What are “smart contracts”?

May 9, 2022

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3 min read

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Origins

In a nutshell, smart contracts are self-executing contracts. Computer scientist Nick Szabo first coined this term in 1996, when he used a ‘distributed ledger’ (a collection of data shared and controlled in multiple digital locations with no centralised administrator) to store and execute contracts. This was originally a concept created to immutably time stamp documents, thus aiding their authentication. Now, blockchain technology provides the basis for this ‘distributed ledger’ within which smart contracts are stored.

Overview

Smart contracts translate the terms of an agreement directly into lines of computer code. The code is composed of simple “if/when…then…” statements, meaning the transaction is automatically executed upon a predetermined condition being met (for example, a certain amount of funds being raised). A variety of actions can be executed, such as releasing funds to appropriate parties, registering an asset or sending notifications.

Vitally, the code is contained within a blockchain network – a digital collection of information regarding transactions (a ‘ledger’). This information is contained within blocks which make up the blockchain. The blockchain is ‘immutable, distributed and decentralised’; qualities which smart contracts have inherited.

To say that the blockchain is a ‘distributed’ ledger means that any entries on the ledger are shared with everyone on the digital network. It is ‘decentralised’ because not one person or institution solely controls the ledger. Thus, instead of using a centralised entity to manage transactions (for example, a bank), blockchains use a peer-to-peer network, and all users must verify any transactions taking place. This eliminates the risk of fraudulent transactions. As the blockchain is ‘immutable’ (or unchangeable), once the smart contract has been created, nobody can tamper with the contract’s code.

Ultimately, these features make smart contracts very secure and trustworthy. To effectively tamper with a blockchain smart contract, hackers would need to alter an entire chain to change a single record, given that all blocks (data records) are connected to previous and subsequent records. The risk of information being used for personal gain is much lower, as no third parties are involved (decentralised). Furthermore, given that encrypted records are shared across participants, a single person cannot force the contract to release funds as others on the network would spot this attempt, marking it as invalid.

As touched on, no middlemen are involved in authorising or executing transactions. Smart contracts are instead self-enforcing, executed immediately by code rather than people, removing the risk of human error inherent in the manual filing of documents. They are hence speedier, more efficient and more accurate than traditional contracts. Eliminating intermediaries can also save time and money for users, making smart contracts financially attractive.

Verdict

Smart contracts can clearly be very advantageous for a variety of industries. Insurance companies could use smart contracts to process claims, reducing the risk of records being infiltrated or fraudulent claims being made. Supply chains could use them for the automation of tasks or inventory management, moving towards more seamless, efficient processes. Some have even suggested the use of smart contracts within voting systems, making elections less prone to manipulation (due to the security of blockchain).

This being said, smart contracts unfortunately come with many disadvantages, hindering their broader adoption. Such contracts are irreversible, making it nearly impossible to fix any problems once the code has been created. Additionally, smart contracts require a high level of technical expertise to develop which makes them very costly. Most importantly, government regulation of smart contracts is sparse, making it very difficult to intervene in the case of fraudulent activity. It is this that has broadly hindered the broader adoption of smart contracts. More cohesive extensive regulation should be implemented to encourage greater acceptance of such contracts.

Although the Law Commission envisages that broader use of smart contracts will likely create novel legal and factual scenarios, it believes that the current contract law framework can easily accommodate any such disputes. Only time will tell how the evolution of technology and legal solutions will help or hinder the advent of the smart contract.

Report written by Lauren Ainscough

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