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The Limitations of Smart Contracts

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By Casey C. Sullivan, Esq. on December 14, 2016 2:59 PM

The blockchain might be the number one tech buzzword of 2016, followed quickly by smart contracts. The blockchain works by creating decentralized, digital ledgers that encrypt, register, and verify transactions. Smart contracts rely on computer programming to create, verify, or execute deals.

Smart contracts have been heralded as the future of contracting, received praise in the legal and tech press, and spawned startups that have earned millions of dollars in venture capital. But, they may not be the panacea some are expecting. Indeed, smart contracts come with some serious limitations.

The Next Big Thing?

First, let's look at how smart contracts work. Instead of relying on clauses and terms negotiated by lawyers, smart contracts rely on computer code that determines when a contract is formed, when necessary conditions have been met, and when an exchange is executed. They're more software than legal documents. As Antony Lewis writes on his Bits on Blocks blog:

The idea is that you can have a normal paper contract with all the "whereas" clauses that lawyers enjoy, and then a clause that points to a smart contract on a blockchain, saying "this is what we both agree to run and we will abide by the results of the code."

That code is distributed and replicated on a decentralized blockchain ledger that reaches across many computers. Those computers run the code and come to consensus about the results.

Why would this be beneficial? For one, increased certainty. Code lacks the ambiguities of human language and because execution is decentralized, there's less risk of individual error. Another reason is security. While you can forge an electronic contract, a smart contract that runs on the blockchain is protected both by powerful encryption and the distributed nature of the system. Finally, there's transparency. Because all participants in the blockchain need to have the same code and need to be able to verify each others' results, the contract code must be shared between all of them.

Smart contracts have yet to be proven in the commercial realm, according to a report by Deloitte, but they could have applications in everything from insurance claim processing to royalty distribution to supply chain documentation.

How Smart Are Smart Contracts?

It's a promising technology, but there is still some skepticism. For one, not everyone is a fan of transparency. Not only can parties to the contract see the terms and their execution, but so can any member of the network.

There's also risk of hacking, as Kevin Gidney, the co-founder and CTO of Seal Software, discussed in a recent piece for Corporate Counsel. Though the blockchain has been praised for its security, a platform connected to Ethereum, a major smart contract player, was recently hacked and $150 million worth of cryptocurrency stolen.

Finally, there are issues with scalability as well. Because smart contract processes run across many computers, the size of blocks in a blockchain is often limited to avoid using too much processing power.

There are potential solutions to these problems, of course. Gidney argues for the evolution from smart contracts to "intelligent" contracts, which mix AI and the blockchain. Companies like Microsoft and Intel are creating additional security measures that could make the technology less hackable. And others are turning to private blockchains to avoid issues with unlimited transparency and processing restrictions.

We'll have to wait and see if these steps are enough to overcome smart contracts' existing limitations.

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