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What are smart contracts? Five key questions

These new technological tools have the potential to improve all kinds of economic exchanges and open the door to new ways of doing business that today are unimaginable.


What are they?

Coined by the computer scientist Nick Szabo in 1994, the term “smart contract” is somewhat misleading. “A ‘smart contract’ is a computer code, which unlike most, isn’t installed on a personal computer or a server,” explains Pablo F. Burgueño, Chief Legal Officer at Nevtrace, a company that has advised the European Commission on smart contracts and cryptocurrencies. The code is registered in a blockchain so it cannot be erased or edited.

What are its main advantages?

The computer code is based on a very basic premise: if X occurs, execute Y. For example, if a plane is delayed more than half an hour, compensate the passengers with 10% of the price of the flight. In the real word, these types of agreements involve paperwork, but a report by the consulting firm Cap Gemini states that: “Classic financial contracts simply don’t work for the digital economy. Using a physical medium means delays and inefficiencies, and increases the likelihood of mistakes and fraud.”

Here is where the advantages of blockchain come into play: the terms of the transaction are written in a computer code located in the blockchain and cryptographically signed by the parties involved, which shall be implemented when the expected conditions are met. Everything is in blockchain, which means that it is transparent for all parties and cannot be modified. This makes transactions among strangers possible without the need for a third party to act as a trustworthy intermediary to validate the transaction. All parties have access to the same information at the same time. It eliminates paperwork, saves time and gets rid of nearly 100% of the risk of fraud and misunderstandings. But there are also disadvantages.

And the disadvantages?

The immutability, or unchangeable nature of blockchain, is an advantage, but it can also be a problem. As Cap Gemini says, “Smart contracts written as computer programs in blockchain mean that once an agreement has been reached, it cannot be easily modified. And this causes problems in real life situations.”  “Escape windows” that make it possible to pre-program ways to change the terms of an agreement through addendas, modifications and cancelations are being investigated. However, they are technically complicated and could make smart contracts less effective, as their effectiveness is based on their simplicity.

The transparency of blockchain also has its downsides. Do companies want their competitors to know about the conditions of their smart contracts? And what about consumer data protection?

Burgueño stresses that encrypting the users’ data that is put on blockchain is not enough. This would be in violation of the Data Protection Law. The answer is to separate the data that includes personal information and put it in a repository, so that only the company in question can relate it to what is written in the blockchain. It’s a solution, but there is a risk of the repository being hacked.

In the future, another possible solution to solve this risk would be the use of decentralised IPFS storage systems (InterPlanetary File System), a new internet protocol that enables the creation of distributed applications.

Security is another big concern about the computer code. The contents in blockchain cannot be hacked, but very serious mistakes can occur. What happened with the DAO is a grave warning.

The DAO was a decentralized, autonomous organization (hence the acronym DAO) that raised the equivalent of $160 million in the ether cryptocurrency to invest in projects related to the decentralized economy. It was all based on smart contracts, but the problem arose when a hacker found a mistake in the computer code and used it to keep part of the money. The promoters reacted by creating an ether split, therefore minimizing the theft. However, the hacker still managed to get away with approximately two million dollars.

How are smart contracts being used today?

The use of smart contracts is tied to cryptocurrencies: they cannot order payments to bank accounts in euros, dollars or pounds. But innovation is moving quickly, and private consortiums are already using private blockchains – with cryptocurrencies and smart contracts – to manage their business relations.

As for how traditional financial institutions are using these solutions, the Cap Gemini report points to many different benefits. For example, investment banks could reduce the time it takes to perform transactions by more than half, lowering operational costs and increasing demand and revenue. Meanwhile, customers would also benefit from lower car insurance premiums and lower mortgage costs. Smart contracts have tremendous potential, but greater standardization and widespread use of blockchain are still needed, concluded a 2015  BBVA Research report.

BBVA is collaborating with R3 consortium in an initiative that aims to re-desing the trade finance infrastructure by building a smart contracts standard supported by a DLT technology. 

What are the blockchain oracles?

Smart contracts could be used, among other things, to guarantee compliance with the contract for the purchase or rental of a home. In these cases, the contract would execute the instructions previously established by the parties. For example, in the event of non-payment of a certain amount on the chosen monthly payment date, the property contract could be terminated. But how do smart contracts know whether the rent has been paid? Or, when using a smart contract to manage a bet, how do you know which team has won a football match? This is where oracles come into play, computer tools that allow updating the smart contract’s status by adding external information.

Oracles are essential for smart contracts to trigger scheduled orders when a specific situation in the real world takes place. This external information can be of many types, be it the value of a specific currency, the execution of a payment, a change in price or the increase in temperature.

The development of these software is advancing swiftly. Projects like Orisi and Oraclize are creating systems that collect all the information from different suppliers and determine the most reliable data based on what the majority indicates. This way, this part of the process is also decentralised to prevent having to use a third party to validate that the information is accurate and real.