How Smart Contracts Work and What Industries They are Most Likely to Affect
Amazon disrupted the retail industry. Uber rendered taxies obsolete and Airbnb, the world’s leading online property marketplace, replaced hotels.
Now, the original disruptors might find themselves in danger too. There’s a new technology emerging – the blockchain-powered smart contracts – that has a potential to take over what is now their place.
What are Smart Contracts?
Smart contracts are something many in the tech world have been dreaming of since the nineties. Nick Szabo, the computer scientist who first described the concept in 1996 (and also coined the phrase), defined them as:
“Computerised transaction protocols that execute the terms of a contract. The general objectives are to satisfy common contractual conditions (such as payment terms, liens, confidentiality, and even enforcement), minimise exceptions both malicious and accidental, and minimise the need for trusted intermediaries. Related economic goals include lowering fraud loss, arbitrations and enforcement costs, and other transaction costs.”
20 years later, the technology he had envisioned was brought to life. The programmable contracts which, following Nick’s idea, combine procedures of advanced contract law with the protocols used in online commerce, can now be implemented easily on the distributed ledger systems otherwise known as blockchains.
How do Smart Contracts Work?
Essentially, smart contracts are blocks of code that can self-execute certain functions, with certain parameters, when predefined criteria are met. They are activated, usually, by someone sending a transaction to their address on a blockchain and, as of now, they are being utilized primarily on the network called Ethereum.
To explain clearly how a smart contract functions, people often compare it to a vending machine.
That familiar box in your office, which resembles a fridge, is programmed to take your money and disperse a product once you push an appropriate button. To get the machine going, you feed it cash and, afterward, an internal detection algorithm, which these boxes all have installed in them, determines whether the bills (or coins) you’ve put into the money slot are fake or not.
Vending machines, being an old and familiar technology, are impressive to no one. But it’s the core principle they operate by, their ability to “execute simple agreements”, that was an inspiration behind Nick Szabo’s smart contract idea.
Why is the Hype About Smart Contracts Peaking Now?
The advent of blockchains (the secure, decentralized recordkeeping systems) made possible the implementation of smart contracts: the key problem that had hindered their adoption earlier – scaling trust – was finally resolved.
You don’t give vending machines a second thought because the transactions they run are insignificant. It’s a matter of few bucks to get a coke or candy.
But what if products behind the glass cost three thousand dollars instead of three. Would you give them a little consideration then? I’m sure most of us would go as far as researching who developed the machine and put it in the corridor, and, also, we’d surely seek a guarantee to be compensated fairly should the machine break down.
Well, now imagine that the vending machine isn’t a physical entity, which you can at least see in front of you, but a script on a blockchain that promises to run a certain set of functions upon receiving funds.
It might have in its core a basic if then logic, the flow of functions you’ve grown familiar with over the years, but since the stakes in the transaction are immensely high, you’d still feel uneasy about sending your money to a program you really don’t know much about.
That is why a complex system of intermediaries – banks and financial institutions – charge considerable fees for ensuring trust: the need to validate parties and settle transactions in the digital world is utterly pressing.
Blockchains, however, are tamper-proof. They can reduce the need for trusted third-parties as, in fact, they are immutable and can provide security far superior to that offered by banks.
How are Smart Contracts Executed on Ethereum?
Smart contracts are meant to be Turing Complete.
Without getting too technical, let’s just say that these programs, ideally, should be capable of computing everything that can be computed, as long as the code has access to unlimited resources and there’s no shortage of time. Besides doing conditional logic (if then), they should be able to loop through, as many times as necessary, in order to complete the instructions drafted in code.
Due to this property, smart contracts can be created simple or infinitely complex, depending on the number of operations they are programmed to execute. What one should be aware of, however, is that each function a contract completes comes with a fee. A gas fee.
Gas, on Ethereum, is the unit by which the degree of difficulty of computational efforts is estimated. A certain contract’s operation, for example, might cost 2 gas (which, in turn, translates to a certain amount of ether) whilst another might require as much as 5 gas. The more complicated the smart contract’s instruction is, the more gas you’ll have to pay to have it executed.
The reason gas exists in the first place is that the price of ether might fluctuate. Depending on these shifts, miners can adjust the ether to gas exchange rate as they see fit; but the price per an operation in gas, on Ethereum, is set to remain unchanged.
Another key feature that distinguishes Ethereum from, say, Bitcoin, is that it doesn’t use unspent outputs. Instead, it maintains a shared state of account balances. This eliminates tracking and compiling of transaction outputs and enables smart-contracts to move balances across different accounts.
What are Some Smart Contract Applications?
Currently, the most popular use case for smart contracts is Initial Coin Offerings. They are means by which startups raise funds for their ventures, avoiding conventional investing regulations, and, nowadays, they are produced at a crazy rate (roughly one new ICO a week) on the Ethereum blockchain.
Ethereum itself was initially an ICO back in 2013. Its founders had acquired nearly $25 million prior to launching a public facing blockchain in 2015.
The network, as we’ve mentioned, introduced a new way of using blockchains, which up to that point had been perceived merely as platforms to run cryptocurrencies on. It enabled smart contracts which were characterized by the following properties:
- Automatic execution based on a logic programmed into a contract;
- Multisignature functionality: two or more parties could approve or reject a transaction execution independently; (this one wasn’t new as multisig wallets had been available on Bitcoin too)
Now let’s look at the industries that haven’t yet been disrupted by smart contracts, but, in our opinion, are very likely to be in the not-too-distant future.
It takes a long time to process a mortgage loan. We’ve grown to expect that. There are initiation, funding, and servicing; a lot of financial and property data has to be verified and no one in their right mind would want to undermine the process’ security by being sloppy and rushing things.
With smart contracts, however, the inefficiency and systemic issues which add on costs and cause delays in mortgage processing can be avoided. By means of automation and redesign, by providing shared access to verified virtual documents and external sources, such as Land Registry, smart contracts can bring benefits to both mortgage loaning companies and their clients.
The firms in the US retail industry alone, according to the research by Capgemini, can reduce expenses by at least $3b once they automate, at least partially, the processes associated with mortgage loans. And the clients, on whom these savings would be passed, might end up paying $480-$960 less each time they take a loan.
Clearing and Settlement
Leveraged loan market can benefit from the adoption of smart contacts too; the technology can help financial firms streamline clearing and settlement activity.
On average, leveraged loans are settled within 10-20 days, which is too long and therefore hinders the market’s liquidity and jeopardizes its growth.
Smart contracts might help companies reduce the delays and cut operational costs of the settlement procedures. They can enable firms to automate buyer/seller confirmation, FACTA, KYC, AML and assignment agreement – the processes that, nowadays, cost too much and take too long for firms to execute efficiently.
Companies that plan on seizing the promising and transformative opportunity that are smart contracts should conduct extensive research before implementing an action strategy; the misleading hype, which circles the term nowadays, might hamper the efforts to craft a pragmatic and well balanced long-term plan.
If you want to learn more about smart contracts and the substantial opportunities they can bring to your business, please contact our expert.