Part One: What are Smart Contracts?
In 1994, Nick Szabo, a legal scholar and computer scientist, coined the term “smart contract” to describe the ability to embed contracts, a legal construct, into computer code.
With the emergence of a blockchain ecosystem, the excitement around smart contracts has picked up.
In this article, I’m going to explore what smart contracts are and why it’s valuable to combine them with blockchain technology to make “blockchain smart contracts.” In the next article in the series, we’ll dive into the core problems they solve at a high level and then look at some potential specific-use cases. We’ll finish up by looking at the barriers and drawbacks of smart contracts. Alas, there is no free lunch!
What Is a Smart Contract Anyway?
The simplest example of a smart contract is a vending machine:
IF someone puts in a dollar
IF they press the button for Diet Coke
THEN dispense a Diet Coke
Smart contracts allow for the conversion of “wet code,” human-readable language like legal contracts, into “dry code,” computer-readable language. Wet code is more malleable and subject to interpretation, which can make it more flexible, but it can also make it less fair and more expensive (lawyers gotta make that Ke$ha too). Dry code is more rigid and deterministic, which makes it less flexible, but cheaper and fairer.
Though we don’t think about them much, contracts are an essential building block of our economy. As economist Ronald Coase pointed out, a firm is just a nexus of contracts with employees, vendors, shareholders and customers.
You live in your home or apartment because you have a contract with a bank (a mortgage) or landlord. Whoever owns your home has a contract with a government entity that maintains the property title register saying who the home belongs to. In many ways, our lives are just nexuses of contracts — employment contracts, mortgage contracts and marriage contracts.
The basic idea behind smart contracts is that many kinds of contractual clauses (such as collateral, bonding, delineation of property rights, etc.) can be embedded in the hardware and software we deal with, in such a way as to make breach of contract expensive (if desired, sometimes prohibitively so) for the breacher and, in so doing, reduce the transaction costs associated with that contract.
A more complex example than vending machines might be dealing with a car lease. A car could have a “smart lien” protocol where if someone failed to meet their contractual obligation of making the lease payment, their electronic key no longer works and a key owned by the bank activates the car instead.
This would be a lot cheaper than using a repo man to chase down the car. If the car was autonomous, you could make it part of the contract that if a payment was not met, the car would simply drive itself to a location designated by the creditor. When the car purchaser paid off the car in full, the contract would make the key that the bank was holding useless. Additional clauses could be added for safety. You wouldn’t want to revoke operation of the car while it’s doing 75 miles an hour on I-40.
Dry, Smart Contracts Vs. Wet, Legal Contracts
Smart contracts are not intended to replace existing common law, but to extend them and make it easier for individuals, businesses and eventually computers to make contracts with each other.
There are four important properties to good contracts:
If you enter into a contract with someone, like an employment contract, you want to be able to:
- Observe they are doing what they said they would do in the contract.
- If they don’t, you want to be able to have a way to verify that they didn’t do what they said they were going to do.
- Have a way to enforce consequences for breach of contract.
- Ideally, you would also like to keep the contract private. Not everyone needs to know the terms of your employment contract or mortgage.
Today, the main role of the accounting industry is to take the “nexus of contracts” that make up the economy and make them observable. The role of the auditing and investigation industries is to verify contracts. The role of the judicial system is to enforce those contracts: if someone violates a contract with you, you have the right to take them to court and punish them (through arrest, confiscation of property, etc.) for violating the contract.
Now that we’ve looked at the basics of smart contracts, next week we’ll look at two ways in which blockchain smart contracts could help the existing system be more efficient and fair.
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