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Blockchain and smart contracts

A smart new world: blockchain and smart contracts

"The application layer that makes the promise of blockchain technology a reality."

UK Government Chief Scientific Advisor

What if a legal agreement could be monitored, executed and enforced without the need for human action or interference? Imagine a world in which a string of code could recognise the fulfilment of conditions, automatically transfer assets at the agreed times and register those transfers. That is the world of the smart contract.

What is a smart contract?

A smart contract is a piece of computer code that is capable of monitoring, executing and enforcing an agreement. On the one hand, code that states: “if X occurs then do Y” is not a new concept. It is how conventional code has long interacted with existing systems. Monthly direct debits out of a bank account for example. However, a smart contract takes such coding, and combines it with the potential of the blockchain to interact with multiple financial systems, asset registers and more.

What could a smart contract do?

By placing a smart contract on a public, permissionless blockchain, control over the execution of the agreement would no longer be in the hands of a single party (e.g. a bank) and interaction would no longer be limited to closed systems (e.g. centralised bank ledgers). The proper execution of contracts could be verified by the network of computers connected to the blockchain. That same network would update the blockchain to record the execution of the contract, and then monitor the blockchain for compliance with the terms of the smart contract.

A smart contract, distributed and replicated across a blockchain, could revolutionise the way business is done. Potential uses are numerous: property ownership could be transferred automatically upon receipt of cleared funds; credits under service level agreements could be automatically paid at the point of violation; and securities could be traded without the need for central securities depositories.

Are smart contracts the future?

We’re not there yet. A blockchain with sufficient interconnections between financial systems and asset registers does not yet exist and might never exist. Even if it did, smart contracts still have their limitations. 

On its face, code is certain. It is a pre-ordained manipulation of inputs to produce an expected output. Contrast this with conventional language – a minefield of ambiguity, sub-text and misunderstanding. The certainty of a smart contract is therefore seen as a key advantage. If the code works, there should be no misunderstanding as to intention and it can be replicated repeatedly, and cost-effectively, for analogous transactions.

But the contrast between the certainty of code and the ambiguity of language may sometimes be a fallacy. Code can never be wrong per se, but it can have unintended consequences. Take the flash crash of the NYSE in 2013 for example, which was caused by algorithmic trading. Where there are unintended consequences, there is liability, but who bears the risk of such unintended consequences is a question that remains outstanding. Many lawyers would also suggest that, sometimes, deliberate ambiguity, and the ability to qualify a requirement, can be vital weapons in the draftsperson’s armoury. 

An interconnected blockchain, and a public language of code for writing smart contracts that execute across that blockchain, would create competition in a range of areas. New-entrants could interact with public registers in a way previously limited to official registrars, and private transactions between individuals would be less reliant on intermediary service providers. It would also expand the ability of disruptive fintech firms to interact with systemic financial infrastructure. But is it realistic to expect conventional financial institutions to usher in such a new age of disruptive competition? 

Where next?

While smart contracts cannot judge if a condition has been reasonably met, or if a document has been satisfactorily provided, there maintains considerable potential in creating standardised protocols for repeat transactions, where negotiated agreements are not the norm. In the financial world, such protocols may be manifested through the execution of derivative trades across a distributed ledger. While, in the physical world, you might envisage a transaction for the sale of a car between two private sellers. Having agreed a price, they could use a standardised (and public, possibly available for a small fee) smart contract to input the price and the vehicle registration details. The smart contact would then execute the agreement: verifying that the seller is the true owner of the vehicle; transferring the cash; and re-registering the vehicle in the name of the purchaser. 

Ultimately, smart contracts are logical processes dependant on the blockchain with which they interact. With the uptake of blockchain technology in its infancy, smart contracts are not currently capable of interacting with the range of systems required to establish them as the default option for the execution of agreements over existing closed systems. When, or if, public registers and financial systems become interconnected by way of blockchain technology, this should change, and the potential age where smart contracts automate the execution of contracts, in particular those with no need for subjective human intervention, will arrive. 


Blockchain & Smart Contracts: Opportunities and Limitations



Certainty of code

No room for deliberate ambiguity

Cost effectiveness for repetitive low value transactions

Decentralisation of computing power can be more inefficient (and
costly) than centralised systems

Increased competition by breaking down monopolised financial systems

The need for a blockchain with sufficient computational power (i.e.
‘Turing complete’)

A truly interconnected world, removing inefficiencies between systems

Huge obstacles in convincing existing systems to transition onto

Decentralisation reduces the risk of permanent data loss and

Lack of centralised control may concern regulators

Transparency may assist effective regulation of markets

Transparency will concern financial investors

Faster settlement of trades, and the removal of multiple layers of
book entries

It remains unclear how real time settlement finality might be
achieved for securities traded on a blockchain

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