Smart contracts promise a powerful new way of doing business. Yet in the noise of the blockchain and cryptocurrency space, the power of these self-executing contracts pre-programmed into blockchains is sometimes overlooked or altogether misunderstood.
Similar to how the Internet revolutionized the way people process information and connect with one another, smart contracts can fundamentally change the way societies make and keep agreements among individuals and groups.
Strong large-scale contracts form the backbone of a smoothly-running society. Countless things we rely upon—work and pay, financial agreements, trading terms—would come to a standstill if people failed to deliver upon them. The better contracts become, the better people collaborate. As such, smart contracts, which are more secure and deterministic, enable societies to operate more fairly and community-oriented.
In this article, we’ll discuss how smart contracts differ from their predecessors and how they can change society in deep fundamental ways.
What is a smart contract?
A smart contract is a deterministic, tamper-proof and reliable digital agreement run on a decentralized blockchain infrastructure.
Smart contracts have an edge over standard, everyday contracts for two reasons.
First, smart contracts are trusted, shared records. They are so secure that individual parties do not need to keep their own backup copies, a boon for modern companies where multiple departments have conflicting workflows due to the lack of a single record of truth.
Second, smart contracts are highly deterministic. In traditional scenarios, contracts may not be executed on as agreed upon out of error or reluctance. Smart contracts run in environments where they are executed exactly as written and do not require approval at each step. If pre-established conditions are fulfilled, key parameters execute automatically.
How do they work under the hood?
Today, most exchanges involve a trusted third party to solve the counterparty risk problem that one of the parties will default on their obligations. Transacting directly with a stranger can be incredibly risky and inefficient; each party is hesitant to fulfill their obligation because there is no guarantee the other side will reciprocate. Thus many business models are designed to offer this trusted value exchange including Uber who pairs drivers with passengers, eBay who matches buyers with sellers and NASDAQ who connects financial instrument buyers and sellers.
Blockchain’s decentralized infrastructure brings trust to transactions without the need for middlemen. The blockchain replaces trusted third parties with an open, reliably secure protocol that both parties can trust, but neither party can influence nor control. It replaces central servers with a decentralized network of computers that run the same software to process and record network transactions in a shared ledger. Distributed computing keeps the ledger accurate and the decentralized network keeps the ledger secure.
Smart contracts are a scripting language overlaid on the blockchain that enables transactions on a blockchain to mirror real life contracts by attaching if/then conditions. For example, if an asset hits a certain price on a specific date, then execute a payout to the other party. A smart contract developer could program the contract conditions to his or her specifications.
The if/then parameters are then tied to inputs and outputs of the smart contract. For example, the input in the smart contract could be the market price of the asset at a particular time and the outputs are the real-world actions that the smart contract triggers. Outputs can be numerous things including payments, transfer of data, updates of account balances, access granted and more.
In this smart contract example, Chainlink is the decentralized infrastructure that reliably connects smart contracts to tamper-proof inputs and outputs using oracles. By combining decentralized blockchains and oracles, these smart contracts have the infrastructure they need to be deterministic, tamper-proof, and reliable for end-to-end execution.
What is the value of smart contracts?
As opposed to probabilistic contracts, smart contracts are deterministic. Once added to the blockchain, deterministic contracts execute as coded. Because the contract is self-executing, neither party can alter the clauses or decide to renege on their end. The deterministic vs probabilistic nature of a contract is the difference between a guaranteed payment and probable payment. In today’s competitive market, a company promising guaranteed payments and service can propel it ahead of its competitors in relationships with its customers and suppliers. In fact, the game theory underpinning deterministic contracts demand adoption of these contracts because they are more reliable and profitable.
In our probabilistic world, many companies simply fail to uphold their end of agreements either purposely or by accident. To solve disputes, companies hire teams of lawyers, accountants, and customer support to draft contracts, track payment and deal with unhappy counterparties. These issues can be minimized or removed completely with smart contracts for the following reasons.
Automated: Using decentralized infrastructure, smart contracts automate the contract’s backend processes such as escrow, maintenance, triggering, and settlement. Once a contract is coded up and sent to the blockchain, the contract will execute as written without human intervention. Companies should see vast reductions in the overhead needed to carry a contract through its end-to-end life cycle.
Reliability: Smart contracts’ autonomous nature make them far more reliable than going through an intermediary. There is no centralized middleman to bribe, no central point of attack to hack, and no issues with server downtime. The lack of fallback mechanisms to escape contractual obligations makes them tamper-proof and secure by design.
Efficiency: Smart contracts are much more efficient than executing digital agreements through a third party. Neither party has to wait for manual data to be entered, for the other side to handle their end, or for a middleman to process their transaction. By eliminating human downtime and counterparty disputes, smart contracts can achieve end-to-end completion at an accelerated rate.
Which industries are most applicable to smart contract adoption?
As outlined in the Chainlink whitepaper, there are three main areas where smart contracts are most viable for initial adoption: insurance, derivatives, and trade finance. Trust in these three industries is key; trust is the very thing smart contracts commoditize and fix.
Insurance allows people to undertake risky economic activity that they otherwise would have avoided. But people do not even bother to buy insurance due to lack of trust in the system. In newer sectors and developing geographies, insurance claims settlements are at the discretion of the parties involved, and sometimes, claimants with valid proof never see a settlement. Furthermore, processing claims can also be very expensive in terms of time and resources. In property and casualty insurance, claim management accounts for up to 24% of operating costs.
Smart contracts can reshape the trust relationships between insurance companies and policyholders by replacing most of the human intervention with automation with decentralized infrastructure. The blockchain can keep reliable records of all claims, which prevents parties from fraudulently filing multiple claims for the same incident. Smart contracts can then automatically trigger payouts based on external data.
For example, much of industrial equipment is equipped with IoT (Internet of Things) sensors. Sensor data for equipment failure can automatically trigger insurance contracts, which execute and pay out settlements directly to company policyholders. Companies can then purchase new equipment and continue business with minimal delay. Thanks to data feeds that act as proof of event occurrence, highly deterministic contracts that execute exactly as written allows insurance settlements to be paid automatically. Both the insurance company and the policyholder can trust in tamper-proof data from an oracle auto-executing a tamper-proof smart contract.
Smart contracts can also be used for automatic insurance discounts, such as health discounts based on biometric data or car insurance discounts based off driving metrics. While more complex models will take time to develop, simple models like those devised for travel insurance are already available, such as Fizzy, developed by AXA.
Financial derivatives is another industry where smart contracts can bring back trust. The derivatives market is extraordinarily large with estimates placing it between $10 trillion and a quadrillion. This is a high value/low trust environment where parties may delay payments or default paying altogether. The market also suffers from inefficiencies that drive up costs such as the need for custodial services, clearinghouses, account reconciliation, manual data entry, redundant paperwork, etc.
Smart contracts offer guaranteed on-time delivery of payments and automation of most of the contracts’ backend processing. It streamlines the entire operation by eliminating the middlemen and manual processes. In fact, certain financial crises could potentially be avoided if smart contracts were the standard in derivatives. Companies would likely employ better risk management since there is no way they can delay or not make payments on their contracts.
Smart contracts are estimated to decrease individual loan costs by 480-960 USD and generate savings of 3-11B USD in the US and Europe combined. If we had had smart contracts back in 2008, the increased access to information could have mitigated the debt crisis.
Leading up to 2008, people acquired mortgages from multiple banks, accumulated debt, and purchased many houses. All sorts of financial institutions (banks, hedge funds, financial firms) packaged, tranched, and resold millions of loans as investment instruments. There were neither visibility nor reliable records of the debts that millions of people were racking up.
Had smart contracts been used, each loan-seeking individual would have had his or her own, easily-retrievable record. Each mortgage-backed security would have been tagged by other smart contracts that contained millions of smaller contracts that would be easily accessible and viewable. Loan officers could look deep into a single, secure, shared record to figure out the good credit holders from the bad in a mortgage bundle.
It’s interesting to ponder if companies would have overleveraged on credit default swaps in the run-up to the 2008 financial crisis had smart contracts been used.
Finally, trade finance is another industry that’s inefficient and prone to mistakes due to outdated infrastructure. Most agreements are still done with paper contracts, making the process extremely slow and leaves room for human errors. Instead, using a blockchain can facilitate easy information flow between parties, while smart contracts can trigger automatic payouts based on data received, such as the Bill of Lading or customs data. When a financier has access to more reliable data using a decentralized oracle network, not only can they use smart contracts to issue payments faster; they can also recalculate lending budgets for new customers.
Countless numbers of industries can be transformed with smart contracts. Examples include identity management, banking/payments, stablecoins, supply chain, real estate/land title recording, gambling, intellectual property rights, and healthcare records, among others.
While we’re still in the early stages of development, the real value in smart contracts is clear. The world is very competitive and so having contracts that cost less but provide more is a no brainer. It’s not a matter of “if” they will get adopted, but a matter of “when.” As is frequently the case with the adoption of new technologies, one or two companies will likely go all in and create a few successful use cases; then the whole market will follow suit in order to stay competitive.
At Chainlink, we believe it is only a matter of time before smart contracts become the industry standard. However, if smart contracts are to become the dominant form of digital agreement, they must be decentralized, tamper-proof, and reliable in end-to-end execution. This is why Chainlink has built a decentralized oracle system to connect smart contracts trustlessly to inputs and outputs they need to be successful across many established industries.