Smart contracts enable the execution of trustworthy transactions and agreements between anonymous parties and without the need for a legal system. Smart Contracts will bring in changes, not as fast as some predict, but will surely change the way we are used to working, as per Kai Schiller, author of the German blog blockchainwelt.de.
You would have heard of blockchains. In our last two articles, we spoke about Non-fungible Tokens and Ransomware attacks, this one is the third in the series concerning blockchains. Apart from cryptocurrencies and NFTs, there is a much more serious and beneficial application of this technology, namely smart contracts.
SMART CONTRACTS VS (TRADITIONAL) CONTRACTS
We are aware as to what entails a traditional legal contract — a document that details an agreement that parties execute with an expectation of being legally binding with a structure that includes offer, acceptance, consideration, and date with the parties signature. The endgame is Judicial Enforcement. Whereas, smart contracts bypass and ignore the legal mode and judicial enforcement is not their endgame. In contrast, smart contracts are computer programs filled with clauses “if/then” laying out every eventuality and obligation. These computer programs, once created and formally accepted by both parties, can be self-enforcing, running in the cloud. Continuous monitoring of key performance metrics determines when one of the “if/then” clauses suddenly switches from false to true, triggering automatic enforcement. Through auto-enforcement, smart contracts can add efficiencies for many kinds of agreements. This includes rental, intellectual property, financing, shipping, and manufacturing contracts.
First proposed in the 1990s by Nick Szabo, the concept of smart contract entails contract clauses written in computer programs. These are to be automatically executed as and when predefined conditions are met. Smart contracts are stored, replicated, and updated in distributed blockchains with logic consisting of transaction status. The integration of blockchain technology with smart contracts has made the dream of a “peer-to-peer market” come true.
LEGAL STATUS
For an enforceable legally binding contract, the common law requires four elements to be present: (a) offer; (b) acceptance; (c) consideration and (d) intentions to create legal relations. The law takes a wider approach and will enforce any promise in whatever form it is in, if the above criteria are met and if there are no vitiating factors such as misrepresentation or duress to taint the contract. Practically a contract concludes upon the agreement of a future contractual performance, which then generates rights and obligations for all parties.
The lingering question of whether smart contracts carry the same legal validity as traditional contracts warrant a definitive and authoritative answer, instead, it instigated a never-ending debate amongst academics and practitioners.
TECH, FUNCTIONALITY
Imagine a self-executing contract that digitally enforces, verifies, and facilitates the performance or negotiation of a contract. Blockchain technology and its distributed nature are used to foster transaction credibility between contracting parties without the necessity of third parties as exhibited in regular contracts.
There are several steps involved in a blockchain-based smart beginning with agreement identification, defining setting conditions, scripting the business logic, encryption with blockchain, execution and processing on event triggers, and finally updating the network status.
Thus contractual performance obligations are memorialised in code using a strict and formal programming language, then they are executed by members of a blockchain-based network. Once a smart contract is triggered via a transaction by one of the parties, the smart contract itself acts as the parties’ agent that is deputised to assist the parties with their arrangement.
The code of the smart contract is stored on each miner’s computer and each smart contract is assigned a blockchain-based address. Parties can initiate a smart contract by sending digitally signed “transactions” to the smart contract’s address. The transactional record is stored on the blockchain, the saved record then triggers the smart contract’s execution. Owing to the consensus-based distributed architecture the smart contract’s code is run by all miners supporting the network simultaneously. The transaction in this case is a record that includes the variables necessary for the code to run, along with a digital signature of the sending party.
ERROR IN CODE — RISK EXPOSURE:
Smart contracts also suffer from material shortcomings. Any vulnerability or even an error in the code may bring consequences. And one such example is when the DAO raised more than $150 million, an individual discovered a loophole in the code and diverted almost $70 million worth of ether and it was observed that the hacker did not maliciously hack the code, but rather used the terms of the existing smart contracts to accomplish something others later found objectionable, i.e. the diversion of their money. Thus, it is evident that the systemic risks exposed by the DAO hack have fuelled the argument that raises several concerns about the functionality of smart contracts. Broadly speaking — the hack reveals that the foundational characteristics which make smart contracts attractive ought to be questioned.
RELATION WITH CRYPTOCURRENCY
Centralised form of transactions may have a single point of failure that has been solved by using blockchain technology, which provides a peer-to-peer transaction without the need of a third party. The Bitcoin decentralised cryptocurrency, released in 2009, has generated great interest in blockchain technology applications. The blockchain technology that used to be applied only for bitcoin peer-to-peer transactions has been also usable for other purposes, such as smart contracts.
In the last few years, there has been significant development in technology related to blockchain-based smart contracts that have been accumulating over the years. It ranges from various platforms that facilitate blockchain-based smart contracts, applications that utilise smart contracts and tools in developing blockchain-based smart contract applications.
While a cryptocurrency is used as a secure medium of exchange due to the use of strong cryptography for ensuring verifiability of asset transfer, control of unit creation and even evasion of regulations as well as oversight by governments across the world, smart contracts are self-executing contracts that utilise blockchain technology to digitally enforce, verify, or facilitate the performance or negotiation of a contract.
COSTS AND ADVANTAGES
Smart contracts provides for many benefits as compared to the traditional contracts: (a) Speed as smart contracts use software code that automates tasks that are typically accomplished manually; (b) Enhanced Accuracy as due to automated transactions the probability of manual error is reduced; (c) Cost-Effective as less human intervention, fewer intermediaries and thus less cost: (d)Auto-enforcement as Smart contracts are unique in their enforceability since these clauses are embedded in the applicable software itself; (e) Reducing risks. Smart contracts cannot be arbitrarily altered once they are issued due to the immutability of blockchains. All the transactions stored and replicated are traceable and auditable.
Despite the advantages mentioned hereinabove, the enforceability of more subjective obligations such as ensuring commercially reasonable efforts is affected by the inherently digital nature of smart contracts.
SMART CONTRACT AND ONLINE DISPUTE RESOLUTION
The dispute arising out of smart contract demand for non-judicial remedy systems that are cross-jurisdictional, extra-legal, and efficient hence the smart Developers and Entrepreneurs are swiftly moving to create solutions for resolving smart contract disputes and accordingly reliance over online dispute resolution systems in the blockchain. Generally, Online Dispute Resolution models have been online arbitration, AI-powered resolutions, and crowd-sourced dispute resolution. It is no surprise, especially given this history of resorting to extra-legal resolutions, that developers have turned to online arbitration for resolving blockchain disputes.
Relying on a distributed consensus model, smart contracts have the DNA of Blockchains and run on platforms similar to cryptocurrencies. These technology-enabled innovations in law are being watched closely as they make contracts more reliable simultaneously making it difficult to evade execution.
The ‘autonomous’ nature of these contracts does not require a third party to evaluate execution and even obviates the need to engage lawyers and experts to estimate execution in a granular fashion.
Despite obvious advantages, blockchain-based technologies have not shown great success as a business model. There are serious concerns about the non-green nature of computing needed to run the blockchains and some security issues which have cropped up despite the self-healing nature of blockchain nodes.
Ethereum has been an excellent example of a platform based on blockchains for smart contracts and the evolution of standards as well as tools for developing applications and utilities will pave the way for wider acceptance of these innovations. On the whole, the world is watching these innovations with caution filled with expectations.
Brijesh Singh, IPS, is an author and IG Maharashtra. Khushbu Jain is an advocate practising before the Supreme Court and a founding partner of law firm Ark Legal. They can be contacted on Twitter: @brijeshbsingh and @advocatekhushbu. The views expressed are personal.
Ethereum has been an excellent example of a platform based on blockchains for smart contracts and the evolution of standards as well as tools for developing applications and utilities will pave the way for wider acceptance of these innovations.