Trust (or lack thereof) is at the basis of the financial system’s current organization. Banks, escrow agents and other financial intermediaries are required to hedge risks in transactions between untrusted parties. But what if you could bypass this need for intermediaries, thereby lowering transaction costs and removing unnecessary complexities? That, and much more, is the promise of self-enforcing or ‘smart contracts’, a technology that is getting closer and closer to reality thanks to cryptocurrencies.
Smart contracts are programs that can automatically execute the terms of a contract. These automated contracts encode certain conditions (business logic, laws, and other agreed-upon rules) and outcomes. They work like any other computer program’s if-then statements, but in a way that interacts with real-world assets. When a pre-programmed condition is triggered, the smart contract executes the corresponding contractual clause.
The term ‘smart contract’ was coined by cryptographer Nick Szabo back in 1994. Szabo’s original idea remained unrealized at the time, because there was no digitally native financial system that could support programmable transactions. However, by combining advances in cryptography, distributed computing, behavioral economics and game theory, blockchain technology now offers the foundations for programmable platforms that remove the need for trusted intermediaries. There are currently several open source projects working on smart contracts, such as Codius or Ethereum.
With smart contracts, you could cut your mortgage rate, update your will more easily, or ensure that your friend would never be able to back down from paying up on a bet. Other applications may include financial instruments such as bonds, shares, derivatives, assurance contracts, and any other instruments and transactions whose events on which the smart contract rules are conditioned can be monitored. For example, smart contracts can easily be set up as escrow accounts that monitor an exchange of goods, property or services between two people. When ownership has been transferred from the seller to the buyer, the contract would automatically release the funds to the seller.
The potential for smart contracts goes beyond purely transactional aspects. Indeed, smart contracts can be embedded into physical objects to create smart properties. For example, a car might be rendered inoperable unless the proper authentication is completed with its rightful owner, preventing theft. If a loan was taken out to buy that car, and the owner failed to make payments, the smart contract could automatically return control of the car to the bank.
Smart contracts thus hold the potential to build more affordable and more efficient legal and financial systems. Someday, these programs may replace notaries, lawyers and banks for handling certain common financial transactions.
The opportunities for creating new kinds of businesses and social institutions based on smart contracts are vast. More generally speaking, smart contracts are but one element of a larger, emerging ‘programmable economy’, where value is exchanged without central authority and where markets can be created on demand, including markets in resources that are not directly monetary.