11 September 2017

What are smart contracts?

A smart contract is a self-executing contract. It contains electronic clauses that trigger processes according to the terms of the contract.

The blockchain provides a multi-verified database of the transactions. A network of participants continuously update the database and verify changes to the contract.

How do smart contracts work?

A smart contract works through automated conditional performance. When a contractual obligation is met, the corresponding obligation is triggered. For example, an obligation could be triggered by:

  • a specific event (“if X happens, then action Y”)
  • a specific date or at the expiration of a period of time (“at X date, action Y”)

A vending machine is a basic example of how conditional performance works. When the buyer inputs money, the vending machine automatically transfers the chocolate bar by physically releasing it to the buyer.

Smart contracts allow the ownership of real assets to be controlled digitally.

By using blockchain technology, it is no longer necessary to physically retain goods until a condition is satisfied. Instead, the blockchain keeps a multi-verified record of the transfer of ownership.

What are the benefits of smart contracts?

Smart contracts provide contracting parties with clarity on the terms of the agreement. The terms of the contract are written in code (rather than legalese) and are accessed via an agreed data source.

Identical, dynamic copies of the contract are kept across the blockchain. Amendments to the contract are verified by the computers of all participants, in accordance with a ‘consensus algorithm’.

This solves the problems of version-control. Contracting parties no longer need to run comparison software over documents to avoid subtle, yet potentially damaging, amendments to the terms by other parties.

Contracting parties can 'view' and 'track' the status of the contract – possibly even in real-time. This could lead to contracts being viewed as their own ‘web-page’, improving transparency and allowing lawyers to report to their clients and clients to report to their board with greater certainty.

Are smart contracts legally binding?

For a smart contract to be legally binding it must have the key elements of a contract, as determined by the relevant jurisdiction. In the UK, a valid contract generally requires offer, acceptance, consideration and intention.

The term "smart contracts” is misleading – many smart contract are better described as “smart processes” with code that automates certain processes to guarantee a set of outcomes.

Are smart contracts secure?

Smart contracts are built on blockchain technology, so this is a question of whether the blockchain that the smart contract sits on, and the code governing the smart contract, is secure. It is generally accepted that most commonly-used blockchains (such as Bitcoin and Ethereum) are secure. This is due to the disproportionate resources that would be required to hack the blockchain and smart contract.

There have been instances of theft and loss of assets stored on blockchains and governed by smart contracts. Examples include the Ethereum DAO attack, a digital decentralised autonomous organisation with its constitution fully coded, and the Bitfinex hack.

As Vitalik Buterin, the co-founder of Ethereum, puts it in his blog Thinking About Smart Contract Security: "All instances of smart contract theft or loss – in fact, the very definition of smart contract theft or loss, is fundamentally about differences between implementation and intent." 

There is a risk of smart contract code being hacked and assets being diverted (as happened with the DAO attack). There is a constant battle to address this risk, but in essence, it is no different from other cybersecurity risks that are being addressed in an increasingly digitised world.

The key risk to security of smart contracts that Vitalik Buterin highlights is the risk that the implementation of the code does not give effect to the intentions of the contracting parties. It is this risk that lawyers, developers and their clients need to address in order to create smart contracts that give effect to the intentions of the parties.

Examples of potential smart contracts

Smart contracts could have a number of applications across many sectors. They could be used to transfer settlement funds between parties upon the performance of a defined obligation, for example on a corporate acquisition or commercial leasing arrangements.

Mizuho Financial Group and IBM are testing the use of blockchain technology to facilitate instantaneous swapping of payments, avoiding delays and ensuring adherence with contractual obligations. 

Smart contracts could also be used in trading “over-the-counter” derivatives, where the source of data for the asset can be agreed, and the data provided by that source is determinative of the terms of the contract. Conceivably, the bank details of the traders could be linked to the code of the contract, allowing for immediate transfer of funds when payments become due.

Do smart contracts mean that we can get rid of lawyers?

The short answer is, probably not – at least not for now. The consensus is that smart contracts will never fully replace traditional legal contracts: there will always be a need for human involvement.

Contracts will always contain provisions that require legal interpretation – by lawyers advising their clients, and by the courts in litigation. Certain legal terms and concepts (e.g. “negligence” or “reasonableness”) can't be defined easily in code – they need humans to make sense of them. Also, transactions that depend upon human performance, rather than the transfer of money, cannot be contained in code.

Lawyers will also need to help construct these contracts. For example, advising on how contractual obligations interact and highlighting contentious areas that could lead to disputes. So, for now, even if smart contracts become widely adopted, lawyers will still be required to help. But hopefully in a more cost-effective and efficient manner!

How can Burges Salmon help?

Through our experience of working with blockchain and smart contract developers, we can help you understand, draft and negotiate smart contracts and smart processes.

To discuss smart contracts in more detail, please contact a lawyer in our fintech team or your usual Burges Salmon contact.

Key contact

Richard Leeming

Richard Leeming Partner

  • Banking and Trade Finance
  • Derivatives, Debt Capital Markets and Securitisations
  • Real Estate Finance

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