Episode 14 – Decentralized finance: What are smart contracts?

“What are smart contracts? Well, this film could be really short, because here’s the answer: 

A smart contract is a SELF-EXECUTING contract where the terms of the agreement between buyer and seller are written directly into LINES OF CODE. Or you can imagine it as a pizza delivery: “within 30 minutes, or it’s free”. (points at the pizza) Now I need to rush, I’m late!

(robin arrives, gary at the door:”mate, you’re late”, grabs cash and pizza, shuts the door. 

The key word here is agreement. If you don’t meet the conditions set in the contract, well then you don’t get what you want.

BUT if we ended it here, you wouldn’t learn the shocking revelation of how smart contracts pre-dated blockchain, why they’re the foundations of the towering world of DeFi, and also why going to put our favourite people – lawyers – out of a job. Kind of. Welcome to School of Block.

A quarter of a century ago American programmer Nick Szabo developed a set of digital protocols for information transfer, which could automatically execute once established conditions are met. Yep, he invented the SMART CONTRACT. But, big problem – he had no way of proving they would actually work, as the necessary technologies required to implement them did not exist.

In 1996 the very concept was pure pipe dream. I mean, it’s got to be the ultimate contradiction… how could a revolutionary digital technology that could disrupt dozens of global industries exist, in a world where Peter Andre was still at the top of his game?

But then over a decade later Bitcoin arrived, the decentralized platform that Szabo had been waiting for. Only it didn’t have the functionality to run smart contracts in the way Szabo intended. We had to wait another half decade for that – until Ethereum was launched in 2015, and suddenly the game was changed.

The transition from the ability to simply ‘transfer value’ to ‘transfer value WITH CONDITIONS’ opened up an enormous number of use cases, and in the six years since Ethereum launched we’re still only scratching the surface of what smart contracts are capable of. 

Their potential for DISRUPTION is huge – across industries as diverse as voting, management, supply chains, healthcare, real estate, your digital identity, insurance – and yes, of course – FINANCE. In our last film we introduced the concept of DECENTRALIZED FINANCE, or DeFi. If you’d like to know more about it, I highly recommend catching up. 

But why are smart contracts so disruptive? Because they generate the ability to have multiple parties cooperate without any of them being able to manipulate or use the system in their favour. That is to say, they are TRUST-LESS. No one has to trust anyone else, because all you need to trust is the code – which you can see right in front of you. 

Speaking of which, being TRANSPARENT and UNHACKABLE makes innovation and collaboration possible where it wasn’t before, and smart contracts introduce mind bending EFFICIENCIES at the same time. 

And some of those are due to the fact that old fashioned ‘legal’ contracts are probabilistic, compared to smart contracts which are deterministic. The difference here is between a PROBABLE payment and a GUARANTEED payment. Which would you rather have? That’s not all they’ve got going for them either…

They’re FAST. No reams and reams of paper to write the contract on, send, sign, scan, send back again. And smart contracts are short in comparison with their real world counterparts. They’re INDEPENDENT. Third parties can’t turn up and interfere in the process, nor are there middlemen to get in the way.

They’re RELIABLE. Data entered in the blockchain cannot be altered or destroyed. The removal of humans from the execution process reduces the chance of human error. And you *know* they’re going to execute. It’s in the code. It’s not like the real world where parties can renege and then you’ve got a long legal case on your hands to enforce the ‘real world’ contract. 

And of course, connected to the EFFICIENCIES I just mentioned – SAVINGS. Operational costs are massively reduced, middlemen cut out and algorithms can create more advantageous terms when it comes to financial transactions. 

Wondering why DeFi platforms can offer you such huge rates of interest? And why borrowing can be so cheap? That’s why. And one of the other cool things about smart contracts? Their capability to make THESE. [demo]

MONEY LEGOS. We mentioned them briefly in the last episode. But how exactly do they work? Well, one of the key concepts here is COMPOSABILITY. Basically, a ‘middleware’ that binds various protocols together and allows you to stack them. You can use different types of finance together, without friction.

Let’s say you need a flash loan. So you want to borrow some money and pay someone else – all in one step. A single smart contract can connect various DeFi protocols to come together and process it all at once. Perhaps let’s say you needed that flash loan to pay for some insurance. You’d just stick the insurance Lego on top. Or rather, the smart contract would do it for you. It’s just like putting pieces together to solve a puzzle, only here you’re putting the components together to provide a solution. 

Pretty cool huh? So how exactly do smart contracts work? What does it look like when you use one? Well – take a look at this…

CHALLENGES 

So the conversation around smart contracts wouldn’t be complete without looking at some of the challenges that you might face using them, and that they face as a solution to a problem. Firstly, the LACK OF REGULATION. The international legal field is playing catch up with crypto in general, so it’s not like there’s a governing body to complain to if something goes wrong. Depending on the industry and application, smart contracts can be DIFFICULT TO IMPLEMENT. Integrating them with elements of the real world often takes a lot of time, money, and effort.

Once you’ve made a smart contract, YOU CAN’T CHANGE IT. Paradoxically, one of the main benefits of smart contracts can also be seen as a banana skin. If the parties want to change the agreement or new factors arise, they won’t be able to change the contract. So options for supplementary agreements need to be implemented as new blockchain platforms are developed.

Sometimes, just sometimes… smart contracts can GO WRONG. They’re programmed by humans after all, and even the cleverest MONEY ROBOT can’t predict every possible outcome. And then there’s the same problem many people have with the CRYPTOSPHERE at large. You’re ON YOUR OWN. Financial freedom and autonomy also has the consequence that there’s no call centre if there’s a problem. So dip your toe in gently to the world of DeFi to become familiar with it before you get too click happy. 

CONCLUSION

Why do lawyers earn such vast sums of money? Because they offer people and business a very valuable asset – CERTAINTY. The problem is, the amount of certainty a real world contract can offer is finite. 

People back out of deals all the time, things can go wrong, and legal proceedings to enforce that certainty can cost money that not all parties might have. And even if they do, it could take years to resolve through the courts.

Whilst SMART CONTRACTS are still behind their “legal” counterparts in terms of how comprehensive they can be, they execute far more swiftly and leave no room for double-interpretation where they are applied. All parties can see the terms, and there’s no doubt upon what will happen when they execute. 

When we start to see just how many industries could benefit from this injection of speed and certainty – you don’t need to be a rocket scientist to see that the money flowing into lawyers’ pockets is going to be staying in yours, and the people you interact with instead – in whatever industry or financial service that might be.

As blockchain becomes more pervasive and integrated into our daily lives, the chances are it won’t be too long before you’re using smart contracts on a daily basis, and not even realising it.”