A smart contract is a piece of computer code that executes on a blockchain such as Ethereum and can transfer value. The purest form of a smart contract is a cryptocurrency for transferring funds to other users based on a public-private key pair of digital signatures (Geiregat 2018). On a smart contract, the terms of the agreement are defined by computer code as a set of instructions (Blockchaintechnologies.com 2016), like unlocking value based on certain conditions. When a value is reached, or certain conditions are met, such as when a user with self-sovereign identity connected to the smart contract sends a command, a smart contract executes predefined code which triggers an event such as a financial transaction. It is characterized by being autonomous, self-sufficient, and decentralized (Swan 2015).
Nick Szabo materialized the concept of a smart contract in (1996) before the crucial cryptographic concept of a blockchain needed to make smart contracts work as intended existed. Szabo defines smart contracts as a combination of protocols with user interfaces that formalizes and secures relationships over computer networks. Smart contract applications discussed include contracting, credit and payment systems enabled by cryptography and other security mechanisms. Relationships can be algorithmically secured from third-party eavesdropping or malicious interference, and breach by principals (Szabo 1997).
Szabo’s idea of a smart contract was too hard and fragile to be implemented as an alternative to traditional financial services due to the lack of blockchain at the time and was never materialized. Possibly because the smart contract conceptualized could be breached by principals controlling the centralized point of failure which existed before blockchain was used to make smart contracts — using the current smart contract technology assets and anything of value that can use blockchain as a public or private ledger of ownership. For example, money, pictures, personal data, academic certificates, medical records, supply-chain assets, physical assets like properties, and gold can be bound to self-sovereign identities. Don Tapscott calls this growing network the Internet of Value (Tapscott & Tapscott 2016).
Using this blockchain, smart contracts have evolved. For example, blockchain networks optimized for smart contracts such as Ethereum (Buterin 2013) is being used as a ledger of ownership of assets such as gold. It also facilitates crowdfunding firms and issuing stocks reliably and transparently, providing immutable receipts for all transactions (Ante & Fiedler 2019).
Werbach and Cornell pose in their (2017) duke law journal entry that there are reasons to be skeptical about whether smart contracts can deliver gains over conventional contracts for contract efficiency and flexibility. Even though smart contracts could fulfill its promises, the bigger question is whether smart contracts can do what courts do, only better. They argue that contract litigation plays a fundamental role in our social system that smart contracts cannot replicate.
A contract often is a manifestation of an ongoing relationship and is often more than a one-shot interaction between parties followed by a judicial resolution of a dispute (Macneil 1978). Several scholars argue that business practices around contracts assume that a contract does not clearly contemplate all the possible scenarios which can materialize (Hart 1988). Before the event, before a particular dispute, and after a contract is signed parties in contractual relationships must expect a renegotiation of the contract, and after the fact, courts must exercise their authority to settle disputes to fill any gaps in the agreed-upon contract (Holmes 1881).
Smart contracts are software programs where the time dimension of interaction between parties is formally stripped away. The uncertain futures of judicial resolution is ignored, yet smart contracts bind real people with real relationships and how their performance unfolds over time, and there is still a possibility of moral hazard and adverse selection. Thus relying on smart contracts is a bet on before the fact formalization, which will never be able to match the flexibility of human decision making (Werbach & Cornell 2017).
Because once written and deployed a smart contract is immutable and enforces itself, it removes the role of courts and authorities as enforcement agents. This means that once the smart contract is deployed, the machinery for its execution is unavoidably set in motion. Such immutability hinders the parties in the contract from affecting the transaction in disputes after the fact unless the smart contract has such a governing mechanism programmed into its code before it is deployed. Ultimately smart contracts cannot supplant the role that law and courts pay. Smart contracts are not a replacement for judicial contract adjudication (Werbach 2018).
To make a smart contract consistent with legal enforcement, the two can be connected. The approach here is to pair smart contracts and contracts explicitly. This idea was explored in the “Ricardian Contract” by the information security expert Ian Grigg in 2004 before the advent of cryptocurrencies while developing the Ricardo digital transaction platform for financial instruments. The Ricardo platform defines its contractual integration solution as having three components:
- Legal code: The human-readable text in a contract.
- Computer code: What steps a smart contract can execute.
- Parameters: Variables for influencing for the computer code execution.
Grigg’s pre-blockchain solution never took off and integrating smart and legal contracts in this manner was mostly a theoretical construct. It was not until blockchain was invented and particularly before the Ethereum blockchain successfully implemented smart contracts that this approach was rediscovered and gained momentum. There are currently several groups integrating smart contracts and legal contracts. These include a sub-group within the R3 blockchain consortium led by the British bank Barclays (Reutzel 2016, Rizzo 2016), Mattereum (2019), OpenLaw (2017), JP Morgan (2019) and the Hyperledger open-source initiative (Eris:Legal 2014).
Want to dive deeper into the subject? I have recently written a master thesis on how to combine legal contracts and smart contracts.
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