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Smart Contracts Replace Paperwork with Automatic Execution

Every human interaction is some kind of transaction. A hug conveys affection; a handshake conveys mutual respect or agreement. A contract conveys an offer, acceptance and consideration--something of value transferred from one party to the other. Execution of a contract involves a sequence of authorization and validation processes that can take days, weeks or even longer. Proof of identity, posting of collateral, title searches, security bonds, validation of bank information, loan approvals, endorsements, affidavits, official certifications…. getting from the handshake to the completed paperwork can take months. But it’s all required in order to build the trust that will support the parties’ exchange of the valuable consideration that seals the deal.

What if it could happen almost instantly?

Smart contracts are computer programs that can automatically execute the terms of a contract. In 2001, legendary cryptographer Nick Szabo spoke of smart contracts that solved the problem of trust between contractual parties by containing embedded information about the parties that rendered them self-executing. For example, the key to a car might operate only if the car has been paid for according to the terms of a contract. As Szabo noted, a key feature of smart self-executing contracts is that they don’t require the involved parties to trust each other.

The technical means to implement smart contracts started to appear after the emergence of Bitcoin, the first cryptocurrency based on a distributed ledger, that rapidly became popular as a native Internet payment system.

The simplest Bitcoin transaction is a payment. Simple Bitcoin payments are executed by the Bitcoin network with no conditions besides availability of funds, and are irrevocable. The creators of Bitcoin saw the need for more flexible transactions, and built limited scripting capabilities into Bitcoin. Bitcoin scripting permits association of programmable logic with Bitcoin transactions, processing a payment only if the conditions specified in the program are met.

A simple application of Bitcoin scripting can be found in multi-signature (“multisig”) transactions, which are sent forward only if a sufficient number of pre-approved parties sign the transaction with their private keys. For example, a 2-of-3 multisig transaction must be signed by two out of three signatories. Escrow and supervisory approval of payments are typical applications of Bitcoin multisig.

Other applications of Bitcoin scripting are limited by the fact that the built-in programming language is very simple. So far, Bitcoin Core developers have stuck to the initial design decision not to implement full “Turing Complete” programmability, or universal computational ability. The idea has been to protect the network from complex, time consuming - and potentially harmful or even malicious - programs that would be executed by all network nodes.

Next-generation “Bitcoin 2.0” systems implement more sophisticated scripting features and position themselves as Turing Complete programming environments able to implement all sorts of smart contracts, with cryptocurrencies used for payment. The best known Bitcoin 2.0 system is Ethereum, a programmable smart contract platform with an internal currency dubbed “ether.”

“Ethereum is how the Internet was supposed to work,” claims the Ethereum website. “Ethereum is a decentralized platform that runs smart contracts: applications that run exactly as programmed without any possibility of downtime, censorship, fraud or third party interference.”

Szabo expects emerging Bitcoin 2.0 smart contracts platforms like Ethereum to have a disruptive impact on financial and legal systems, comparable to that of Bitcoin itself. “[E]ventually more so, since Ethereum’s more flexible and general language can facilitate a much wider variety of commercial and other formal relationships,” said Szabo.

At the same time, some more cautious observers fear that self-executable smart contracts could empower criminals with sophisticated trustless collaboration means, as reported by the prestigious MIT Technology Review. For example, malicious agents could anonymously hire hackers to compromise a website by creating a smart contract that, upon automatic verification that an agreed code string has been added to the hacked website, pays the hackers a reward in cryptocurrency. The method doesn’t require that the two criminal parties trust each other. Similarly, self-executing smart contracts could be used in “assassination markets.”

Ethereum developers counter that their smart-contract platform can enable all sorts of positive, radical social changes. For example, smart contracts could enable decentralized versions of services such as Uber, eBay and Airbnb, handling the payments without the need for a company in the middle. In fact, exchange networks built around self-enforcing smart contracts don’t require trust, and therefore don’t require intermediaries.

“The potential for Ethereum to alter aspects of society is of significant magnitude,” said Wood. “This is something that would provide a technical basis for all sorts of social changes, and I find that exciting.”

“It's a smart contract's lack of a central counterparty agent that will enable these contracts to service markets with greater efficiency,” notes Chris DeRose, community director of the Counterparty Foundation. “And much like Bitcoin itself, smart-contract technology can unlock untapped markets by circumventing existing regulatory infrastructures. This could lower the costs for a subset of our most common financial transactions.”

Counterparty is another Bitcoin 2.0 platform. In November 2014, Counterparty developers ported the Ethereum programming language to the Counterparty platform, enabling smart contracts to run on the Bitcoin blockchain, without having to switch to a new cryptocurrency.

Similarly, “sidechains” - blockchains separate from the main Bitcoin blockchain but interoperable with it by means of two-way pegs, allowing for the transfer of assets between sidechains and the main blockchain - could implement scripting features more powerful than those available in Bitcoin Core, while still using bitcoin as a currency. The company Blockstream, which recently established a partnership with PricewaterhouseCoopers (PwC), is pioneering the implementation of sidechains.

Some companies are beginning to offer smart contracts platforms for securities trading. Overstock’s t0 platform is advancing steadily toward fully operational status, and could have a big and disruptive impact on securities trading. Another smart securities trading platform, Symbiont, recently closed a $7 million funding round, valuing the company at $70 million, according to credible sources. According to the Symbiont website, the company is building the first issuance and trading platform for smart securities on blockchain technology.

DeRose noted that some companies are introducing private blockchains to provide the robust smart-contract options that Bitcoin Core lacks. Private, “permissioned” non-Bitcoin blockchains are supported by Accenture and by Digital Asset Holdings CEO Blythe Masters. Permissioned blockchain developments for banks and financial operators have been started by giant Swiss bank UBS, Bitcoin exchange itBit and others.“However, these companies have only been able to offer such solutions by removing the ability to settle among untrusted parties, and instead, relying on security through trust,” said DeRose. “It is questionable whether much more efficiency remains in such a private ledger model.”

“[Smart contracts] embed contracts in all sorts of property that is valuable and controlled by digital means,” wrote Szabo in 1997. “Smart contracts reference that property in a dynamic, often proactively enforced form, and provide much better observation and verification where proactive measures must fall short. [These protocols] would give control of the cryptographic keys for operating the property to the person who rightfully owns that property, based on the terms of the contract.” In November 2015, Slock.it, a German startup specializing in blockchain and Internet of Things (IoT) applications, announced that it’s moving to realize Szabo’s vision of smart contracts embedded in IoT-enabled devices. The company will sell smart locks linked to the Ethereum blockchain.

Smart contract technology is likely to have a radical impact on the Internet of Bits, the Internet of Things and society at large. Every industry in the world contains smart contract use cases in which contractual trust processes, replaced by irrefutable cryptographic code, could save enormous amounts of time and money. Those who carefully follow the many ongoing developments in the smart contract sector will be the first to reap the benefits.

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