How smart contracts partner with blockchain to keep your agreements secure

12/08/2020

How smart contracts partner with block chain

How smart contracts partner with block chain

With a background as an electrical engineer, it’s not surprising that W. Edwards Deming repurposed the ideas of connections and electric circuits as he became a business consultant.

One of his well-known theories is the “System of Profound Knowledge”, a concept that defines an organization as nothing more than a holistic system, connecting not only internal resources, but also interlinking with external stakeholders. For managing the system, four pillars are relevant: Appreciation of a system, knowledge of variation, theory of knowledge, and psychology.[1]

Deming published this concept back in 1993. But despite being almost three decades old, the philosophy sounds more modern than ever. Thanks to digital twins – virtual replicas of physical devices – his philosophy can now be practically implemented, not only in production facilities but also the office environment.

The new workforce is ready to take on AI systems

Believe it or not, Generation Z (born 1997 and later)[2] is now in the process of entering the  workforce. These employees not only grew up with the internet, but also have extensive experience with voice assistants and other forms of artificial intelligence. Accordingly, they appreciate the technology and are comfortable interacting with AI to achieve the required results. With Generation Z, the future workforce is skilled in system-thinking.

The concept of smart contracts was first defined one year after the “System of Profound Knowledge”, not by a lawyer, but the computer scientist Nick Szabo:

“A smart contract is a computerized transaction protocol that executes the terms of a contract. The general objectives of smart contract design are to satisfy common contractual conditions (such as payment terms, liens, confidentiality, and even enforcement), minimize exceptions both malicious and accidental, and minimize the need for trusted intermediaries. Related economic goals include lowering fraud loss, arbitration and enforcement costs, and other transaction costs.”[3]

As a mathematician, his definition of a legally biding document is nothing more than a rules-based algorithm.

Smart contracts can keep your company sustainable and secure

With extraterritorial laws such as the U.S. Foreign Corrupt Practices Act or the UK Modern Slavery Act 2015, companies can be held responsible for their vendors, sales agents and other partners. As a consequence, they must elaborate a code of conduct for vendors, and in parallel conduct background checks and request evidence.

The electronic signature on a contract is based on conditions. If a vendor stops complying with one or more of them, much like the effect of an electric circuit getting interrupted, the validity of the contract is disrupted.

For example, a company may require its vendors to upload an annual statement that their products are free of conflict minerals. Based on this condition, the agreement was signed. If the vendor does not comply with the deadline of the rule, the smart contract gets automatically abrogated until the issue gets resolved or the company decides to terminate the agreement.

Smart contracts can be combined with continuous monitoring, where an algorithm connects  automatically with various databases to check if a used vendor gets listed or delisted from a governmental sanction-list, is involved in a lawsuit, or negatively mentioned in the news which could lead to reputational risk.

Human interaction is still needed to execute smart contracts properly

The ideal collaboration of AI with humans is that the machine is responsible for the level 1-tasks, freeing up the human expert to focus on the level 2-priorities. Regarding smart contracts, this means that the algorithm can continuously monitor that all defined rules are still valid. The moment the AI perceives that this is no longer the case, it interrupts the smart contract and alerts the employee to analyze the situation.

The human stays in charge, and accordingly must make final decisions to confirm or dismiss the computer alert.

This requires not only that the human understands the system, but also that they are capable of critical thinking to avoid falling prey to automation bias or a general over-trust of the AI. This has become increasingly important in the current environment, where a host of disruptions have been deemed “force majeure” due to the COVID-19 pandemic.

Deming’s focus on human psychology inside the system is imperative. He says a contract is “a voluntary, deliberate, and legally binding agreement between two or more competent parties. Contracts are usually written but may be spoken or implied, and generally have to do with employment, sale or lease, or tenancy.”[4]

This broad definition should also apply to smart contracts. The province of Alberta published the “Electronic Transactions Act” in 2001. The law defines the validity of electronic contracts, including the option of “the interaction of an electronic agent and a person or by the interaction of electronic agents.” Today the wording “electronic agent” has become outdated, replaced by as the terms “automated” or “autonomous software”.

As the demands of all included parties must be ensured, it’s crucial that smart contracts need to be auditable at any time.

Blockchain technology adds an extra layer of security and transparency

Modern definitions align smart contracts with blockchain:

“A smart contract is a self-executing contract with the terms of the agreement between buyer and seller being directly written into lines of code. The code and the agreements contained therein exist across a distributed, decentralized blockchain network. The code controls the execution, and transactions are trackable and irreversible.”[5]

The blockchain technology promises enhanced cyber-protection for smart contracts, as the information does not get stored on just one server, but is encrypted and decentralized on numerous servers. The different machines validate each other, and any deviating information (such as a manipulated contract),  would be automatically overwritten with the correct authorized information stored on the other servers.

As expressed by “chain”, no information gets deleted, but all changes are registered with the date and time. If the smart contract is enabled to connect automatically with other databases where certifications are stored in blockchain, the contract would add those. If not, it could connect to an internal server, where vendors manually upload such documents.

In times of global anti-corruption enforcement and rising stakeholder activism, companies want to ensure that their partners continuously comply with the law and defined human rights-initiatives. As a result, more documentation and statements are required. Smart contracts are a possible solution to achieve transparency, and automatically control the needed certifications. In the spirit of W. Edwards Deming, they can act as a bridge to connect two crucial organizational systems.

[1] Deming, W. Edwards (1993): “The New Economics for Industry, Government, Education”

[2] Dimock, Michael (2019): “Defining generations: Where Millennials end and Generation Z begins”

[3] Szabo, Nick (1994): “Smart Contracts”

[4] BusinessDictionary (fetched 04.04.2020): “contract”

[5] Frankenfield, Jake (2019): “What is a Smart Contract?”

Disclaimer: The opinions expressed in this article are those of the contributing author, and do not necessarily reflect those of the Forum for International Trade Training.

About the author

Patrick Henz

Author: Patrick Henz

Patrick Henz works as Head of GRC and Regional Compliance Officer Americas. He is author of the books “Business Philosophy According to Enzo Ferrari” and “Tomorrow’s Business Ethics: Philip K. Dick vs W. Edwards Deming”

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