You have probably heard the expressions ‘smart contract’ and ‘blockchain’. You have most likely heard them in connection with someone saying they are revolutionary and will change the world. Are they?
A smart contract is a contract between two or more parties that is self-executing. It is self-executing as it relies upon blockchain technology. Blockchain technology is programmable applications that manage exchanges conducted online.
The definition is not that helpful to those of us who are not computer programmers.
So back to basics. A contract is an agreement between two people that involves an exchange of some sought. For example:
I will give you $100.00 if you give me your car.
I will paint your house if you give me $1000.00.
Most if not all contracts involve exchanges of some type.
Contracts have traditionally meant that one party to the exchange has to bear a credit or trust risk. If you do not have the car at the time I give you the $100, I have to take the risk that you will deliver the car to me later. If you don't, I may have lost my $100. Likewise, if I paint your house before I receive any money, I risk not getting paid. Conversely, if I am paid first, the other party runs the risk that the house will not get painted or not be painted in a tradesman's manner.
Smart contracts seek to avoid the trust risk inherent in traditional contracts by being self-executing. An example of a smart contract is the Fizzy AXA insurance contract. (See Figure 1 www.fizzy.axz)
The idea is simple: it can be challenging to get compensated for late flights, even if you have travel insurance.
It can be a headache depending on why the flight was delayed. With Fizzy, if your flight is more than two hours late, you’ll get automatically notified and paid your compensation options. Once you make your compensation choice, the money is sent directly to your credit card.
Currently, this product is only available for flights between the U.S. and Paris.
The self-executing arrangement is derived from the contract being formed online using blockchain. Once the contract is made the compensation is scheduled to be paid if your flight is delayed beyond the agreed time it is to arrive. There are no if's or but's. Payment is immediate and without question: "Self-executing".
Yes, the smart contract removes some administrative hassle. But it is fundamentally no different to any paper contract. There are terms of when the money will be paid. The only difference is you do not have to claim as AXA knows from available public data if your flight is late; how late and if late beyond the agreed time your agreed compensation is sent to your credit card.
Smart contracts can manage financial interactions between machines, vehicles, humans, regulators, government, and financial service providers. Indeed, many of these processes are already managed online via processes that are automated. At present, some steps along the path still require human intervention. For example, to pay for electricity, a service provider needs to calculate the amount owing by measuring consumption and then applying a formula that generates an invoice. These processes (the register of consumption, the calculation of the amount owing, the generation of the invoice, and its delivery via email) are all currently automated and (as long as there are no disputes) they require no human intervention. The only step along the way that requires a human to do something is when customer pays the invoice.
The use of the blockchain does reduce some risk, but it does not remove risk completely. For instance: It is possible that AXA is placed into liquidation mid-flight and even though the flight is delayed you will receive the agreed compensation because the liquidator has ceased all payments. The credit risk is reduced by smart contracts but not eliminated.
Smart contracts that require a physical item to be delivered do not eliminate the traditional risk of paying first and not receiving the item and having to seek recovery of it or your money.
As Phillipa Ryan has expressed in her paper Smart Contract Relations in e-Commerce, Technology Innovation Management Review, October 2017 Volume 7, Issue 10:
"(O)nline transactions become a bit more complicated when the exchange is payment for the delivery of a physical item, for example a widget. The delivery of a widget would be managed off-chain and would require human intervention to complete delivery. In this case, one solution is for the smart contract to provide an escrow service until such time that the widget has been successfully delivered. Of course, this may reduce the risk for the party paying for the widget (they will not authorize release of the funds on escrow to the sender until they receive the widget), but it leaves the sender exposed to two obvious risks. The first risk is that the party receiving the widget does not release the funds from escrow. However, this risk is quite low as the terms of the escrow will mean that the funds remain held in suspense until the dispute about delivery of the widget is resolved. The second risk to the sender is that the widget is sent to the wrong recipient, stolen, or not delivered for some other reason. In this case, the sender has parted with the item but has not been paid. This second risk can eventuate as readily off-line and off- chain as it can on-chain. The blockchain does not give rise to the risk of the missing widget and it cannot eliminate it. Equally, the presence of a bank or trusted third party would not have reduced or eliminated that risk. In practical terms, where the transaction value is low, the party at risk is likely (implicitly) to assume (that is, accept) the risk. When the transaction value is low, the party at risk is likely (implicitly) to assume (that is, accept) the risk. When the transaction value is high, the risk solution probably lies in an insurance policy."
The use of smart contacts using blockchain technology is not a panacea. But they are an improvement. Just as reducing contracts to writing was and the improvement of education whereby most people can read and if they take the time understand a written contracts terms. The benefits of smart contracts will be dependent on the commercial uses to which they are put.