Picture the house-buying process. An already daunting endeavor, the buyer and seller come bristling with lawyers, real estate agents, a representative from a lending institution and more. These external verifiers, or third-parties, are all in place to make sure that both parties implement the terms of a contract before the deal is closed and the title delivered from seller to buyer.
But what if you could enforce the rules of the contract through computer code? That’s exactly what a smart contract does. In other words, a smart contract eliminates the need for third-party enforcement.
How are smart contracts and blockchain technology related?
A formal definition of a smart contract is “an electronic agreement that uses computer code and blockchain technology to execute the terms of the contract automatically when certain conditions are met without the need for third parties.” The smart contract is essentially a contract with a digitized trust system — “You do X, I’ll automatically do Y” — between two parties coded into its DNA.
A smart contract needs three components:
- Signatories: the parties in the agreement, whose digital signatures can be used to facilitate the process
- The subject of the agreement
- The terms to implement the agreement
Blockchain is the key driving technology and can be defined as a record-keeping system that can’t be changed and that delivers a single source of truth to all parties. Whoever has access to the blockchain can see transactions, which are documented for eternity. All parties are quite literally on the same page.
Blockchain is a distributed ledger technology with three key advantages:
- Decentralization: No single entity owns the data
- Immutability: Data can’t be changed; blocks can only be added, not deleted
Such an ecosystem is particularly ripe for smart contracts. The parties in a contract need all three of blockchain’s advantages — decentralization, immutability and transparency — to retire third-party intermediaries.
The advantages of smart contracts
Many of the smart contract’s advantages are related to its operating in a blockchain ecosystem.
In addition to the reduced need for third-party intermediaries, smart contracts help build trust as documents are encrypted and saved in a distributed ledger format.
Smart contracts save you time and money and are more efficient than traditional models. Verifying personal contracts on an individual level might not be difficult, the time and value inefficiencies add up when you must execute such work at scale. Smart contracts enable you to rethink old ways of doing business.
For example, smart contracts could improve speed of commerce by facilitating capital transfer much more smoothly. The delivery of goods to a warehouse can automatically trigger an approval process and include necessary electronic signatures so payment for goods received can be wired immediately.
While not entirely foolproof, smart contracts are also more difficult to hack than traditional record-keeping methods.
Where can you use smart contracts?
At least for now, smart contracts help when the terms of the contracts are objective in nature. These include monetary payments and imposing fines. The document can code these “if-then” conditions into the contract and execute the processes automatically.
Although adoption of smart contracts is still in the early stages, the financial services industry currently sees significant use in dealing with decentralized finance and cryptocurrencies.
Supply chain management is another attractive growth area for smart contracts. Existing supply chains are complicated tangled webs that are time-consuming and difficult to trace. Using smart contracts can increase efficiency and drastically improve traceability. TradeLens, for example, is helping Maersk and IBM collaborate on digitizing their global supply chains by using smart contracts.
In addition to closing procure-to-pay gaps, these mechanisms help vendors better keep their ears to the ground and react faster to changing consumer demand. Since smart contracts facilitate smoother flow of all information and capital, overall processes become much nimbler instead of being tied up in endless procedural red tape.
Healthcare records can be stored on the blockchain and smart contracts used to record surgeries, follow-ups and other caregiving touchpoints that can be programmed at specific intervals. The records would have to be encoded and access granted only to authorized individuals but saving all receipts this way can facilitate easier access.
Governments too can use smart contracts. Estonia uses smart contracts and blockchain as immutable records of patients’ healthcare challenges and helps enforce “once-only” government policies, which mandate that a patient or citizen shares essential information only once with requisite authorities.
Challenges and regulations
The advantages of smart contracts can sometimes lead to significant issues if not fully vetted. Because they are immutable, any errors can be permanently coded as truth, and changes are difficult to make. Additionally, if an oral agreement is coded into a smart contract, there’s little fallback if things go awry.
The technology is still in its early stages. While state laws have been deemed unnecessary to provide oversight over smart contracts, hurdles such as potential regulations over related commerce and more remain to be ironed out. U.S. federal legislation, such as the Electronic Signatures in Global and National Act (ESIGN) and Uniform Electronic Transactions Act (UETA), pave a smoother groundwork for smart contracts.
However, the future looks promising for smart contracts. Though they run mostly objective transactions for now, more complex programs can make smart contracts even more powerful, capable of handling more difficult transactions.
Smart contracts deliver additional efficiencies as global business moves to ever-increasing digitized processes. If your enterprise is struggling with manual workflows, multiparty agreements, an inherent lack of trust and expensive reliance on intermediaries, it might be time to give smart contracts another look.