Chris DeRose is a Bitcoin evangelist, public speaker, community director at Counterparty Foundation, journalist, and software developer. In this feature, DeRose examines the potential and problems of smart contracts, autonomous financial products that some market observers see as a key application of blockchain technology. As the study of “smart contracts” began to transform from an unfamiliar academic curiosity to cutting-edge financial technology, the vast majority of market observers were wondering how this revolution in value transfer would play out. For those who don’t know about smart contracts, a smart contract is a small code attached to an asset that will determine where and how the bound asset will operate based on events in the network. The potential for financial instruments to automatically flow through the economy is huge, which will no longer require the intervention of a custodian. But how exactly does such a technology work? And how are smart contracts different from other solutions for similar financial logic that have been prevalent in our modern banking systems for at least a few decades? The invention of the Bitcoin blockchain was a huge breakthrough that made the innovation of smart contracts possible and has continued to advance its development. Before Bitcoin, the concept of programmable money was just a pale hope. After all, any programmable currency will eventually be overturned by regulators who control the funds involved, which means that overriding routing restrictions will overturn all network functions. The upper layer system is necessarily designed so that any programmatic logic can be used to control fund holders. Such contractual restrictions leave little room for feature development because it removes the middleman and ensures regulatory arbitrage. However, through blockchain technology, only the two parties involved in the "contract" have the right to control the funds. When the contract takes effect, these funds will be determined by the blockchain allocated to this contract. No party has the right to control these funds before the terms of the contract expire. By removing the third-party contracting agency, no party or party to the contract can control or change the assets during the contract formulation or approval stage. Target Market But who would need such a service? Who would seek such an unchangeable settlement environment, and can it really improve efficiency? Yes, any institution that supports the removal of funds custody will benefit from it, and they will improve efficiency by using the functions of the blockchain. Or, better yet, these features will create efficiencies in the underserved world where there are no people or institutions providing custody for these funds, or worse, some companies will find many problematic institutions with no insurance or verification of custody. Currently, two different kinds of “blockchains” compete for this market: public blockchains, such as Bitcoin, and distributed ledgers (sometimes called “private blockchains”). However, both systems have deficiencies in their current forms that limit their ability to find widespread application. Private blockchains are clearly less efficient than smart contracts in many ways. First, bearer assets are not backed, so value of any kind cannot be held in escrow. This means that while a “distributed ledger” or “private blockchain” can determine how funds are transferred, there are still barriers to change and regulation when funds are transferred through an upper-layer network. This raises the question of why fund managers don’t just run a user’s code on their own servers, perhaps with an encrypted verification number. But as of now, users don’t need such a feature to register assets, and who knows if moving forward will actually improve efficiency. If you believe that “blockchain” is a digital asset invented by Satoshi Nakamoto, then public blockchains will demonstrate the efficiency of all smart contracts. However, these systems are also blocked by significant technical obstacles. Fundamentally, the concept of “fungibility” remains a large part of the burden of these systems, as it is assumed that securities that are reversible by custodians will still allow regulators and coordinators to place roadblocks in the execution of smart contracts. So far, only the Bitcoin blockchain has addressed this obstacle, with remarkable developments in “confidential transactions” and even “coin connectivity”. Another obstacle that has sparked much debate in the public blockchain space is the “hash power” of a public blockchain. In simple terms, this hash power represents the amount of energy burned to obtain a blockchain. As the financial benefits of executing contracts on public blockchains increase, there is a greater incentive for attackers to disrupt the blockchain. For Bitcoin, the cost of disrupting its blockchain is approaching $1 million per day, which is horrible, although still small compared to the ambitions of many large institutions. For comparison’s sake, Ethereum, the second-largest public smart contract platform, burns about $25,000 in “hash power” per day. Need to keep up the good work While the potential for automation and efficiency in this emerging field is enormous, both aspects of the technology remain largely unproven and frequently present important flaws in our current implementations. One flaw in the current design of blockchain is that the code in smart contracts needs to be public to everyone on the network. For many financial transactions, this vexing limitation means that once funds are held in escrow, non-participating parties on the network will be able to actively trade on results that were previously unavailable, which can have adverse effects on the stakeholders in the contract. This means that a non-participant in a blockchain smart contract may hoard or sell an asset through information that it previously had no access to, resulting in a trade loss for one of the parties in the contract. At the same time, smart contracts are necessarily slow due to their distributed nature across the network. While many in the private distributed ledger world like to brag about their transmission speeds by blockchain standards, in the upper system world of trading registered assets, these transmission speeds are as slow as glaciers. Smart contracts may find their initial niche in underserved areas or among hobbyists, just like Bitcoin did. While banks will rush to this technology with the same enthusiasm as they did with blockchain, they will eventually find that traditional messaging systems have advantages in clearing strategies not only for confidentiality of information, but also for high throughput and reliable delivery requirements. Smart contracts are the most transformative technology we have seen in the financial services industry since computer data processing. However, there are many large hurdles to overcome before these capabilities can be realized. Fortunately, breakthroughs in blockchain technology have finally brought smart contracts out of academia and into the financial technology space, bringing together some of the world’s most talented minds who are working hard to make this amazing innovation work for the needs of modern financial institutions. | 
