A Primer On Smart Contracts

A smart contract, like any contract, establishes the terms of an agreement. But unlike a traditional contract, a smart contract’s terms are executed as code running on a blockchain like Ethereum. Smart contracts allow developers to build apps that take advantage of blockchain security, reliability, and accessibility while offering sophisticated peer-to-peer functionality — everything from loans and insurance to logistics and gaming.

This information is from Coinbase.com

A “smart contract”[i] is essentially defined as an agreement between parties based upon a computer program stored on a blockchain.  Unlike traditional contracts, the content of the parties’ agreement in a “smart contract” is embedded in code prepared by programmers.  “Smart contracts” are generally considered to be secure based upon their permanence and immutability attaching from the blockchain.  They are also often touted for their ability to autonomously execute transactions upon the occurrence of stated events, thereby eliminating the need for intermediaries such as attorneys and financial institutions.  As noted earlier, the ability to enter into a contract without the participation of an attorney has always existed. The question that arises, however, is whether, depending upon the complexity of the transaction, it would be advisable to utilize the services of an attorney.  As will be discussed, this question is also relevant with respect to the formulation of “smart contracts.” Questions can also arise with respect to the involvement of third-party financial institutions.

“Smart contracts” have tremendous market potential in a variety of real-world uses and their application continues to rapidly and exponentially expand as the technology evolves. Examples of “smart contract” applications include financial transactions such as investing, trading, lending and borrowing. Other uses and projected uses of “smart contracts” include gaming, real estate, voting, healthcare,  configuration of corporate structures, and legal transactions.

“Smart contracts” support documentation and transaction processes by incorporating blockchain technology.  Decentralized finance (DeFi) on the blockchain offers a competitive edge over traditional banking and financial transactions in that decentralized applications (dApps) provide greater transparency, elimination of intermediaries, greater access (24/7), and lower fees for users.  Blockchain technology in gaming is largely driven by non-fungible tokens (NFTs) which are unique tokens that can represent in-game assets. These NFTs rely on “smart contracts.” Additionally, through tokenization, “smart contracts” are advancing fractional ownership of real estate.  “Smart contracts” have the potential to lower costs and save time by streamlining processes associated with real estate transactions. Delaware, which has traditionally been known as a business-friendly state, is among the first states to allow businesses to be incorporated and managed through blockchain technology. These types of moves open the door for decentralized autonomous organizations (DAOs) which allow for corporate ownership and compensation to be built into “smart contracts.”[ii]  The areas of healthcare and voting are also gearing up to incorporate blockchain technology.  “Smart contracts” allow patient data to be securely stored on the blockchain where it can be accessed only with the patient’s private key.  “Smart contracts” also have the potential for making voting secure, safe and convenient via digital means.[iii]

As with most groundbreaking and disruptive inventions and technologies, both purveyors and opponents of the new developments often rely on puffery, on the one hand, and overly harsh, and sometimes, baseless criticisms, on the other, to support their respective positions.  The same can be said for the blockchain in general, and “smart contracts” in particular.  Supporters of “smart contracts” often have much to gain financially from the adoption of the “smart contract” technology, while opponents often stand to lose financially from the interruption of traditional methods of conducting certain types of transactions. Consequently, the most accurate assessment of the performance of and potential for “smart contracts” lies somewhere in between the competing claims of the purveyors and opponents.    

As stated earlier, “smart contracts” offer up a great deal of potential to increase the security, transparency, accuracy and speed of certain transactions, while lowering the cost of doing business by eliminating the need for intermediaries. However, it is important to keep in mind that there are few, if any, absolutes in life; thus, most transactions involve both pro’s and con’s, and sometimes it’s a matter of determining which outweighs the other.  Some of the most favorable characteristics of the “smart contract” are, at the same time, characteristics that can serve as drawbacks.   For example, the immutability of “smart contracts” is often touted as one of its best features because it, along with other features of the blockchain, allows for trustless transactions.  Conversely, immutability can create issues for parties who have entered into an agreement and thereafter want to modify or renegotiate some of its terms – a not uncommon circumstance.  In a traditional contract, the parties can come back to the table and agree to revise the terms.  The immutability characteristic of the “smart contract,” to the contrary, does not allow for such changes absent in-depth approaches (e.g., forking the blockchain). Moreover, the immutability of “smart contracts” sets them apart from other apps where software errors can often be rectified by simply downloading a patch.[iv]

“Smart contracts” are also touted as being more direct and simplistic since they are based on specific self-executing coded instructions, thereby eliminating the need for expensive attorneys’ fees.  At the same time, however, technical experts such as programmers, computer scientists, cryptographers, engineers, etc. are required to develop the code for the “smart contracts.” Thus, for the layperson who is no more familiar with coding than with the law, the preparation of the “smart contract” will, nonetheless, require the skills and expense of a third party.

The agreements that are most often associated with “smart contracts” are those that involve basic “if/then” scenarios such as, “If x delivers described goods to y, then y will pay x a specified sum.” However, this scenario does not include a broader spectrum of transactions that rely on subjectivity and other factors such as, “If x delivers to y described goods within a reasonable amount of time following y’s request, y will pay x a specified sum.”  Currently, developers  have not yet devised a program that enables “smart contracts” to determine what is “reasonable.”

“Smart contracts” are subject to hacks. A blockchain start-up reported that a hacker stole $31 million by exploiting a bug in software the service uses to draft “smart contracts.”[v] It is to be expected that no system is invincible.  Consequently, the conversation should center, not on the invincibility of certain systems, but instead, on the most effective ways to guard against and address breaches when they do occur.

How we approach “smart contracts” will depend primarily on the capacity in which we are acting at the time we interface with them.  When we are engaging in transactions as users or consumers, the work of “smart contracts” will be interwoven into the background of the contract such that our interaction with “smart contracts” in that context will feel much like our engagement in e-commerce where, depending on the nature of the transaction, we are prompted to click “I agree” in order to move forward with the transaction.  There is no opportunity for negotiations over the terms of the agreement we are about to enter into.  Instead, the contract consists of standardized terms prepared by attorneys who work for the e-commerce companies.  In much the same way, “smart contracts” that drive the typical consumer transactions will be developed unilaterally by programmers hired by the companies with which we are doing business.  Moreover, the process will be the same in other arenas where the institutions, agencies, businesses, etc. will contract with programmers and other technical parties to develop and build the desired code on the blockchain. For patients, customers, voters, gamers, and other users, the “smart contract” will be an integral but unseen part of the transaction.

In a setting involving businesses on both sides of the transaction, the extent of the engagement with “smart contracts” will largely depend upon the complexity of the transaction.  Basic repetitive transactions such as fill-in-the-blank offers to purchase can be programmed by use of a template containing the agreed upon terms by the parties in much the same way that standardized contracts are currently in use.  More complex transactions, however, will likely require, at least for the time being,  that the “smart contract” be accompanied by a traditional, or text-based, contract prepared by an attorney. 

The rapidly evolving technology of “smart contracts” has the potential of revolutionizing the manner in which many industries and institutions function.  It is pretty much a truism that technology races ahead of the law, and the evolution of “smart contracts” is no different. While precedent would indicate that “smart contracts” will be favorably received by the legal system, because we are on the cutting edge of the development of this technology, it brings with it questions that have yet to be answered.  For example, what is the process for validating programmers who code “smart contracts”? How is risk allocated for losses resulting from  incorrect coding and hacks? What type of insurance is available? Since “smart contracts” are immutable, how can revisions to the contract be made? While the “smart contract” can program for automatic payment, what happens if the funds are unavailable when payment is due? Should there be limits placed on the extent to which the “smart contract” can control the transaction?

As we enthusiastically look forward to the improvements and enhancements made possible by the development of “smart contracts,” it would be prudent to temper our excitement with the realities of the accompanying growing pains.

Dr. Mary Wright – Freelance Writer