Smart contracts and blockchain: What happens if the blockchain breaks?

When you receive a chain letter, it usually promises that you will receive great rewards, but only if you don’t break the chain. When you do break the chain, it’s generally because you don’t trust those promises. While blockchain technology offers a different equation, trust in its promises is equally important.

Many within the financial inclusion community have been (understandably) excited about the potential of blockchain and smart contracts to enable greater financial access for customers at the base of the pyramid. Blockchain – which underpins Bitcoin and other cryptocurrencies – is a shared distributed, decentralized ledger technology (DLT) that keeps a permanent record of transactions that take place across a public or private network of computers. (IBM’s Think Academy has a helpful primer on how this process works.) Blockchain could be promising for financial inclusion for a number of reasons, including cutting service costs by eliminating financial intermediaries. Blockchain has already been applied to a diverse array of sectors.

Beyond the world of finance, blockchain has been used in supply chain management, logistics, real estate, distributed energy resources, retail, and even the diamond industry (as part of the Kimberley Process certification scheme). Yet, blockchain is still a relatively nascent technology. Its first widespread use in Bitcoin was first introduced in late 2008. And as with other financial innovations, blockchain poses potential risks that may be difficult to foresee and challenging for regulators to effectively monitor, although some U.S. regulators have already been engaging with blockchain applications in recent years. One use case of blockchain – the smart contract – has been identified as a potential pain point for the broader adoption and scalability of the technology.

On a blockchain, a smart contract consists of self-executing code that automatically implements the terms of an agreement between parties based on certain pre-defined criteria. “Smart contract code”, is stored, verified and executed on a blockchain. As different from other kinds of software, smart contracts are recorded on the blockchain, can control blockchain assets, and are executed by the blockchain. For example, following “if, then” logic, if I want to send $20 to a friend across the country, then $20 will be deducted from my account and transmitted to my friend only if I have the requisite funds. Once I indicate that I would like a transaction carried out, the blockchain and its self-executing code perform the transaction, including seamless/automated digital coordination among the related financial entities, according to the parameters set forth in the embedded smart contracts.

Smart contracts, therefore, reduce transactional risks and potentially other costs – such as manipulation, intervention, manual error, or other inefficiencies created through the involvement of traditional intermediaries and other third parties – through nondiscriminatory transaction execution and validation. All transactions are recorded simultaneously and permanently across the nodes of the entire distributed ledger system.

Within the context of financial inclusion, smart contracts allow users to send remittances across the globe with lower fees than traditional money transfer operators and fewer intermediaries. Smart contracts can also help to provide economic identities for some of the world’s most vulnerable populations, such as refugees and internally displaced persons (IDPs). BanQu, for example, enables individuals to set up a personal digital identification profile and accumulate a transaction history on the BanQu blockchain, creating a footprint for the unbanked to participate in the global economy.

Even with these advantages, smart contracts are not impervious to human error. Smart contracts are only as smart as the programming code on which they are based. Recent attacks on blockchain applications, particularly the nearly $80 million hack of “The DAO” – a crowdsourcing venture capital platform based on the Ethereum blockchain – in mid-2016 have underscored the importance of programming code in ensuring the security of blockchain-based transactions. The DAO hack was enabled by a vulnerability in the code of the blockchain’s smart contract. The attacker’s knowledge of a particular feature in the code demonstrated that such an asymmetry in information could prove to be a lucrative, if nefarious or even illegal, competitive advantage.

As acknowledged by Ripple’s CTO Stefan Thomas, blockchain technology lacks a history of secure code, and specialists have not yet had enough time to anticipate what those flaws might be. Others, too, have suggested that smart contracts be written, tested, and deployed in well-defined processes with strong controls around them. Yet, some have cautioned against the implementation of too many security protection measures, which would decrease the efficiency of the blockchain and may obviate the value of the technology in the first place.

Considering this, the role of trust in blockchain applications should not be overlooked. Blockchain technology and smart contracts have been designed to reassign trust from more traditional laws and institutions – including the intermediaries the blockchain largely aims to eliminate – to the community of individuals who support the blockchain itself. Blockchain, however, cannot entirely eliminate or automate the human dimension of trust. The stability of the entire blockchain depends on its users placing stock in the individuals who able to verify the code, thereby ensuring that smart contracts will be executed as intended. Without centralized oversight, end users must trust that these gatekeepers share the same values and belief in the blockchain platform as themselves, and wouldn’t act to undermine the system by exploiting vulnerabilities for personal gain.

For the most financially vulnerable populations, the democratic nature of the blockchain and the current application of smart contracts might be a double-edged sword: while users at the base of the pyramid may benefit from some reductions in transaction costs as a result of less intermediation, without lawyers and other middlemen, it is unclear what protections or legal recourse these users would have in the event that their blockchain-enabled transactions are compromised. Furthermore, if even highly financially-literate and tech-savvy consumers cannot see fatal flaws in the smart contract code, can we reasonably expect less financially- and technically-literate users at the base of the pyramid to catch these same mistakes, even if the code is theoretically open to the public eye? And even if users at the base of the pyramid could afford the services of lawyers who were well-versed in blockchain and smart contract coding, can we really be certain these individuals could recognize and enforce airtight smart contracts?

It is naïve, and even dangerous, to take an overly optimistic and utopian vision of blockchain and smart contract technology without further scrutiny of these unresolved fundamental issues on the alignment of economic incentives of users, consensus mechanisms, and trust. Until we have a better understanding of the potential benefits and harms to end users and a broader consensus regarding the larger aims blockchain and smart contract technologies are meant to achieve, such as those promoted by the Smart Contracts Alliance, for example, we must be careful about extending blockchain-based services to those who stand to lose the most when something goes wrong.

This post originally appeared on the Center for Financial Inclusion blog.

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