The rapidly accelerating pace of technology can feel overwhelming at times. Is a dystopian future a reality where computers have taken over the world and people no longer have any purpose? While it is true that there are frightening possibilities, we should not lose sight of the opportunities that technology brings. One of these developments is the smart contract but, before we get ahead of ourselves, let’s start at the beginning by unpacking how smart contracts work.

1. What is blockchain?

To understand what a smart contract is, we must first understand blockchains – which is a whole new technology. The most well-known example of the use of blockchain technology is bitcoin. But how do blockchains function? 

The Hash function: Blockchain takes information that has been uploaded into a computer, and by using the Hash function, it converts the data into a fixed-length string of numbers. Try it out yourself at the following link by typing any word or sentence into the block and clicking compute: https://www.freeformatter.com/sha256-generator.html#ad-output. If you use the same input, the output value will always be the same, but each different input will produce a different output. For example, each time I type in ‘hello’, the same string of numbers will be produced, but if I type in ‘goodbye’ a different set of numbers are produced. One of the most important features of the Hash function is that the conversion is one-way: you cannot reverse the function to generate the original input. The blockchain uses Hash functions to create a unique identifier of any block of transactions, and every block includes the Hash value of the previous block. Since every block of the chain contains the Hash of the previous one, it is not possible to modify any block without changing the entire chain, creating an unchangeable record of every transaction.

Peer to Peer: Another reason why blockchains are unique is because the chain of transactions is stored on every computer that has been involved in creating the blockchain, so it is not possible for anyone to alter the information in the chain since it is not stored by an individual entity. Any change that is made will be notified to the entire network who will be able to invalidate it if it has not been authorised or agreed.
Consensus Protocol: This is the final step in ensuring that the blockchain is incorruptible and unchangeable. A block can only be added to the chain if all the users validate it by using a common protocol, i.e. by complying with the pre-determined set of rules or procedures for transmitting the chain between computers. If the new block complies with the protocol, including ensuring that all the transactions inside the block are validated, then it will be considered as part of the blockchain.

2. But how does this relate to contracts?

With this understanding of some of the unique features of blockchain, it’s easier to see its value in creating smart contracts. Smart contracts use blockchain to create a contractual relationship in a transparent, conflict-free way while avoiding the services of a middleman. Like traditional contracts, smart contracts define the rules and penalties around an agreement, but then also automatically enforce those obligations. Let’s look at an example:

Example: I rent you my apartment and in exchange you pay me using bitcoin. I give you the digital entry key which we have agreed will be released to you on 1 May. If the key doesn’t come on time, the blockchain releases a refund. If I send the key on 25 April, then the key will be held by the blockchain until 1 May, at which time the key will be released to you, and the funds will be released to me.

3. Potential smart contracts going forward?

Mortgage loans: The process of getting a mortgage today can be lengthy, time-consuming, and not always fair. Traditionally, each transaction involves various facilitators and middlemen, for example, financial services, realtors, appraisers and other professional bodies, and this can create delays and inefficiencies. However, by using blockchain, each party to a mortgage transaction (buyers, sellers, lenders and borrowers) will be able to transact directly with the other parties through a single platform that electronically verifies, manages, records and enforces the parties’ agreement through a smart contract, thereby cutting out the middleman.

Insurance: It can take a long time for an insurance claim to be processed and paid, leading to increased administration costs and overall inefficiency. Using a smart contact, the insurance claim process can be streamlined and simplified. For example, a claim may be automatically triggered when a certain event occurs and specific details about the event could be recorded on the blockchain.

Supply chain management: Businesses in the supply chain management industry could use smart contracts to record ownership rights (as well as when risk and title passes) as various products move through the supply chain so that there is no question as to who owns a product at any given time.

Copyrighted content: In the music industry, online music streaming services (for example Spotify or iTunes) are paid to distribute a musician’s music and then pay a royalty to the record label for each track that a user downloads or plays. The label passes royalties to the publishers of the underlying composition and pays a percentage of the remainder to the musician. This means that the musician only receives a small portion of the profits. However, blockchain technology can be used to create a transparent and decentralized database of rights and rights owners that eliminates the need for middlemen like distributors and publications. An example is ujomusic.com, a platform that allows musicians to (i) automatically licence their works using blockchain technology, and (ii) receive royalty payments immediately using cryptocurrency, and earn a bigger portion of the profits by using smart contracts that cut out the middlemen.

4. How does this impact traditional contracts?

The use of smart contracts presents many distinct features that are not inherent in traditional contracts (for example, irreversibility and autonomy). However, smart contracts also create challenges for the enforcement of contract law. All jurisdictions contain certain requirements for the validity of a contract, for example, capacity, legality, certainty, consideration (in the UK) and the absence of circumstances such as duress or undue influence. 

The challenge is that smart contracts do not allow for moderation on these issues because the code self-executes. The performance of a traditional contract can be stopped by the parties or by a court if, for example, there was undue influence, or the contract was illegal, but a smart contract must execute once initiated. This poses challenges for the legal system. How can a court undo a transaction that is self-executing and irreversible, where there is no technical means, short of undermining the integrity of the entire system, to unwind the transaction? The answer may lie within smart contracts themselves, as it is possible to incorporate logic into a smart contract that allows for various exceptions or conditions. Currently, smart contracts have had limited testing against traditional contract law principles, and we will all have to wait and see what the future holds. What is clear is that the law generally, and contract principles specifically, will need to adapt and develop to stay relevant in the changing world of commerce and technology.

5. So, what does the future hold?

Smart contracts are a natural progression for the legal system, and lawyers will need to adapt and rise to meet the challenges. At this stage, the application of smart contracts is mainly in simple transactions that follow the same formula and are easy to replicate and automate. This has the potential to simplify certain types of transactions and manage cost and complexity for the many consumers.

However, there is still the need for human lawyer input in certain types of transactions. For example, the types of transactions that require us to structure deals that take account of a myriad of financial, commercial and legal considerations which are different depending on the deal, the sector, the parties, the jurisdiction, the risks and a range of other factors. The lawyer is then required to translate all that into legal agreements to support that deal, taking into account a wide range of circumstances and possible outcomes. Perhaps more than ever before the lawyer has to navigate the difficult dual role as (a) the custodian of risk and compliance for an organisation, and (b) the enabler for an organisation’s business to progress through contracting. As a lawyer, it seems that while smart contracts could play a truly valuable role in this process, robots won’t be taking over our jobs just yet.

Tamlin Higgins, August 2019

The information and views contained in this article do not constitute legal advice. If you do require legal advice please contact us on info@lighthouse.law.