Why do we need smart contracts?

Smart contracts were first described in 1994 by a computer scientist, legal scholar and cryptographer Nick Szabo, as:

“A smart contract is a computerized transaction protocol that executes the terms of a contract. The general objectives are to satisfy common contractual conditions (such as payment terms, liens, confidentiality, and even enforcement), minimize exceptions both malicious and accidental, and minimize the need for trusted intermediaries. Related economic goals include lowering fraud loss, arbitrations and enforcement costs, and other transaction costs.”

This definition does not specify which technology to use to implement smart contracts. However, the emergence of blockchain technology, and in particular Ethereum, has many features that make it an ideal development platform. Blockchain automates work flow, thereby enforcing and regulating transactions, which in turn ensures that contractual and regulatory parameters are not breached. Ethereum extends blockchain by supporting the development of distributed applications.

Streamline processing

The blockchain is a shared, distributed ledger that enables interactions between parties to take place on the shared ledger. This eliminates the need for intermediaries that previously provided ‘trust’ or clearing house services. The overall effect is streamlined process flow and the removal of human intervention. This reduces the time taken from initiation to completion, which in turn reduces cost. The reduction of human interaction further reduces cost by eliminating human errors.

Business processes that involve numerous handoffs and in particular wait states are likely candidates for automating with a distributed application on blockchain.

There are numerous real world examples of processes that fulfil this criteria particularly, but not limited to, financial services. Examples are mortgage applications, insurance claims, and securities settlements.

Trust

With blockchain Trust can exist between parties where it would not occur naturally. Blockchain is a technology for creating databases shared by multiple non-trusting writers who input and modify data records directly. Transactions can be independently verified and processed by every node in the peer-to- peer network. Smart contracts have a further advantage in that these can include embedded rules that can ensure that transactions adhere to agreements.

These rules are different from traditional database constraints, because they relate to the legitimacy of transformations rather than the state of the data at the time. Every transaction is checked against these rules by every node of the network. Those that fail are rejected and not added to the blockchain.

When transactions are executed and settled on a distributed ledger, counterparties do not need to have an established trust relationship. When counterparties trust the blockchain, they need not trust each other. Therefore transactions that require establishing trust beforehand can benefit when adapted to blockchain.

Disintermediation

Blockchain technology eliminates the need for a trusted third party to act as a central clearing house or the trusted intermediary. Having to rely on a trusted third party can slow down transactions, and add cost. In addition intermediaries are not always that forthcoming about sharing data, whereas the blockchain does not conceal information from any of the parties transacting business.

Visibility

Blockchain technology has been described as anonymously transparent. Every transaction is recorded on the shared ledger. The legitimacy of every transaction is verified by a decentralized peer-to- peer network of computers, effectively eliminating the risk of manipulation by a third party. This enables trust in a way that was previously hard to achieve.

Auditability

All transactions are recorded in real time on a shared ledger. This eliminates the need for each counterparty to produce separate reports that then need to be reconciled. Reconciliation is automatic and continuous therefore blockchain enables all parties to produce reports for any reporting period right up to the current minute with the shared transaction data.

Who benefits?

Aside from intermediaries, all counterparties interacting in blockchain transactions benefit to a greater or lesser degree and in proportion to their degree of involvement. The market that is the most likely to adopt smart contracts on blockchain is financial services. Most financial service transactions are conducted between a number of counterparties and these interactions are governed by agreements and regulation. Historically, financial services has tended to build new technology on top of old technologies and efficiencies have not necessarily been realised. Smart contracts on blockchain is an opportunity to build in efficiencies from the ground up.

By teamblockchain On Thursday, February 16 th, 2017 · no Comments · In Blockchain basics