Smart Contracts: What Are They and Will They Replace Traditional Contracts?

Smart contracts are one of the most popular and interesting areas being developed in the rapidly growing blockchain industry.  Depending on the particular situation or transaction, their application can be a great alternative to traditional contracts, which are sometimes complex, slow, and expensive.  Smart contracts, however, are not suited for all transactions and, sometimes, a traditional contract is best.  And, while smart contracts may streamline certain transactions, they are not free from legal issues or the potential to create legal disputes.

Discussed here are some of the main differences between smart contracts, traditional contracts, and established automated electronic transactions, as well as legal issues associated with smart contracts.

What is a Smart Contract?

Smart contracts are self-executing transactions written in computer code that can automatically monitor, execute, and enforce a legal agreement.  The relevant contract terms and functional outcomes of the agreement are mapped as code in the distributed, decentralized blockchain network.  Thus, smart contracts inherently include the key characteristics of blockchain technology.

The decentralized and public nature of the blockchain network allows transactions and agreements to be performed among disparate, anonymous parties without the need for a central authority, legal system, or external enforcement mechanism.  That means contracting parties can deal directly with one another without the need for any offline registries or intermediaries such as banks or clearinghouses.

Smart contracts are final and cannot be modified because retroactive alteration is not possible with blockchain technology.  In other words, an automated transaction performed pursuant to a smart contract cannot be reversed or undone.  This creates an issue when a contract or an action performed under the underlying smart contract needs to be declared void.

Differences From Conventional Contracts

Smart contracts are technically not contracts.  Instead, they are mechanisms that enforce agreements using software rather than law.  Yet, given their name, smart contracts are often directly compared to conventional contracts.  Putting aside their technical differences, smart contracts can be said to differ from conventional contracts in several ways, including

• The entire lifespan of a smart contract, from formulation to execution, occurs online.
• That lifespan need not at any point involve any other entity other than the contracting parties.
• Performance is automated and is carried out by computer, following the applicable code.
• Transactions are immutably recorded on the blockchain and cannot be reversed. (If performance under the smart contract needs to be undone, a new contract must be written which reverses or modifies the results of the previous contract).
• Smart contracts follow programmed algorithms, and thus potential outcomes will be in binary form. There is no room for discretion, reasonableness, or subjective judgment.

Differences From Established Automated Transactions

At first glance, a smart contract might resemble other established automated transactions.  For example, automated banking payments, standing orders, or buying media online and downloading it after confirmation of payment.  However, smart contracts differ from these established forms of automated contract execution of an underlying agreement in significant ways.  These differences are a function of the public and decentralized nature of the blockchain.

• Established automated transactions typically include third parties that retain control over the relevant transaction. For example, in a transaction involving a money transfer, a bank could interfere in the process and add or subtract money to any account at any time or could charge fees.  In a smart contract, the need for third parties is eliminated.
• Established forms of automated transactions lack technical flexibility because they are a function of the conditions and attributes included by the developer of the respective code. For example, traditional automated transactions are not triggered by events, such as specific weather conditions, unless the developer included such an option.  In contrast, a smart contract permits for such a trigger even if the developer did not explicitly provide for this condition when creating the code.
• With traditional automated contract executions, the code is exclusively in the hands of the third party responsible for it. For smart contracts, the use of blockchain technology requires that all participants are running the same code, and this code is stored with all participants (or even publicly available).

Thus, smart contracts create trust by using the decentralized, open and encrypted nature of blockchain technology that allows parties to trust each other and transact peer-to-peer, making the need for intermediaries and third parties obsolete.

Ideal – and Not So Ideal – Applications of Smart Contracts

Smart contracts are best suited for agreements between parties without any third-party validation, such as trading in over-the-counter derivatives and the execution of contracts when the triggering event can be measured digitally (e.g., changes in public records or weather information as published by an official source).

An ideal example is a smart contract for the transfer of title to specific real property upon the receipt of a certain amount of funds into a particular account.  This is an action to be performed on the satisfaction of a given condition or set of conditions, which is ideal for a self-executing computer program.  This particular smart contract would eliminate the need for third-party involvement to transfer the funds (since payment can occur directly from bitcoin wallet to bitcoin wallet).  Relatedly, if the title history to the relevant property existed on the blockchain, the need for title insurance could arguably be eliminated as well.

Smart contracts could also be used by airlines, for example, to implement settlement systems for airline passengers regarding their rights, paying out compensation automatically upon qualifying delays.

Smart contracts do have their limitations.  As mentioned above, the potential outcomes of a smart contract are binary in form.  Thus, deliberate ambiguity in a smart contract is not possible.  Contract provisions involving terms such as “reasonable,” “best efforts,” or “to the extent possible” cannot be implemented as code and can therefore not be part of a smart contract.

Potential Legal Issues

With smart contracts, securing performance will be far less of a problem than it is in relation to conventional contracts.  The automated nature of a smart contract means that actions are far more likely to be executed than those promised in the traditional way.  Legal issues are therefore more likely to arise after a transaction has occurred.  In particular, dealing with void contracts could pose a significant challenge because a smart contract, once executed, cannot be legally reversed.  The relevant transaction would be permanently kept on the smart contract’s blockchain (although the parties could agree on further transactions reversing the result of the void transactions).  Thus, it seems litigation of smart contracts is likely to focus on restorative rather than enforcement remedies.

Another key issue for lawyers will be aligning the legal component (i.e., the parties’ agreement), with the technical component (i.e., the computer code responsible for implementing the agreement as logic “if-then” statements).  If these two components are not aligned, a smart contract might generate more legal issues that it aims to solve.

Smart contracts will have far-reaching effects on several areas of law, such as contract law (particularly regarding general terms and dealing with void contracts), license management, products liability (for damage resulting from incorrect or incomplete code), corporate law, as well as regulatory concerns and data privacy issues.  The full extent of their impact is currently unknown, but it will begin to be seen as blockchain technology becomes more pervasive.

Conclusion

Smart contracts are gaining widespread use and ease of creation, and they are being implemented in a wide variety of financial and business processes.  However, the conventional contract is not in any danger of becoming extinct.  While smart contracts may streamline certain transactions, they are not ideal for all transactions.  Moreover, they are not free from the potential to create legal issues or disputes.  Any party entering into a smart contract should consult an experienced attorney, to discuss the fundamental mechanics of the agreement, as well as their rights and remedies should a legal issue arise.

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