Use of Blockchain Technology for Legal Contracts: Will Smart Contracts Replace Lawyers?

in Research   Posted on April 16, 2021  Author: Imed Bouchrika,

The emergence of blockchain gave birth to cryptocurrencies and provided the groundwork for the transformation of global finance. That happened a decade ago. Today, through smart contracts, blockchain is changing how legal practice is done.

Are smart contracts the blockchain technology that will replace lawyers or are they merely a passing trend?

No one really knows what the future will bring. But at the rate this major technology is developing, it is best to know more about smart contracts. This article will explain the basics of smart contracts, the blockchain technology behind them, key smart contract benefits and challenges, and other details.

 

Will Smart Contracts Replace Lawyers? Table of Contents

  1. What is a smart contract?
  2. How does a smart contract work?
  3. Smart Contract Best Practices
  4. Are smart contracts enforceable?
  5. Use Cases of Smart Contracts
  6. Benefits of Smart Contracts
  7. Challenges of Smart Contracts
  8. Smart Contracts in the 4th Industrial Revolution

Closing and executing deals are among the most labor-, time-, and money-intensive activities any business can have. Once a buyer and a seller reach an agreement, the terms of the contract are carefully put into words. Both parties must thoroughly examine the contract before they affix their signatures on it. A series of changes often occur before the entire contract becomes accepted by both parties.

With the emergence of smart contracts, this complex and tiresome process is finally made easier, faster, and more secure. However, will this robust, disruptive technology ever take the place of lawyers and other third parties involved in creating contracts? Will the relationship between smart contracts and law firms become beneficial or detrimental to one another? Read on these key details about smart contracts and be the judge.

What is a smart contract?

A smart contract is a digital contract that automatically executes the terms of an agreement by itself. In layman’s terms, it is a computer code that holds the terms of a contract. It is stored in decentralized, distributed public blockchain networks that contracting parties can access from anywhere, at any time. With these designs, this purely digital type of contract that runs on blockchain nodes cannot be changed.

Unlike its traditional counterpart, a smart contract automatically facilitates, certifies, or carries out the negotiation or implementation of a business deal. Likewise, because its design has solved the issue of trust and that it is self-executing, the need for a third party to process the contract has been removed.

Origin of Smart Contracts

It was 1994 when Nick Szabo, a cryptographer and computer scientist, first proposed the notion of using computer codes to record contracts, which he then published in an academic paper. He initially defined smart contracts for different uses like enforcing contracts, detecting frauds, and digital currencies. He also developed Bit Gold, which is one of the first versions of Bitcoin.

In a follow-up article, Szabo (1997) discussed some smart contract protocols, which elaborated on the use of cryptography and other digital security methods to secure deals and remove third-party intervention.

The first blockchain was developed from the early 1990s until the late 2000s. In 2009, Bitcoin introduced the first use of blockchain technology. In 2013, programmer Vitalik Buterin proposed Ethereum, while the first functional smart contracts were introduced in 2015.

Smart Contracts and Bitcoin

Of all blockchain applications, bitcoin is the most popular and most used. It is the oldest and largest cryptocurrency and it continues to be a peer-to-peer (P2P) network for sending and receiving digital currencies. However, it does not offer smart contracts nor has any other uses.

To a large extent, smart contracts have helped reestablish blockchain’s technological domination on the world stage. These are the notable characteristics that differentiate smart contracts:

  • They are transparent since they are open-source.
  • Smart contracts are bits of computer code that run on the Ethereum blockchain network.
  • Because the outcome of a smart contract is already recorded on a blockchain ex ante, the result of executing a smart contract cannot be reversed.
  • After deploying them, no one can alter smart contracts since they are stored on a blockchain.
  • Smart contracts are self-executing and move cryptographic assets as per the pre-designated rules.

blockchain history

How does a smart contract work?

A smart contract is an agreement between two parties in digital format. But with all the highly complex technicality of blockchain technology, ordinary people will find it really difficult to understand how a smart contract works.

To help grasp what is a smart contract, Szabo compared it to a vending machine (Levi & Lipton, 2018). He explained that users only need to drop the correct value of the cryptocurrency to create and execute a smart contract—including required payments and documentations like permits, valid IDs, etc. Once the contract stipulations are established, the smart contracts will automatically implement them. Both parties can just sit back and observe as the deal unfolds and gets completed.

Theoretically, entire organizations and computer systems can operate completely on smart contracts. Actually, to some degree, several cryptocurrency networks are already doing this. Because all rules are predefined prior to deployment, the system itself can run independently and autonomously.

Aside from existing on their own, smart contracts can also be executed together with other smart contracts, without any constraint on the number of integrating systems. However, this entails the need to make each system depend on each other in order for each smart contract to function. For instance, a successfully completed smart contract can initiate another smart contract to be implemented, and so forth.

Moreover, by using smart contracts, different parties who are totally unknown to each other can partake in a highly-secure deal. This robust system ensures that any form of cheating will not happen and expedites that a stipulated fund transfer will occur as determined. These are the essential exchanges of powers that transpire on decentralized networks like Ethereum and Bitcoin.

Objects of Smart Contracts

Every smart contract has three essential elements, called objects. These objects are the signatories, the subject of the agreement, and the specific terms or rules.

The signatories are the two or more parties that participate in the smart contract. These parties use their digital signatures to express their concurrence or disagreement with the agreement conditions.

Next is the subject of the agreement, which is an object that can only exist inside the environment of the smart contract. Because of the need for parties to have direct, unobstructed access to the object, the subject of the agreement had caused considerable challenges and delays in the development of smart contracts. It was only after the first cryptocurrency was introduced in 2009 that this issue was resolved to some extent.

The third object is the specific terms of the agreement. This involves the particular set of rules of engagement for both parties, completely defined mathematically. It also uses a deep programming language that suits the specific environment of the smart contract (such as Solidity). The terms include rewards and penalties, rules, and the extent of responsibilities from each party.

How are smart contracts created?

Since it is entirely digital, a smart contract contains all the terms of an agreement, including its penalties and rules. These pieces of information are securely embedded in highly-secured code that is very difficult, but not totally impossible to interfere with.

To create a smart contract, some key variables must be established to properly frame the terms of the agreement:

  • Identities of the participating parties (can be two or more, individuals or organizations)
  • The valuable item or asset being exchanged
  • The way and time when the transaction rules will be executed.

It is only when the agreed terms are satisfied that a smart contract will be triggered to implement itself, which in the process removes the traditional middleman from the equation. This is why the novel idea of potentially removing lawyers in transacting business deals has emerged and continues to intensify.

To allow smart contracts to function and exist correctly, they must operate in:

  • A particular, suitable environment. The environment should enable users to utilize public-key cryptography. This allows contracting parties to terminate the deal with their cryptographic codes that are unique.
  • An open and decentralized database. This is a fully automated, decentralized environment that users can trust completely. This makes the Ethereum Blockchain the most suitable environment for these digital agreements.
  • A completely dependable source of digital data. This involves the use of secure-connection protocols like HTTPS and SSL security certificates.

The Role of Tokens in Smart Contracts

Like in traditional contracts, the use of smart contracts also involves the exchange of valuable things like money or service. But for smart contracts, digital tokens and cryptocurrency are used in the exchange. Tokens basically function as the digital representation of the resource or asset being exchanged.

It should be noted that while there are smart contracts that are also tokens by themselves, such as ERC-721 and ERC-20, not all small contracts are tokens.

Still, one of the major functions of digital contracts is the transfer of cryptocurrencies. For instance, if bitcoin is used in the agreement, the seller’s bitcoin will transfer to the seller once the payment is confirmed.

Moreover, not all tokens have financial value. Depending on its design, a token can also be used to provide users with the authority to vote on a decision about the contract.

Are smart contracts as good as business rules?

As mentioned earlier, smart contracts have the capability to expedite the exchange of anything of value, in total trust and transparency. This is done without the need for and related cost of a middleman, with all the agreed-upon conditions and terms embedded securely in a blockchain, and stored in a decentralized, distributed ledger.

Nonetheless, in legal terms, smart contracts are, in fact, neither contracts nor smart. They are actually business deals converted and stored into a software program.

On the one hand, in principle, smart contracts are similar to automation platforms that organizations use today. On the other hand, the automation processes that smart contracts can perform go beyond organizational limits and can entail numerous corporations or groups. Further, they can exist in ways that even the most robust automation software cannot.

Simply put, since the code of a smart contract operates on top of a decentralized, distributed ledger, the stored business conditions can be applied to any party included in the blockchain and even beyond. However, converting contractual conditions into computer codes does not automatically make such agreements legally-binding among the agreeing parties.

While there are efforts to make smart contracts automatically legally enforceable, such initiatives are presently beset with considerable issues and uncertainties. This is because there are still no universally accepted standards on what a smart contract is.

To appreciate the differences between a smart contract and a normal/traditional contract, here is a good comparison:

how smart contracts work

Smart Contract Best Practices

Smart contract adoption is still in its early stages and this means its implementation is still developing. As such, there are still no existing best practices available.

Nonetheless, there are a few guidelines that programmers can consider in designing efficient smart contracts and considerations that organizations can take into account when using this blockchain-based technology.

  • Simple contractual agreements. It is best for individuals and organizations to use code-only smart contracts for executing simpler agreements until there are considerable improvements in their enforceability and legality.
  • Continue producing physical contracts. Parties will continue to prefer having text versions of agreements so they can read the agreed-upon terms, memorialize things that smart contracts are not equipped to address, and have a document they know any court will enforce.
  • The hybrid method. Because of the partially-enforceable nature and validity of smart contracts across the world, it is best for private and public organizations, to use the combination of physical and code-based contracts. In the U.S., a few state/local contract laws are already enforcing smart contracts, but still not at the federal level.
  • Specify the smart contract code. When using hybrid contracts, the physical contract must bear the corresponding code of the smart contract. This will allow all parties involved to have complete visibility over the smart contract’s variables, milestones that will push code implementation, as well as all pertinent definitions, assets, and information.
  • Insurance versus related risks. Parties may also decide to insure against potential errors that the smart contract might contain. Although they are designed to eliminate third-party engagement, it is best to have the code reviewed by professionals at this stage.
  • Risk allocation. Allowances should be considered by both parties to anticipate the occurrence of coding errors.
  • Documented representation. The physical contract must also provide some statement that each party has reviewed the digital contract code and that it displays the correct and complete agreed terms. This will facilitate any claim that the code was not reexamined.
  • Contingency when the oracle fails. These are smart contracts that depend on oracles for pushing out off-chain data. In case the oracle fails to do so, offers wrong data, or just malfunctions, parties should determine what must be done.

A sample smart contract code using Solidity (Source: Ethereum.org, n.d.).

Are smart contracts enforceable?

As earlier mentioned, only state-level interpretation and enforceability of smart contracts are currently observed in the United States. As such, any determination involving smart contracts must include the fact that different American states may assume diverse perspectives. Nonetheless, these are certain key legal principles that uniformly apply throughout the U.S., and initiatives to unite state and federal laws continue to develop (Levi & Lipton, 2018).

In general, American states recognize that while two parties can enter into various types of agreements, a contract indicates that the agreed-upon arrangement is enforceable and legally binding. To establish enforceability, state courts usually examine whether a contract satisfies common legal requirements, i.e., offering, acceptance, and consideration.

At present, some types of contracts are required to be made in writing, where supplementary procedures may be needed. These may involve those required under the state statutes of frauds and the Uniform Commercial Code (UCC). This shows that contracts must not always be in a notarized text to become enforceable. This makes numerous code-only smart contracts also enforceable under contract laws at the state level.

traditional contract vs. smart contract

Due to the fact that even if a contract is delivered only in code (smart contracts), there are no specific hindrances in the formation of contracts beyond the limits set by statutes of frauds and the UCC. Actually, the role of IT in creating contracts had long been considered by several legal perspectives and laws.

The Electronic Signatures Recording Act (E-Sign Act) and the Uniform Electronic Transactions Act (UETA), for example, have, to some extent, acknowledged the enforceability and validity of digital contracts (Levi & Lipton, 2018). These laws include stipulations regarding electronic agents, whose functions and outcomes can be legally assigned to the agreeing parties (Carey & Sayer, 2019).

Around 47 American states have existing legislation that suggests that both electronic records and computer applications should be given similar legal outcomes as textual documents. Nevada and Arizona, for example, have introduced amendments to their local UETA laws to integrate smart contracts and other blockchain applications.

As of 2018, only a few states had passed legislation recognizing smart contracts, and the existing legislation was very modest in scope. The fact that these states have adopted decidedly different definitions of those critical terms suggests that as more states follow their lead, there may be increasing pressure to adopt unified definitions to reflect blockchain and smart contract developments.

The State of Smart Contract Legislation 2018

StateYearLegislation
Arizona2017AZ HB2417 (Passed):
Signatures; electronic transactions; blockchain technology
Tennessee2018TN SB1662 (Passed): As enacted, recognizes the legal authority to use distributed ledger technology and smart contracts in conducting electronic transactions; protects ownership rights of certain information secured by distributed ledger technology
Nebraska2018NE LB695 (Pending): Authorize and define smart contracts and authorize use of distributed ledger technology as prescribed
New York2018NY A08780 (Pending): Relates to allowing signatures, records and contracts secured through blockchain technology to be considered in an electronic form and to be an electronic record and signature; allows smart contracts to exist in commerce
Ohio2018OH SB300 (Pending): Revise Electronic Transactions Act/blockchain/smart contracts
Vermont2018VT S0269 (Passed): An act relating to blockchain business development
Illinois2020HB3575 (Passed): Blockchain Technology Act
Source: Adcock (2020).
Note: Other American states continue to study legislation pertinent to the utilization of both blockchain technology and smart contracts.

Use Cases of Smart Contracts

Since it was initially suggested by Szabo in 1994, smart contracts had received varying views from central banks, financial institutions, and governments across the world. Some continue to remain highly tentative, while others had been cautiously accepting.

Nonetheless, most financial regulators and experts tend to agree that their underlying technology—blockchain and cryptocurrencies—has been widely considered as ‘disruptive,’ which fuels smart contracts’ implementation across all levels.

For instance, smart contracts were successfully used in blockchain-based credit default swaps involving the Depository Trust and Clearing Corporation and several major banks that include J.P. Morgan and Bank of America Merrill Lynch. A consortium of South Korean and Japanese banks is testing the combined use of smart contracts and blockchain to allow cross-border money transfers between the two countries.

Similar use cases that have successfully deployed smart contracts already abound. Here are some notable examples per sector or industry.

Insurance Industry

Some of the early adopters of smart contracts are insurance firms. In fact, the worldwide blockchain market in insurance is predicted to reach around $4 billion by 2023. In many cases, smart contracts have been proven to further enhance insurance process efficiency through proactive and real-time claims automation.

Notable examples include:

  • Fizzy. This air travel insurance developed by AXA uses smart contract technology to offer a reliable, automated system in managing flight delay insurance claims. Linked to live air traffic databases worldwide, the smart contract is designed to automatically trigger once more than two hours of delay happens (Terekhova, 2017).
  • Blockchain Insurance Industry Initiative (B3i). A Swiss-based startup insurer conglomerate of 15 member firms offers innovative blockchain-based insurance products using smart contracts to validate claims situations. More than making insurance more efficient and lucrative, B3i aims to leverage smart contracts in transforming how insurers work.

As a nascent technology both in design and real-world implementation, constraints on the use of smart contracts in insurance still abound. In fact, after one year of operations, AXA stopped offering Fizzy due to poor market response (Wood, 2020). AZA is also part of the B3i consortium and plans to develop and new blockchain-based products in the near future.

Here are some of the concerns that limit the popularization of smart contracts:

Chart context menu
View in full screen
Print chart

Download PNG image
Download JPEG image
Download CSV
Download XLS
View data table

Constraints of blockchain smart contracts in insurance

Constraints of blockchain smart contracts in insurance
Understanding blockchain and use cases: 53

Understanding blockchain and use cases

%
Constraints of blockchain smart contracts in insurance
Communicating blockchain to key decision makers: 50

Communicating blockchain to key decision makers

%
Constraints of blockchain smart contracts in insurance
Evaluating cost-benefit of use cases: 50

Evaluating cost-benefit of use cases

%
Constraints of blockchain smart contracts in insurance
Uncertainty around time needed to start repaying benefits: 43

Uncertainty around time needed to start repaying benefits

%
Constraints of blockchain smart contracts in insurance
Other technology investments taking priority: 43

Other technology investments taking priority

%
Constraints of blockchain smart contracts in insurance
Re-engineering business process: 41

Re-engineering business process

%
Constraints of blockchain smart contracts in insurance
Understanding legal and compliance issues: 40

Understanding legal and compliance issues

%
Constraints of blockchain smart contracts in insurance
Procuring talent and expertise: 40

Procuring talent and expertise

%
Constraints of blockchain smart contracts in insurance
Ensuring data security: 38

Ensuring data security

%

Source: Intellias (2018)

Designed by

Healthcare Industry

For decades, medical practice and healthcare provision must continuously deal with the huge challenge of efficiently managing patient data, records, and health information. There’s also the increasing number of fraudulent cases involving patient data, which is mainly due to the systemic weaknesses of antiquated systems still being used even in modern hospitals and clinics.

These problems will continue to persist unless something drastic is done. To improve the situation and allow practitioners to focus more on providing better care, smart contracts become compelling. Here are some healthcare areas where smart contracts are currently being used or are being considered for deployment:

  • Clinical research. The need to make archival patient data automatically become permanent and protected from unauthorized access is where smart contracts come in. For instance, Encrypgen employs smart contracts to provide genomic data of specific patients to support researchers in their work. With easy and secured access to key DNA data, clinical researchers can better dispense with their work in exploring promising cures and treatments.
  • Telemedicine. Using smart contracts can help guarantee the privacy and safety of patient data and other essential clinical information. This blockchain technology can be deployed on a large scale for protecting patient information, ensuring record-keeping transparency, as well as enabling access to authorized users (Thomson, 2019).
  • Health records. With smart contracts, patient data and records can be securely stored on decentralized, distributed ledgers. This makes the system more efficient and fast because the need to always fill-up numerous forms whenever patients transfer from one hospital to another will be eliminated. This also allows physicians to access patient data on the blockchain network.
  • Health insurance. When patients use smart contracts to purchase health insurance, all policy information will be automatically protected in their profile, which is then safely stored on a decentralized, distributed ledger (Thomson, 2019).

Government

The worldwide shift among countries toward implementing e-government systems has become more compelling with the entry of smart contracts into the realm of public service. By providing services based on blockchain technology, governments can securely exchange information and share resources with individuals, groups, and other governments over a distributed, decentralized public ledger.

Aside from ensuring the safety of government and citizen’s data, the use of smart contracts removes the single point of failure that is inherent in most public services models (Moné, 2019). It also can help regain or improve public trust in government service as well as enable officials and administrators to achieve greater transparency and accountability.

Here are some of the real-world uses of smart contracts in government systems:

  • voting (elections and proxy)
  • taxation
  • legal entities management
  • health care
  • corporate registration
  • supply chain traceability
  • land registration
  • identity management
  • digital currency/payments.

A good use case of smart contracts is during elections. This blockchain technology can be used for validating the identity of voters and for recording votes. Once all votes had been counted, this data may also be used to trigger other actions. For example, because smart contracts do not allow blocks to be altered after they have been recorded, it is impossible to manipulate election results, thus further ensuring the sanctity of citizen’s right to vote (Chin, n.d.). This also helps restore the public’s confidence in the system.

Overall, a blockchain-based e-government model offers the potential to address inherent public service problems and provides the various advantages that include:

  • Reduced likelihood of graft and corruption
  • Safe and secure storage of all government data
  • Minimized labor-intensive activities
  • Reduced exorbitant costs related to managing accountability
  • Higher trust in online civil systems and government.

Payroll and Other Business Management Process

Smart contracts also offer revolutionary changes in how organizations manage their payrolls and other key corporate systems. As more organizations operate with a remote, distributed workforce, managing employee salaries had become more complex.

For employees who work and reside domestically, employers only need to process paychecks through a local bank. However, things become complicated and burdensome when an employee transfers residents or when employees from other countries get hired. In these scenarios, the employer either uses third-party providers (e.g., fintech) or transact with international banks. However, this option increases payroll processing cost and time.

When money crosses borders, currency exchange costs are added, while intermediary banks must also be paid for their services. Some banks also charge client or encashment fees for transborder money transfers.

These money and time-intensive processes to transfer paychecks across national borders will either be eliminated or drastically reduced with the P2P system that blockchain can offer. A blockchain-based P2P system will transfer money faster from one country to another worldwide while offering more convenience, transparency, and flexibility to employees and companies alike, both domestically and internationally.

With blockchain’s decentralized, distributed network, this system also allows employees, professional service providers, or freelancers to directly receive money 24/7 from anywhere in the world. Likewise, payroll and other employee information cannot be manipulated without authorization. Moreover, the transparency of payroll history and information will become more transparent, while hindering transactional errors and delays.

Bitwage is a good example of a blockchain application that companies use at present. Another is Etch, where tokens can be used by employees to facilitate payroll payment and run under smart contract rules. This innovative solution also offers a payroll card that employees can use for buying online goods.

Sample smart contract for payroll

A sample smart contract for payroll (Source: Frega, 2018/Medium).

Initial Coin Offering (ICO) / Crowdfunding

Since their first public offering in 2013, which raised around $0.6 million (Merre, 2019), ICOs had been using blockchain and smart contracts when conducting crowdfunding events.

A smart contract is needed to create an ICO, which also uses a token from the smart contract for the initial process. The next step involves framing the rules of the smart contract (Momtaz, 2018).

More and more ICO events had been successful to date (Reiff, 2018). Many people take part in ICOs mainly because, once the product is completed, the tokens can be used on the application. Likewise, just like the appeal of bitcoins, people purchase coins or tokens because these are good investments, especially for trading.

Some of the biggest ICOs, whose ROIs range from as low as 26,367% to as high as 1,265,555%, include NXT, IOTA, Neo, Ethereum, Spectercoin, Stratis, Ark, and Lisk.

Smart Contracts Use Case Applications

IndustrySectorWhat Smart Contracts Can Do
Financial ServicesTrade clearing and settlementManages approval workflows between counterparties calculates trade settlement amounts, and transfers funds automatically
Coupon paymentsAutomatically calculates and pays periodic coupon payments and returns principal upon bond expiration
Insurance claim processingPerforms error checking, routing, and approval workflows, and calculates payout based on the type of claim and underlying policy
Micro-insuranceCalculates and transfers micropayments based on usage data from an Internet-of-Things-enabled device (e.g., pay-as-you-go automotive insurance)
Life sciences and health careElectronic medical recordsProvides transfer and/or access to medical health records upon multi-signature approvals between patients and providers
Population health data accessGrants health researchers access to certaln personal health information; micropayments are automatically transferred to the patient for participation
PersonaI health trackingTracks patients' health-related actions through loT devices and automatically generates rewards based on specific milestones
Technology, media, and telecomRoyalty distributionCalculates and distributes royalty payments to artists and other associated parties according to the contract
Energy and resourcesAutonomous electric vehicle charging stationsProcesses a deposit, enables the charging station, and returns remaining funds when complete
Public sectorRecord-keepingUpdates private company share registries and capitalization table records, and distributes shareholder communications
Cross-industrySupply chain and trade finance documentationTransfer payments upon multi-signature approach
Product provenance and historyFacilitates chain-on-custody process for products in the supply chain where the party in custody is able to log evidence about the product
Peer-to-peer (P2P) transactingMatches parties and transfers payments automatically for various P2P applications (e.g., lending, insurance, energy credits, etc.)
VotingValidates voter criteria, logs vote to the blockchain, and initiates specific actions as a result of the majority vote
Source: Deloitte (2016)

Benefits of Smart Contracts

When buyers and sellers use smart contracts to finalize their business deal, both parties tend to gain the following:

  • Efficiency — Rather than wasting considerable time, money, and effort in creating and managing text-based contracts, code-based smart contracts offers unparalleled efficiency. Aside from removing the need for manual processing loads of paper files, both parties can easily and safely share or access smart contracts from any particular location, and so forth.
  • Security and safety — If designed and executed correctly, smart contracts are very difficult to penetrate without the right credentials (Cointelegraph, 2020). By using high-level cryptography, smart contracts are stored in perfect environments, which ensures the total safety of documents.
  • Resource savings — Third-party intermediaries like consultants, agents, and notaries are not required when using smart contracts, thus the considerable resources that can be saved. Even financial services firms like banks and insurance firms can achieve considerable financial savings by using smart contracts (Capgemini, 2017).
  • Trust — Your documents and other confidential information cannot be stolen since they are safely stored and encrypted on a decentralized, distributed ledger. The unbiased technique used by smart contracts removes the need for participating parties to trust each other.
  • Autonomy — Smart contracts are self-executing, thus it removes the common need for a facilitator or intermediary. This provides users total control of the deal.

Source: Capegemini (2017); *Deloitte (2016).

Challenges of Smart Contracts

Smart contracts provide unprecedented functionality and the automation of contract terms. However, no court anywhere in the world will acknowledge the legality of code-only smart contracts. This is because current legislative systems do not recognize the validity of electronic contracts.

Another challenge is the notion that code-only smart contracts will soon become at par with traditional, text contracts. Therefore, the issue does not concern much legal limitations but more about how transactions are conducted by the different parties and how code-based smart contracts operate.

There is also the reality that smart contracts are new and still developing. Even with their numerous potentials, smart contracts can still be vulnerable to issues. For example, there is an urgent need that the code comprising the smart contract must be perfect and free of any glitch. If the code contains errors and bugs, a smart contract becomes susceptible to attacks.

Like in the case of the DAO hack, which involved 3.6 million Ether stolen (amounting to $70 million at the time), money put into a smart account with a coding error can be stolen from the blockchain (Güçlütürk, 2018). A recent study found that about 34,200 existing Ethereum smart contracts worth $4.4 million Ether are vulnerable to attacks because of poor coding that contains bugs (Nikolic et al., 2018).

In addition, a long list of uncertainties continues to cloud smart contract progress in the legal environment. These include questions such as: How will smart contracts be regulated by the governments? What will happen if something unforeseen happens to the contract? Will smart contracts be taxed? And so forth.

In spite of these challenges, like with other innovative technologies, smart contracts will likely become more integrated into the legal environment in the near future.

Potential Problems with Contract Data

At present, smart contracts are deployed as a program that links to a text-based contract through an addendum that validates an unchangeable connection between the code-based contract and the text-based one (Mearian, 2019).

Like any form of technology, a smart contract is not without any issues. For instance, since smart contracts can be implemented without the need for parties to meet in person, the likelihood of fraud or misrepresentation is considerable (Sharma, 2020).

Another problem is how far will smart contracts will be made enforceable and valid under contract law (BAL Lawyers, 2018). This issue will likely remain for the time being, considering courts have yet to give this some attention and interest.

Likewise, people still find it hard to accept that agreeing parties in smart contracts essentially surrender their jurisdiction over certain aspects of a contractual obligation to a computerized protocol that is immutable. This is another major reason why smart contracts continue to lag in penetrating legal frameworks worldwide.

Theoretically, the innovations that smart contracts offer are indeed remarkable and far-reaching. However, problems will likely continue to persist, especially those that express the collective sentiment against the remote possibility of having high-level algorithms control human existence, like what AI advancements often elicit.

Auditing Smart Contracts

The process and considerations involved in conducting audits on regular computer codes are basically the same as auditing smart contracts, i.e., both entail painstakingly examining code to identify vulnerabilities and security cracks before it is deployed publicly (Hussey & Phillips, 2021). It is similar to test driving a newly manufactured car before certifying it as safe and ready for public consumption.

This is why program designers of both regular and high-level programs like blockchain and smart contracts have the critical responsibility to ensure the safety, security, and integrity of their products. It is crucial to identify and correct any flaws in any smart contract before it is launched since it is self-executing and is immutable, being a replicated, append-only connected array of Merkle trees.

A solid, foolproof auditing protocol will be key in identifying bugs, security flaws, and other vulnerabilities in the code. A robust audit process must involve stringent validation with underlying practice, theory, and tool application. One such approach is HashEx’s audit report for smart contracts (Mishunin, 2018):

  1. Disclaimer. This opening section is very important as it informs clients that meeting the audit requirements does not mean their system is totally free of security flaws, bugs, or any vulnerability. Human errors are inevitable.
  2. Background. Provide information for conducting the audit, such as rationale and authorities that allowed the activity.
  3. Critical Severity Issues. This portion presents systemic vulnerabilities and problems that can cost the client unlimited funds.
  4. High Severity Issues. Describes issues that can cost the client unlimited funds. This cost can be calculated prior to having the contract deployed.
  5. Low Severity Issues. This section does not involve any fund loss but discusses better solutions or minor issues.
  6. General Recommendations. Expert suggestions to code enhancement are provided here, including guidelines for implementing best practices.
  7. Conclusion. The next steps that clients must undertake after reading the report are presented here.

Contingent on the detected vulnerabilities, Blockgeeks (n.d.) suggests auditors concentrate on certain aspects of the smart contract to allow enhancement of the overall systemic integrity. Experts also recommend implementing a bug bounty (e.g., the Ethereum Bounty) and continuous penetration testing to better discover bugs and issues prior to launching.

In addition, clients should be informed that an addendum to the smart contract will put them into unaudited status. This is because code refactoring could give rise to new flaws or vulnerabilities.

Smart Contracts in the 4th Industrial Revolution

Blockchain technology can be considered as among the most important innovations of the 3rd Millenium due to its power in transforming how sectors and industries operate (Iredale, 2020). It also merges with other major technologies to further magnify its considerable impact on the world at large.

To have the capability to validate, verify, capture, and implement agreements among parties, smart contracts combine with Distributed Ledger Technology and Industrial Internet of Things. After collecting actual, legal events, a smart contract gathers IoT data—business processes, meters, sensors—to allow for performance assessment. Afterward, this information communicates the automated rules of a contract by posting outcomes and supplemental evidence to the blocks (Schmitt et al., 2019).

The increase in the number of IoT connected devices is expected to drive the further deployment of smart contracts. Juniper Research (2020) predicts that by 2023, a considerable part of the approximated 46 billion connected enterprise and industrial machines and devices will depend on edge computing such as blockchain. Thus, resolving deployment and standardization issues will be critical.

This is another potential for boosting smart contract deployment because these digital agreements can provide a standardized approach to advancing information exchange. This will also expedite processes between IoT connected devices by eliminating third parties. Taking the place of these intermediaries will be the cloud service or the server that functions as the IoT-connected devices’ central communication spoke for transmitting requests and other network traffic.

With smart contracts, central agents are eliminated and replaced by decentralized, distributed nodes that verify each transaction within the network. The time needed to finish the information processing and exchange is significantly reduced with the use of blockchain ledgers.

The emergence of blockchain and edge computing is central in augmenting technology implementations. According to Juniper Research (2020), this is due to factors such as enhancements of data security, quicker application response times, and decreased bandwidth requirements. When IoT and blockchain are properly integrated, blockchain experts say that this has the potential to really revolutionize vertical industries, including how many professions are practiced.

What will the future of legal contracts be?

The future of digital transactions, business deals, communications, and modern life will likely bear the footprint of smart contracts. This blockchain-based technology has the potential to disrupt many businesses and industries and help rethink the way they operate. As such, smart contracts are a perfect example of Amara’s Law, the notion that people have the propensity to exaggerate the effectiveness of new technology early on, while downplaying it in the future.

Some realizations we can make from this article echo those deliberated in a recent industry forum on blockchain: that we already have robust technologies for spawning new foundations for new world systems. The ultimate goal is to use these technologies to help create harmony between man and machine and minimize the toll on finite resources.

Precedents suggest that so much work still needs to be done before smart contracts can fully achieve their full potential. Crucial to this is the need for smart contracts to still evolve further to complement existing procedures and paradigms. One such need is transforming the incentive and reward systems that dictate how contracting parties will transact in the coming years, including how smart contracts and lawyers will achieve a mutually beneficial relationship.

With these goals in mind, it will be crucial not to merely think about how current structures and perspectives can be adapted to this new technology. Conversely, the genuine transformation that smart contracts can bring will likely emanate from totally new standards that we have yet to conceive.

 

References:

  1. Adcock, C. (2020, April 15). An update on State smart contract legislation. The National Law Review.
  2. BAL Lawyers. (2018, November 25). The problem with smart contracts. Lexology.
  3. BlockGeeks. (n.d.). How to audit a smart contract. Guides. Ontario, Canada: BlockGeeks.
  4. Buterin, V. (2016). What is Ethereum and how does it work? Binary.com.
  5. Capgemini. (2017). Smart Contracts in Financial Services: Getting from Hype to Reality. Paris, France: Capgemini Consulting.
  6. Capitol Tech (n.d.). Smart Contract Hacking: What is it and What Does it Affect? Capitology Blog.
  7. Carey, T., & Sayer, L. (2019, March 19). Guernsey’s recognition of electronic agents and smart contracts. Lexology.
  8. Chin, C. (n.d.). Charted: Blockchain use in governments. GovInsider.
  9. Cointelegraph Editors (2020). What are smart contracts? Guide for beginners. Cointelegraph.com.
  10. Deloitte (2016). Getting smart about smart contracts. CFO Insights.
  11. Fritz, G., & Treichl, L. (2021). What’s in a smart contract? Freshfields Bruckhaus Deringer.
  12. Güçlütürk, O.G (2018, Aug 1). The DAO hack explained: Unfortunate take-off of smart contracts. Medium.
  13. Hussey, M., & Phillips, D. (2021, January 8). What are smart contracts and how do they work? (2021). Decrypt.
  14. Iredale, G. (2020, November 3). History of blockchain technology: A detailed guide. 101 Blockchains.
  15. Juniper Research (2020). IOT ~ The Internet of Transformation 2020. Hampshire, UK: Juniper Research.
  16. Legetsky, V. (2020, September 4). How blockchain transforms the financial industry. TechReviewer.
  17. Levi, S. (2018). An introduction to smart contracts and their potential and inherent limitations. Skadden.
  18. Levi, S., & Lipton, A. (2018, May 26). An introduction to smart contracts and their potential and inherent limitations. Harvard Law School Forum on Corporate Governance.
  19. Mearian, L. (2019, July 29). What’s a smart contract (and how does it work)?Computerworld.
  20. Merre, R. (2019, May 23). ICO 101 — History of initial coin offerings (ICOs). Medium.
  21. Mishunin, D. (2018, January 30). How to perform a smart contract audit? HashEx.
  22. Momtaz, PP. (2018). Initial coin offerings. PLOS ONE. https://dx.doi.org/10.2139/ssrn.3166709
  23. Moné, L. (2019, November 18). Which governments are using blockchain right now? Consensys.
  24. Nikolic, I., Kolluri, A., Sergey, I., Saxena, P., & Hobor, A. (2018). Finding ‘The Greedy, Prodigal, and Suicidal Contracts’ at scale. ArXiv:1802.06038 [Cs]. https://arxiv.org/abs/1802.06038
  25. Reiff, N. (2018). The most successful ICOs of all time. Investopedia.
  26. Schmitt, G., Mladenow, A., Strauss, C., & Schaffhauser-Linzatti, M. (2019). Smart contracts and Internet of Things: A qualitative content analysis using the Technology-Organization-Environment framework to identify key-determinants. Procedia Computer Science, 160, 189–96. https://doi.org/10.1016/j.procs.2019.09.460
  27. Sharma, R. (2020). How are disputes in smart contracts resolved? Investopedia.
  28. Smith, C. (2019, July 10). Advantages and disadvantages of using smart contracts – How to create a smart contract? KnowTechie.
  29. Szabo, N. (1996). Smart contracts: Building blocks for digital markets. Extropy: The Journal of Transhumanist Thought, 16. Semantic Scholar
  30. Szabo, N. (1997). Formalizing and securing relationships on public networks. First Monday, 2 (9).   https://doi.org/10.5210/fm.v2i9.548
  31. Terekhova, M. (2017, September 15). AXA turns to smart contracts for flight-delay insurance. Business Insider.
  32. Thompson, E. (2019, May 31). Three ways smart contracts are used in healthcare. Yahoo Finance.
  33. Wood, M. (2020). AXA withdraws blockchain flight delay compensation experiment. Ledger Insights.