Nick Szabo: Smart contracts differ from traditional contracts and their use

Hi, I’d like to introduce you to smart contracts. I coined the term in 1993, and its meaning has evolved in different ways since then.

Let me start by talking about why smart contracts are necessary. Traditional contracts are the result of integrating different people and things to produce goods and services that create value for others. A car engine, for example, is made up of thousands of different parts. If it’s impossible to produce so many components in one plant, because it involves so many different areas of expertise, we have to create contracts where we outsource the production of a component to someone else, and they outsource it to someone else, and it’s a network of contracts. So for every transaction, a contract is made.

In a typical contract, there are two parties, Bob and Alice, who want the deal to benefit them, so they need to create a win-win situation. Under contract law, people make rules about relationships, and they can make their own rules about business. Trading requires rules, and sometimes you can control assets by rules, and if there’s a lawsuit that involves control of money. Contract law is the basic layer or basic agreement of the whole society, no matter enterprises, economy or other societies depend on the existence of contract law. Contracts have actually been developing in Europe and elsewhere since the Middle Ages, when there was a new kind of contract in the Mediterranean world called insurance contracts. Traditional contracts were very simple, usually one page long, not as complicated as today’s contracts. We create smart contracts for the same reason as traditional contracts — to create win-win deals.

So why use smart contracts? Because dry code has an advantage over wet code. Smart contracts are dry code, whereas traditional lawyers, traditional contracts are wet code. Traditional contracts are based on contract law, which is largely based on subjective perceptions and analogies. Smart contracts are based on software, which is built mostly on bits. Traditional contracts may face legal constraints in terms of security, software features based on replication and cryptography, and other computer science, they are also very powerful. The law is flexible in terms of predictability because it involves human judgment, which can be a good thing, but it also means that sometimes there are vague judgments or bugs, but the software is fixed and rigid. In terms of maturity, the law has been polished for hundreds of thousands of years, and software and smart contracts are relatively new and less experienced, so I suggest that we look at the design patterns of the law to see if we can learn something. While traditional law is generally artificial, local, and uncertain, public blockchains tend to be automated, global, and unforgiving.

Some people think that smart contracts are just computer programs running on a blockchain. That’s fine, but that’s not the definition, and I’ll give you my take on that. Ethereum’s contracts are still central to smart contracts, controlling assets, controlling what happens in what circumstances, affecting incentives. It also requires people to agree, and for people to agree it requires a user interface, such as search, for both parties to find each other, and the ability to negotiate and customize the contract. There is also execution monitoring, where users can monitor each other’s execution of contracts. Part of it is down the chain, and that is the testing that is done, for example, with marketing on social networks, to see if at some point in time such an event is actually taking place. There are some things that we can verify on the chain, like payment of tokens.

There’s a lot more we can do on blockchain. Smart contracts can be customized and negotiated. Here with two negotiations forward contracts, for example, you will see the exchange can only handle some standard contract, and exchange is not trust to minimize, decentralized market, it may have to sacrifice a lot of security, or even slower response time, so the order record is hard to escape from centralized mechanism, Buying and selling records are meaningless if the volume is small. If the transaction is on a blockchain, then the whole transaction life cycle is like this. For Bob, it’s a smart contract. First there’s the search, there’s the negotiation, there’s the execution of the contract, and then the execution of the contract may be collateral management or arbitration, etc. At the contract execution stage, we can see clearly whether the parties have fulfilled their obligations, paid their money, delivered their products on time, etc.

If you look at the innovation in the transaction stage, there are many innovations in the transaction stage, like Amazon, Uber, Google. For example, Uber in the search phase has a map that tells you where the driver is, you know where there’s a car to pick you up, GPS tells you where the driver is, so you can match, it’s a match between the user and the provider. You either accept it or you don’t accept it at the negotiation stage, which is a price matching algorithm. In retail is generally you accept or do not accept, because the cost of bargaining is relatively high. Uber is a little more flexible here, allowing for cost differences, such as different prices at different times. So as long as both sides agree on the cost, they don’t need to haggle. So in the execution phase, there’s encrypted credit card payments, and there’s GPS to verify where you actually went. The post-execution stages include scoring, refund, etc. Uber scores drivers and fires them if they misbehave, using an algorithm that improves the overall efficiency of transactions.

Smart contracts also apply to cash flow products. By putting traditional assets like bonds and stocks on the blockchain, bypassing traditional financial information carriers, more cross-border investments can be made, which reduces transaction friction, minimizes trust, and makes the world seamless. Right now cryptocurrencies and tokens are worth over $140 billion, but there’s no backing from Wall Street, there’s no backing from central institutions. Although GFA, a finance-focused contract firm, defines a smart contract as a program, it is also a human relationship, so we also want people with expertise to negotiate smart contracts.

Bringing together fixed income, loans, over-the-counter transactions, options, forwards, we’ve built tools to reduce the trust intermediaries for these transactions, and that’s the public chain. Those who are not programmers with financial expertise can write smart contracts on the chain. There are 12 million professional programmers in the U.S. right now, but financial professionals far outnumber programmers, so take advantage of this huge pool. There are very few people who understand both finance and programming, so we focus on non-programmers with financial knowledge. Smart contracts can be negotiated, you can take some inspiration from contract law and traditional contracts, and you can see that Alice can make an offer, Bob can reject an offer, Bob can accept an offer, and it’s very similar to the old contract form. Smart contract can also be customized. In the process of smart contract partner, Alice and Bob customized the smart contract. So smart contracts are trust minimization of simple transactions, very straightforward, can be used for loans, forward, mutual, contracts for difference, and so on.

There are two human elements involved: Composer, which is the UI for smart contract negotiation; Performance Manager, which is the PI for smart contract execution checks and asset account monitoring, these paired transactions forma natural online marketplace. The market here is not a record of buying and selling, it’s a network of bilateral contracts that exists in the economy today, and I think that’s the core of smart contracts, and that’s where we’re going. We want to create pairs of transactions so that there is a spontaneous network around the world, so that there is no friction for transactions around the world, so that transactions can be seamless around the world. Offshore mutual funds, depositary receipts and ETFs have poor liquidity, high costs and poor permeability, so it is difficult to make cross-border investments. For example, argentines or Chinese find it difficult to invest in other countries, but with high investment demand in emerging markets, they don’t have access to the most reliable investments in the world. Our solution is to safely reflect the most important characteristics of financial assets on the blockchain. We have been thinking about how to make cash flows that do not require so many trusted intermediaries, so we take full advantage of the power of cryptocurrencies and smart contracts to significantly reduce the risk of intermediaries and counterparties.

Up here you see depositary receipts, which are actually a very common way to invest in foreign stocks. Now there are a lot of trade friction, such as depositary receipts particularly illiquid, but volume is very big, but also involves the international political risk and counterparty risk, because it is a private bank, transparency is poor, moreover also involves cross-border contracts, so don’t know where to go when there are disputes for prosecution. Through a blockchain-based solution like ours, these problems described above can be solved. We can use highly liquid market prices to make decisions, which reduces political risk and allows cash flow transactions to arrive in a timely manner, rather than waiting weeks.

I know a lot of people are developing blockchains, and I have my own wish list. I want blockchains to be globally seamless, secure and permissionless, and with simple, conservative governance. The innovation we have now is not to say that there is no governance, in fact we have made a major breakthrough in computer science, it is too idealistic to design a new form of governance, so I still want our governance to be very simple and conservative. As for the software update, I hope it can be decided by people with computer science and technology, without accountants and lawyers to see whether the transaction is legal or not, which will greatly reduce the transaction cost.

A smart contract on a blockchain is a financial discovery service that allows financial assets to move seamlessly across borders. Of course, software cannot solve the problem of wet code, which involves human subjective judgment, such as insurance claims or risk assessment. It involves not only human subjective judgment, but also local support, so it cannot rely solely on blockchain.

Take full advantage of blockchain. Blockchain can’t do everything, and neither can traditional finance. So in order to use the most optimal block chain, we must put the two together, such as cash flow is the financial products and chain blocks, technology integration of the financial industry, if want to be able to use private chain, I think is wrong, purely subjective think public chain can do everything, don’t need any traditional finance, I think this view is wrong. People in the bitcoin and Ethereum world don’t know much about the actual situation in the financial field, and people in the financial field don’t know much about the ethereum or Bitcoin world, and sometimes they may not be able to reach a consensus and fight, which is the cultural barrier. But putting the two together may create the most valuable solution.

Finally, long-standing laws have evolved very well, contract law in Europe, for example, from the middle Ages, has evolved very well, and is much more effective than new invention trading. Our smart contracts can be customised and negotiated just like any normal contract. As for dry code and wet code, we’re still learning when to use traditional contracts and when to use smart contracts. So we also want to transform from a traditional vending machine to a global financial machine, providing financial smart contracts. Thank you.

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