The development of blockchain technology has uncovered new possibilities for regulating contractual relationships. Parties to a contract now have at their disposal a new digital environment where contracts may be concluded, performed and enforced in a more efficient and smarter manner, and where middlemen become redundant. What are smart contracts? What benefits will they bring? What challenges do they raise and what constraints would they impose on the parties?
Smart contracts: what are they?
The term 'smart contract' was allegedly coined in the 1990s by Nick Szabo, an American computer scientist and cryptographer (suspected by some to be the creator of Bitcoin), who described smart contract as “a set of promises, specified in digital form, including protocols within which the parties perform on these promises.” This definition still seems to be accurate. Smart contracts operate electronically and contain algorithms for automated performance of the contract (and are therefore irrevocable). In this manner, smart contracts combine the conclusion of the contract with its enforcement. Recourse to the courts is no longer needed as the contract is “self-executing”. This increases the equality of the parties and mitigates the risk that the stronger party will attempt to take advantage of the weaker party.
In short, we can say that smart contracts are decentralised agreements built in computer code and hosted by blockchain technology — a distributed digital ledger (a database spread over multiple computers). In the blockchain, the records of concluded transactions are enclosed in blocks of code and appended to the ledger of transactions (using sophisticated cryptography). The security of the blockchain is increased, in that the cost of breaking the rules is far greater than the benefits such a breach could bring. To reverse any transaction concluded in blockchain, the user needs to control more than 51% of the computer power (or “hashing power”) in the network. Blockchain allows users — by default — not to have to rely on trust in other parties, and therefore constitutes a “trustless” environment. This in turn enables the parties to dispense with participation of a centralised authority or trusted third party to act as an intermediary in the transaction, which makes the entire process more efficient and cost-effective.
Areas of use
Smart contracts seem to be the obvious solution wherever mass transactions are carried out, as they effectively allow transfer of an asset or currency into a computer program, which once launched, validates the conditions (by applying 'if/then' logic) for automatic transfer of the asset or funds to another person, or refund if the condition is not met. The simplest example for use of a smart contract could be a purchase of real estate. Upon payment of the purchase price, the new owner would be entered automatically in the land register (stored in blockchain), and the access code to the property would be delivered directly to the new owner. The seller will also have certainty that when the access code is released to the new owner, and the entry is made in the land register, the purchase price will be credited to the seller’s account.
Smart contracts could also be applied in many ways in the financial sector, in almost any area where a process or transaction may be automated. They could be used for securities, facilitating payment of dividends and voting while eliminating counter-party and operational risks (by cutting out intermediaries). They could also be used for export financing; one could easily imagine smart contracts facilitating streamlined international transfers of goods through faster credit and trade payment initiation. In this area, the benefits of smart contracts could include increased efficiency in creating and validating trade, title and transport-related contract agreements.
Another example could be the use of smart contracts by financial institutions for accurate and transparent recording of financial data and verification of customers’ identity; counter-parties will no longer need to collect and store data to authenticate transactions, which will significantly speed up know-your-customer (KYC) procedures.
Some insurers have recently announced their plans to offer delayed flight insurance on such basis, where the disbursement of proceeds under the insurance occurs automatically without any formalities. This could be one of the areas where the first smart contracts are applied on a larger scale.
Challenges and limitations
Smart contracts could simplify how transactions are conducted, but there are also some serious challenges and limitations that need to be considered.
The first limitation of smart contracts is that they are deterministic. They leave no space for elements to be assessed or for using general clauses (such as 'fairness', 'good faith' or standards of 'reasonableness'), or, simply, room for mistakes by both parties (which in traditional contracts can be rectified by the court). In smart contracts, the parties gain the certainty of executing the assumed algorithm, but lose the opportunity to introduce intentional ambiguity. This is largely due to the limitations of the language that can be used to create a smart contract. Traditional (or 'semantic') contracts are more flexible and can be enforceable without requiring complete knowledge of what might happen in the future — in this sense ambiguity is a semantic feature, not a bug. The need for the parties to a smart contract to envisage every aspect of the transaction and every contingency can also increase the costs of contracting.
Contractual relationships are often too complex to be governed by smart contracts. In such cases the parties need to assess the effects of the given situation and provide for appropriate remedies under a semantic contract, while smart contracts could only be used to implement selected elements of such a semantic (traditional) agreement.
Smart contracts only work in blockchain space. Accordingly, due to the technological limitations of the blockchain technology itself, a smart contract can prove very inflexible and incapable of adapting to changing circumstances. One of the key features of smart contracts is that they are irreversible (written in 'blockchain stone') and cannot be modified by the parties throughout the performance of the contract, other than by conclusion of a brand-new smart contract. So even a small change like deferral of payment by a couple of days may require conclusion of a new contract. This, in turn, contributes to an increase in contracting costs. By contrast, traditional contracts can usually be freely amended by the parties, and some rights under such contracts may be easily waived (for example by a waiver letter) during the term of the contract.
Since humans are flawed by nature, in some circumstances the use of smart contracts may not be suitable, and intervention of state institutions may be required. An example would be delivery of a defective product under a smart contract, which would then give rise to a dispute between the parties, or a situation where the blockchain private key is lost.
Smart contracts also fail to accommodate the social context of contracting. The negotiation process between the parties helps to strengthen their business relationship and allows each party to achieve a better understanding of the other party’s business. This process is also invaluable in preserving certain social norms, which cannot be achieved by smart contracts. Also, for some reason, despite the advent of new technologies, people still prefer to meet one another and interact, and such interaction is also more valuable and rewarding in a business context.
There are many other issues connected with smart contracts and blockchain that remain unsolved, such as restricting minors and other persons without legal capacity from concluding contracts. And with the development of the technology and popularity of smart contracts, more such problems and questions can be expected to come up in the near future.
Smart contracts are an area with great growth potential. They can provide simplicity, speed of execution, and real-time updating in areas where traditional 'dumb' contracts simply can’t. They also reduce drafting time and accounting costs, and the cryptographic technology underlying blockchain provides a cheap and effective way to ensure the integrity of data. Smart contracts based on blockchain technology could make contractual relationships more efficient, with potentially fewer opportunities for error, misunderstanding, delay or dispute.
However, there are many areas where smart contracts will not be suitable; in such cases traditional semantic contracts have significant advantages over smart contracts. Therefore, it is unlikely that smart contracts could ever fully replace semantic contracts, but in the long run they may be a useful device that can make life easier.