Every time you deposit money in your bank account, you’re engaging in a contract. You’re giving the bank a certain amount of money, and in return, they keep it safe, give you a small amount of interest, and give it back to you when you request it. The problems in this arrangement come with the imbalance of power it presents. Since banks now hold the capital, they have the power to loan out (other people’s) money and make significant returns. It is difficult for individuals with capital to be a lender for multiple reasons: it’s difficult for an individual to withdraw and loan out significant amounts of money to third parties, with banks often making customers go through additional hoops to withdraw large amounts of money.
It’s also hard to secure the investment without additional resources. Banks have the resources to track down defaulting borrowers, while individuals do not have the power to fight with a bank that will not release funding, furthering this imbalance of contractual obligations - banks can enforce contracts, while individuals cannot. In fact, when banks fail on their side of the contract, they get bailed out by the government, which has happened several times over the past century.
Smart contracts could be a step towards smoothing out these types of imbalance in contracts and aid the individual. Smart contracts are blockchain enabled contracts that digitally facilitate contract negotiation. More simply, a smart contract is a program that executes automatically when specific conditions are met. One of the main advantages of this is that they are self-executing: the code controls both sides of the assets and the execution. This is different from traditional contracts, where one party often has to complete their side of the contract first: think online shopping, as an example - a buyer pays for an item online, and once the money is received then the company begins the process of shipping. In contrast, a smart contract delivers both sides of an agreement simultaneously. Additionally, smart contracts are controlled by blockchain technology, which allows for all of the security inherent in blockchain as well as transparency and recording. I’ll go into more detail about blockchain in future articles.
This simple combination of security and simultaneity has a massive benefit for contracts and transactions. It enables transactions to be secure and assured in an anonymous ecosystem, such as the internet.
An example of a traditional contract falling short comes from my own life. I recently signed a new lease to live in an apartment. Going through the process of beginning to rent the apartment, I was required to wire the equivalent of 3 months of rent–no small amount–before the landlord would even sign the lease, and nearly an entire month before I even moved in. This is the issue of trust that I mentioned above. Because the landlord doesn’t inherently trust me (tenants in general), I am required to prove that I have the money to stay for the terms of the lease. On the flip side, I have to have a massive amount of trust to wire thousands of dollars to a person I haven’t met.
This leads me into the next issue with standard contracts: centrality. Even though a contract is between two people, there is often someone who controls the execution of the contract. In my case, it’s the landlord. Since I don’t control the terms of the contract, it can be heavily sided against me. I am required to spend 3 months of rent nearly a month before I move in. This is in addition to proof of income and a good credit score. In contrast, the landlord doesn’t even have to show me the deed of the apartment to prove that they own it or that they can rent it. I just have to trust someone I don’t know. This isn’t unique to me, this is standard renting procedure.
Smart contracts have the potential to force trust into situations like this. Imagine instead of a large sum ahead of time, I was able to pay a single month’s rent the day I moved in. This example showcases the true potential of smart contracts. They allow both sides to trust each other, inherently, since smart contracts automatically execute whenever the parameters are met, so it removes the one-sidedness inherent in many current agreements.
Are smart contracts unique?
The idea of removing the control of the contract from the parties involved isn’t completely new. An escrow account does a similar thing: it’s an arrangement by which a third party controls the goods being exchanged, so (in theory) neither party in the contract is advantaged over the other. This still requires that both parties trust the escrow account holder. This arrangement is most commonly used in housing, although Poshmark, an online resale marketplace, has a similar system. Poshmark holds the buyer’s funds, and only releases them to the seller once the buyer has confirmed that the item has been delivered and matches the description. This system allows for more trust than traditional online resale marketplaces such as ebay, since the company serves as a mediating third party, similar to an escrow. Smart contracts remove the need for a third party, which removes the need for trust altogether, as well as removes the work of finding a third party that’s mutually agreed on.
Where are smart contracts used today?
Smart contracts are beginning to gain traction today, although they are far from widely utilized. Decentralized finance, abbreviated as DeFi, is a major player in smart contracts. DeFi is primarily based on Ethereum, a blockchain platform that executes and verifies smart contracts. The idea is taking control of finances away from banks, and putting them in DeFi apps that provide services similar to the banking industry, such as lending, borrowing, and trading. Smart contracts have increased transparency, and by taking control of the contracts away from banks, it avoids potential large issues. An example of this is during the Great Depression, where banks went insolvent and refused to release money.
What industries could benefit from smart contracts?
It seems that smart contracts have the potential to be extremely useful and are currently underutilized. Any industry that benefits from rapid, trustless transactions can benefit from smart contracts. There is great potential for loans and mortgages, financial data recording, insurance, as an escrow replacement. I’ll expand briefly below.
Loans and mortgages I’ve covered above with my renter’s example, so I’ll be brief here. By taking control away from one of the parties involved, smart contracts could enable a fair contract without either side requiring to give out undo trust for completion. This could allow for fair exchanges between parties. Insurance and escrow are similar examples.
Financial data recording is built into smart contracts. Because it’s built on blockchain (more on blockchain in a future article), a distributed and secure database, record keeping of transactions is default. As a result, every smart contract record is accurate, transparent, and uniform.
Another great potential field for smart contracts is potentially in dynamic spectrum management (DSM). More on DSM in another article, but essentially DSM is a way of increasing spectrum efficiency by real-time adjustment of radio resources, and dynamically adapting to the current situation. I believe smart contracts have the potential to solve this issue by providing simultaneous, transparent exchanges of frequencies. Springbok is working on this very issue.
Smart contracts are programs that allow for transparent, simultaneous contracts. They decentralize the terms of the contract to enable a fair exchange from both sides, and allow for trust where there may be none. Smart contracts are similar, in a way, to escrow accounts in that they’re a third party that manages contractual exchanges, but should prove to be easier to use, and doesn’t require trust of that third party. Smart contracts are gaining popularity in some fields, namely DeFi and Ethereum, although they have significantly more untapped potential. I believe we will see smart contracts in increased traction over the next decade