These irrevocable computer programs generally deployed on a blockchain and which automatically execute a set of predefined instructions offer considerable leverage to a multitude of contractual relationships. Their applications are very numerous.
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Smart Contract : a definition
The ‘smart contracts’ are computer protocols that facilitate, verify and execute the negotiation or the execution of a contract. They usually have a user interface and emulate the logic of contractual closes. Most of the time, they deploy on a blockchain.
Behind this concept of smart contract, the key idea is to guarantee the contract power, no longer by law but directly by computer code. As with every computer program, the complexity is variable from one smart contract to another. Some are implementing simple conditions, like a « IF » Excel function (if such a condition is met, then the contract is executed-or “if this then that”) while other smart contracts are much more complex. In fact, smart contracts have ambition to replicate all the clauses and rules that allow companies to operate. Then we talk about DAO, acronym of Decentralized Autonomous Organization’ (read our article published February 7).
Often associated to the Ethereum protocol which is positioned as a Bitcoin programmable version which widens considerably the field of decentralized applications, the word « smart contracts » was invented by the computer scientist Nick Szabo in 1993, to highlight the importance to bring “highly evolved practices” to the contract law, but was inspired by some researchers like David Chaum. Nick Szabo thought that the specification, the verification and the operation, thanks to cryptographic protocols and some other digital security mechanisms can make a big improvement compared to the traditional law that supervises the contracts associated with their different clauses. Some researchers emphasized the interest that smart contracts can bring in terms of security. This was done in parallel to David Chaum and some other researchers of the financial cryptographic community that have emphasized the interest of cryptographic protocols in order to ensure digital money confidentiality, the identification information and the digital signature of the contracts. Development of smart contracts is also and finally coming from a lot of efforts for improving operations in several industries using digital technology.
With the advent of the distributed consensus protocols and crypto currencies created to allow borderless, secured, resistant to censorship and programmable digital assets trades, it is a whole technological sector that is opening to smart contracts coding. Ethereum is the best known protocol dedicated to smart contracts coding, but it is not the only one anymore, and smart contracts can now be deployed with a lot of other competing blockchains (EOS, Tezos, NEO ,…).
Smart contract operation
A smart contract is proposing a digital equivalent to the paper contract. During the smart contract operation, all the steps of validation are recorded in the blockchain (the most used being Ethereum nowadays). This process allows to secure all the data by preventing their modification or their deletion ex post.
In practice, an overwhelming majority of the smart contracts are used to automate security trades under the form of crypto assets. All accounting entries relative to digital assets trade operations are systematically recorded in the blockchain. Then, all assets transfers are both public, predictable and irrevocable. Anyone can check on the blockchain the correct execution of the contract and determine who owns the asset.
So, smart contracts guarantee an extremely loaded set of performance conditions that leave no room for doubt or confusion. Conditions are very clearly set and the code interpretation is unequivocal, on the contrary to human interpretation that let room for negotiation or the discovery of a legal vacuum. Indeed, the blockchain aims to eliminate uncertainty and randomness as much as possible, or the contingent, so that substitute to the confidence, confidence that is always correlated to the system fallibility, the notions of insurance and guarantee. Insurance and guarantee are produced by calculation iteration whose results are considered statistically satisfactory. Therefore, it is the human domain that is gradually disappearing to the benefit of automated processes, not based on deliberation but on certification.
Most of the smart contracts are standardized (like for the paper contracts), for which we have the possibility to use templates. The smart contract standard the most widespread is known under the ERC-20 name, and its main function is to allow tokens creation (digital assets, crypto currencies) on the Ethereum network.
Strengths and weaknesses
Public blockchains offer strong opportunities to deploy smart contracts in an extremely secured way. Today, it does exist hundreds of ERC20 tokens (as for example crypto currencies created by a ERC20 ‘smart contract’) for which the total valuation represents several billions of dollars.
Strengths (advantages) of smart contracts are multiple. They allow to :
- Secure an agreement between two counterparts (or several) thanks to the transparency and immutability of blockchains
- Automate payments and eliminate unpaid risks, often observed in the context of a traditional contract
- Drastically reduce the costs for elaborating, the follow up and the contract signature (example of contracts with lawyers or notaries
However, smart contracts have disadvantages (weaknesses) for which experts are working on. The major one remains the risk of failures inherent to each computer program.
Smart contracts code is very often ‘open source’, but if the code is poorly designed, it gives room to hackers to take advantage at the expense of other users.
The most well known ‘hacking’ is ‘The DAO’ one which implied a loss equivalent to dollar 150 million (in ethers). Following this famous hacking, the Ethereum community decided to make the painful choice of rewriting ex post the transactions history in the Ethereum blockchain in order to dispossess the hacker of his booty and to restore the stolen ethers to the victims.
That kind of problem asks the question of blockchains immutability (« Code is Law ») facing the need to re-introduce human intervention, even in a smart contract framework.
A doctrine does exist, saying and upholding that it could be possible to introduce a sort of additional governance to blockchains, driven by a keen play on smart contracts in order to define some different possible arbitrage scenarios in case of emergency. On the contrary, pure Bitcoin enthusiasts are more keen to protect as much as possible these ecosystems from human and political intervention.
Smart contracts examples
Several blockchains let the possibility to deploy these contracts. Of course, the most well known is Ethereum, which already includes a large number of decentralized applications through the use of smart contracts. But some other promising protocols such as EOS, Tezos, NEO Cardano, Cosmos and some others are also conceived and able to compute smart contracts.
For now, the most mature smart contracts are computed on Ethereum.
We can find out some of different types depending on economic sectors such :
- Decentralized monetary exchanges : 0x, OmiseGo, MakerDAO
- Games on Blockchain : Cryptokitties, My Crypto Heroes, Etheremon
- Gambling : FCK, Playtowin, FunFair
- Decentralized Cloud : Storj, iEx.ec
- Predictive markets platforms : Augur, Gnosis
And many others…
The smart contracts economy is still embryonic but seems to have a very bright future. Numerous decentralized applications in the healthcare sector, in the insurance, or supply chains (pharmaceutical ones, food industry, cosmetics, etc…) are currently under development. In the coming years, it is actually probable to have proposals of significantly different organizations from today (with current versions of paper contracts and applications governed by trusted third parties). It will be an economy in which crypto assets will play an essential role.
About the editor…
A passion : Economics, behavioural finance and emerging digital assets
Yves started his career in the asset management in 1986 where he worked at different positions as manager of equity funds and diversified funds. at Crédit Commercial de France and later, at Barclays group in Paris. In 1998, he took the lead of equity funds and diversified funds, then of the whole fund management business at the French team of the Dutch Robeco group before joining Natixis Asset Management in 2012 as Director of the Equity Investment business unit. Yves left Natixis AM in 2018 to start as an independant player for professional investors and corporates (advisor and fund raiser).
He likes to engages in sports that test his endurance like running and swimming, Yves is also fascinated by social sciences, and more specifically by history and economics. But this is the economics mechanisms behavioural aspect and the markets behavioural analysis that are a constant source of thought and discussion. Since few years, the blockchain issue and emergence of crypto assets is a new field of passion and opportunities for him.
Financial markets and asset management
Financial markets and asset management