This article is written by Rajat Chawda of the Institute of Law, Nirma University, Ahmedabad. In this article, the author tries to explain what smart contracts are and the pros and cons attached to it.
In every contract, there are always three parties involved: two parties and the middleman i.e. the State. The role of the State is to keep a check whether the obligations under a contract are being or honoured or not. In case a party breaches an obligation of the contract, the other party has the right to approach the State and claim an appropriate remedy.
With the rapid development in technology, conventional institutions are also changing to make things effective and efficient. One such change is brought by smart contracts that try to eliminate the middleman and make the contract enforcement more effective and efficient digitally.
This post deals with how smart contracts make the life of an individual hassle-free, how smart contracts are created and in which situations they can be used and what are advantages and disadvantages attached to the smart contracts.
What is Blockchain?
You must have definitely heard this buzzword when the bitcoin had bull-run in the crypto world whereby a single bitcoin cost was more than $10000 at that time. This is the same blockchain technology that provides the platform to make smart contracts.
A Blockchain is a shared and distributed ledger on which every transaction is recorded and linked together in an encrypted form only after being validated through a consensus-based protocol. A transaction is added to the blockchain only after validation, which ensures that it is the only version of the truth.
‘Immutability’ and ‘Transparency’ are the two benefits attached to blockchain technology which makes it more useful. The records are immutable because one cannot change the record once the transaction is made and it is transparent because every person related to that transaction has the same access to that transaction, mostly because in a blockchain, every block has its own hash identity which can easily be traced.
Definition of Smart Contracts
After explaining why smart contracts are revolutionary and beneficial and explaining the blockchain technology on which the whole idea of the smart contracts is based upon, what exactly is meant by a ‘smart contract’?
In one line, smart contracts are the lines of code that are stored on a blockchain ledger with certain predetermined terms and conditions. When these predetermined terms and conditions are fulfilled, the code stored will be automatically executed.
So a smart contract is an agreement between two people. Since the agreement is stored on the blockchain, it is available to the public and cannot be changed or tampered with. Blockchain processes the transaction which happens in a smart contract.
Think of a landlord, who at the beginning of every month calls his tenant to check whether he has paid the rent or not, all the companies which lose their efficiency because of the tiresome paperwork to be completed, a victim of a car accident whose insurance claim is delayed because of the communication gap between the hospital and the insurance company or, every time you have to contact your courier service to get an update on your package delivery. All of these are soon to be considered as problems of the past.
The rapid development of science and technology has impacted every aspect of human lives from the way of interacting with others to how we behave. Technology has made the work of human beings more effective and efficient. The smart contract is one such path-breaking development in technology with the use of blockchain which changes how contract enforcement works and people rely on contracts.
The founder of smart contract, Nick Szabo in 1996 described smart contract as numerically coded ‘promises’ which includes some protocols. If the other party fulfills these coded promises, the conditions will be fulfilled of the program and the contract will be performed.
A simple example of a smart contract can be a vending machine whereby the coded ‘promise’ to vendor the commodity in the machine. The protocol assigned is paying a certain amount of money to the machine, if the condition is fulfilled the vending machine will give out the commodity.
Hence there is no third party requirement in a smart contract. Since the entire thing is stored on a public database and the transaction processes only when the conditions are met, there is transparency and trust devoted to the system.
Creation and Working of Smart Contracts
How Smart Contracts are created?
It is said that the smart contract negates the requirement of the middleman to enter into a contract. Smart contracts involve blockchain technology and programming. To resolve this issue parties usually hire a program developer which renders his service by encoding the contract as per the requirement of the parties. The program encoded is stored on a blockchain ledger and is controlled by the parties.
How Smart Contracts work?
Simple ‘If-else’ logic is used in smart contracts to work. There are predetermined conditions set in a smart contract, if a person fulfills these conditions the code will run automatically and complete the remaining part of the contract.
For example: You want to rent your apartment to someone but not below Rs 10000. To do this on the smart contract you create a Licensor-Licensee agreement with the help of a developer and put a condition of rent equivalent to Rs 10000 or above it. This smart contract is recorded in a ledger and anyone searching for a house will be able to see it. If the person pays rent of Rs 10000 or above it digitally, the code runs automatically as the condition is fulfilled and the parties enter into a contract.
Usage of Smart Contracts
Smart contracts are still at an early stage of mass acceptance and institutionalization but still, there are various sectors where they are being used. Some of the sectors where such smart contracts are used have been discussed below:
Blockchain can be used as a platform to record encrypted patient details with a private key which allows access to only specific individuals meaning restricted entry. The ledger can also be used to maintain general hospital management by managing compliances, quality of drugs used, testing results and managing healthcare supplies.
Blockchain could also ease the communication between hospital management and insurance companies as the hospital could automatically send the medical history and costs of treatment of a patient directly to the insurance company through blockchain and this could be used as proof of delivery.
Conventionally, renting an apartment includes the interference of middlemen through brokers or advertising agencies. A person also hires a person to check whether the tenant paid rent and followed through. Using smart contracts removes all these expenses as the cost is saved by using a ledger. A person has just to pay through digital currency to create one’s contract on it. Everyone sees, and there the goal is automatically accomplished to sell or rent the property. This can help to save costs of those dealing in real estate properties and add more to their revenue.
We are leading towards an automated world whereby soon there will be automated cars and systems. The blockchain technology can be used by both the automobile industry and the insurance industry to share the real-time functioning of one’s automobile: speed, vehicle condition, etc. So that in cases of accident, the insurance company will have a complete case file already with them to find out the liability and the compensation to be paid to the victim. This will ease the work of all the parties: the victim, the automobile company which used to send the documents manually, and the insurance company.
Proper functioning of the supply chain is very crucial for the growth of a business. The flow of goods and products from the initial stage to the final stage is part of the supply management. Smart contracts help to increase efficiency in the supply chain by providing a platform where everyone in the network can track the location of the product at any given time until it reaches the end customer. This reduces the chance of losing the package while delivering. Smart contracts have more advantage than conventional paper contracts as it reduces overhead costs, provides transparency, and saves time. Smart contracts are also more reliable, secure, efficient and trustworthy than paper contracts.
Since the blockchain and ledger technology works on conditional based programming it provides a source of trust. While paying salaries to employees, the management is eased by setting a fixed date in the smart contract on which salary will be paid to an employee automatically hence there is no need for an appointment of a person to check whether payrolls are being given or not.
Also, since everything is automated and pre-decided, possibilities of discrepancies or biasedness are minimized while getting project clearances or passing orders.
There is always a hue and cry that governmental elections are rigged and not transparent to the public at large, also there is the problem of low voter turnout because of the tiresome long cues, identity verification and filling of forms. Smart contracts resolve all these problems and make the process of election efficient and effective. This system provides more security and efficiency than the conventional system. Since every information of the voters and candidates will be encrypted on a ledger it cannot easily be tampered with. Because everything would be online, there will be no procedural lag in voting and the voters can vote even being at their home and hence increasing the voter turnout.
It should be noted that this list is not exhaustive and with the development in technology the usage of smart contracts is too widening.
Throughout this post, we have covered how smart contracts are created, to what extent smart contracts can be used and in which field they are being used. This part will deal with the advantages involved with using smart contracts, which the conventional traditional contract lack. The following are the advantages attached to using the smart contracts:
Smart contracts cut the role of middlemen. Therefore, there is no role of any third party interference like a broker or lawyer to confirm the validity of a contract. Since, there is no involvement of the third party, there is no scope of manipulation by a third party. The execution of a smart contract is also automated, therefore chances of errors are less.
The documents of contracts are encrypted and shared on a ledger, no one can know the details of the contract other than the parties involved in a smart contract. Since smart contracts are shared on a ledger, therefore these contracts will never get lost.
In a smart contract, there are servers backing up the documents in a blockchain every document is duplicated many times over.
Smart contracts use cryptography means that the content of documents is kept encrypted. Therefore, for a layman, it will be hard to hack the system and access the documents encrypted.
Commission has to be paid to a third party and state institution while making a conventional contract. Since the middlemen have been removed from the transaction between two parties in a smart contract, extra costs involved are brought down. Therefore, a person does not need to pay fees to his lawyer or have to pay fees to a notary while entering into a smart contract and hence eases the burden on his pocket.
In a conventional contract, everything needs to be passed through the middleman and is performed through paperwork and is manually processed. While in a smart contract, everything is digital and automated using software codes. Therefore, it provides a hassle-free experience and saves hours of processing time.
It is in human nature to make mistakes, therefore when contracts are made manually in conventional ways errors are expected to exist. Since smart contracts are digitized and automated, the involvement of human error is reduced.
Nothing is perfect in this world. It’s a myth if something claims that. The same is with the technology of smart contracts. Smart contracts are still at a developing stage whereby either people are not aware of their existence or hesitate to use this way of making contracts. Also, there are some industries where this technology still cannot be used yet. The following are some of the present disadvantages of using smart contracts.
It has been made clear that smart contracts negate the role of the middleman in a transaction and make the work of parties efficient and effective by saving costs and since it’s online, it is faster than the conventional paper contracts. Immutability and transparency are other benefits that promote the use of a smart contract. But to make these contracts online, the help of programmers is required who will encode these contracts into codes and make them available on the blockchain.
Since programmers are humans too, there are chances they might make mistakes sometimes while encoding the contract. Once the mistaken code is recorded on the blockchain, it takes time and pain to change the code again. Hence, the parties will lose their time and money because of the mistake of a programmer. There can also be bugs in the program, which can cause it to malfunction. Therefore, still a lot of development is required to make it flawless.
Since smart contracts are new in the field, there is still a lot of work to be done regarding their regulations and enforcement. Data privacy and cyber laws are still developing and there is no proper legislation dealing with smart contracts and liability in case of damage being caused to a party or when the technology used is faulty.
For example, the legislation has to still work upon who will be liable if the code does not perform accordingly because of the mistake of a programmer or there is a malfunction in technology without the fault of anyone. The court system also needs to be trained and equipped well to deal with cases arising out of such things and the courts currently are not prepared to deal with such cases efficiently and effectively.
Since on blockchain transactions recorded are encrypted and can only be accessed by the persons who are related to that transaction. This benefit can be used by criminals to carry out their purpose of money laundering or for executing any other work. Illegal use of blockchain technology through cryptocurrency is not a new thing. People use it to launder money because it is encrypted and can only be accessed by the parties related to that transaction.
Since smart contracts have not been effectively legalized and regulated, there is a grey area regarding its legal usage till its clarified and declared by the authorities.
These are some of the disadvantages related to smart contracts that will probably be resolved in the near future with further developments in the technology.
Smart contract-based companies
After discussing what smart contracts are, how they are created, how they function, the pros and cons attached to its usual, the reader might be curious and excited to know what are the companies which are currently dealing with smart contracts and promoting it to become mainstream? Some of those companies are mentioned below:
- Solulab: This is a startup located in Gujarat. The company was started by the ex-vice president of Goldman Sachs and ex-principal software architect of Citrix. Blockchain development is one of the things they specialize in.
- Leeway Hertz: This is another startup dealing in blockchain technology for building enterprise-grade blockchain applications and developing blockchain solutions.
Future of Smart Contract: A Way Forward
It is no doubt that smart contracts have a lot of potential to be efficient and effective in how people make contracts. But it should be remembered that blockchain technology is still at a nascent stage and will take some time before smart contracts become a mainstream thing. Contract laws of almost every country are century-old and require revamp to include data protection and privacy laws into it.
It should be also understood that with the use of blockchain, decentralization occurs which is different from the conventional paperwork system where the state is always there to act as a regulatory body and punish the defaulters. But in the case of using smart contracts, this regulatory body will be absent because of the decentralization established by it and therefore, there will be a lack of deterrent force. But, these things will surely be addressed and resolved in the coming future and smart contracts will become mainstream.
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