What is the technology underpinning Smart Contracts?
Smart contracts rely on distributed ledger technology. As the name implies, a distributed ledger is a digital record shared electronically by a number of users, with each participant holding a copy of the same record. Any change in the ledger is broadcast to the entire network, with the result that once an update has been accepted it cannot be altered except with the consent of the whole network. While there are multiple copies, therefore, there is only one record.
Blockchain is a particular kind of distributed ledger technology which is widely used and underpins the digital currency Bitcoin. In a blockchain, data is stored in discrete blocks, each of which is linked to the previous block in such a way that the previous blocks are unable to be changed; the blockchain is shared by the members of the network as a distributed ledger.
If contracts are encoded on blockchain it allows both parties to the contract to access the encoded contract in a single unalterable version. Control over the 'execution' of the agreement does not rest with a single party (e.g. a bank) but is verified by the network of computers connected to the blockchain. That same network would update the blockchain to record the execution of the contract, and then monitor the blockchain for compliance with the terms of the smart contract.
What is a Smart Contract?
Smart contracts themselves use smart contract code to carry out defined functions automatically if predetermined conditions are met. They have been described as self-executing, though such terminology can be confusing: execution in this context means taking certain actions that flow from the contract, rather than referring to the formalities associated with contract formation.
Indeed, in many cases, smart contracts are not contracts at all in the traditional sense, but rather represent the automation of certain functions that may arise from the contract. For example, an early application of smart contracts by AXA has seen them develop a flight-delay insurance product, Fizzy, which will process and automatically pay compensation once pre-determined parameters have been met such as a flight is delayed for a pre-determined period of time. Alternatively, smart contract technology could be used to verify conditions precedent, for example by confirming that a corporate party is a company in good standing.
Why would I use a smart contract rather than a traditional written contract?
There are a number of benefits in using smart contracts including:
- The security of blockchain makes the transactions more secure including removing the risk of error or fraud from a third party intermediary.
- As the terms of the contract are encoded they arguably have more clarity than written instructions which can be interpreted and misconstrued.
- The efficiencies and cost savings of automating processes can be realised.
- It creates a relationship of trust as blockchains are immutable and transparent so transactions can easily be verified.
Do I need any written terms if I use a smart contract?
The requirement for defined functions in a smart contract makes it likely that a smart mechanism will be used only for certain provisions for which automatic performance is appropriate. This could be by way of a smart mechanism which translates those provisions into machine-readable code. In this scenario, the legal contract includes all the contractual terms in the usual way and the smart contract encodes certain of those terms so that they will be implemented them automatically when appropriate.
Alternatively, the self-executing provisions could be hived off from the legal contract into a separate smart contract written in computer code to which the legal contract would simply refer. In some contexts, it may be appropriate to have a master contract, written in natural language, containing boilerplate and other standard provisions, and subordinate smart contracts to deal with particular points for which the use of conditional logic is appropriate.
An issue here is how the parties, who may lack programming expertise, would understand the obligations to which they have committed themselves under the contract, as well as the obvious danger of programming errors leading to unintended consequences when the contract is implemented.
Can smart contracts be used to replace any contractual relationship?
The dependence of smart contracts on conditional logic makes them best suited for contingencies that are binary in nature. In the field of financial services, for example, a smart contract could ensure that a certain payment is made if certain conditions (relating perhaps to exchange rates or share prices) are fulfilled. Smart contracts are less suitable for contingencies where there may be an element of judgment or nuance, and it seems unlikely that they will be able to be used in circumstances where, for commercial or relational reasons, a party might want to be able to choose the extent to which it will seek to enforce its rights under a contract. It is also seems unlikely that smart contract code will be used for boilerplate provisions, such as jurisdiction or entire agreement clauses.
It seems unlikely that smart contracts will replace traditional contracts in their entirety. But we may well see their use increase in certain contexts, especially in the light of technological developments in related fields. For example, the potential for smart contracts to gather data from external sources, such as company registries or stock market prices, known in relation to smart contracts as oracles, will increase as such data is made available in such a way as enables it to be more easily interrogated.
Developments in fintech or cleantech may interface with smart contracts in productive ways, and the combination of smart contracts with the internet of things may have a significant effect on e-commerce. IBM and Samsung have developed a proof of concept for a Samsung washing machine which could deploy a smart contract to order and pay for detergent as and when required, and to detect a failing of any of the parts of the washing machine, investigate and determine the warranty status and order a repair service under any existing warranty.
The future of smart contracts
Smart contracts are part of the 'blockchain revolution' and create a mountain of new opportunities. They will inevitably bring efficiencies and benefits for businesses'. However they still have their limitations and the quality of the output depends on the quality of the input. Furthermore smart contracts must still operate within the boundaries of the law. A transparent, immutable ledger must be reconciled with embedded principles of confidentiality, data protection and the ability to rectify 'errors of intention'.
Suzie Miles, Associate at Ashfords
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