We’ve discussed the role of “smart contracts” in blockchain technology briefly on this blog, mostly in terms of their limitations in governing a complex organization like the ill-fated DAO. But they are highly useful in many cases where contracting parties lack a strong ex post enforcement mechanism (like a court system) and need to pre-commit to not defrauding or otherwise taking advantage of each other when executing a contract.
Smart contracts are typically defined as any agreement whose execution is automated, usually by computer code. For example, I could agree to a smart contract with a local library stating that if I do not return a book by a certain date (assuming the library scans a book as it is returned), the cost of the book will automatically be charged to my credit card. In contrast, under a traditional contract, the library would send me a bill, which I could choose to not pay in violation of the contract. In the extreme case, the library could resort to legal means to force me to pay.
One important distinction is that under the smart contract, I have pre-committed to paying the penalty should I not hold up my end of the deal. Such pre-commitments can have even more teeth when using cryptocurrencies. In my example, I could still call up my credit card company and dispute the charge. But if instead, bitcoins were transferred from my wallet to a wallet controlled by the library, the transaction would be irreversible.
In a recent paper published in The Georgetown Law Technology Review, Max Raskin points out that the combination of smart contracts with blockchain technology serves as a substitute for third-party contract enforcement. Rather than a third party determining that I am delinquent on a bill and forcing me to pay, ultimately through the coercive power of the government, a blockchain establishes the consensus that the portion of the contract requiring me to pay for the book should be executed, and the charge happens automatically based on pre-agreed-upon terms.
These pre-commitment strategies are useful in mitigating some types of fraud. Smart contracts based on multisignature-escrow Bitcoin wallets, such as the system employed by blockchain-based retail platform OpenBazaar, can go a long way in allowing a buyer and seller to commit to fairly executing a contract. Noah Driggs points out that many contracts in corporate governance are also pre-commitment devices—for example, to preclude management from behavior that isn’t in shareholders’ best interests. Smart contracts have a great deal of potential in this area too. Smart contracts, and their inherent pre-commitment devices, will likely go a long way in driving blockchain technology beyond the realm of simple cryptocurrency transactions.