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Blockchain 101: what is a smart contract?

In our previous articles, we have explored blockchain, cryptocurrencies and ICOs.  This article focusses on the smart contract or, more precisely, the blockchain-based smart contract.

What is a smart contract?

While they might be called smart contracts they, rather confusingly, are neither smart nor contracts.  The concept was conceived in 1994 by Nick Szabo, who coined the term ‘smart contract’ for his invention.  Szabo used the real-life example of a vending machine, which is programmed to transfer ownership and possession of property (i.e. confectionery) on receipt of a defined input (i.e. a set amount of money).  At a very basic level, this concept is not dissimilar to the Excel IF function: a logical test which returns one value for a TRUE result and another for a FALSE result.

A smart contract is a mechanism by which assets can be deposited and transferred or redistributed in accordance with pre-defined rules.  More technically, we use the term ‘smart contract’ to refer to a piece of code which is deployed to an underlying blockchain and which can maintain its own state, control its own assets and execute pre-defined actions in response to pre-defined inputs according to pre-defined rules.  Once the distributed network of nodes participating in the underlying blockchain determine and verify that the relevant pre-defined rules have been met, the smart contract is ‘triggered’ and the relevant transaction is automatically executed.

Of course, smart contracts go far beyond the humble vending machine Szabo referred to.  Smart contracts can range from comparatively simple escrow type arrangements to sophisticated mechanisms with multiple parties and a complex rule matrix.  They enable the creation of decentralised applications, or dApps, which can have applicability in a wide range of industries, including insurance, healthcare, logistics, gaming and financial services.  At the more ambitious end of the spectrum, smart contracts may be used to represent and govern decentralised autonomous organisations, or DAOs.  DAOs’ transaction records are maintained on a blockchain and are therefore (subject to the characteristics of such blockchain) transparent and open to stakeholder scrutiny.  No wonder people are so excited by smart contracts!

A note on DAOs – it is important to distinguish them as a concept from The DAO, which was an example of a DAO which was hit by a high-profile scandal whereby a vulnerability in its code was exploited and around one third of its funds (approximately $50m) were siphoned off by a nefarious and, to this date, unidentified user.  Despite this incidence, DAOs remain an interesting and exciting possible application of smart contracts and we are sure to see more of them in the future.

Why is a smart contract not ‘smart’?

Fundamentally, smart contracts are not capable of free thought and are arbitrary in their execution.  Smart contracts automatically execute in accordance with their pre-defined rules which can be written by anybody.  As a lawyer, I can testify that people are very capable of creating, agreeing to and writing some incredibly foolhardy rules to govern their transactions!

Perhaps The DAO referred to above is the best example to date of a smart contract that was decidedly not ‘smart’.  The DAO did not malfunction.  Indeed, it functioned perfectly according to its code and automatically executed in accordance with its pre-defined rules.  The issue was that those rules were arbitrary in their application – as mentioned above, a smart contract is incapable of free thought.  Ultimately a smart contract can only be as ‘smart’ as its creator and, due to human error and the absence of ‘standard form’ coding in all but the most straightforward arrangements, many are flawed.

Why is a smart contract not a ‘contract’?

This is a far more interesting question and goes to the heart of what a contract is.  Leaving complex jurisprudence aside, the Oxford Dictionary defines a ‘contract’ as:

“a written or spoken agreement…that is intended to be enforceable by law.”

A smart contract is written (that it is written in code is not in itself an issue), but its enforceability by law is less clear.  Again I turn to the Oxford Dictionary, which defines ‘law’ as:

the system of rules which a particular country or community recognises as regulating the actions of its members and which it may enforce by the imposition of penalties.

A number of online articles and materials refer to smart contract code as a law, but I disagree.  A smart contract certainly regulates the actions of its members (i.e. the parties to it), in accordance with its pre-defined rules.  It does not enforce itself however – indeed, it is incapable of doing so.  Subject to the inclusion of complex query functions (which again, operate in an arbitrary fashion), a smart contract auto-executes and cannot be challenged by the parties to it.  A smart contract does not penalise non-compliance, it simply does not permit it.  A smart contract does not have any inherent nexus to ‘the real world’, i.e. that which exists off the relevant blockchain, including governing law.

The issues raised above may not be relevant in simple escrow arrangements and are almost never insurmountable.  We routinely advise on smart contracts which are intended to have legal effect and be subject to legal determination in the event of a dispute.  There are a number of ways in which this can be achieved, with the most simple manner being the provision of a legal ‘wrapper’, which incorporates the smart contract and can provide for legal determination of disputes arising out of its operation in the normal way, whether by arbitration or jurisdiction clauses.  These wrappers can also incorporate ‘off-chain’ assets and create interesting on-chain/off-chain hybrid arrangements.

What are the benefits of utilising smart contracts?

There are a number of potential benefits to the use and adoption of smart contracts and this article has only scratched the surface of their potential use-cases.  The technology is still relatively immature but, in my view, the three most prominent benefits of its implementation are:

  1. Disintermediation – smart contracts eliminate the need for trusted intermediaries and the inherent agency problems which arise from their inclusion in transactions;
  2. Efficiency – smart contracts are more efficient in terms of time and cost.  Their auto-execution is instantaneous and free (subject to the limitations and transaction costs of the underlying blockchain) ; and
  3. Security – smart contracts benefit from the secure features of their underlying blockchain, with their verification and operation encrypted and distributed among network nodes and an immutable record of the transaction preserved on the ledger (again, subject to the characteristics of the underlying blockchain).  Of course, this final advantage comes with a huge (‘The DAO’ shaped) caveat – flaws in the coding can leave a smart contract vulnerable to attack and expose the entire network of blockchain participants.  Comfort should be sought from experienced developers prior to the deployment of complex smart contracts.

If you have any questions regarding cryptocurrency, blockchain or smart contracts and how they might impact you or your business, please get in touch with Tom Grogan.

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