual activities in business processes.9 By using if-then clauses it is possible to execute standardized processes without human interaction. Examples are interest payments and the settlement of insurance claims.

Independence:

Automation not only reduces capital and time expenditure but also the quantity of involved individuals. Intermediaries, involved in traditional procedures, such as lawyers, notaries, and bankers are no longer necessary as the contracts are executed through the consensus of the nodes in a network.6 This enables the conclusion of trustworthy contracts between two independent parties without using an intermediary as a basis of trust.

In addition to these substantial benefits, smart contracts provide the ability to connect to a wide range of other systems such as IoT devices, smart property, and real-world assets. Thus they are applicable in e.g. production and supply chain focused industries and add substantial and elementary value by enabling automation.

Areas of application

Smart contracts can be used wherever contracts and standardized procedures of any kind are concluded on a regular basis. This e.g. is the case in the financial industry, software licensing, the procurement of resources and various other industries. The possibilities are almost unlimited and suggest the creation of blockchain-based ecosystems. Frequently mentioned (potential) areas of application beyond the previous are Industry 4.0, the real estate market, elections, and insurance.6 In production-based industries especially, the linking of conditions in a smart contract to KPIs from IoT devices bares huge potential. With this possibility, manufacturers are able to e.g. automatically order new stock of materials or track machinery to keep it from overheating effectively.

An appropriate example to emphasize the possibilities is custody of digital assets. Digital assets, such as keys, are saved in custody storage to prevent both loss and theft of those. Nevertheless, if they are kept in a safe without the possibility of access from other applications they cannot be used and thus the custody storage would not be of use to the client. For other applications to access the asset, an interface, which could be a smart contract, has to be implemented (see Figure 1). This code would facilitate the exchange of information between the custody solution and the application requesting the use of the digital asset. By that verified applications are able to automatically access the digital asset without a time-consuming, manual approval procedure.

Conclusion

The use of smart contracts, defined as computational code in combination with blockchain technology, offers a wide range of benefits to applicants. Be it manufacturing companies or any other company. The advantages are characterized by increased efficiency through automation, disintermediation, increased security and little room for interpretation. Despite the advantages, smart contracts do not necessarily represent a legal claim to the executing parties. Beyond that, nevertheless, smart contracts are not only limited to traditional contract situations but can also be used effectively across a wide range of industries for the automation of processes triggered by threshold values or other events.