What is a Smart Contract?

Editor’s Note: The authors of this post are attorneys at Holland & Knight and are writing a series of articles on blockchain technology and its potential application to the legal industry. Below, the first article sets out basic concepts and terminology.

By Joe Dewey, Partner, and Shawn Amuial, Associate, Holland & Knight

In our last article, we set forth the basic framework and mechanics of the blockchain , which we illustrated through a very simple transaction: we transferred a Bitcoin to our friend, Alex.

In this article, we will build on our basic understanding of the blockchain and discuss more complicated objects (or relationships) that can reside on the blockchain — smart contacts.

What exactly is a smart contract? While there is no universally accepted definition, most people involved with the blockchain would expect at least the following three elements in order to consider something to be a smart contract: i) the transaction must involve more than the mere transfer of a virtual currency from one person to another (i.e., a payment transfer), ii) the transaction involves two or more parties (as every contract must), and iii) the implementation of the contract requires no direct human involvement after the smart contract has been made a part of the blockchain. It’s this last element that makes these contracts “smart,” and therefore, merits a more detailed discussion.

But before taking a deep dive into the self-implementation of smart contracts, let’s first explore the current state of traditional contracts in order to understand why smart contracts are a significant improvement.

As every first year law student knows, a contract is an agreement between two or more parties where one party agrees to do (or refrain from doing) something in exchange for something else (that something else could be the payment of money, the performance of services or the delivery of goods) — we’ll spare your from an in-depth discussion of offer, acceptance and consideration (since most of you have suffered through first year Contracts in law school). Sophisticated parties go through great lengths to draft (or pay attorneys to draft) comprehensive contracts that meticulously describe what each party must do (or refrain from doing), how each action must be done, the current state of an asset, contingencies that will occur if certain conditions are not met, and so on — you get the point.

So what makes smart contracts so innovative? Well, the simple answer is that smart contracts are not very different from traditional contracts, except that they are coded and digitally recorded on the blockchain. And this last quality gives smart contracts a host of significant advantages over traditional contracts — smart contracts are trustless, autonomous, and self-sufficient.

Yes, that’s a long list of fancy tech jargon, so let’s unpack each concept one-by-one.

As mentioned above, parties strive to draft traditional contracts in a manner that reduces risk for themselves, but ultimately, an element of risk is almost inevitable in the traditional contract setting. Parties must trust that the other does in fact have what they claim they have, that they can indeed do what they say they can do, or, if all else fails, that the U.S. judicial system will interpret the contract in their favor.

Smart contracts, however, reduce these risks as a result of the following characteristics: (i) smart contracts are coded and computer code ultimately boils down to 1’s and 0’s — there are no gray areas or ambiguities, (ii) the current state of things (whether this thing is a home or your bitcoin wallet) digitally tied to the blockchain is verifiable (hence, no need to meticulously explain what is you think you are getting), and (iii) smart contracts are self-executing, which means that the contract cannot be reneged, no one can decide not to perform a certain task (at least one that is linked to the blockchain), and there are less human hands (and hence human corruption) that influence performance throughout the contract’s term.

Smart contracts aren’t reinventing contractual relationships, but they are making their formation and performance more efficient, cost-effective, and transparent.

Two important factors will ultimately make smart contracts the standard for many types of relationships/transactions. The first is a revolution commonly referred to as the Internet of Things (IoT). All of the people and objects around us (from our refrigerator to our cars) are coming online and communicating information through the internet. In five years, the amount of information available online about the state of countless objects will have grown exponentially, and made ever more accessible by cloud technology.

The second is a function of cost efficiency. The risks that exist in traditional contractual relationships are often mitigated by appropriate due diligence and other measures. This traditional approach is often expensive, and in many cases, create transactional costs that frustrate otherwise economically efficient transactions. Smart contracts have the ability to significantly reduce, or in some cases, eliminate these transactional costs.

So how does it work? First, it is important to note that a transaction involving smart contracts must be front-loaded — almost all of the work must be done upon the contract’s formation when all terms and outcomes are considered, coded and uploaded onto the blockchain. Remember, once uploaded onto the blockchain a smart contract is set into motion, which means that unless you code in the ability to reverse course, the contract becomes non-voidable.

In order to better understand the basic mechanics behind a smart contract, let’s walk through a real world example of a simple smart contract — the sale of a used car. Let’s say my friend Alex wants to buy my Toyota Prius for $15,000. Traditionally, my friend and I would draft a written contract whereby I would agree to transfer my certificate of title to the vehicle to Alex, and in exchange for that title, Alex would pay me $15,000.

This transaction poses risks for both parties. For my friend, there is a risk that I do not have the certificate of title, that the certificate of title is a counterfeit (maybe I’m not a very good friend) and/or that there is a lien against the vehicle noted on the certificate of title securing a loan that I do not repay. For me, my friend Alex may not pay me the $15,000 after I deliver the title to him or he may tender a check that later bounces for insufficient funds.

Now both of us can mitigate against some of these risks by engaging a third party intermediary to act as an escrow agent — but this adds an additional time, costs, and complexities to the transaction. Alternatively, we can each accept the associated risks without the assistance of an escrow agent — but this approach increases the risk of litigation and is thereby likely to generate greater social costs.

Now let’s look at how the same transaction can be accomplished on the blockchain.

First, rather than the state issuing a paper certificate of title, each vehicle’s VIN and the name of the owner would reside on the blockchain. Similarly, liens against vehicles would also reside on the blockchain, each lien associated with the VIN of the vehicle being financed.

With this system, I would be able to transfer my Prius to my friend with an app on my iPhone. I could load a contract offer on the blockchain to sell my vehicle to Alex in exchange for $15,000. If accepted, the smart contract would be self-executing — the title of the vehicle would automatically be updated on the blockchain to reflect Alex as owner and would transmit $15,000 in virtual currency (e.g., Bitcoin) to my blockchain account. If there are any liens against my title, the blockchain can automatically deduct sufficient amounts from the $15,000 sent to me and re-direct those amounts to repay the loans secured by my vehicle (all of which payoff information would be available on the blockchain).

In a world IoT (Internet of Things), Alex would now be given the ability to unlock and start the car with his smartphone, while my access would be revoked upon transfer. This process eliminates all of the transactional risks associated with our traditional contracting system and simplifies the process so much that Alex and I can complete this transaction with nothing more than our smart phones. The transactional savings and reduced governmental cost to maintain vehicle registries will be significant. Even odometer tampering would be greatly reduced because my vehicle would constantly transmit its mileage statistics to the blockchain through an internet connection(IoT) —thereby reducing fraud.

In our next article, we will discuss more complicated applications of the blockchain, such as creating a modern real estate registry that utilizes the blockchain, utilizing the blockchain to memorialize our testamentary wishes and even more complex smart contracts pursuant to which entire organizations can be governed in a decentralized manner through the blockchain. These possibilities (and realities in some cases) will have a radical impact on how we organize our lives and the very fabric of our social contract — but more on that later.