Smart Contracts Can Be a Short-Term Bandaid for Bitcoin’s Price Volatility Issues

As we’ve previously discussed, bitcoin price volatility is a main area of concern for people who are thinking about moving into the world of cryptocurrency for the first time. This is an issue that can only be solved with time, but it’s possible that smart contracts will be able to enable a bit more stability for those who seek it over the short term.

What is a Smart Contract?

“Smart contract” is a term that every new blockchain-related project stuffs into their marketing materials, but the technical meaning of this phrase has been mostly lost in all of the hype around applying this new technology to almost every aspect of our daily lives. In short, a smart contract is a type of contract that has its terms executed by computer code. One of the simplest examples of a smart contract is a multisig bitcoin transaction. If a sufficient number of relevant parties sign a transaction, then the transaction (or contract) will be executed on the bitcoin network.

The idea is that there’s no way to get around the rules of the “smart agreement” and the “code is law;” however, the fiasco around Ethereum’s The DAO smart contract illustrated how this is not always necessarily the case.

Bitcoin Hedging

One of the more interesting types of smart contracts that has been talked about since the early days of bitcoin is a contract-for-difference. The basic idea is two parties would place a wager on the future price of a real-world currency, commodity, stock, or other asset, effectively allowing users to hedge their bitcoin to the price of just about anything. A simple implementation of this concept can use a 2-of-3 bitcoin multisig address, with the two parties of the bet and an oracle as the three signatories.

The two parties will place an amount of bitcoin into the multisig address, and then the oracle will eventually return an amount of bitcoin to each party after a previously specified period of time has passed. The amount of bitcoin each party receives at the execution of the contract depends on the price movements of the asset on which the bet was based. Notably, the oracle is unable to steal the funds without cooperation from one of the other parties in the bet. This functionality is not theoretical, as Abra has already implemented this type of smart-contracting system as the basis for their mobile app, which runs on both the Bitcoin and Litecoin networks.

Through the use of these sorts of smart contracts, users are able to hedge the risk associated with holding bitcoin. In fact, these smart contracts enable users to hold any real-world asset, from US dollars to Apple stock, with properties that are similar to holding bitcoin. There are some drawbacks to this system, such as the possibility of the contract executing before an expected deadline due to a sharp decline or rise in the bitcoin price; however, smart hedging contracts should be viewed as a valuable tool by those who wish to gain some of the feature of bitcoin while avoiding the price volatility.