Today let’s discuss smart contracts basics and why blockchain is a contracts game changer.
Blockchain technology is the basis for Bitcoin and other cryptocurrency and that’s how you may know about it but I believe that in addition to cryptocurrencies like Bitcoin, blockchain technology will change legal contracts forever.
If you don’t know, and to keep it as simple as possible, blockchain technology is a distributed network -meaning that the data or in our case the smartcontracts – are kept on numerous computers, not just one. And it’s called blockchain because once data is locked in by another block of data, it can’t be changed, so once the contract is in place on the computers, it can never be changed. Imagine lego blocks that have built-in superglue and once in place are locked in and can never be changed.
Back to smart contracts, for our purposes, a smart Contract is: (1) any self-executing legally binding contract; (2) on a blockchain; and (3) which tends to remove any third parties from the agreement.
Smart contracts were made popular by the rise of Bitcoin and blockchain technologies but have actually been around for a long time.
In 1880, if you wanted to buy a Coke, you would go into a store, put the Coke on the counter, hand the cashier a nickel and then walk out of the store with the Coke. This was a simple traditional contract – you agreed to give the owner a nickel in exchange for the drink.
Fast forward to 1930 and we have the first Smart Contract – at least that I can think of. In 1930, the first vending machine was put into operation and the vending machine is actually a type of smart contract. You put in a dime, push the button of the drink you want and it self-executes – the drink comes out. It also meets our definition of a smart contract because it tends to remove middlemen – In this case the cashier. He is no longer needed (sorry cashier). The vending machine is a very successful smart contract but which can only be used in a limited way.
Fast forward again to the 1990s and we have the beginnings of the modern smart contracts in the form of computer programs which in theory could be programmed to execute contracts. In other words, in 1994 you could have written a computer program (on your IBM probably in Cobol85 which would have taken forever) and even back then the program could have “self-executed” contracts but the functionality was extremely limited, they struggled to remove middlemen and they were pretty much useless.
Blockchain technology has changed ALL of this. Blockchain technology is ushering in the age of the smart contract. Why is that?
The first difference blockchain brings is that blockchain is decentralized and the contract will reside not on one computer but on thousands of computers all around the world and all at the same time. This is inherently safer than when a self-executing contract would have resided on a mainframe. If one computer is hacked or dies, the contract remains on 999 computers. It also happens to be safer than paper contracts – go back in time to 2009 and ask the banks how safe it was to have paper copies of home Notes in bank safes. That cost the banks billions of dollars.
The next difference is that the block chain is immutable – meaning that once the contract has a block placed on top of it, it cannot be changed – ever – like the superglue legos. It will never change. This actually is a challenge from a legal perspective for us lawyers, but is a great thing in terms of safety and making the parties feel confident in using self-executing contracts.
Third, blockchain, by its nature, is transparent and either party can view the contract at any time – this is obviously a good thing. There’s no password or other hindrance to viewing like there could potentially be in a traditional software setup or mainframe.
FINALLY, and most importantly, blockchain technology removes ALL third parties in a way that computer software can’t do thanks to Bitcoin and other cryptocurrencies. This is extremely important so let me give you an example and see if we can show a simple diagram to illustrate.
So as you can see in this diagram, let’s say we have a simple “self-executing” shipping contract on a computer – software based – that when I deliver a shipment of goods from the port of entry to a warehouse, the other party will pay me $100,000. I deliver the goods to the warehouse and scan them in the computer so the computer knows the goods were delivered – that’s the trigger mechanism that I completed my end of the contract. And, let’s also assume we have hooked up the software somehow to both parties bank accounts allowing for the transfer to take place electronically. This would be a state of the art software based self-executing contract and, as good as it is, we haven’t been able to remove all third parties because we are still reliant on the bank for the transfer of funds. So what? You might think – what’s the big deal. Well, let’s say the other party to my agreement decides they are going to mess around for some reason – happens every day. At the port of entry, the other party’s inspection guy says that not all of the goods arrived and therefore the amount of the contract is incorrect because there is only 50% of the goods to be shipped and they go to their lawyer and the lawyer files an injunction with the Court and obtains an emergency injunction which does not allow the BANK to disburse funds. The injunction is served on the BANK and the bank freezes the transaction so that even though the software asks for money to be paid, the BANK doesn’t transfer the money. I scan the shipment at the warehouse thinking the $100,000 will automatically be transferred to my account and … the money isn’t transferred. In other words, the existence of the third party has screwed up the self-executing nature of the agreement. Let’s look at the same scenario on a blockchain smart contract.
Here in this diagram, the lawyers go to Court and get the same injunction – the same paper signed by the Judge that funds shouldn’t transfer. But NOW, since we are on the blockchain, we have $100k dollars worth of Bitcoin being transferred and, here’s the important thing: THERE’S NO WAY TO STOP IT FROM HAPPENING. There is no third party outside of the contract that can change what happens. Even the parties can’t stop it from happening. And that’s because we’ve removed all entities outside the contract system from the equation. This one simple change makes all the difference. Now the parties don’t have to trust each other – it’s a trustless system.
Blockchain and blockchain currencies are the safest, most open, and importantly, the most inevitable way to create SmartContracts. That’s why it is a GameChanger even more than the invention and rise of the computer.
But that doesn’t mean they are perfect. The American legal system is slow to adapt – by design, and smart contracts will bring many legal issues and challenges with them. I am running out of time for this blog so in Part II we will talk about legal issues surrounding the drafting and enforcement of SmartContracts. Very interesting stuff.