Smart contracts have been an impossible dream since the 1990s, but now blockchain technology has breathed new life into this concept aimed at automating contractual relations between people or machines without the involvement of a trusted intermediary.
Distributed ledger technology (DLT), of which blockchain is a specific type that tends to be used in a broad sense as DLT, guarantee that everyone sees the same information. This eliminates the need for one party having to trust that the other party acting honestly, as nothing in the blockchain can be falsified, making these platforms ideal for smart contracts.
There are many challenges that still need to be overcome, but smart contacts are a business application with significant potential for DLT technologies.
What are smart contracts?
The cryptologist Nick Szabo was the first to think up an IT protocol that would allow eCommerce between strangers and eventually replace legal paperwork. Today a smart contract refers to a contract that executes itself without the involvement of third parties, and is written as an IT program instead of using a printed document with legal language.
Computers play a key role in smart contracts. And this is not only a matter of storing documentation electronically or allowing electronic signatures, as has been the case until now. These programs analyze and execute some parts of its internal logic.
“The program can lay down strict rules and consequences in the same way that a traditional legal document would, but unlike traditional contracts, it can also take information as input, process it according to the rules established in the contract, and adopt any measure required as a result”, explains Javier Sebastián, head of Digital Regulation at BBVA Research.
How are they being used?
The most frequent uses being studied range from simple actions like voting for a publication on a forum, through to actions with a greater level of complexity such as loan guarantees and futures contracts, all the way to highly complex actions such as fixing payment priorities in a structured note.
Some platforms based on DLT technologies are already beginning to offer solutions to develop smart contracts. Ethereum, Hyperledger, Counterparty, Rootstock and Corda in the R3 consortium (of which BBVA is a participant) have made the most progress in the use of this type of contracts.
“The potential of DLT technologies to transform the way the financial industry works is enormous. However, we're at the start of the exploratory phase: the technologies are still very immature and we need to make more progress in standardizing processes”, says Alicia Pertusa, head of Digital Strategy and Transformation at BBVA Investment Banking.
One of the main challenges facing smart contracts is the difficulty of joining the two worlds –technological and legal. Smart contracts written by technicians, and the actual contracts written by legal specialists. “The challenge lies not only in conveying the whole legal language to a computerized world, but also in taking major steps to achieve their legal validity and standardization in the industry” emphasizes Pertusa.
Goodbye to lawyers?
These smart contracts allow strangers to do business with each other with total trustworthiness and without the need for a trusted intermediary. The software will also automate the compliance with contractual pledges.
This possible scenario raises the question of whether the technology will be able to replace the work of lawyers or legal services within a company. “The role of lawyers may shift from awarding individual contracts to producing templates for smart contracts in a competitive market. But smart contracts are an evolution of the legal system, not its replacement”, concludes Sebastián at BBVA Research.