Smart Contracts: Boon or Bane?
by Darren Chia and Shjoneman Tan
The emergence of Artificial Intelligence (AI) and an emerging legal technology industry has thrown a spanner into the works of the legal industry and seems to threaten lawyers’ (and law students’) prospects of stable employment. A not-so-new, yet critical component of this technological shift is the smart contract, which seems to be the new buzzword for such technologies. Considering how the smart contracts could shake up the industry, we will attempt to uncover and debunk what makes a smart contract “smart.”
What is a Smart Contract?
The original definition of a smart contract originates from Nick Szabo, a computer scientist, law scholar and cryptographer, well known for his research in digital currency. In 1995, he defined a smart contract as:
A set of promises specified in digital form, including protocols which the parties perform on those promises.
To put it simply, a smart contract is a contract whose terms are encoded in computer language instead of legal language. They are just like any other contract. The major difference? They are entirely digital as opposed to a traditional pen-and-paper contract.
How do Smart Contracts work?
Traditionally, for most contracts, you would seek the help of a middleman or a 3rd party. Let’s take Kickstarter.com, a popular American crowdfunding platform as an example. To start a fundraising project on Kickstarter.com, you as the organizer, would write about your fundraising project, state the fund target and wait to receive donations from users all across the globe. Kickstarter.com is essentially the 3rd party, acting as the middleman for all transactions from the donors to the organizer.
With smart contracts, this middleman is not required. A smart contract is self-executing so long as its terms have a digital representation. An easier way to think of a smart contract is to compare them with a vending machine. With smart contracts, you simply drop either a bitcoin, etherum or any other alt coin into the ledger and just like that – your driver’s license, escrow or whatever drops into your account. Let’s use the same example of a crowdfunding project. A smart contract can be created and programmed to hold all the received funds until the fund target has been reached. The donors can transfer their funds in the form of cryptocurrency to this smart contract. Once the fund target has been reached, these funds will be transferred directly to the organizer.
What is the technology behind Smart Contracts?
A smart contract is a tiny computer programme that is stored inside of a blockchain. Smart contracts are stored on a blockchain, thus making them possess these 2 properties: (1) immutable; and (2) distributable.
What does “immutable” mean?
Being immutable means that a smart contract can never be changed or tampered with. Once a smart contract has been created, the details in the content are permanent and unalterable. This unique nature of smart contracts being immutable is considered by many as a blessing since the performance of the contract in the manner in which it is coded is guaranteed. Furthermore, each and every transaction on the smart contract is recorded on the blockchain forever – making smart contracts extremely safe and secure for operation.
However, nothing is really as alluring as it seems to be. There is a dark side to this feature of immutability – in the event of any errors in the code, the immutability feature prevents any rectification of such errors. The smart contract would still execute the performance regardless of the major error, which could very well lead to severe ramifications for the party/s. Additionally, in the world that we live in, a common saying is that “change is the only constant”. In the likely event that circumstances change, it is unfortunately impossible to make any amendments to the original smart contract.
What does “distributable” mean?
Exactly as the word implies, a smart contract being distributable means that the code can be seen by everyone who accesses the technology, and the code is easily replicated. The advantage of this is transparency: Anyone can access the source code and verify that it is functional and free of improper or malicious coding.
Benefits and Applications of Smart Contracts
So what exactly are the benefits and applications of smart contracts?
One of the key problems clients of insurance policies face is the lengthy duration for the processing and receiving of payment. Smart contracts can help to simplify this process by automatically triggering the transaction when certain events are coded to occur. Specific details could be recorded on the blockchain to determine the exact amount of compensation
Supply Chain Management
Supply chain management involves the flow of goods from raw materials to the final product. Currently, the technology utilized comprises the Internet of Things sensors, which track goods from producers to warehouses to manufacturers to suppliers. Smart contracts can help to record ownership rights at all times, providing clarity and transparency as to who is responsible for the product at any given time.
It is not uncommon for companies to take advantage of employees by refusing and delaying their payment of salary. By entering into a smart contract, wage payments can be facilitated in a fair and transparent manner according to the agreed amount and within a specific time period. This provides certainty for employees.
Real Estate Industry
The real estate industry stands to gain from the application of smart contracts as the real estate sector is traditionally an illiquid sector, and the benefits of a smart contract, bringing transparency, improved contracting speeds and a history of the transaction (for ownership records) are especially pertinent. In fact, in the United States and United Kingdom, property has already been sold using cryptocurrency, and it is likely only a matter of time before contracts for the sale of property are moved online.
Concerns and Implications regarding Smart Contracts
As we have seen, smart contracts confer an array of benefits over a wide swathe of industries. Considering how prevalent smart contracts have the potential to be, the next considerations are the shortcomings of a smart contract, and the implications that stem from them.
Regulation of Smart Contracts
In traditional contract, parties reason and negotiate to arrive at a set of terms. Similarly, parties to a smart contract will have to reason and negotiate over their set of terms, but with a twist – parties to a smart contract must also reason and negotiate over the intricacies of the smart contract code itself. Control over performance of a contractual obligation is ceded over to a set of code that runs regardless of circumstance (unless it is programmed to). A problem this raises is whether the contractual obligation has been aptly performed – there is (currently) a limit on how smart contracts, through software languages, are able to assess whether a contract has been aptly performed. For simple transactions this problem might not arise, but where contractual obligations are held to a subjective standard requiring a human to assess if the contractual obligation has been properly carried out, there is (currently) a lack of technology in assessing the completion of this crucial step. For example, applying the crowdfunding scenario, suppose for a $10 donation, the crowd funder will provide a painting in return every month. A traditional transaction would have the purchaser able to scrutinise the painting and ensure it meets his standards before payment is made, and if the painting does not arrive monthly, the purchaser party can take the seller to the courts to get his promised dues. Over a smart contract, however, there is no scrutinization, and the code will simply check if the painting has been completed, regardless of the promised standard of quality of the painting. The solution to this could be found in AI, where a machine learning software could be used to assess that the painting is of objectively passable quality, but there is currently no such software to ensure that subjective standards are met.
A second concern regarding smart contracts is how they interact with traditional laws. For instance, certain areas of contract law like frustration, unconscionability, duress, and undue influence are highly fact specific and inherently not compatible with a self-executing code. It remains to be seen how traditional laws will interact and change to accommodate these developments.
As alluded to above, smart contracts, being written in code, are susceptible to errors in programming or software bugs, which can lead to a transaction being improperly executed and hence resulting in damages. Whose shoulder does liability for this transaction then fall on? The platform, for not having enough checks and balances? The contracting party, who ought to have checked and ascertained that the code was correctly written? Or even the writer of the code, who wrongly coded the software? Comparing this issue to the issue of a contract being poorly drafted in traditional contract, it would seem that traditional laws could apply, but one could always make the argument that improper code carries with it greater ramifications, seeing as to how the code affects the performance of the contractual terms itself. Only time (and cases) will tell how these issues interact with the law of contract.
A further complication of a smart contract being poorly coded arises considering how once code is written onto a blockchain, it is immutable and cannot be changed, which in turn creates another issue – congestion. Blockchains have a limit as to the amount of transactions it can take. For example, Bitcoin blocks, operating on the bitcoin network, have an average creation time of 10 minutes per transaction. The effect of having such a limit is that the network’s throughput, the amount of material passing through it, is limited, creating a bottleneck in the network: There is too much data waiting to pass through the maximum throughput of the network. This has resulting in higher transaction fees, and a higher transaction time which creates delayed transactions, which could affect the profitability of a transaction, especially when considering how exchange rates of virtual currency to actual currency can fluctuate. Who bears the risks of this and who bears the liability? A lawyer dealing with these blockchains would have to advise a client on drafting force majeure clauses or recalibrate traditional clauses to reflect this new technology.
In conclusion, a smart contract has many applications and could alter the meaning of what makes a contract a “contract”. The lawyer in the digital age will have to adapt traditional notions to the new digital era and understand the technology behind a smart contract in order to smartly draft around it. Whether the smart contract will replace lawyers remains to be seen, as does its overall effect on the legal industry and the study of law.