What are Smart Contracts?
A "smart contract” is a term utilised in Financial Technology (FinTech). They are essentially self-executing contracts with the terms of the agreements between the involved parties being written into code. This means it’s a transactional protocol intended to automatically execute, control or document legally relevant events according to the agreed terms of the contract.
The functionality of a smart contract is for them to be self-enforcing agreements embedded in a computer that is managed by a blockchain. The contract will run once the pre-determined conditions are met. The purpose of this is so all parties can be immediately certain of the outcome of an agreement and be time efficient.
Blockchain is the system that records the transaction made by the buyer and seller. It's a digital database that collects the information together in groups known as “blocks” that hold sets of information. Blocks are limited by storage capacity. When the storage is full it is closed and linked to the previously filled block, thus forming a chain of data known as “blockchain”.
How are Smart Contracts Used?
Smart contracts may be embedded into anything valuable that is controlled digitally, it’s a form of automated transfer Service (ATS). Smart contracts differ from other ATS’ such as bank payments.
Concerning bank payments, third parties still retain control in contrast to smart contracts. This is due to the payment being facilitated and instructed through a third-party server which could risk third-party failure whilst smart contracts eliminate this.
Smart contracts are utilised in cryptocurrencies such as those found in Ethereum’s ecosystem of decentralised applications that make up decentralised finance. They are also utilised in financial derivatives, supply management and non-fungible tokens (NFTs).
Norwegian Central Bank’s Use of Ethereum To Build its Digital Currency
Currently, the Norwegian Central Bank is in its prototype stages of forming a digital currency network whereby they are using Ethereum technology as its base.
This knowledge was released when they released the open-source code for the central bank’s digital currency sandbox (which offers an interface to interact with the prototype network).
Within this sandbox, appropriate smart contracts are deployed which suggests possible future integration and uses for the smart contracts in other countries' central bank digital currencies (CBDCs) as well. Especially when integrating different digital currencies such as Bitcoin, the usage of smart contracts will only increase with the International Monetary Fund releasing a report indicating that 97 countries (more than half the world’s central banks, were exploring or developing CBCDs.
This certainly hints at a future in which smart contracts are further integrated into banking systems and our lives all across the world.
The Benefits of Smart Contracts on Blockchains
Independence:
Smart contracts guarantee the immutability of data.
It avoids possible breaches of conditions or errors in the execution of contracts since it’s autonomous and thus does not require intermediaries to confirm the agreement which could result in these errors.
Cheap:
Furthermore, the absence of intermediaries in smart contracts saves costs.
Greater security:
Smart contracts are more insurable, and secure and offer better protection than traditional contracts. This is due to the digital data stored on the blockchain being duplicated; it ensures data protection in the chance of any data loss. The encryption of Smart Contracts fortifies this as it keeps the data safe from intrusion.
Efficient:
Smart Contracts thrive in terms of speed and preciseness. The nature of smart contracts eliminates errors since it occurs automatically using computer protocols. This is beneficial as it improves the accuracy and speed of the business activities overall making the users of smart contracts more productive.
The Inherent Disadvantages of Smart Contracts
Legal status:
They aren’t legally enforceable although they have the potential to be legally binding. The UK Jurisdiction Taskforce stated these contracts can be legally binding if they follow the basic rules of contractual agreements. However, they don’t follow normal contractual law due to the fact the contract isn’t written in ordinary language; it’s written partially or fully in code. Since the party's contractual obligations are written in code it's difficult to interpret the contract in a traditional sense and apply its ordinary meaning. This highlights the difficulty of smart contracts being legally binding.
Lack of flexibility:
It’s also disadvantageous due to the difficulty of amending a smart contract in contrast to traditional contracts which can be amenable if both parties mutually agree to change aspects of the business deals. Smart contracts are not flexible like this due to the fact blockchains are immutable. It would be difficult to modify such a code that's stored in a blockchain, and the result may have higher transactional cost regard to a traditional contract.
This challenge also applies when terminating a smart contract thus its capability is limited due to the difficulty of modification and termination of such a contract stored on a blockchain.
Fortunately, projects are underway to create smart contracts that are terminable at any time and mandible more easily. Although this reduces the effectiveness of smart contracts having immutability and automation; it increases the utility of smart contracts for more organisations making this financial technology more commercially acceptable
Difficult to implement:
However, the fact still remains that integration of smart contracts in the real world and into the population's daily lives takes a large amount of effort, money and time and remains difficult to implement.
How are Smart Contracts Integrated into Different Industries?
The energy sector is a prime example of integrating Smart contracts into their industry. The evolution towards a more decentralised and adaptive energy system means the use of smart contracts is becoming increasingly common. It Is self-executed as energy is released to the consumer once payment is received through the smart contract.
The conveyancing service is using smart contracts in a blockchain-based transaction system to eliminate the need for individual data verification by multiple intermediaries in a conveyancing transaction.
The music industry is utilising this system to pay equitable royalty payments for the artists, concerts can eliminate counterfeit tickets and record companies are utilising them to trace streams efficiently allowing easy payment for artists.
The future of Smart Contracts?
Smart contracts have a bright future as it lays to impact more industries capitalising on market trends. The fashion industry is a prime example of an industry blockchain may be integrated into in the future. In the past blockchain technology has not been understood efficiently by the fashion industry.
Currently, there seems to be a shift in dynamics as more designer organisations are utilising blockchain-based solutions to tackle issues. They are currently being utilised to make the supply chain process, information and transaction smoother and more accessible.
For example, if the market wanted to confirm if the organisation was using ethical business practices, this would be accessible and certifiable since it would be recorded on the blockchain smart contract.
Smart contracts are rapidly growing and their functionality demonstrates how they can be a powerhouse within FinTech and change the business world albeit a slow change.
By Alvi Chowdhury, Innes Flett
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