A simple framework for understanding smart contract applications

Why blockchains and smart contracts will be useful for both digital and physical assets.

In this short piece I will propose a simple and intuitive approach to smart contracts that presents two categories of use cases: 1) internal enforcement and 2) external enforcement. For both of them I will present some examples as well as a brief discussion of their limitations. The goal here is to cut away all the buzz and fog around their potential applications and provide a simple and intuitive starting point for future discussions. Having read many articles and posts regarding smart contracts, I feel the lack of the segmentation I will present below leads to a lot of confusion surrounding their applications, often resulting in a) an over estimation, or b) a complete dismissal of their potential. I believe smart contracts can add a great deal of value in a variety of scenario’s but we have to understand the context in which we aim to apply them.

A quick note. The arguments below are applicable to smart contracts in general, and not necessarily the now-well-known Turing-complete smart contracts that Ethereum enables. Also, I do not have a complete understanding of everything blockchain or smart contracts by any stretch of the imagination but do believe the following dissection assists in simplifying the context in which smart contracts can be successfully used. I don’t claim this is a universal framework or that it covers all cases (as a matter of fact, it is most likely very simplified), just that it might be an interesting way of looking at blockchain/smart contract use cases. Lastly, when referring to “blockchain(s)” I am interchangeably talking about the database type or the database type and the entire p2p network and its protocol.

The goal here is to lay out a simple framework from which potential applications for smart contracts can be discussed and approached. Instead of treating any scenario from a similar mindset and dismissing other scenario’s based on its limitations, here are two categories that we can use: 1) internal enforcement, and 2) external enforcement.

Internal Enforcement

Digital assets or their use are released in closed systems upon ownership validation and can per definition only be used by the owners.

This means that owners of the digital assets can only use them within these systems and will not be able to extract the asset or its code to use for any (valuable) way outside of the system. What we are really talking about in these cases is that the owners are giving “permission of use” within the system (after ownership — which is tracked on the blockchain — is verified) in comparison to being able to own the asset and use it elsewhere (although it is possible for systems to partner and allow cross-platform use). Now, this is rather abstract. An example here would be an in-game item that is “owned” by a user. Upon log in, ownership of said item is verified, and thus the user gets to use it in the game. Here, no external party is necessary to enforce correct use of the digital asset: the software of the game (which can be decentralized) provides the usability of the asset and the blockchain/smart contracts provide the ownership validation. If you do not “own” it, you cannot use it. Extracting this principle of “permission of use”, we can highlight a few more examples. In any scenario where ownership can be tracked on the blockchain and the usefulness of the digital asset is determined by the system in which it can be used, smart contracts can work without any intermediary to successfully determine ownership, transfer ownership, and enable use. A decentralized music streaming service can enable an owner of a song to stream it without actually owning or extracting the code representing the song. A similar situation would go for video streaming, or anything else that gives access to value based on ownership.

Fig. 1: Internal Enforcement

It circumvents any scenario where I might be able to get value out of using a digital asset that I do not own because there is no scenario where this is possible (in comparison to the use of smart contracts that fall into the second category of “external enforcement”; more on this shortly). There is another example which will present some overlap with the external enforcement category: permission to use an image. If a system only enables image posting based on whether the user owns that digital asset, smart contracts combined with the systems code can enforce whether the image can be used or not. All that has to be done is verify if the user owns that digital asset (read the blockchain) and enable or disable use accordingly. You do not own the image? You cannot use it in this system.

This bridges us to our second category: external enforcement.

What if I am the owner of an image but there is no practical prevention of others using it? In other words, I can access the code of the image (download it) and redistribute it on the internet without anything in practical terms stopping me. Think of how image licences are currently used on the web; even though you are not allowed to use a certain image if you do not have the license, it does not mean you can’t. The only way to enforce this is via external prosecution.

External Enforcement

Ownership of digital assets or of physical assets with a digital representation can be tracked and transferred using blockchains and smart contracts but these assets can technically be used by anybody (nothing practical is preventing them from using an asset they do not own). The only enforcement of ownership is via external prosecution.

Some excellent examples here are of property right ownership and product ownership tracking. Ownership of the asset can be represented by a digital asset (e.g. a token of some sort) which can be used to transfer and track ownership. We could say in these scenario’s the digital asset enables “permission of claim”. However, even though you might own the digital representation of the asset, there is no inherit nature that prevents somebody else from using it. For example, I might be the owner of a product as verified on the blockchain but somebody else can take this product from me and use it. External enforcement is necessary.

Often the leap is made that because in these scenario’s smart contracts cannot enforce ownership, they are useless. Permissions are not enforced within the system of use but only by (the fear of) external prosecutions and repercussions, still requiring lawyers and prosecutors. Although the latter is true, I argue that dismissal of the use of blockchains and smart contracts here would be a big mistake. Blockchains and smart contracts can enable more efficient transfer and tracking of ownership with more accuracy and transparency than done today. They might not be as encompassing and multi-functional as with internal enforcement but they can definitely provide a step up from traditional systems in terms of efficiency and transparency.

Fig. 2: External Enforcement

Something to note, however, is that in the case of external enforcement we also need an initial party to credit value to the digital representation of the asset. If there is no real-world party (with power) that can determine whether the digital representation actually represents a physical asset, it is rather useless. For example, if I store a document online that says I own a house but this is not recognized by my government, it is useless. Where internal enforcement has recognition from the system within it is used, we will also need such a party here (unfortunately, these will most likely not be decentralized, something which we would desire from the systems mentioned above). Does this mean we should dismiss the use of blockchains and smart contracts as a result of this? I don’t think we should. Even with these limitations, blockchains and smart contracts make it much more efficient and transparent to track ownership.

To wrap up this piece, here is is the core takeaway.

When evaluating the potential of the use of blockchains and smart contracts in different scenario’s, it is helpful to consider this framework: whether they allow for internal enforcement or need external enforcement. In either case, they can add a great deal of value, although we see a more all-round effectiveness of blockchains and smart contracts when ownership is internally enforced. Still, they can provide an incredible improvement for physical asset tracking when ownership tracking is largely inefficient (such as often the case in supply chains) and should not be dismissed merely for its limitations in terms of automated enforcement.

Fig. 3: Internal/External Framework

Let me know what you think in the comments below. What do you agree with and what do you disagree with? This is just me sharing an approach to smart contract usage that I find helpful. Evidently, it is not this simple and clear-cut, and a great deal of cases will probably fall outside of this framework. Still, I found it an interesting approach that I wanted to share. I would love to hear what you think.

All the best.