The recent rise in bitcoin has spurred increased interest in cryptocurrencies and the underlying blockchain technology that powers this asset class. This is not surprising considering the massive rise in value of bitcoin and other cryptocurrencies. Between January 2016 and June 2021, bitcoin rose over 9,000% in value, reaching its peak in April 2021. While much attention has been paid to the price of cryptocurrencies, the consequent volatility and the recent regulatory threats, a quiet revolution is underway that could change how the world trades. And it requires cryptocurrencies and smart contracts, both powered by blockchain technology. If statistics on total value of global trade ($18 trillion) is taken into account, this could be a real paradigm shift.
Smart contracts: What are they?
Over twenty years ago, Nick Szabo, an American computer science graduate student, devised the concept of smart contracts. He used a simple analogy to describe his concept: the vending machine. A buyer goes to the nearest vending machine, deposits a certain amount of money (paper and/or coin), selects his favorite drink or cookie, and gets the selected product. The latter process is successful if the deposited amount is equal to or above the programmed price of the selected product.
Smart contracts work in a similar way. They are simple programs written on the blockchain in which certain actions are completed if pre-programmed conditions are met. This could be transfer of cryptocurrencies for goods delivered, title to properties bought or any other transaction. Smart contracts follow “if/when…then” protocols. Since the code is written on the blockchain, actions can be carried out as soon as conditions are met without the need for a middle man. The completed transactions are published as a block on the blockchain, creating permanence and easy reference. While the vending machine analogy simplifies the concept, smart contracts are being deployed in very complex use cases. Among possible applications is cross-border trade.
How does international trade work today? Think a thousand and one paperwork, multiple licenses, a slow and inefficient clearance process, arbitrary port fees, letters of credit and more. And when the goods are delivered? It could take forever to get payment, especially for developing countries with less mature banking and international funds transfer systems. This inefficiency slows trade, cuts off some members of the developing world from global markets, and leads to significant cost in transaction processing fees. Can this system be improved on or upended?
The combination of cryptocurrencies and smart contracts presents a potentially more efficient solution. As previously explained, a smart contract automatically executes an action as soon as certain conditions are met. Imagine getting paid for shipped goods as soon as they arrive at the port (or airport) without waiting for weeks to get payments from your bank and paying enormous transfer/processing fees. Even more, consoling is the fact that you don’t have to worry about counterparty risks, possible court cases, and all the other troubles that prevent people from trading beyond their country’s borders. Did I mention mistrust of people from certain countries?
Well…What’s the catch?
Good question! The system described is just being deployed, so it isn’t without challenges. Foremost, some smart contracts rely on external data feeds to trigger programmed actions. For instance, when goods arrive at the port, there should be a way of confirming their arrival (through data feeds from the port) and the condition of goods delivered. This reliance on external data feeds poses possible risk of occasional error in reports which might lead to unintended actions on the blockchain.
Secondly, the “if/when…then” protocols of smart contracts do not capture the ambiguity in human relationships especially among long time clients. Goods might not arrive in totally perfect conditions due to sudden weather changes. But these contracts were signed many months ago and cannot be altered. Such stringency in smart contracts could affect business relationships since payments will not be made if goods aren’t up to programmed quality. This could affect business relationships. But these are technical issues that will be fixed in due time as interest in smart contracts increases.
Finally, there is the problem of volatility in cryptocurrencies. Between April and June, bitcoin (which currently enjoys the largest share of the crypto market) dropped from a peak value of $63,000 to around $34,000. This massive volatility, pushed by everything from Elon Musk’s tweet to China’s crackdown, hardly fits well with the need for some measure of predictability in international trade. Stable coins, especially those pegged to certain commodities, might be better suited to fulfilling this role. Similarly, users could pursue hedging strategies before entering into multi-month trade agreements to control this currency risk.
The world continues along the steady path of increasing integration. The local farmer in Tanzania would like to trade her coffee beans on the international markets where prices are more reflective of value. The Chinese PV manufacturing company ships products across the world, from Europe to Africa. These cross-border trades make our lives better by granting us access to a wide variety of goods and services at competitive prices. But there are challenges. Financial and logistic bottlenecks continue to hamper trade among nations. Smart contracts combined with cryptocurrencies hold the potential for creating a more efficient global trade system; one that is fast, efficient and trustworthy. Challenges remain, but there is no gainsaying the fact that we face a paradigm shift in how the world trades.