A “smart contract” is a new type of digital agreement that uses software to build trust between parties, and thereby slash costs, reduce errors, and manage contract performance.
For as long as people have been entering into contracts, they have been relying on trusted third parties to facilitate agreements. And for centuries, parties have built trust using classic legal tools such as guarantees, escrow or letters of credit. But until recently, each of these tools has relied on a trusted third party, either an individual or institution, who vouches for one or both other parties. What’s new and transformative about smart contracts is that a piece of software can take the place of that trusted third party.
How Smart Contracts Work
Victoria the video game publisher is developing a new game, and she wants the game to use a song written by Carlos the Composer. So Victoria offers Carlos a royalty deal. But Carlos is a little wary, because he’s never heard of Victoria, and he’s heard horror stories of composers getting ripped off.
The autopay scenario: Let’s imagine two scenarios. In scenario 1, the “autopay scenario,” Victoria tells Carlos, “Don’t worry, I have set up an autopay and every month it will automatically calculate your royalty and wire it to your account.” Is Carlos reassured? Maybe a little, but Carlos knows that Victoria has the power to turn that off at any time. It’s still Victoria calculating the royalty, using Victoria’s data, and Victoria is still deciding whether to pay Carlos each month.
The smart contract scenario: Let’s consider an alternative “smart contract” scenario. Victoria tells Carlos “Every month (or for that matter every 10 seconds) a smart contract, i.e. a piece of software that is outside my control, will calculate the royalty and pay you.” (As discussed below, this scenario is not just a hypothetical—Microsoft recently launched a similar system to manage IP licensing for Xbox games.) If Carlos trusts the software (which may be a big “if” as we’ll see later), Carlos may be willing to enter into that deal, whether or not he trusts Victoria.
In both scenarios, Victoria and Carlos are using software to manage the payments under the contract, but it’s only in the second “smart contract” scenario that the software is building trust by guaranteeing performance.
The definition of the term “smart contract” is hotly debated, but for the moment, the important aspect is that the software is autonomous, i.e. outside the control of either party. And because it can exercise control over some asset, such as funds to be used for payment, then it can fulfill the “trust-building” role previously handled by third-party institutions.
Blockchain Moved Smart Contracts from Theory to Practice
While they’ve been discussed as a theoretical possibility for decades—the term “smart contract” was coined by Nick Szabo over 20 years ago—smart contracts stayed in the ” sounds like a cool idea but how would we ever implement it?” pile for years because no one could figure out how to build trust in the smart contract. The smart contract scenario only works if both Virginia and Carlos trust the smart contract to calculate and pay out the correct royalties.
For many years, no widely accepted solution to build autonomous software that contracting parties could trust existed. But the rise of distributed ledger technology (DLT)—of which the Bitcoin blockchain is the most well-known example—offers a new solution to this “trust problem.”
Just as no consensus is shared about the definition of smart contract, there is no universally accepted definition of “blockchain” or DLT. But a helpful report, published by the Cambridge Center for Alternative Finance, offers a useful definition of a DLT as “a system of electronic records that enables independent entities to establish a consensus around a shared “ledger”—without relying on a central coordinator to provide the authoritative version of the records.” The details of how this works are complex and highly technical, but the important point is that DLT offers a new way to create a consensus without a central coordinator. In practice, this means that DLT offers a way to implement sophisticated business rules—such as calculating royalties based on downloads of a game and managing payments—using software that is outside the control of either party to the contract.
Beyond Bitcoin: Smart Contracts for Enterprise
Most people are familiar with only one type of DLT—blockchain as used to implement Bitcoin, Ether, and other cryptocurrencies. For better or worse, the hype and counter-hype around cryptocurrencies has obscured the point that DLT has many important uses beyond currencies and payment systems.
In the past year, several important projects have launched to use smart contracts and DLT to solve urgent, real-world problems. Three of the most important are: 1) using smart contracts to manage clearing and settlement of stock trades, 2) using smart contracts to automate and track shipping transactions, and 3) using smart contracts to calculate copyright license royalties.
Clearing and Settling Stock Trades on the Australian Stock Exchange
While advances in technology have made it possible to buy or sell stock in fractions of a second, the process of transferring the funds from the buyer to the seller and the stock from the seller to the buyer—a process known as “settlement,” still takes several days. The reason for this discrepancy is that multiple parties, including brokers, clearing houses and transfer agents, just to name a few, are involved in finalizing a stock sale, and, because these parties don’t trust each other, they need to go through a fairly laborious process of reconciling their records. The Australian Securities Exchange (ASX) decided to find a better way to manage this process. So the ASX enlisted the aid of enterprise blockchain technology vendor Digital Assets LLC to create a new smart contracts system for managing stock trades. Given the size of this project—the ASX handles $2 trillion per year in securities transactions—this is, of course, a long-term project, and the official “go live” date is 2021. But the results will transform the securities industry.
Tracking International Shipping Using DLT and Smart Contracts
The shipping container, an innovation that came into widespread use in the 1950s, has revolutionized the global economy by slashing costs to ship goods worldwide. But the shipping industry uses outdated systems to track shipments. Multiple players, including freight forwarders, customs workers, ports and terminals, ocean carriers and inland carriers all have to share information. Because they don’t all trust each other, each must maintain its own records, and these are often still handled with paper documents.
This year, container shipping company Maersk teamed up with IBM to launch a new platform, TradeLens, that uses DLT to track global shipping. By tracking data about shipments using smart contracts, TradeLens hopes to eliminate paperwork, costly delays, and labor intensive, error-ridden systems. TradeLens is replacing multiple systems with a single trusted DLT, using smart contracts to track each transaction.
TradeLens is not the only platform in this space. In November, nine major terminal operators and shipping companies announced that they were forming the Global Shipping Business Network, a consortium aimed at using blockchain developed by CargoSmart to “facilitate the seamless sharing of documents and data across all stages of the shipping lifecycle.”
Using Smart Contracts to Calculate and Manage Royalties for Videogames
Remember our scenario with Victoria the video game publisher and Carlos the composer? Earlier this year, Microsoft teamed up with EY to launch a system that uses smart contracts to track royalty payments for Xbox games. Up to now, data on game downloads were not available to publishers until, at the earliest, 45 days after the end of each month. And games include multiple contributors, including authors, composers, photographers, video makers, developers, and production houses.
The advantage of the smart contract system over a traditional central database comes in as they scale up the system and attract other companies. As explained by EY’s global innovation leader for blockchain, the rationale for using DLT and smart contracts comes down to trust: “If we ever want the system to appeal to a non-Microsoft company, those firms have to be confident that there’s no systems administrator who can look at everything.”
How Will Smart Contracts Will Transform Your Industry?
To see how smart contracts can and will transform your industry, first, look for applications, such as selling securities, in which existing contracts are narrow, objective, and mechanical, with straightforward clauses and clearly defined outcomes. Second, look for applications, such as global shipping, where, due to lack of trust between multiple players, each player is maintaining its own set of records, and each player must devote time and energy to reconciling their records with the other players. Finally, look to applications, such as calculating royalties for video games, where lack of transparency is a barrier to trust that prevents deals from getting done.
Smart contracts are going to transform every industry by transforming every aspect of the way we do business by (1) building trust and eliminating obstacles to trust; (2) slashing costs, errors and delays; and (3) unlocking innovation to allow for new types of transactions.
All of these present massive opportunities, but obviously they also raise massive questions. How can we as lawyers help create smart contracts that help our clients achieve their goals while protecting them from the—as yet not fully known—risks of this new disruptive technology? How can we plan for and manage the inevitable problems that our clients will face when autonomous smart contracts, inevitably, go wrong? How will courts, legislators, and regulators handle smart contracts and how can we help them make better decisions? This article has focused on smart contracts for the enterprise, but this technology will transform all aspects of the economy. How can we ensure that they are a force for transparency and fairness? What will consumer debt collection look like when consumer debts are handled through smart contracts? What will housing court look like when smart contracts are used for residential leases? How will the role of the lawyer change?
You can be part of figuring out these answers, and, more importantly, figuring out the right questions. We need your help.
About the Author
Adam Long is an attorney, entrepreneur, and consultant helping businesses and law firms to embrace smart contracts. Follow his blog at lawsnap.com or contact him at adam@lawsnap.com.