Those who have visited the tax office for some procedural work, surely did not return with pleasant memories. With interesting stories and hair-raising details perhaps, but certainly not with an eagerness to do it again. Perhaps this happens because we are talking about the bureaucracy organization of a specific state, while elsewhere it might be different. However, the goal of smart contracts – which is our topic here – is not simply to improve existing procedures, but to fully replace them. Or so at least claims the “philology” with which it is advertised. We, on our part, try to understand the functions of the new condition that “is coming” and to identify potential points of dysfunction with the existing one.
In issue 14, we provided an initial description, primarily using technical terms, of what blockchain technology is and how it works, through the example of bitcoin – a form of cryptocurrency that is the first and most well-known application of this technology. We mentioned that cryptocurrencies are only one case where this “chain of blocks” technology finds application, and that these two concepts are sometimes mistakenly equated. In reality, a large part – if not the largest – of the discussion and application of this technology revolves around “smart contracts,” which we also first referenced in issue 15, translating a text that dealt with their relationship to legislative regulations.
Let us briefly note some basics, so that it will be easier for those who encounter this topic and its terminology for the first time to read what follows. Essentially, blockchain is an “accounting file,” a database in which transactions/movements between two or more parties in a network/community are recorded. The difference from traditional forms of such bureaucratic tools that we are familiar with (accounting books in a bank or hospital registries—whether in digital or paper form) is that in blockchain, this database does not exist centrally somewhere. It exists on every node of the network and, through various techniques, algorithms, and cryptography, its validity and security are confirmed. In this way, transactions become more direct and more reliable—or so they say—since there is no intermediary guarantor beyond the “neutrality” of the machine. Reading the article in issue 14 would help significantly in understanding this operation better, although in this specific case, several key elements will be highlighted and repeated—intentionally or not.
“Smart contracts” are coming (to be precise, they have already arrived, they are claiming space and time in discussions and practices concerning social organization, they occasionally show their faces but continue relentlessly, since according to experts, they represent the great upcoming change) to provide a solution to what many consider impossible to achieve any longer by people and the way they have structured their societies: the creation of a trusted, fair, transparent, incorruptible, etc.-etc. entity, which would confirm their transactions with each other and – why not – their relationships with each other. Since interests (individual or collective), corruption (at all social levels), and ultimately the inadequacy of human ability and subjectivity to build something like this are obstacles to achieving this goal, we must turn to something more objective. And what could be more objective than the language of the machine that “thinks” (processes, to be precise) with mathematical accuracy and “neutrality”?
The ideology behind blockchain and smart contracts has as its main concern the “elimination” of the trusted third party, which as a bureaucratic institution (a combination of paper trails and hard drives with the human factor) has now become obsolete. What we need now are regulations written in a highly objective language, without room for misinterpretations and alterations, that will be executed directly and automatically on the same logic.
In practice, it is evident that what is happening is replacement and not cancellation of the intermediary. In an agreement between two people, the third party who comes as a guarantor does not only have the role of mediator in this relationship. But along with this role, or even more so because he has this particular role, he carries with him a burden of responsibility. The assignment therefore of responsibilities of various disgruntled parties and at the same time their projection onto the institutions of bureaucracy (whether of the state or of capital), can, in the not so distant future, be shifted towards machines.
what are smart contracts
IBM, one of the key players in the field of blockchain and smart contracts, supports that blockchain is something more than technology. It is a “movement” that will redefine business relationships through trust, transparency and a new way of collaboration.1 The applications of IBM blockchain vary from applications for the public good, simplifying the processes needed to restore those who survived Hurricane Harvey, to applications for a new economy, rationalizing the food supply chain – from the field or the sea to the shelves of supermarkets and our tables. As a passionate supporter of this technology, IBM presents it with all the enthusiasm one would expect from an advertiser of any product:2
Have you ever bought a car? If so, then you have experienced this intense discomfort caused by the process of these complex transactions. Many leaders in the automotive industry feel the same discomfort and are exploring how the use of smart contracts on the blockchain can alleviate it.
Smart contracts are lines of code stored on the blockchain that execute automatically when certain predefined terms and conditions are met. At their most basic level, they are programs that “run” in the way defined by the people who designed them. The benefits of smart contracts are more evident in business collaborations, where they are used to enforce some kind of agreement, so that all participants are certain about the outcomes without the involvement of any intermediary.
Blockchain is a shared, distributed ledger where transactions are digitally recorded and linked together to provide the complete history or origin of an asset. A transaction is added to the blockchain only after it has been verified as valid by a consensus protocol, ensuring that it is the only version of the truth. Each record is also encrypted so that there is an additional layer of security. Blockchain is said to be immutable because records cannot be changed and transparent because all participants have access to the same version of the truth.
The easiest way to explain what a smart contract does is through an example. If you have ever bought a car, you know there are several steps and that the process can be tedious. If you don’t have the ability to pay the full amount, you’ll need to take out a loan. This requires a check for your creditworthiness and you’ll need to fill out several forms with your personal information to verify your identity. Along the way, you’ll need to negotiate with various people, such as the seller, the financier, etc. For their work, various commissions are added to the final price of the car.
What smart contracts do is rationalize this complex process, which involves several intermediaries due to lack of trust between the transaction participants. With your identity stored on the blockchain, lenders can quickly decide on credit. Then a smart contract will be created between your bank, the merchant and the lender, so that after the money is released to the merchant, the lender will hold the title of the car and repayment will begin based on the agreed terms. The transfer of ownership will be automatic as the transaction is recorded on a blockchain, will be shared among the participants and can be checked at any time.The benefits of smart contracts go hand in hand with those of blockchain:
- Speed and accuracy: Smart contracts are digital and automated, so there is no need to spend time processing paperwork or correcting errors that often appear in manually completed documents. Computer code is also more accurate than terms drafted in traditional contracts.
- Trust: Smart contracts automatically execute transactions following predetermined rules and the encrypted records of these transactions are shared among all participants. Thus, no one needs to wonder if the information has been altered for personal gain.
- Security: Transaction records on the blockchain are encrypted, making them very difficult to tamper with. Because each individual record is linked to the previous and next record in a distributed ledger, the entire chain must be altered to change just one entry.
- Savings: Smart contracts eliminate the need for intermediaries because participants can trust the accessible data and technology to correctly execute the transaction. There is no need for an additional person to confirm and verify the terms of an agreement, since these are embedded within the code.
the promises of smart contracts
Perhaps a bit more realistically, but within the same optimistic framework, the Foundation for Economic Education explains “smart contracts” and their functions:3
Stan: Jerry, there’s no way we’re giving you 750,000 dollars like that.
Fargo (1996)
Wade: What the hell are you thinking? If I’m only going to earn the interest rate that banks offer, I might as well go for full security. FDIC4 damn it. I don’t see anything resembling that here..
Jerry: Yes, but I – ok, I will.. guarantee that you get your money back.
Wade: I’m not talking about your damn word, Jerry.Fargo is basically a movie about promises, direct or indirect. It deals with keeping promises, even at the cost of personal gain. What makes the movie gripping is that many of the promises are not backed by the legal system – and rightly so, because they are illegal. Fargo poses the question of whether we can trust each other even in the absence of a governmental force that compels us. Put differently, can we make contracts based on our natural condition? Hobbes, in 1651, argued that we cannot:
“A contract in which neither of the contracting parties is obliged to act immediately, but there is mutual trust in the mere state of nature (which is a state of war of every man against every man) and without any suspicion, is void. But if there is a force above and beyond both of them, with the right and the power needed to enforce its implementation, then it is valid. For he who will act first has no guarantee that the other will act in turn, because the bonds of words are too weak to restrain human ambition, sin, anger and other passions, without the fear of a coercive power.”
A person can make a promise, but at every opportunity, they could break it and pursue their own interest, a scenario called opportunism. However, business agreements depend on trust in promises, otherwise our society would be limited to instantaneous transactions. Fortunately, there are various mechanisms that can be used to secure a promise, all with their advantages and disadvantages.
For example, we could rely on personal ethics and build trusting relationships only with people who have a strict moral code. Trusting in ethics has the advantage that it does not require any institution or external enforcement, but it also has a serious limitation: it is difficult to know many people well enough to trust them to do the right thing. Also, even the best people may break their promises at some point.
Another mechanism is reputation. Before entering into a contract with someone, we can ask around and learn how their previous interactions went. Reputation is extremely useful in small communities, with repeated transactions, since if someone breaks their promise they will be characterized as unreliable and excluded from future interactions. However, reputation is more difficult to apply when there is interaction with strangers.
It is important to realize that all enforcement mechanisms (of reliability) are simply tools that should be used when needed. Like a hammer or a screwdriver, each tool can be applied to different situations. Thus, as tools, various regulatory mechanisms are subject to evolution. For hundreds of years, since Hobbes’ time, we have considered contracts as legal agreements that must be enforced by the judicial system. However, the court is just one of many ways to enforce commitments, and we must keep the possibility open for further improvement.
Such an example of technological improvement is the invention of smart contracts. Smart contracts are a new mechanism for keeping promises, allowing us to make reliable commitments to each other on the blockchain, including commitments with strangers from other countries. To be more precise, smart contracts are not legally enforceable, but this is part of their unique advantage. The commitments of smart contracts are governed outside the law, outside legal jurisdictions, without state enforcement.
Given that our legal jurisdiction is limited to geographical borders and many countries have fragile or unreliable legal institutions, this represents tremendous social progress. This means that with an Internet connection, someone from one of the poorest countries in the world can conduct business transactions and make reliable commitments with someone in the US, as if they themselves were American. By creating trust where there is none at all, the world will become more open than ever before.
A smart contract can be as simple as transferring money from one account to another after a certain period of time, or it can be something much more complex. However, a significant limitation is that smart contracts can only transfer digital assets as defined on a blockchain, such as cryptocurrencies. Nevertheless, even contracts involving actions with physical objects can potentially be applied, by creating commitments that will be lost if the promise is not fulfilled.5
Another limitation is that smart contracts cannot access external information unless it is written on the blockchain. For example, a smart contract does not have access to weather data. To create a contract where a parameter is temperature, someone third-party needs to receive the data and write it to the blockchain. This reliable data source is called an oracle.6
Smart contracts have many limitations. However, we tend to forget that courts also have limitations. We should not compare smart contracts with an idealized version of contracts enforced by courts. If we look critically at both, it is clear that court-enforced contracts have inherent deficiencies. Firstly, access to the judicial system is on a “queue waiting” basis, so there are many who wait in line just to use the service. This means that some cases may last for years or decades. Due to this slowness, businesses often use private agreements in their contracts, which allow them to negotiate outside of courts.Another overlooked constraint of the judicial system is that because the court is an external third party, it can only guess the actual damages in case of breach of contract. This is problematic because it is the court that determines what will be given to the injured party.
The solution is for the contracting parties to explicitly write their damage assessments in the contract. However, courts may decide not to enforce these damages if they consider them unfair. Therefore, even in countries with the best institutions, contracts enforced by courts have inherent and paternalistic constraints.Smart contracts are not legal contracts and in many cases may not be a good replacement for them. However, they are a valuable tool in our limited toolkit. They allow us to make commitments – even with strangers – without state enforcement, something that for hundreds of years was considered impossible. In the coming decades, smart contracts will give people around the world the power to enter into agreements with each other, despite corrupt and bankrupt institutions, and thus transform the lives of millions of people.
some examples
We briefly outline some of the cases in which smart contracts can be applied:7
Government/Elections: Insiders support that it is extremely difficult to tamper with the voting system, however smart contracts will reduce all concerns by providing an infinitely more secure system. Votes protected on the blockchain should be decrypted and it requires excessive computational power to be altered. No one has that much computational power, so it would take God himself to hack the system! Secondly, smart contracts will increase low voter turnout. Much of the inertia comes from this clumsy system that includes waiting in line, presenting identification, and filling out forms. With smart contracts, voting can be done electronically and younger people will participate massively.
Management: Blockchain doesn’t just provide a “ledger” as a source of trust, but also corrects possible flaws in communication and workflow due to accuracy, transparency, and automation. Usually, business activities must undergo a back-and-forth process while waiting for approvals for internal or external issues. A blockchain “ledger” streamlines this process. It reduces deviations that typically occur with manual processing and that can lead to costly lawsuits and settlement delays.
Automotive industry: An example is autonomous vehicles, in which smart contracts could activate an “oracle” that would determine whether the sensor, the driver, or many other factors are responsible for an accident. Using smart contracts, an insurance company can charge different rates based on where and under what conditions customers use their vehicles.
Real Estate: There is room for greater profitability with smart contracts. Usually, if you want to rent out your apartment to someone, you need to pay an intermediary, such as a newspaper, to advertise it and then an escrow agent for funding and rent payment. The blockchain bypasses all of this. All that is needed is payment via bitcoin and encoding the contract on the blockchain network. All users can see the contract and if they are interested, its fulfillment is done automatically. Everyone involved in the real estate field can benefit.
Healthcare: Personal medical records could be encoded and stored on the blockchain with a private key that would allow access only to specific individuals. The same strategy could be used to ensure that any research is conducted in accordance with HIPAA laws8, in a secure and private manner. Evidence from surgical procedures could be stored on the blockchain and automatically sent to insurance providers as proof. Blockchain “ledger files” can also be used for general healthcare management, such as drug oversight, regulatory compliance, test results, and the management of healthcare supplies.
Supply chains: Often, supply chains are trapped in a paper-based bureaucratic system, where various forms and documents must go through multiple confirmation stages, which increases exposure to errors and corruption. Blockchain eliminates these disadvantages by providing a secure digital “ledger” that is accessible to everyone in the chain and automates processes and payments.
A special category of supply chains, which industry leaders are actively engaged with, is that of food9. You can watch a “fun” video10 describing the implementation of Hyperledger Sawtooth Lake, presenting an example where Rich, a fish tavern owner, wants to know what quality of fish he serves to his customers. Until now, he only trusted two suppliers he had worked with for years, which limited his ability to expand. However, with this technology, which uses blockchain and IoT sensors on the fish, he can be certain of all the details of each sea bream, from where it was caught to the storage conditions and temperature fluctuations. Thus, he can trust all suppliers participating in the platform, without needing to know them personally or worry about the remaining details.
Continuous monitoring of the fish’s biometric data, from the ocean to our plate, is therefore essential, since “we are what we eat” – right? What could better express and simultaneously address concerns about how well we know what we eat? Let’s just hope they remember to remove the sensors before serving them, because some strange results might emerge over time!
collision with reality: the failure of “The DAO”11
All of the above sounds great, but what happens in practice? It is known that most of the time there are deviations between theory and practice. However, in the case of ideology, these deviations seem to grow considerably. This is what happened with the first attempt to create a decentralized autonomous organization (Decentralized Autonomous Organization – DAO), “The DAO” in 2016. Let’s take things from the beginning.
The idea of a decentralized autonomous organization had been formulated very early on with the emergence of cryptocurrencies. Thus, the appearance of advanced blockchain platforms with built-in capabilities to be programmed at will (such as, for example, programming the terms and conditions of a smart contract) gave enthusiasts of the subject a practical way to approach their dream. The first and still the most well-known platform of this kind today is Ethereum, which is described as a “Turing-complete”12 distributed computer. Just as Bitcoin is “built” on the blockchain, whereas miners in Bitcoin confirm transactions, in the case of Ethereum they confirm and “run” executable program code. For example, if an application (such as Photoshop) “runs” its code on our computer so that we can use it, in the case of Ethereum this code “runs” distributed across the nodes of the blockchain network.
In the authentic vision, as described by Ethereum creator Vitalik Buterin, DAOs are pseudo-legal entities that operate through a combination of human and robot. The robots are algorithms that “run” on the distributed Ethereum blockchain and automatically respond to inputs based on programmed rules. The inputs can come from fully autonomous sensors (e.g., digital thermometers), online data (e.g., changes in a stock’s price), or even external actions from the physical world by humans or oracles. A DAO implements the corresponding actions and decisions, based on the inputs it receives and the logic with which it has been programmed, in an irreversible manner since all moves are recorded in the blockchain “ledger”. Possible actions may include transferring cryptocurrencies, presenting a calculation, or even activating another program or an IoT electromagnetic device.
“The DAO” was meant to become a decentralized, user-funded (crowdfunded) and directly managed (or direct democracy as they call it) organization and investment platform. Something similar to Kickstarter, a platform where anyone can present their idea and those who want to contribute to its funding, with the difference that it would be decentralized and would have all the characteristics we have described for the blockchain and “smart contracts”.
While there have been and still are various DAOs, this was the first large-scale one that would “run” on Ethereum, with expectations to eliminate/absorb the rest, due to size and “optimal technique”.
For the first funding of the project, a 28-day time frame was given, starting from April 30, 2016, where interested parties would fund it with ETH, the cryptocurrency used in Ethereum. In exchange, they would receive the corresponding DAO tokens, with which they could vote/fund the proposals that would appear in “The DAO”. Members who had the most tokens would also have greater influence on one or the other project seeking funding.
Also, the funders of “ideas” in the DAO would have a more active role in managing them, compared to other online funding platforms where users/investors simply financially support each project. Since all proposals are made in full transparency through automated predefined processes, investors could vote, through funding or not, on whether an employee would be hired or not. Or even pay them directly, with the amount that would be co-decided automatically via voting/funding.
It is estimated that during the 28-day period set for the funding of “The DAO”, between 10 and 20 thousand user-investors contributed. A total of 11,994,260.98 ETH was raised, which was 14% of the ETH in circulation at the time, valued at approximately 250 million dollars according to the then exchange rate, breaking all records for such funding efforts.
This was followed by discussions regarding which project would be the first to be funded through “The DAO”. By far the most popular—and ultimately selected—project was that of the company Slock.it, which was also among the main funders of “The DAO” itself. The idea was to design and implement “smart” locks that would be used for automated access (or denial of access) by property owners to tenants, similar to an Airbnb-style service.
In the following days, concerns were raised regarding the security of this system by various prominent members and researchers in the cryptocurrency community, however, these were based on game theory, essentially on probabilities and not on any specific technical bug. But a little later, a few days before the official launch of “The DAO”, such a technical bug was discovered and disclosed, named “race to empty”. The founder of Slock.it, Stephen Tual, stated that once the system is operational, it has gained its autonomy and any attempt to tamper with the code to fix the bug should be done based on the rules. That is, the majority of shareholders should vote for the change and subsequently the Ethereum miners should confirm and implement it.
This bug essentially allowed a user to recursively call a withdrawal function, without waiting for the account balance to be confirmed by the network each time, thus collecting as many tokens as possible. In the end, however, they would not be able to withdraw the “gains” from the network, because there were still some additional security locks, such as a limit of a few days before disconnecting any account, along with the corresponding redemption of cryptocurrencies. This specific flaw had also been identified in a smaller DAO, whose creators had warned those of “The DAO”.
An announcement was made by Slock.it that an updated version, which would fix the bug, would be released soon, but until then the project’s operation would continue as originally planned, reassuring users-investors not to worry and that their digital funds were safe. On June 17, 2016, an unknown user exploited this flaw and the “The DAO” fund began to drain. By the time it was stopped, 30% of the ETH had been drained.
As one can imagine, panic prevailed in the following hours. Founders, developers and generally all those responsible for the “project closed” themselves in a private digital channel to see how they would react. They contacted the responsible parties of cryptocurrency exchange points, where the perpetrator could possibly convert the ETH into physical money, to urge them to freeze any transaction with the specific characteristics. They initially refused because something like that would affect their reliability, but because the issue had to do with 250 million dollars and an “existential crisis” of the entire Ethereum platform, they eventually agreed. Finally, the leak was frozen and a new round of discussions began about what should happen next. And here is the interesting part..
The core developers, along with the majority of users-investors, proposed and ultimately implemented what is called a “hard fork.” Essentially, this involved cutting the blockchain chain right before the point of the problem and restarting it with new terms and rules. However, this approach faced opposition from several users, as the “actor” himself declared in a letter of questionable credibility, stating that “The DAO” is defined by its code, and exploiting the technical flaw was nothing more than a smart move based on the rules. Since it had been agreed that “code is law,” any attempt to reverse this action would be morally wrong and contrary to the very spirit of decentralized autonomous organizations. As a result, those who disagreed continued the existing blockchain without implementing the proposed changes and named this new project Ethereum Classic. The discussion regarding DAOs and their prospects, which had previously been at the forefront of the blockchain application field, began to fade away.
epilogue
Viewing the law as code facilitates its reversal, that is, the claim that code can become law. However, for this reversal to occur, the elements that make law something more than code must remain outside. Such as the process of definition, formulation, interpretation, and ultimately the application of a law. Also excluded are the conditions that preceded each law. Additionally, all behaviors and transactions or compromises that arise at a broader social level, which has its own unwritten rules, must be cast aside. More on this in the next issue.
We recognize that the proponents of this new digital governance do not yet claim that all before, after, and in-between must be replaced by code – not yet. Attention for now is focused on bureaucracy and its application. However, as was the case with the creation of the legal system and traditional bureaucracy, so too will the new paradigm influence, directly or indirectly, everything around it, supporting the trend toward universal mechanization. And certainly, within the framework of codification, where all parameters must be explicitly declared and all functions are confined to conditional statements of the type “if this happens, then do that,” there is no room for exceptions.
Wintermute
- More here: https://www.ibm.com/blockchain ↩︎
- We copy from: What are smart contracts on blockchain? ↩︎
- The Promise of Smart Contracts – Foundation for Economic Education (https://fee.org/articles/the-promise-of-smart-contracts) ↩︎
- Federal Deposit Insurance Corporation – Federal Deposit Insurance Company. ↩︎
- STM: Refers to cases where “smart contracts” communicate with devices in the physical world, usually IoT (Internet of Things) devices, such as for example a “smart lock” that locks when the tenant has not paid the rent. ↩︎
- Stm: Look, we can’t get away from this third-rate guy! Don’t worry though, the futurist advocates mention that these details will be resolved with Artificial Intelligence and the Internet of Things (IoT). ↩︎
- Here’s How You Can Use Smart Contracts ↩︎
- Health Insurance Portability and Accountability Act ↩︎
- For example, the IBM Food Trust ↩︎
- Introduction to Hyperledger Sawtooth (https://www.youtube.com/watch?v=8nrVlICgiYM) ↩︎
- For the events and timeline of this specific topic, we relied on the publication “Experiments in Algorithmic Governance: A history and ethnography of ‘The DAO,’ a failed Decentralized Autonomous Organization.” ↩︎
- A simplified explanation for Turing completeness is that it constitutes a criterion for what capabilities a language (programming or not) and/or a system (computational or not) has in solving the problems set to it. For example, some computational system (combination of programming language and hardware) is Turing Complete if it has the ability to implement all possible formulated algorithms. If it cannot utilize some algorithm or mathematical model that has been formulated, then it does not meet the requirements for Turing completeness. ↩︎