Blockchain Smart Contracts

One of the ideas that inspired the development of blockchain technology was the idea to remove third-party intermediaries, such as banks and governments, from an individual’s financial affairs. It remains questionable whether this goal has been achieved, but the rise of cryptocurrencies—most famously, Bitcoin—has raised many questions about existing centralized financial institutions and whether such analog behemoths can be replaced with a system that is better suited to the current digital information age. This line of thought led to the conception and creation of smart contracts, or “Blockchain 2.0.”

What Is a Smart Contract?

Legally, a contract is an agreement between private parties that creates mutual obligations enforceable by law. The vast majority of legal contracts are expressed verbally—by either oral or written communication. If one party fails to fulfill its side of the agreement, then the other party can take legal action to account for its damages. Because of this, traditional contracts require the involvement of at least three parties: two parties to make an agreement and one party to enforce it. This aspect is where smart contracts offer an advantage.

A smart contract leverages the decentralized blockchain’s power to all but eliminate third-party enforcement of legal contracts. Once both parties have agreed to the terms of the smart contract, the smart contract self-executes. Immediately, the terms of the contract are programmed and placed onto the blockchain, making the contract immutable, so much so that even a smart contract’s creator cannot modify it once it is agreed upon. If a party fails to follow through on its obligations, that party is charged the agreed-upon penalties. Smart contracts also reap the other benefits of blockchain technology, such as enhanced security and permanence.

Currently, smart contracts are limited to contracts transferring funds or ownership. Contracts that require more subjective interpretations are not well-suited to the black-and-white, analytic nature of computer code.

How Do Smart Contracts Work?

Smart contracts use code to enforce agreements between their parties. Since the code can only operate in the way that it was programmed, smart contracts eliminate any uncertainty regarding the terms or outcome of an agreement from the outset.

The most basic form of a smart contract is a conditional one. Conditional smart contracts take the form of “if/then/else” statements, which are common to most programming languages. Smart contracts apply this logical programming language to legal contracts. Consider this simple example:

Alice lends Bob two bitcoins at an interest rate of 5%, and Bob puts up unspecified collateral. Alice and Bob agree that the loan will be repaid within one year. All of this information is programmed into a smart contract, and the collateral is held in escrow. If Bob pays back the loan on time, then the smart contract will automatically release his collateral back to him; or else, if he fails to pay back the loan, the smart contract will release his collateral to Alice.

The vast majority of smart contracts are programmed using the Solidity language on the Ethereum platform. On Ethereum, submitting a smart contract requires a small fee, called Gas. Programmers pay this fee to the network to supply the computing power needed to run the smart contract’s code. Some Ethereum users, called miners, dedicate processing power to validating smart contracts. In return, miners receive Ethereum tokens, called ether, as payment. The amount of Gas that a smart contract requires depends on its complexity and the network’s current ratio of miners to smart contract requests.

Smart Contracts and The Law

Even though these contracts are designed to operate independently of any justice system, many smart contracts fall under the scope of state contract law in the United States, per the buyers’ “implied right” in lieu of any written terms. Nick Szabo, the inventor of smart contracts, proposed that a vending machine is, in essence, a primitive smart contract because buyers have implied rights to receive the goods that they ordered whenever they insert the correct amount of currency into the machine. Like a smart contract, nothing other than the correct amount of currency can make the vending machine release the product.

Legal enforcement of smart contracts has come a long way. The Uniform Electronic Transactions Act of 1999, for example, granted electronic signatures and records the same legal standing as paper. Later, the Electronic Signatures Recording Act eliminates any remaining prejudice against electronic legal documents. Recently, some states, such as Arizona and Nevada, have expanded the scope of their laws to include blockchain-based exchanges and agreements.

Still, whether smart contracts will be utilized in any significant capacity in the near future remains an open question for a variety of reasons. First, the technology is still in its infancy stage. Second, it suffers from the same problems that the Internet faces: unintended downtime and clogged networks. Finally, smart contracts require lawyers to be experts in interpreting code.

Fortunately, smart contracts and traditional contracts can coexist. Different from the “code-only” smart contracts described in this article, “ancillary” smart contracts are able to complement a written contract by enforcing certain provisions. In such cases, the written contract always mentions the existence of an additional smart contract.

The DAO Question

Perhaps the most infamous blunder in smart contract history was the 2016 hack of the Decentralized Autonomous Organization (DAO). The DAO was a platform through which venture capital fund stakeholders could vote directly on which projects they wanted to fund. The DAO was created using smart contracts on Ethereum. However, a bug in the organization’s code allowed hackers to siphon off funds without opposition, even after the hack was discovered. Hackers were able to take 3.6 million ether, worth approximately $50 million at that time, from the fund.

But, were these ether really stolen? Technically, the DAO smart contract executed everything according to its code; the bug was simply a loophole in the contract. For these reasons, businesses must consider the possible benefits and risks of these revolutionary technologies before rushing into adopting the technology into their operations.

Final Thoughts

The American Bar Association (ABA) believes that smart contracts are a disruptive technology that will change how individuals conduct business, practice healthcare, and govern society. Lawyers who wish to anticipate these widespread changes may want to familiarize themselves with smart contracts and blockchain technology as a whole so that they can effectively communicate this information to their clients

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