Blockchain technology handles cryptocurrencies and tokens as mentioned earlier in this chapter and throughout the book; it is the underlying platform for a new way of organizing and managing relationships. These include legal relationships and contracts. In order to best explain what a smart contract is, we must first look into the problem of trust.
The Trust Problem
The trust problem has been around since the dawn of time. In order to progress, a society or group of people has to cooperate with each other. When people cooperate they can do more collectively that they could individually. However, in doing so they are also opening themselves up to being deceived, misled, and subsequently disappointed. To attempt to address this issue, societies have instituted rituals, passed laws, and even installed governance processes. All of these elaborate techniques are in place to address the trust problem. To better explain the trust problem, let us use an example. A man frequently uses his credit card to pay for goods and services. He can walk into a store, pick an item, go to the checkout, and pay with the credit card. The store allows the purchase because the credit card, when swiped or inserted into the chip reader, checks with the bank to see if the shopper is a good risk for them to authorize the purchase and confirm that he is the person to whom the card was issued. The bank will actually collect the payment from the shopper some time later when it bills him. So, you see, there is trust all around here. The store trusts the bank and the shopper, and the bank trusts the store and the shopper, and the shopper trusts the store and the bank. The shopper can carry around a small piece of plastic instead of a wad of cash. If he loses the card, he can have it replaced within a few days. If he had to carry the cash equivalent, he might lose it or get robbed and would never get it back. Having the trust element makes it easier to purchase items, and that’s also good for merchants, who always want and need to sell more items. As the barriers to payment come down, a whole lot more commerce occurs. That brings us back to the original point that trust is needed for cooperation, which in turn leads to progress.
Trusted Third Party
One way to solve the trust problem is to use a trusted third party. The bank and credit card example given above is this exactly. The transactions between the customer, the merchant, and the shopper are passed through and logged by a bank (credit card issuer). The bank facilitates the transaction; see Figure 2-10 for a diagram depicting a trusted third party. The bank can also step in and resolve a dispute in the event that a customer finds a transaction on their monthly statement that they didn’t make.
Distributed Ledger and Consensus
What we have just described is still a centralized way to solve the trust problem. There is another way to solve it using a distributed ledger (or shared ledger) and combining this with a consensus methodology. Figure 2-11 depicts a ledger that is distributed across multiple parties. So, instead of logging transactions with a single third party, you send a single copy of each transaction to all parties in the network. All parties in the network would be required to keep an ongoing ledger of all transactions. Therefore, every party in the network would have the exact same set of transactions. At a point in time, everybody would know how much the shopper owes the merchant. If a dispute arises, the consensus majority (51 percent) of the network of ledger keepers would decide what he owed.
Blockchain technology follows this distributed ledger and consensus method. It is a network for resolving the trust problem through a distributed (decentralized) and publicly verifiable (open) ledger.
Source: Blockchain: A Practical Guide to Developing Business, Law, and Technology Solutions 1st Edition by Joseph J. Bambara