Smart contracts are said to bring together some of the main advantages of blockchain and automation to provide speedy, peer-to-peer validated, contract formation.  So what are the key features of smart contracts, their limitations, and what challenges do they present to lawyers?

Blockchain – a refresher

Blockchain harnesses “distributed ledger technology” (DLT), which is an aggregation of replicated, shared, and synchronised data accessible across multiple sites, countries, and/or institutions.  Blockchain is a type of distributed ledger, comprised of unchangeable, digitally-recorded datasets called “blocks”.

The blockchain is used (for example, and most famously, in Bitcoin) as a public record of peer-validated transactions on a particular network.  The blockchain is maintained by users of the network (called “miners”) and requires no centralised or intermediary involvement and so the blockchain is said to be “decentralised”.  A key feature of decentralisation is that, by removing the need for the traditional, cumbersome, paper-heavy processes typically associated with complex transactions, contract formation is made more efficient (but which can bring with it certain disadvantages, as we shall explore later).

In the case of Bitcoin, transactions are recorded on time-stamped blocks.  Miners are then able to verify the accuracy of these blocks using an algorithm and, upon verification, add the block to the chain, and this activity is incentivised as miners earn Bitcoins for doing this.  Blocks added to the chain comprise an immutable, publicly accessible, chronological record of all verified Bitcoin transactions.

Smart contracts

Smart contracts are expected to bring together the advantages of the blockchain and of automated or autonomous processes, to provide peer-to-peer, validated, contract formation without the need for independent verification.

A smart contract is coded so that it contains the terms of the agreement together with an automated function to form a binding contract upon certain conditions being met.  The conditions could include the performance of an activity by a party to the contract or the occurrence of certain specified events, such that once the conditions are met the contract becomes self-executing and the transaction is recorded on the blockchain.

The efficiencies associated with blockchain have encouraged businesses to explore its use in relation to smart contracts. Although smart contracts have been spoken about for decades, the emergence of DLT and blockchain has brought the potential cost-savings into sharper focus.  For businesses entering into a high volume of contracts, or where rapid contract formation is important, the efficiencies presented by moving away from traditional, hard copy, contract formation are obvious.

Smart contracts are of particular interest to financial institutions given the high number, and frequency, of contracts they enter into.

In August 2016 Bank of America Merrill Lynch, HSBC and the Infocomm Development Authority of Singapore successfully demonstrated, as a proof of concept, the application of distributed ledger technology in a transaction for a (traditionally paper-heavy) letter of credit (LoC).  The platform works by sharing information between the relevant parties to the LoC and their banks, on a private distributed ledger.  The distributed ledger protocol applies a multi-step process to authenticate data and, ultimately, execute the contract.  Use of the distributed ledger replaces the time-consuming bureaucracy necessitated by the issuance and review of paper documents.[1]

In October 2016, Capgemini reported its belief that smart contracts will transform the financial industry by providing significant savings for both financial institutions and their customers, by reducing the need for manual processing and independent verification traditionally associated with contract formation, particularly for products such as mortgages and insurance.[2]

What are the key benefits of a smart contract?

• Trust and transparency: the key feature of blockchain-based applications is transparency.  Transactions are typically validated by a number of users and, at least in the Bitcoin model, the blocks on the chain are publicly viewable and cannot be modified.  This means there is a very high level of confidence in the authenticity of transactions on the blockchain.  This is clearly an advantage for parties requiring certainty that a contract is valid and binding on the contracting parties, however it is likely to be a problem if the subject matter of a contract (including the mere fact a contract has been entered into at all) is commercially sensitive.  This has led to the use of private blockchains, serviced by authorised individuals, private organisations or at an industry level, but this approach could lose one of key advantages of blockchain if only the contracting parties are able to view transactions, without third party verification – without that external verification, it is arguably a form of internal database rather than a true blockchain.
• Efficiency: the automated nature of smart contracts removes the need for the manual processing of documentation and human review, reducing the bureaucracy associated with traditional contract formation.  Automated processes are expected to bring other efficiencies by improving security, eliminating human error, and increasing convenience for all parties through the use of an electronic platform.
• Certainty: upon the condition(s) being met, the smart contract automatically executes without any further need for formalities.  This is advantageous to parties seeking comfort that once certain conditions are met, a binding contract is formed, without the need for further negotiation with the counterparty.  Of course, this could present a problem for parties if automation is found to be too inflexible.

Limitations

The smart contract cannot outright replace contracts in common use today.  The smart contract refers to the automated process by which the contract is formed, and the need for contract terms (whether they are standard terms or negotiated) remains.  Furthermore, at least initially, the implementation of a smart contract structure will require more resources as the smart contract will need to be carefully coded to ensure it performs properly without error.

Such is the nature of smart contracts that they are more likely to be adopted for commoditised products and services, where the underlying terms are not negotiated, or the execution of the contract is dependent on a condition being met (as is the case in certain financial transactions).  The rationale for using a smart contract in connection with an outsourcing agreement, for example, is much less clear.  Even in the case of commoditised, high-volume, contracts, such as customer-facing website terms, it is difficult to perceive the advantages of a smart contract above those of a simple click-through contract.

The need for confidentiality may require the use of a private distributed ledger which would remove some of the key benefits of a blockchain platform, by preventing public scrutiny of transactions and shutting out a larger user base which would otherwise be able to validate blocks on the chain more quickly.

Legal issues

• Execution of contracts: there are likely to be issues around the validity of smart contract execution.  If the smart contract self-executes at the end of a series of inputs or events, the basic contract law requirements for an offer to be made, which is clearly and unambiguously accepted, remains.  Lawyers shall need to ensure that these fundamental principles are addressed such that it is clear at what point (and on what terms) a party is committing to entering into a smart contract.
• Rectifying errors: given that smart contracts self-execute, it could make rectifying errors in the contract much more difficult.  Lawyers would quickly find themselves in uncharted territory if errors in contract drafting or contract execution occur due to poor coding.
• Contract management: self-executing contracts are likely to require active monitoring by contracting parties, as well as monitoring potential contractual exposure, so that parties are aware of contracts which are likely to become binding if certain events take place. In financial services, it is possible that many contracts could become binding if, for example, triggered by specified currency fluctuations, stock market changes, or exposures under hedged positions.  Without adequate monitoring a party could find itself entering into contracts quite unexpectedly.  Lawyers may need to address then possibility of “contract in error” along the same lines as rectifying a “manifest error” at present.
• Privacy: blockchain orthodoxy requires that the blockchain itself is publicly-viewable.  Although transacting parties on the blockchain are typically anonymous, the details of a particular transaction under a smart contract could allow someone to guess a contracting party’s identity, depending on the subject matter and date of the transaction.  Data protection lawyers have not yet begun to address the problems this would present under existing data protection laws, nor the forthcoming GDPR, and are not likely to be able to do so until the ledgers used for smart contracts are developed.
• Confidentiality: as stated above, the blockchain may display commercially sensitive information which could deter businesses from using the platform altogether, unless a private blockchain is used, with strict controls over user access.  If a private blockchain is used, lawyers will need to consider confidentiality provisions covering the operator of the private blockchain and ensure controls are passed through to the individual users verifying the blocks, in tandem with the use of access keys.
• Decentralisation/regulation: if the blockchain is used to support smart contracts used for common investment vehicles and financial products marketed to the public, jurisdictional and regulatory issues may arise.  Although the construction of a blockchain itself may be highly secure, there remains a real possibility that errors in the coding of the smart contract may cause a loss to third parties. This in turn could cause regulators to scrutinise smart contracts and the blockchains upon which they are documented.
• Liability: blockchain platforms have so far utilised open source software (including in the case of the Bitcoin code), which encourages trust in the system as anyone can scrutinise the code and check for coding errors and security weaknesses.  However, there remains the possibility that flaws in the code may give rise to smart contracts which contain errors or are triggered by mistake.  In a traditional contract, the drafting and entry into the contract is the responsibility of the parties and their lawyers. Mistakes are likely to be the result of incorrect commercial instructions, the mistranslation of those instructions by the lawyers, or simply poor contract drafting.  In such situations it is possible to discern the origin of such mistakes and apportion blame (and impose liability).  In smart contracts, where coding gives rise to a mistake, it is not clear how these liability issues could be addressed such that the contracting parties have recourse.  It is likely that the developers of the code underpinning the smart contract would be brought within the scope of liability clauses.  However, imposing some liability on coders would be made more problematic if the smart contract is a collaborative effort between lawyers and the coders, unless lawyers use their own coders and assume all responsibility for coding mistakes. Mistakes in the coding of the blockchain itself would be even more difficult to address given that there in the world of open source software there is no commercial software provider to pursue in the event of failure.

Although certain businesses are beginning to champion the use of smart contracts it is likely that their use shall remain limited to high-volume and commoditised, or low value, agreements.  However, as such businesses seek to harness the efficiencies presented by smart contracts, particularly in more complex situations, both lawyers and regulators will need to move quickly to find the limits of established contract law principles and, where necessary, regulators will need to publish new guidelines, or implement new regulations, to provide legal certainty for the use of an emerging and largely untested technology.

For more information from Kemp Little on digital currencies, please see our article Digital Currency: A primer for in-house lawyers, or refer to our cryptocurrency portal.

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