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App Economy

What Are Smart Contracts? Cryptocurrency's Killer App

By giving computers control over contracts, we can make business more efficient and make the legal system more equitable.

What Are Smart Contracts? Cryptocurrency's Killer App

[Pen and White Paper via Shutterstock; Background photo: Flickr user Antana]

What if you could cut your mortgage rate, make it easier to update your will, and ensure that your buddy was never able to weasel out of paying up on a bet? That and much more is the promise of smart contracts, a technology that is getting closer and closer to reality thanks to cryptocurrency.

Smart contracts are computer programs that can automatically execute the terms of a contract. Someday, these programs may replace lawyers and banks for handling certain common financial transactions.

And the potential for smart contracts goes way beyond simple transfers of funds. The door of a car or a house could be unlocked by connecting smart contracts to the Internet of everything. But as always with this cutting edge of financial technology, major questions abound: How will this all align with our current legal system? And, of course, will anyone actually use these things anyway?

What Is A Smart Contract?

The idea of smart contracts goes way back to 1994, nearly the dawn of the World Wide Web itself. That's when Nick Szabo, a cryptographer widely credited with laying the groundwork for bitcoin, first coined the term "smart contract." At core, these automated contracts work like any other computer program's if-then statements. They just happen to be doing it in a way that interacts with real-world assets. When a pre-programmed condition is triggered, the smart contract executes the corresponding contractual clause.

Szabo's original theories about how these contracts could work remained unrealized because there was no digitally native financial system that could support programmable transactions. (It defeats the purpose of smart contracts if a bank still has to manually authorize the release and transfer of money.) "One big hurdle to smart contracts is that computer programs can't really trigger payments right now," says Phil Rapoport, Ripple Labs' director of markets and trading.

The advent and increasingly widespread adoption of bitcoin is changing that, and as a result Szabo's idea has seen a revival. Smart contract technology is now being built on top of bitcoin and other virtual currencies—what some have termed "Bitcoin 2.0" platforms. Because bitcoin is itself is a computer program, smart contracts can speak to it just like they would any other piece of code. The puzzle pieces are falling into place. A computer program can now trigger payments.

There are currently two major open source projects working on smart contracts, both of which have taken big leaps forward this year. One is called Codius and the other is Ethereum. Codius was developed by Ripple Labs, which also created its own digital currency called Ripple. Codius aims to be interoperable between a variety of cryptocurrency, such as Ripple and bitcoin, although it is managed by the private company.

"Codius can interact with other ledgers and web services. It can work on bitcoin and it can work on any other system," says Stefan Thomas, Ripple's CTO.

In contrast, Ethereum is an entirely new currency with smart contracts baked into its payment system. Originally developed by 20-year-old programmer Vitalik Buterin, it would replace other "coins" like bitcoin, but appears to be more of a community project.

Cryptocurrencies like bitcoin are poised to help smart contracts become reality. But the effect may also be reciprocal. Smart contracts can illustrate a unique benefit of virtual currencies that some advocates think could entice more users.

"Smart contracts are really the killer app of the cryptocurrency world," says Chris Ellis, host of a show about cryptocurrencies on the World Crypto Network.

Automating Simple Transactions

Let's take a simple example, like a Super Bowl bet. Say you want to bet $500—or roughly one bitcoin—that the Patriots will win, while your friend is betting the same amount that the Packers will take the title. Step one is for you and your friend to place your bitcoin in a neutral account controlled by the smart contract. When the game is over and the smart contract is able to verify via ESPN, Reuters, or elsewhere that the Patriots beat the Packers, the smart contract would automatically deposit your bet and your winnings from your friend back into your account.

Because smart contracts are computer programs, it would be trivial to add more complex betting elements like odds and score differentials into the mix. While there are services out there today that might handle this sort of transaction, they all charge a fee. The key difference with smart contracts is that it is a decentralized system accessible to anyone, that doesn't require any intermediary party.

A more everyday example would be online shopping. "If you order something online you might not want to pay a merchant immediately until they fulfill their end of the bargain," says Rapoport. "So you could easily have a contract that looks for FedEx tracking data saying that the package you ordered has been delivered to your address before releasing payment to the sender."

Say Goodbye To Lawyers And Banks?

If you think about a lot of routine financial transactions, what lawyers and banks do boils down to repetitively processing mundane tasks. And yet we still have to shell out huge fees for lawyers to go through wills or for banks to process our mortgage payments.

Smart contracts could automate and demystify these processes, making it so that ordinary people can save time and money.

Although you got your mortgage through a bank, that bank won't generally hold onto it for the entire 30-year loan; it will be sold to an investor. But you keep making payments to the bank, not the investor that owns your mortgage. The bank just becomes a processor for your monthly payments, sending a chunk to the investor, a slice to taxes, and a bit for homeowner's insurance.

"That's just a real simple operational task, but that bank will often take a quarter to a half percent per year to service that mortgage," says Rapoport. "They're just doing an operational headache of receiving payments and redirecting them. And they're charging people for that. But it's something that a smart contract could theoretically administer very easily."

If mortgage payments were handled by smart contracts, mortgage processing fees could be eliminated and that savings passed on to consumers. The result would be a lowered cost of home ownership.

Although smart contracts are still in their nascent stage, the potential is clear. If a simple enough user interface were developed it could remove a host of legal headaches, like updating your will. Imagine if allocating your assets after your death was as simple as moving an adjustable slider that determines who gets how much. Just like with the bet or FedEx example, once the smart contract can verify the triggering condition—in this case, your death—the contract goes into effect and your assets are divvied up.

With all this, it may sound like we won't need lawyers anymore. But enthusiasts say that smart contracts should be seen as an evolution of the legal system, not its erasure.

"We don't think that this will replace the legal system as much as provide an intermediate layer between transacting and going to court," says Thomas.

Nonetheless, the role of lawyers might look very different in the future. Rather than having lawyers adjudicate individual contracts, the role of lawyers might shift to producing smart contract templates on a competitive market. Contract selling points would be their quality, how customizable they are, and their ease of use. It sounds a bit like the marketplace for WordPress themes.

"I imagine a lot of people will create contracts that do different things," says Rapoport. "And they can essentially sell them for others to use. So if you make, for example, a really good equity agreement that has a bunch of different functionality a company can charge for access to their contract."

Smart Property And The Internet Of Things

It's easy to think about a smart contract managing a will, up to a point. It all makes sense if you can imagine yourself keeping all of your assets in bitcoin. But what if you live in the real world and have physical possessions like, you know, most of us? The answer is something called smart property.

"This starts to get more sci-fi when we talk about smart property," says Ellis.

The so-called "Internet of Things" is constantly growing, with more and more interconnected devices out there every day. Some forward-thinking developers are already working on ways to combine the Internet of Things with bitcoin infrastructure so that something like a bitcoin can actually represent a physical object. That token is what these developers call smart property.

But more important than representing some object, these new smart property tokens would actually grant ownership and control to a networked object, whether that be a computer, a car, or even a house.

How does this all come together?

Ellis gives the example of renting out his house. "Let's say all the locks are Internet-enabled and they've all got network connections. When you make a bitcoin transaction for the rent, the smart contract you and I agreed to automatically unlocks the house for you. You just go in using keys stored on your smartphone."

A smart contract would also make it trivial to set up dates when those digital keys would automatically expire. It sounds a bit like Airbnb without the need for Airbnb.

And if you think about it, that's the fundamental transformation smart contracts are after. A service like Airbnb is desirable because it obviates the need for the host and the guest to trust each other—they both only need to trust Airbnb. If the guest doesn't pay up, or the host doesn't leave the keys, either of them can take it up with Airbnb.

Doing the same sublet with a smart contract would supplant a business model like Airbnb's. The homeowner and renter still don't need to trust each other—they just need to trust the smart contract. Smart contracts would decentralize the model of who needs to be trusted. And in doing so, it would cut out hefty fees by brokering services like Airbnb.

But smart contracts don't have to just disrupt existing business models. They can also complement them. Way back in his '94 essay, Nick Szabo envisioned the idea of smart property writing that "smart property might be created by embedding smart contracts in physical objects." His example of choice was a car loan, writing that if you miss a car payment, the smart contract could automatically revoke your digital keys to operate the car. No doubt car dealerships would find this appealing.

Justice For Poor People?

Admittedly, at some point it does start to sound like the makings of a dystopian sci-fi film. If you can't make a payment all of a sudden your car could be digitally and remotely repossessed, all without any human interaction.

But in theory, the upside is that financial institutions should be more willing to take risks on people who might not otherwise get loans. Because, worst case scenario, if someone can't pay up, it's inconsequential for the bank to take back the asset in question.

In addition to expanding opportunities to get credit, smart contracts also have the potential to open up access to the legal system for disadvantaged people who might not otherwise be able to reap its benefits. Thomas believes that smart contracts "will make the legal system available to people who might not be able to afford it on their own."

Although the law in theory treats everyone equally, you more often than not need money to take someone to court over a breach of contract.

"At present justice really only works if you can afford a lawyer to enforce that agreement. So once smart contracts have the ability to enforce agreements on their own it will be game-changing. " says Ellis.

Of course it may not play out that cleanly in reality. While this all sounds good and noble in theory, it's impossible to predict how a smart contract would hold up in court if it were ever challenged. Dethroning lawyers as the high priests of arbitrating contracts is certainly appealing. But do we run the risk of just replacing literacy in legalese with literacy in code?

Rapoport acknowledges that there may be drawbacks. "Everyone reads English, so in some ways it's easier to read a traditional contract. But this is still very bleeding-edge technology, so who knows what kinds of user-facing improvements will be made eventually?"

Despite unforeseen pitfalls, the promise of smart contracts is clear. Right now we're waiting to see if either Ethereum or Ripple's Codius will be able to become usable and really take off.

"Right now there are lot of clever people working on this who are high on ideas because they can see the potential," says Ellis "What we don't know yet is who is going to win this race—Ripple or Ethereum. It's a bit like VHS vs. Betamax."

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