Navigating the Next Wave of Blockchain Innovation: Smart Contracts

Blockchain is a decentralized ledger system that stores data in encrypted, time-stamped blocks. Though best known as the technology on which Bitcoin is founded, its capabilities extend far beyond cryptocurrencies to potential applications in cloud computing, auditing, health care, and trade.

Lin William Cong, professor of finance at the University of Chicago Booth School of Business, first began to follow blockchain as a doctoral student at Stanford, based close to Silicon Valley. His research on financial innovation includes the study of smart contracts — tamperproof digital transactions conducted on blockchain platforms that could make certain processes infinitely quicker and more efficient.

MIT Sloan Management Review spoke to Cong about the new economics underpinning blockchain and how smart contracts could revolutionize trade finance and other fields. Contributing editor Frieda Klotz conducted the interview, and what follows is an edited and condensed version of their conversation.

MIT Sloan Management Review: How do you define blockchain?

Cong: There’s a general lack of clarity and confusion about blockchain. It’s the technology behind Bitcoin and many other cryptocurrencies — so many people know of it in relation to digital cash. But it’s not defined by these cryptocurrencies.

Blockchain brings a whole new dynamic into play. It provides decentralized consensus through a ledger system allowing the agents within the ecosystem to participate in it. It can be used across a range of functions — cloud computation, financial transactions, and all sorts of digital records. It also facilitates what are known as smart contracts, which are automated contracts that can be speedier and more secure than those that use paper documentation.

In what way does blockchain allow for a new economics to come into play?

Cong: That’s primarily because of decentralization. Let’s take Bitcoin as an example. Once a protocol is introduced in the Bitcoin network, anyone who accepts it can interact according to its rules. It’s basically a peer-to-peer interaction with no centralized party running it. A fundamental network effect is at play when people use bitcoin tokens. The more people using Bitcoin, the more stores accept it, the more utility a person derives from holding bitcoins.

The same decentralization operates across blockchain technologies. In decentralized cloud computing, for instance, when more users are on a platform, additional spare power is generated for computational tasks. This sort of project is very much happening in the blockchain space — one example being a company called Dfinity, which is hoping to create a decentralized cloud that can run on fewer resources than traditional operators like Google Cloud or Amazon Web Services.

Why is this kind of decentralization such an important development?

Cong: There are two benefits of decentralization that advocates typically mention. First, we can potentially prevent single points of failure. For example, if we have cloud computation running on something like Amazon Web Services, but with the hard disks located in a particular region — if that factory is damaged or destroyed, then the system breaks down. Whereas with decentralized cloud computation, one computer breaking down won’t stop the system from working. There are also other types of single points of failure too. If a judge runs the system, someone could bribe the judge.

Second, if we eliminate or reduce the need for centralized third parties with market power, we can potentially reduce costs for users and consumers. Just imagine a decentralized Uber system: Drivers and passengers wouldn’t have to pay a cut to the centralized party running it.

That said, maintaining consensus in a scalable manner under decentralization is fundamentally challenging. That is what many practitioners are working on.

You’ve written recently about the benefits of smart contracts, which are conducted on blockchain platforms. What are they, and how could they be used by businesses?

Cong: Smart contracts are digital agreements that are, ideally, automatically executed once a consensus on an event’s outcome is generated on a blockchain. This makes them tamperproof and highly efficient. The technology is still at an early stage, but it’s receiving a lot of attention. Many large institutions, like JPMorgan and Goldman Sachs, have created their own divisions and are devoting resources into research on smart contracts.

While the use of smart contracts is still limited, several kinds of applications are happening in trade finance. Traditionally in this industry, when an exporter wants to ship food to an importer in a different country, the process is very slow. Senders don’t want to send the goods before they receive payment, and receivers don’t want to pay before they receive the goods in good condition. Multiple banks get involved, creating letters of credit to monitor the shipment. It’s a $10 trillion business annually.

So, how can smart contracts improve this process? Users can attach internet of things (IoT) sensors to the shipment vehicles to monitor temperature and provide real-time updates that are automatically recorded in blockchain. Online feedback through blockchain records outcomes and enables both sides to reach a consensus about the condition of the delivery. If everything is satisfactory, the smart contract is cleared, and a transfer of money is triggered.

What potential do smart contracts have for changing the landscape, not just for trade finance but perhaps for other fields too?

Cong: The benefit of using smart contracts is that it is easier for parties to agree on certain details, because the information is digitally recorded and shared automatically.

Let’s go back to the trade finance example. When the shipment arrives, if there’s a real-time record of where the goods have been on the way to their final destination, it’s easier to reach agreement on the condition of the shipment and the delivery itself.

Or think about auditing. Auditing companies generally don’t collaborate or share information because of the need to protect proprietary information. That reduces efficiency and makes it hard for regulators to monitor companies’ financial health. But if everything were on blockchain — with the right amount of encryption, of course, so that when the auditing companies shared information, they shared just enough to validate certain transactions — then the supervisory body could easily access a clear, digital record of an organization’s financial activities. That would make oversight more robust and prevent cases like Enron from happening.

Can you talk about some smart contracts in action?

Cong: One of the earliest examples was a collaboration between the blockchain startup Wave and Barclays. They completed the first smart contract in 2016. It mediated a trade finance transaction between a company called Ornua, an Irish agri-food cooperative, and a Seychelles trading company. The payment transfer still went through Swift. Ideally, it should have been conducted through cryptocurrencies, on a blockchain. But that’s something people are working on.

Another recent example is Walmart, which introduced a blockchain-based system for some of its suppliers in 2018. The basic idea is that, if I deliver wine, I want to make sure it’s in good condition when it arrives. Using blockchain to verify the condition reduces paperwork exponentially, in this case from days to just a few seconds, and it also reduces waste and supports sustainability.

What are the risks in using smart contracts?

Cong: For public blockchains, more people are getting involved, so we necessarily have to contact them and distribute information to them in order to solicit their information. That distribution creates a fundamental tension, and privacy could be a big concern if a transaction’s details are shared with multiple validators. However, computer scientists are coming up with clever ways to deal with that through encryption and zero-knowledge proof, where they don’t have to reveal the exact information about a transaction beyond what is absolutely necessary.

Quite a few blockchain startups are working on this — figuring out how to design a system or protocol, so that it distributes only enough information to generate consensus while encrypting the data to avoid infringing on privacy. But a fundamental trade-off remains: The more we want to verify, the more information we have to distribute.

Getting back to blockchain more generally, what’s your perspective on how quickly this technology will take off? Are you optimistic or pessimistic?

Cong: There are hurdles to wider application — technical issues, and the need to coordinate the agents who would use it. Some companies may resist blockchain because it disrupts traditional business models. The internet took two decades to fully take off, so it’s hard to predict. I would describe myself as slightly optimistic, but I also have to constantly remind myself not to go with the hype and transient trends. It’s important to really dig deeper to see what is fundamental.

Some applications will appear earlier than others. Decentralized cloud computation is something we’re already doing and is very much in demand. I’m less optimistic about blockchain-based platforms such as Bitcoin or Tether as competitors to money for general payment. I also believe consortium blockchains with an alliance of influential incumbent companies are more likely to take off than public or private blockchains.

Blockchain also has huge potential benefits for society when it comes to ethics, contracting, legal enforcement, and many other areas. Decentralized consensus improves a system’s transparency. Smart contracts can force companies to compensate in cases where they don’t deliver.

Finally, blockchain helps new entrants, so it’s pro-competitive: Right now, companies can promise a rebate if a product doesn’t arrive, but that requires some trust and reputation in the market which new entrants do not yet have. With smart contracts and blockchain, there’s an easier way for newer businesses to establish trust with customers.