Part I: Smart Contracts: Evolution, Benefits, Risks and Challenges
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Have you ever felt a need where the sale of your old car is effortless to such an extent that you would not even need to bother who’s the purchaser, let alone how the consideration would be paid?
What’s more interesting is the fact that it is possible. Imagine a contract that automatically calculates the payments that are due and the goods to be delivered between the parties, and then automatically arranges for those payments to be made and the goods to be delivered, by merely relying on software code.
This is a smart contract.
In the real world, a contract is an agreement between parties that is intended to be enforceable by law. Within these contracts are agreements that lay out what each party is to do to fulfil the contract. However, with the development of blockchain technology, it has become possible to ensure enforcement of conditions in a contract to be done automatically. A smart contract, which is a set of promises, specified in the digital form, including protocols within which the parties perform on these promises, makes it possible to do so. The capabilities necessary and the data required to execute a smart contract to execute itself is present in the distributed ledger system. These are basically coded into the smart contracts in such a manner that once the obligations are met, the contract is automatically executed.
We know that a smart contract is an autonomous computerized algorithm capable of performing the terms of the contract. But is it any different from similar contractual constructs implementing automated performance, such as vending machines, where goods or services are dispensed/provided when coins are inserted or payment is made?
It’s astonishing to know that the vending machines predate the birth of Christ himself. The first vending machine was set up in Greece in the first century and accepted coins in lieu of dispensing holy water. Would that mean smart contracts are as old as the Roman Calendar itself?
Most of the legal contracts drafted today use customized templates containing standardized legal languages which provide for various terms and conditions. These contracts mostly rely on third parties (i.e. courts, arbitrators, sureties etc.) for their execution and enforcement. This process is redundant and time-consuming, not to mention expensive and unpredictable. This can be circumvented through smart contracts which contain a code that is capable of executing the terms and conditions of an agreement. The contract code defines the terms and conditions as a set of syllogisms in a way similar to that of a legal document.
Much akin to any new technological innovation, smart contracts are subject to various risks and challenges. For instance, a distributed blockchain ledger is a much better alternative and offers more trustworthiness than a central ledger. With blockchain technology, there is more security, traceability, and transparency of records and transactions for participants and regulators as well as lower operational costs. The combination of smart contracts with blockchain adds certainty, security, and resilience. Terms can be verified by independent parties. Moreover, the information stored on the blockchain is protected from security threats as it is maintained on multiple nodes where more than 51 per cent of the nodes would have to be compromised before any problematic issue would be manifest.
The use of evolving smart contracts and blockchain technologies does create a number of potential risks, including governance, deployment, regulatory, risk management and legal risks.
To be effective, blockchain and smart contracts require certain standards, or more plainly, a set of common rules by which all participants operate, in order to ensure accuracy and trustworthiness. The decentralized model poses challenges when you need to change the rules because those changes need to be agreed upon and accepted by all participants to function consistently. A governance framework will be required to implement and operate blockchain as a legal application and needs to take into account oversight and monitoring functions, rule setting, and acceptance and change control management. Governance, in general, will be a requirement not only for legal but for all technologies that manage information. This transformation to some common rules for information governance is not only critical to blockchain but to other pursuits like e-discovery and cybersecurity. Governance standards around the blockchain will eventually contribute to market confidence in the technology and the legal and regulatory environment. This will accelerate the adoption and success of the smart contract.
Though there are various benefits, as we covered above, the practical implementation of smart contracts is also subject to several risks and challenges. These include:
Interoperability – Making sure interoperability exists between different blockchain implementations is necessary so that they can communicate with one another.
Performance – The performance potential and computer resources required to validate, process and detect fraud will be a determining factor for applicability of smart contracts to various services such as banking, financial and payment services. In its current form, blockchain is not capable of handling thousands of transactions with the same level of efficiency that does not sacrifice on the security and decentralization aspects of it.
Scalability - Each node in the particular blockchain network must know about every single transaction that occurs globally, which may create a significant drag on the network. The goal is to perform all transactions with higher efficiency, but in a way that doesn’t sacrifice the decentralization and security that the network provides.
Legally, there also exists uncertainty as to binding nature of smart contracts, the applicability of laws and jurisdictional issues etc. They can broadly be classified into:
Enforceability - Where a smart contract has a legally binding contractual effect, the technology within which it is deployed may sometimes give rise to problems in relation to legal enforceability. There may be no central administering authority to resolve a dispute. Currently, dispute resolution mechanisms are one of the possible ways to address jurisdictional variations and enforceability issues.
Transparency - Blockchain can involve a level of transparency. But what if the parties don’t want the details divulged? It will be difficult to keep the contract private while also retaining other benefits of blockchain.
Liability for Mistake, Error, or Fraud - If something does go wrong with the execution of the contract and someone suffers a loss, where do they go for recourse? We will need a court system that is tech savvy. The courts have started to recognize blockchain not only for cryptocurrency but also for how it can improve the administration of law. Just as the courts got technical with e-discovery, they will need to be able to work with blockchain evidence.
Amendments - How do you unwind transactions that shouldn’t have happened? For instance, if there has been duress or it is a contract that is illegal or in breach of regulatory requirements, how do you make a person liable? Instances of these have occurred on a few platforms already, with a technical “hard fork” response (a split in the blockchain where non-upgraded nodes cannot validate blocks created by upgraded nodes following new consensus rules).
Smart contracts will herald the dawn of new attorney and legal professionals who by necessity will need to be versed in both law and computer programming. In practice, the programmers and legal professionals are already working their way out by tackling the legal and technical issues. The new world where lawyers will draft smart contracts will involve a team of legal and technology professionals. Much is, however, left to be innovated in this domain.