What Are Smart Contracts?
There is a great deal of excitement surrounding this technology. Smart contracts have the potential to be traceable, transparent, and irreversible. As for security, they can record an undisputable history of changes and verify electronic signatories. Scalability and lower compliance costs are also important benefits to consider when looking at the future of this field.
With these benefits in mind, you’re probably wondering how it all works. Smart contracts are made up of code, which can self-execute and enforce an agreement. The entire process is automated via a ‘distributed ledger’. The same copy of the contract is downloaded onto every computer for all users to see. This results in a secure system, as any manipulation can be seen by others. Mutual trust is created between the parties, as the execution of the agreement is certain if the negotiated conditions are met. Therefore, intermediaries are no longer needed when agreeing to a contract. Smart contracts can define the obligations for both parties in deterministic code, leaving no ambiguity in the case of a disagreement.
Translating a Contract into Code
So, why aren’t traditional paper contracts fading into obscurity? Since the code behaves in a pre-defined way, it doesn’t have the linguistic nuances of human languages. Negotiated terms of a contract might not be binary in their language, and therefore they can’t be assessed deterministically by a computer program. It’s very difficult to translate the concept of reasonableness into code, for example.
Since smart contracts are basically executing a particular code base, it’s difficult to decipher the context surrounding the agreement. What if it was signed under duress, or one of the parties was under age? This complicates the implementation of smart contracts, and creative solutions will need to be found to eliminate these potential pit falls.
Where Could They Be Used?
The technology works best when there is a set of deterministic obligations. An ‘escrow’ mechanism, where money is paid to a trusted third party stakeholder and then released under certain specific conditions, is where the smart contract industry is showing greatest promise.
As we progress into the future, it’s important to consider how autonomous smart devices will conduct business. For example, how will a washing machine buy its own detergent? Machine-to-machine commerce is just on the horizon, and human intervention for each individual contract would be cumbersome. Smart contracts would fit this role neatly, taking the burden off those who usually sign and oversee these types of agreements.
Another sector of the industry that’s gathering some steam are smart financial instruments. Shares, bonds, and derivatives contracts are ripe for a technological revolution. It’s even possible that intellectual property could be stored and traded over a distributed ledger. The music industry, for example, could use smart contracts to automatically keep track of ownership of material to facilitate licensing and royalties.
The Risks of Implementation
Despite a bright future, this technology doesn’t operate without a degree of risk. With most things digital, cyber-attacks always have a presence. The Distributed Autonomous Organisation (DAO) was a smart contract intended to pool investment funds. At one point, it had over $150 million worth of cryptocurrency. A hacker spotted a mistake in the programming and subsequently drained its funds. Rather than infiltrating the smart contract’s security measures, the hacker simply noticed a loophole within the code. This is similar to how some traditional contracts can be manipulated with their own loopholes. Even with this new technology it seems that human error will remain a risk.
Regulation and enforceability are also relevant when examining limitations of the platform. Currently, smart contracts aren’t regulated in Ireland, with no relevant case law to date. Kevin O’Brien of the Central Bank of Ireland said, “If we cannot understand it, we cannot supervise it, and if we cannot supervise it, we cannot authorise it”. However, Italy has recently taken steps to implement a legal framework for smart contracts with Law Decree No. 135/2018.
The Relationship between Traditional and Smart Contracts
Academics at Oxford University have suggested having a traditional contract act as a ‘legal wrapper’, which sets out the terms that can’t be effectively translated into code. Commercial agreements regularly have clauses and protections for both parties. Most of these clauses won’t be suitable for a smart contract’s binary code, and will require the deft hand of human intervention. Examples would include the right to terminate a contract, or take a particular action because of a ‘material adverse event’.
The smart contract would then be used to execute deterministic terms. This could include an obligation to pay a certain amount of money at a fixed time. The legal wrapper would then reference the smart contract code, thus binding the two elements of the agreement together.
If a conflict between the two occurs, the traditional contract would likely take primacy. It’s also important to consider a ‘fail-safe’ in the code that allows for termination in certain pre-determined scenarios. The legal wrapper could incorporate this into the agreement.
This hybrid model of paper and code seems to be the way contract law is heading when it comes to smart contracts. While smart contracts offer many benefits, they aren’t ready to make traditional contracts obsolete just yet. Translating the nuances of human language is a giant technological hurdle to overcome, and risks are still present when it comes to cybercrime and regulation. Regardless, all lawyers and others with an interest in commercial contracts should keep an eye on this area in the coming years.