The blueprints for smart contracts have been around for decades, first proposed in 1994 by Nick Szabo[1]. So why has it been a buzzword recently? While smart contracts have been hailed for their efficiency and relatively low costs, they nevertheless have an impediment that begs the question; is it truly the inflection point that will alter practically every industry or is it just overhyped jargon? In this article, I will aim to offer a comprehensive analysis regarding the key limitations of today’s smart contracts.

Before delving into the conversation of smart contracts, it is important to first break them down and define their purpose in today’s society. To put it simply, it is a piece of code that is written to automate certain actions under a contract. For example, a power plant has a smart contract with the local council based on their Co2 emissions. Once the power plant has surpassed the agreed-upon emission rate, the smart contract will automatically trigger and thus pay a fine to the local council.

The Bridge between Blockchain and Smart Contracts

Many people might not have heard of distributed ledger technologies. However, it is a crucial component in creating a reliable and tamper-proof smart contract. In essence, it is a system that records information across several computers (nodes)[2],  making it difficult to alter recorded information as consensus needs to be achieved over multiple nodes within the network.

Smart contracts do not necessarily have to work on distributed ledgers. This is shown by S&P Global Platts successful deployment of a smart contract on a centralised ledger.[3] However, if we are to create a smart contract that has practical applications for the wider population, we have to develop them on distributed ledgers with enough decentralisation to produce a valid consensus. This is mainly due to the blockchain’s decentralised framework which allows for a completely secure and tamper-proof network.[4]

At the moment, smart contracts built on top of blockchains have certain limitations in addition to other issues such as scaling and cross-communication[5]. More precisely, smart contracts cannot access data outside of the blockchain, commonly referred to as the “Oracle Problem”.[6] Likewise, it has limited the scope of smart contracts and has ultimately reduced their case use within the DLT space alone. Therefore, industries such as derivatives, insurance, and so on have not been able to utilise smart contracts as they require constant off-chain data to execute conditions successfully.[7]

Contrary to popular belief, a smart contract working on a distributed ledger does not necessarily mean that the smart contract is impenetrable to attacks. While distributed ledgers are completely tamper-proof, the problem arises when the smart contract accesses data through one source (Centralised Oracle), similar to how a centralised database is largely more susceptible to attacks and manipulation than a distributed one. Present-day smart contracts are specifically vulnerable to attacks due to the use of centralised oracles. For instance, Defi Capital, a blockchain investment fund suffered multiple attacks in February[8] as the company used a single oracle as the provider of information.

Essentially, a centralised oracle feeds data to the smart contract which would be controlled by a single entity and thus be the sole provider of information. This is one of the reasons smart contracts have not been adopted for wide industry use as having a centralised oracle creates a single point of failure, imposing additional risks as a result. Using only one source of information can be risky, as the execution of the smart contract depends on the information available. This could lead to interference from the single entity which could make the contract vulnerable to attacks.

The Chainlink network is important because it has provided an abstraction layer for feeding real-life data into smart contracts. Chainlink takes a two-step approach giving the end-user the choice of not only decentralising the data required into as many different chunks they would like but also providing a trusted hardware mechanism to execute these transactions.[9]

This is done through decentralised oracles that verify and authenticate the information and then relays it to the smart contract. The use of decentralised oracles provides valid data based on a majority consensus from multiple parties thus, widening the pool of information and increasing the reliability of the smart contract.[10]

Furthermore, Chainlink smart contracts have unlimited practicality due to its oracles supporting any type of data[11] as opposed to present-day smart contracts which continue to depend on centralised entities providing data but also being good actors. This provides a holistic approach that does not limit smart contracts to a specific industry but instead extends it to practically any industry.

Features - Chainlink
Image Source: https://chain.link/features/

Decentralised Finance (DeFI)

The resourcefulness of Chainlink based smart contracts can be seen by their functionality in industries such as derivatives. The global derivatives industry is worth trillions[12]. This industry is incredibly high stakes and has several risks, some of which are rooted in the lack of trust among the parties. A good example can be seen in the 2008 financial crisis where many parties employed delaying tactics to buy some time to avenge the monetary losses. This led to many delayed payments which caused serious problems especially as the failure of certain contracts led to bankruptcy. Although, the risk of the counterparty is decreased to a certain degree by a middleman such as the CCP (Central CounterParty).[13]  Regulators such as CCP assist parties in a bid to reduce counterparty, settlement, and other things.

However, they might not be seen as favourable by firms due to their high commission rates[14]. Additionally, by allowing the CCP to act as the middleman, the firm itself is giving away a large portion of control to another entity. This can result in many problems, specifically the security risks associated with a centralised body which can lead to hacks, bribery, and so on[15]. There can also be times where there is more incentive for a middleman to act dishonestly than honestly and that itself is the biggest risk when it comes to introducing multiple parties into the chain of trust.

On the other hand, this problem can be solved fairly quickly by chainlink enabled smart contracts through using smart contracts which hold the agreed-upon payment, the contract can automatically trigger the payment when it receives the required data through multiple oracles. Consequently, it solves the issue of delayed payments while also promotes trust and allows for a secure transaction.

The demand for decentralised finance (Defi) grows every day. This is evident as the International Swaps and Derivatives Association (ISDA) published its first model for digitizing derivatives contracts[16]. As it stands, Chainlink based smart contracts empowers the financial sector by allowing for decentralised finance.

Decentralised Oracle, a reliable network?

We have established that valid information is the key to creating a workable and reliable smart contract. But, how do we ensure that each party provides the correct information?

Although this problem is somewhat solved by the individuals providing skin in the game which discourages them from providing dishonest information, it still remains a key problem. To overcome this, Chainlink has been focusing on two specific ways that data providers (Oracles) could be motivated into feeding valid data.

Reputation system

Firstly, the Chainlink network has created a reputation system for its oracles[17]. Simply put, it is a rating system where each oracle will have its own rating based on their performance. If the oracle has provided invalid information, it will go against the majority consensus and will thus be given a negative rating. This will, in turn, penalise the oracle and show consumers the quality of each oracle. The better the rating, the more employable the oracle will be which encourages oracles to provide reliable data to reap the rewards.

Skin in the game

Secondly, every time an oracle accepts a job on the chainlink network, they will have to provide collateral in Chainlink tokens[18]. By providing financial collateral, the oracle will be discouraged from being a bad actor and providing invalid information. If they do relay bad data, the collateral will be lost, and their reputation damaged as a consequence. It also discourages bad behaviour when multiple data providers are involved as it decreases collusion and the more decentralised the input will be, the more difficult it will be to tamper with.

Additionally, there is also no incentive to provide false data because firstly the other nodes would disagree with you and maintain consensus. Secondly, you would lose the collateral held to secure that contract. These features promote the collection of valid data and work hand in hand in doing so.

Investments

Interest from VC’s has been low in the space when it comes to decentralised oracles. It’s a philosophical problem at its core and solving it remains difficult. Although once solved, it will drastically change the way we see the world. That being said, there are players in the market that have extensively invested in the Chainlink ecosystem. As an example, Fortem Capital[19], an investment fund out of Malta, has had a surge of investments after 2017. Notable for investing in Chainlink and then onward, Linkpool amongst other things. There are investment vehicles that have allocated a number of their resources in funding development and expanding the ecosystem, growing day by day as the adoption of decentralised oracles increase.

Conclusion

Ultimately, smart contracts are the inflection point that will have a significant impact on the majority of industries. The implementation of these can certainly be used as tools in creating an efficient and secure supply chain. However, due to certain limitations, it has been misunderstood and thus overlooked.

Nevertheless, Chainlink based smart contracts offer the solution through its use of decentralised third-party services. Decentralised oracles enable us to enter the fourth industrial revolution. Agreements and trust have been philosophical problems that have plagued humans for the longest time. Every advancement to further these two concepts have allowed humans to progress at a faster rate than before. Imagine the problems we could solve when trust is guaranteed!

Author: Ahmad Akbar

Edited: Bryher Rose

Bibliography:

[1] Investopedia ‘Smart contracts’ (Investopedia website) <https://www.investopedia.com/terms/s/smart-contracts.asp> accessed 5 July 2020

[2] TechTarget ‘Distributed ledger technology’ (TechTarget website) <https://searchcio.techtarget.com/definition/distributed-ledger> accessed 5 July 2020

[3]Medium ‘Worlds Biggest Commodities Pricing Firm Using Smart Contracts Without Blockchain’ (Medium website) <https://medium.com/swlh/worlds-biggest-commodities-pricing-firm-using-smart-contracts-without-blockchain-8af80dc3ee2> accessed 5 July 2020

[4] Investopedia ‘Blockchain explained’ (Investopedia website)  <https://www.investopedia.com/terms/b/blockchain.asp> accessed 6 July 2020

[5] COINTELEGRAPH ‘Blockchain’s Scaling Problem, Explained’ (COINTELEGRAPH website) <https://cointelegraph.com/explained/blockchains-scaling-problem-explained> accessed 6 July 2020

[6] Data Driven Investor ‘What is the oracle problem & how Chainlink solve it?’ (Data Driven Investor website)

<https://www.datadriveninvestor.com/2019/06/15/what-is-the-oracle-problem-how-does-chainlink-solve-it/> accessed 7 July 2020

[7] Chainlink ‘Oracles: The Key to Unlocking Smart Contracts’ (Chainlink website) <https://blog.chain.link/oracles-the-key-to-unlocking-smart-contracts/> accessed 7 July 2020

[8]Daily Fintech ‘A great oracle is the one with the right data’ (Daily Fintech website) <https://dailyfintech.com/2020/04/27/great-oracle-is-the-one-with-the-right-data/> accessed 8 July

[9] Chainlink ‘Features’ (Chainlink website)

<https://chain.link/features/> accessed 8 July 2020

[10] BINANCE ACADEMY ‘ Blockchain Oracles Explained’ (Binance Academy website) <https://academy.binance.com/blockchain/blockchain-oracles-explained> accessed 8 July 2020

[11] Medium ‘ Analysis of Chainlink - The Decentralised Oracle Network’ (Medium website) <https://medium.com/@jonnyhuxtable/analysis-of-chainlink-the-decentralised-oracle-network-7c69bee2345f> accessed 9 July 2020

[12] Investopedia ‘How Big is the Derivatives Market’ (Investopedia website) <https://www.investopedia.com/ask/answers/052715/how-big-derivatives-market.asp> accessed 9 July 2020

[13] European Parliament ‘Economic and Monetary Affairs’ (Report 2011) <https://www.europarl.europa.eu/RegData/etudes/note/join/2011/451488/IPOL-ECON_NT(2011)451488_EN.pdf> accessed 12 July

[14] Chainlink ‘Solving Deep-seated Trust Problems in Derivatives Using Chainlink-enables Smart Contracts’ (Chainlink website) <https://blog.chain.link/solving-deep-seeded-trust-problems-in-derivatives-using-chainlink-enabled-smart-contracts/> accessed 12 July 2020

[15]Chainlink ‘Solving Deep-seated Trust Problems in Derivatives Using Chainlink-enables Smart Contracts’ (Chainlink website) <https://blog.chain.link/solving-deep-seeded-trust-problems-in-derivatives-using-chainlink-enabled-smart-contracts/> accessed 12 July 2020

[16] International Swaps and Derivatives Association (Report 2020) <https://www.isda.org/a/I7XTE/ISDA-Legal-Guidelines-for-Smart-Derivatives-Contracts-IRDs.pdf> accessed 15 July 2020

[17] Medium ‘ Analysis of Chainlink - The Decentralised Oracle Network’ (Medium website) <https://medium.com/@jonnyhuxtable/analysis-of-chainlink-the-decentralised-oracle-network-7c69bee2345f> accessed 15 July 2020

[18] Medium ‘ Analysis of Chainlink - The Decentralised Oracle Network’ (Medium website) <https://medium.com/@jonnyhuxtable/analysis-of-chainlink-the-decentralised-oracle-network-7c69bee2345f> accessed 15 July 2020

[19] Fortem Capital ‘Articles’ (Fortem Capital website) <https://fmcptl.com/articles.html> accessed 16 July 2020