“Smart” Contracts – what you need to know

What is a "smart" contract?

“Smart” contracts are digital agreements written in code that are automatically executed, or run, when predetermined conditions are met.

Because this can be automated, and often is, all parties know the outcome instantly without an intermediary needing to be involved.

For example, the conditions or variables could be the amount of time built up on a project by a service provider. Because this is automated and no intermediary is needed, the whole process is streamlined, saving time overall.

They are, or can be, self-functioning. Once a particular variable has been met, the code will automatically and without human intervention perform the defined process. It can also trigger the next action in a workflow too. Furthermore, the code relies on “consensus algorithms”, as the code will be replicated across all blocks on the chain. Each block will verify the previous blocks transaction, ensuring that the wider distribution network will not fall foul to one block’s error.

As highlighted by the Law Commission, smart contracts can be used to define and perform the obligations of a legally binding contract.

This all sounds great, what are the drawbacks?

Contracts are by their nature flexible. Code is not. Parties are severely limited in their ability to amend the contract or alter its application when it has been put into a smart format. It can also be difficult to make sure the code accurately reflects the agreed process and all its permutations. This will involve several parties, and with ever more complex or discrete contracts the difficulties become exponential. The Law Commission has stated that not all legal contracts will be appropriate for automation and it will be for the parties involved to decide how their contract is to function.

Relevant to this problem, smart contracts rely on information as certified by the blockchain platform it is codified on. The nature of blockchain technology means that the distributed network may be receiving differing information simultaneously. One solution to this is to include “off-chain” information which is translated by an “oracle” into the smart contract. In basic terms, the oracle is a third party which receives information outside of the blockchain and then pushes that information to the smart contract at set points.

However, further potential issues arise such identity of the third party, liability and force majeure events, being only some examples.

The benefits of smart contracts are strongest when the contracts are standardised, clear and at scale. Smart contracts may not be appropriate for contracts that require flexibility and / or frequent amendment.

Summary

Smart contracts have the ability to revolutionise the transactional elements of contracts. They can automate processes and remove the potential for mistake. They provide opportunities for more academic study, practical application and innovation within the legal sector. Clients must, however, be warned of their relative modernity and the potential pitfalls with them. The benefits of the common law system, with its ability to react to new technologies, are apparent when considering the advantages of the English and Welsh legal system in the judgement and enforceability of smart contracts.

If you would like to learn more about smart contracts or interested in applying the technology, contact one of our commercial contract experts.