Contract in the digital era (2nd draft)

-- By RyoichInoue - 2 Jan 2021

The way by which people form the contract is in the verge of change, utilizing blockchain. Blockchain is based on several technologies, like public-private key encryption and Peer to Peer Network. I will first explain the concepts of Public-private key encryption and Peer to Peer Networks. Then, dig ito the nature of blockchain, and analyze what the implication of blockchain to the formation of contract.

Public-private key encryption

The traditional way of sending secured message is to encrypt massage with the shared “secret key”. The “secret key” must be communicated from the sender to recipient somehow. Because of this necessity to communicate the “secret key”, the message was always under the risk of inception. If unintended third party obtains access to the “secret key”, security of the message will be ruined.

The technology called public-private key encryption had changed this traditional way of exchanging secured message. The message is encrypted using public key and private key of the sender, public key can be freely communicated to the recipient, and the recipient will decrypt the message using his public key and private key. In this way, there is no need to communicate “secret key”, significantly reducing the risk of interception of it. Using primitive numbers for public key and private key, it is nearly impossible to find out the right combination even for the powerful computer.

Peer to Peer Networks

The traditional way of network is client server model. Under client server model, there is a central party who is managing and operating the server, to which users will access. Under this model, the success of network depends on the central party, giving rise to the risk of failure of such central party. Peer to Peer Networks is the technology which enabled the network to operate without the central party, distributing the information to the computers of peers. Under Peer to Peer Network, because the network is widely distributed to the computers of peers, failure of certain computer will not result in the failure of network.

Blockchain

Blockchain is the distributed database, in which Public-private key encryption and Peer to Peer Networks are used. By using Peer to Peer Networks, Blockchain is operated without central control. Copies of ledgers are distributed in Peer-to-Peer Networks, and anyone with device connected to Internet can access to the ledgers. For the authentication mechanism, Public-private key encryption is used. Blockchain is updated by peers. When peers update the blockchain, they use public key as reference point, and use private key as authentication / validation. The true identity is not associated with the public key, giving the “pseudonymous” nature to the block chain.

Smart contract

There are various applications of blockchain, Bitcoin being most famous example. But crypto currencies are not the only one application. Other important application is “smart contract”. The parties will reduce their agreements into “code” of blockchains. The obligations under the smart contract will be monitored and operated by blockchain, increasing the possibility of the contract being executed. Utilizing temper resistant nature of blockchain, it would bring benefits in the contractual relationships. For example, car manufactures can monitor the whole supply chain. If there is defect in parts, the manufacture can trace back from which supplier the defected parts came and recall only those cars in which defected parts are integrated, rather than recalling the whole products in the market. Also, smart contract will facilitate business transaction between unknow parties. Under smart contract, the obligations under the contract will be automatically executed by blockchain, therefore it is not necessary for the parties to trust each other, and they can trust the code.

Limitation of smart contract

Blockchain is pseudonymous, but not completely anonymous. Anyone with Internet access can have access to the copies of ledgers in blockchain. Public key is not directly associated with identity. However, once the relationship between public key and the true identity are revealed, anyone can know the whole history of transactions executed by the account with such public key. This gives concern of privacy, making smart contract not fit for transactions which requires high confidentiality. In traditional contracts, the parties have option to make the contract completely confidential. The other limitation is that the smart contract is only fit for the types of contracts which can be reduced into rigid mathematical formula. Contracts which contain open end terms such as “in good faith” and “best effort” is not fit for smart contract, given it is not possible to reduce such terms into code. One of the resolution for such problem is to use “oracle” which is the third party which will input necessary information / instruction to the blockchain code.