Understanding Smart Contracts - Part 3

What are Smart Contracts?

Suppose two parties A and B, have to get into a contract, they will utilize the services of a third-party, whom they have to trust and get the contract executed. The introduction of smart contracts removes the dependency on such third-parties and automates the execution of such contracts.

A smart contract is a self executing contract which contains the terms and conditions of an agreement between the peers. The terms and conditions of an agreement are written in a piece of code. It is executed on a blockchain based decentralized platform. These agreements facilitates the exchange of assets. A blockchain based platform gives you a democratic system where the transactions are authorized by a majority of the participants and the identity of the participants is also kept anonymous.

Smarts contracts are executed automatically based on real-world inputs in data. It's best to think of them as an "if-then" event statement. If condition A exists, then perform function B. The code on which smart contracts are built cannot be interfered with by either party (at least not without the other party knowing). Now smart contracts are just like traditional paper contracts. The only difference is that they are completely digital. They are immutable and they are distributed. Being immutable means that once the smart contract is created, it cannot be changed again, so no one party can go behind the back of the other to tamper with the code of the contract. Being distributed means that the output of the contract has to be validated by everyone (or at least a majority) on the network. So no single person can force the contract to release funds when the terms and conditions have not been met. If this happens, other people on the network will spot the attempt and mark it as an invalid transaction. With these two attributes, tempering with smart contracts become almost impossible.

Acknowledging the wide-known statement that there is nothing new under the sun, it is still necessary to analyze, whether there is something principally new in Smart contracts comparing to automated vending machine or not. The degree of novelty of Smart contracts and presence of certain special features in it becomes especially relevant if we turn to practices used in exchange markets, where so-called automated trading systems is widely used. For example in foreign exchange markets, trades are frequently executed not by the trader himself, but by a computer system based on a trading strategy implemented as a program run by the computer system.

As of 2014, more than 75 percent of the stock shares traded on United States exchanges originate from automated trading system orders. So, automated contracts per se are not something new: they are widely used in many spheres for a long period of time already. So what is so special with Smart contract then?
For this it is worthy to refer to another definition of Smart contract provided by Gideon Greenspan: “A smart contract is a piece of code which is stored on an Blockchain, triggered by Blockchain transactions, and which reads and writes data in that Blockchain’s database”. This definition is more concrete, as it makes an emphasis on the Blockchain technology as one of the core features of Smart contract.

However, the question is: whether Blockchain has certain legal implications on contracting process, which would make it significant for characterization of Smart contract, or it is only a fashionable technology, representing interest mostly for IT-specialists. Blockchain can be regarded as a “paradigm-shifter” in the sphere of contracting: it allows to automate the process of performance contractual process of both parties. Old-school vending machines automate performance only of one party, requiring at least some personal involvement on the other side (e.g. coin insertion or application of a banking card). When both parties’ performance can be fully automated it creates a new quality of the contract, even triggering a question, whether there is still a contract in a legal sense and not some other kind of phenomena. Another peculiarity of Blockchain-based contracts is that it allows not only to automate performance of a contract, but also a process of its conclusion: it can be concluded by electronic agents, employed by the parties.

In some cases, a contracting party can be represented by the so-called Decentralized Autonomous Organization (DAO). This concept has not yet received universally-recognized definition. According to one of the positions, DAO is nothing more than a set of long lasting “Smart” contracts as opposed to a regular “Smart contract” having specific purposes and coming to an end once they are achieved.

In my next article I will talk more about the legality of Smart Contracts and how they apply in real life.