Smart contracts can completely subvert existing business logic. Currently, blockchain technology and cryptocurrencies are widely discussed, yet self-executing smart contracts on the blockchain are often overlooked or even misunderstood.
In the same way that the Internet has revolutionized the way people process information and communicates with each other, smart contracts will also fundamentally change the way individuals and organizations reach and fulfill agreements.
The large-scale application of powerful and reliable smart contracts will be the cornerstone of ensuring the smooth operation of society. Everything in our lives work, play, financial agreements, terms of deals, and more depends on the commitment of all parties to run smoothly. The more watertight the contract is, the smoother the cooperation will be. Therefore, because smart contracts are more secure and more deterministic, it can improve the fairness of society and be more community-centric.
In this article, we will discuss the difference between smart contracts and traditional contracts, and how smart contracts can fundamentally change society.
What is a smart contract?
Smart contracts are highly deterministic, tamper-proof, and reliable digital agreements that run on a decentralized blockchain.
Smart contracts have two major advantages over standardized traditional contracts.
First, records in smart contracts are trusted and sharable. Since the content of a smart contract is so secure that the parties to the contract don’t even have to back it up, this will be of great value to a modern enterprise where there are often multiple departments where workflows arise due to the lack of a single trusted record conflict.
Second, smart contracts are highly deterministic. Sometimes traditional contracts cannot be executed as agreed due to errors or unwillingness of one party to perform the contract. The environment in which the smart contract operates determines that it can be executed in strict accordance with the agreed terms, without the need for approval at every link. If the pre-set conditions are met, the key parameters in the contract will be automatically executed.
How do smart contracts work in the background?
Today, most exchanges require a trusted third party to deal with counterparty risk arising from the failure of one party to a transaction to perform. Trading directly with strangers can be hugely risky and extremely inefficient. Both parties to a transaction have concerns about performance because there is no guarantee that the counterparty will perform the same. As a result, many companies provide a trusted value-exchange intermediary in their business models, including Uber (where Uber matches drivers and passengers), eBay (where eBay connects sellers and buyers), and Nasdaq (where it connects financial products). buyer and seller).
The decentralized architecture of the blockchain removes the middleman in the transaction and guarantees the trust of both parties in the transaction. Blockchain replaces trusted third parties with a more open, reliable and secure protocol that both parties trust, but neither can influence or control. Blockchain replaces centralized servers with a decentralized network of computers running the same software that processes and records transaction across the network in a shared ledger. Distributed computing ensures the accuracy of the ledger, and a decentralized network ensures the security of the ledger.
A smart contract is a scripting language on the blockchain. If/then conditions are added to the script, the transactions on the blockchain can mirror and simulate contracts in the real world. For example, if the price of an asset reaches a certain price on a certain date, a payment to the counterparty is performed. Smart contract developers can write contract terms according to specific requirements.
Then hook the if/then conditional parameters to the external API of the smart contract. For example, the data input to a smart contract can be the market price of an asset at a specific point in time, while the data output can be real- world operations triggered by the smart contract. Data output covers a wide range of topics, including payments, data transfers, account balance updates, access rights, and more.
For such smart contracts, Chainlink is a decentralized network that utilizes oracles to reliably connect smart contracts to tamper-proof APIs. Once a decentralized blockchain and oracles are combined, smart contracts are able to achieve a high degree of certainty and tamper resistance throughout the entire contract execution process.
What value do smart contracts hold?
Traditional contracts are probabilistic, while smart contracts are deterministic. Once put on the blockchain, smart contracts are executed strictly according to the code. Since smart contracts are self-executing, neither party to the contract can change the terms or break the agreement. Whether a contract has certainty also determines whether its payment can be guaranteed. In today’s highly competitive market, companies that can ensure that they pay as agreed will greatly improve their competitive position with customers and suppliers. In fact, the underlying theory behind deterministic contracts is game theory, and game theory also determines that smart contracts will be more reliable and more profitable.
In a world of probabilities, many companies unknowingly or unknowingly default on their contracts. In order to resolve disputes arising from non-performance, companies employ an army of lawyers, accountants and customer service agents to draft contracts, track payments and handle counterparty complaints. Smart contracts can minimize or completely eradicate such problems for the following reasons:
Automatic execution: Smart contracts utilize a decentralized network architecture to automatically execute contract back-end processes, including custody, maintenance, triggering, and settlement. Once the contract code is completed and sent to the blockchain, the contract will be executed strictly according to the blockchain code, and human intervention cannot be performed. As a result, company-related operating expenses will drop significantly over the life of the contract.
Reliability: Smart contracts have a high degree of autonomy, so they are much more reliable than transactions through intermediaries. Since there is no man-in-the-middle, there is no way to bribe or attack the man-in-the-middle , and there are no server downtime issues. Since smart contracts have no compromise mechanism and cannot escape contractual obligations, they are naturally tamper-proof and secure.
Efficiency: Smart contracts are extremely efficient compared to digital agreements executed through third parties. Neither side of the contract has to manually enter data and wait for the other to process it, and there is no need for a middleman to process the transaction. Smart contracts can eliminate human error and disputes between counterparties, thus speeding up the execution of contracts end-to-end.
Which industries are best suited for applying smart contracts?
As stated in the Chainlink white paper, smart contracts are initially best suited for three areas, namely insurance, financial derivatives, and trade finance. In these three industries, trust is paramount, and trust is what smart contracts solve.
Insurance products allow people to engage in risky economic activities that they would otherwise avoid. But because of the lack of trust in the insurance system, people don’t even think to buy insurance. In emerging industries and geographic markets, the outcome of insurance claims is full of variables, and sometimes claims adjusters may not be able to obtain compensation even if they provide sufficient evidence. In addition, the claim itself is time-consuming and labor-intensive, and the management cost of property insurance claims is as high as 24% of the operating cost.
Smart contracts will reshape the trust relationship between insurance companies and customers, replacing human intervention in the process with decentralized networks and automation. The blockchain can record all claims truly and reliably, avoiding repeated claims for the same accident. Smart contracts can also automatically trigger payments based on external data.
For example, many industrial devices are equipped with IoT sensors. Sensors detect equipment failures and automatically trigger insurance contracts that automatically execute and pay corporate insurance customers directly. Businesses can purchase new equipment immediately to ensure business continuity as much as possible. The data proving the occurrence of the event can be transmitted to the contract, so the contract can be strictly executed according to the agreement, and the compensation will be paid automatically. Both insurers and customers can trust tamper-proof data from oracles and automate the execution of tamper- proof smart contracts.
Smart contracts can also be used to automatically calculate premium discounts, such as health insurance discounts based on biological indicators, or auto insurance discounts based on vehicle driving data. Complex premium models take more time to develop, while simple premium models such as travel insurance have already been developed (eg Fizzy by AXA).
2. Financial derivatives:
The financial derivatives industry can also use smart contracts to build trust. The derivatives market is extremely large, estimated to be between $10 trillion and one trillion dollars. The financial derivatives industry has high value but low levels of trust, and parties to transactions may delay payments or simply not pay. In addition, there are inefficiencies in the derivatives industry, resulting in increased costs, such as custody, clearing, reconciliation, manual data entry, and duplication of data.
Smart contracts guarantee on-time payments and automate most of the back-end processing of the contract. It also simplifies operations by eliminating intermediaries and manual processes. In fact, if smart contracts were widely used in financial derivatives, a financial crisis might not happen . Risk can be better managed because companies cannot delay or fail to pay.
Smart contracts are expected to reduce personal loan costs by $480-960, and reduce personal loan costs in the US and Europe by a combined $3-11 billion. If we had smart contracts in 2008, we would have achieved greater transparency and lessened the impact of the subprime mortgage crisis.
Before 2008, people would apply for home mortgages from multiple banks and buy many properties. Financial institutions of all types (banks, hedge funds, and financial corporations) package millions of loans, slice them up, and resell them as investment products. These loans are neither transparent nor true and reliable records.
If smart contracts were used at the time, each loan applicant would have a separate record readily available to read. Each readily packaged into a security product is marked by other smart contracts, which contain millions of small contracts that can be easily accessed and read. This secure, public and truthful record can be assessed in detail by the loan officer to determine whether the applicant is eligible for the loan.
If smart contracts were applied before the 2008 financial crisis, would financial institutions still be abusing credit default swap (CDS) derivatives? This question is worth pondering.
3. Trade Finance:
Finally, the trade finance industry also suffers from inefficiencies and high error rates due to its outdated system architecture. Most agreements still exist as paper contracts, so the process is extremely slow and prone to human error. Using blockchain can help all parties communicate with each other, and smart contracts can automatically trigger payments based on data input such as bills of lading or customs data. If financial institutions can use a decentralized oracle network to obtain more reliable data, they can not only use smart contracts to pay faster, but also recalculate loan amounts for new customers.
Smart contracts will revolutionize countless industries, including identity management, banking/payments, stablecoins, supply chains, real estate/title records, gambling, intellectual property, and healthcare records, to name a few.
While the development of smart contracts is still in its early stages, its real value is clear. Competition is fierce in the real world, so all businesses will pursue lower-cost, higher-benefit contracts. The key question is not “if” these companies will apply smart contracts, but “when” they will. Often, when a new technology first emerges, there may be one or two companies that go all out to create a few successful use cases, and then the entire market follows suit to stay ahead of the competition.
The Chainlink team believes it is only a matter of time before smart contracts become the industry standard. However, if smart contracts are to become the dominant form of digital contracts, they must be decentralized, tamper-proof and reliable throughout the process. Therefore, Chainlink has developed a decentralized oracle system to connect smart contracts to external APIs in a trustless manner, which is necessary for the success of smart contracts in various mature industries.