Smart contracts: The backbone of blockchain technology

By Dr. Jörn Heckmann and Dr. Markus Kaulartz

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The rise and fall of cryptocurrencies (for example, Bitcoin) has dominated the financial press in recent months. As a result, people have started to believe that Bitcoin and blockchain technology are synonymous. But they are wrong: Cryptocurrencies are just one of many uses for blockchain technology. Due to the fact that blockchain technology can be used in many other applications, it is expected that blockchain technology will become a game changer for many industrial sectors. One of the reasons for this expectation is the potential the technology holds to enable the execution of encoded “smart contracts” within the blockchain. But what is a “smart contract” from a legal point of view, how can these contracts be used, and why do they have the potential to disrupt today’s use of ordinary software?

At the end of the 1990s, early pioneers of smart contracts discovered that legal contracts could be transferred into source code in such a way that they would execute themselves (a “self-executing contract” or “smart contract”). This new process was expected to reduce both risks and transaction costs, given that the new technology would be able to execute the contracts without human interaction. The pioneers of this idea were led by the hope that large-scale business conducted through microtransactions — for instance, energy trading with the small amount of renewable energy necessary to charge an electric car — would finally become financially sustainable.

However, the technology of the 1990s required an intermediary to execute the smart contract as a trustworthy authority. It is obvious that this need for an intermediary as a trustworthy authority is at odds with the goal of reducing costs. As a result, the idea of smart contracts sank into oblivion. This fundamentally changed with the rise of blockchain technology, which does not need an intermediary as a trustworthy authority.

Blockchain as a trustworthy authority

To understand the symbiosis between smart contracts and blockchain technology, it is essential to look at the underlying principles of blockchain technology. Broadly speaking, blockchain is a kind of digital ledger for statements between computers. This digital record is stored on the participating computers in a distributed manner and does not require a central authority. This departure from a central authority is groundbreaking because until now, data has always been stored in a centralized location (for example, a server) with an intermediary.

Instead of a central authority, validation from a majority of participating computers in a peer-to-peer network (P2P) guarantees the integrity of the data and dramatically reduces the risk of data manipulation. This means that the participants are not trusting an intermediary; instead they are only asked to trust the technology and its cryptography.

How smart contracts work

The ordinary use of blockchain technology is the transfer of assets, both material (such as money or objects) and nonmaterial (such as rights). Smart contracts are the conditions under which transactions are executed on a blockchain, where there is no limitation on the complexity of a given scenario. This means a smart contract can require various inputs, even from the analog world (known as “oracles”). To give an example: A transportation company could use a smart contract in association with its insurance company. The contract could include a provision that damages for melted ice cream will be paid automatically if the temperature in the trailer rises over a predefined number. In this example, the contract would utilize blockchain technology to facilitate the entire claim-settlement process, potentially reducing the administrative burden.

Smart contracts: Legally binding agreements?

The questions arises whether a smart contract is actually a legal contract or not. One might say a smart contract is, in general, neither smart nor a contract. A smart contract is only software that transfers assets under predefined conditions.

But could it, nevertheless, be possible to enter into a legally binding smart contract in the form of a software code? It’s up to the parties whether to write a contract in English or another language. Of course, this encompasses the possibility of using a programming language as a contract language — as long as the parties agree on the programmed code with two corresponding declarations of intent. In practice, though, it is rather rare that parties will do this, especially because most people do not understand code, and often there is no reason to use code instead of a human language. Legally binding smart contracts may, therefore, be more relevant in the realm of machine-to-machine communications, where it does not in fact make sense to use English or another human language.

But there’s an urban myth that says if you decide to use a programming language, you’re only bound to the programmed rules within the smart contract. In fact, even in using a programming language, developers have to fully comply with the applicable laws.

Smart contracts: A tool for contract execution

In addition to the (uncommon) function of a smart contract as a surrogate for a written (paper) contract, smart contracts will be used to execute contractual agreements. One reason is obvious: When using smart contracts, there’s no need for expensive monitoring of the contract after it’s signed. The potential for automatic execution of a contractual agreement is one of the main advantages of smart contracts.

But where there’s light, there’s also darkness. For example, one of the technical restrictions of a smart contract is that the fulfillment of a condition has to be programmed with mathematical precision. In other words, the programmer is obliged to use fixed values in the analysis of conditions, instead of vague legal terms such as “a reasonable period of time.” But perhaps this restriction is only temporary and will disappear with the spread of artificial intelligence, given that AI has the potential to help machines properly interpret ambiguous terms.

Warranty law

From a legal point of view, one of the most exciting questions is what happens if the source code of a smart contract contains a discrepancy in the service provisions compared with the parties’ original agreement. To illustrate this problem, let’s assume the parties verbally agree on a transfer of €100.00; but due to a misspelling in the source code (a “bug”), the smart contract executes a transfer of only €10.00 to the receiving party. If this party claims it’s still owed €90.00, the other party might claim it can rely on reference to the source code (“code is law”), thus substantiating that the parties only agreed to transfer €10.00, instead of the verbally negotiated €100.00. To enforce their rights, the parties would then need to take legal action through the traditional avenues. At that point, the advantages of a smart contract and blockchain technology vanish into thin air.

This leads to another question: Is it possible to program “the law” into a smart contract so there’s no longer a need for judicial decisions? Despite the fact there are still serious issues about programming “the law” into a smart contract, this seems to be quite logical at first. Upon further scrutiny, however, programming “the law” into a smart contract is not the only difficulty contract writers will encounter. They must also figure out how to evaluate issues outside the digital sphere of the smart contract (for example, faulty goods). Bearing in mind that a smart contract cannot recognize if goods are faulty and will continue to execute itself without consideration for the quality of the goods, there is a need for another means of dispute resolution. One of the options — even if this remains some way off — is to implement a dispute-resolution interface. This would enable the parties to ask an arbitrator or a court for a decision and to “insert” the decision retroactively into the smart contract. As a result, the smart contract and the arbitrator’s or court’s decision would be synchronized.

Smart contracts: A long-term perspective

Many companies, from small start-ups to global players, are testing and working on potential uses for smart contracts in their businesses. This process is ongoing, and there are already some very promising ideas. From a long-term perspective, the most promising idea might be the use of smart contracts in scenarios that, until now, have needed an intermediary for contract execution. Thus, it comes as no surprise that the financial sector and big banks have been early adopters of smart contracts. In addition, smart contracts offer huge advantages to those who want to create a contract platform between independent strangers. In this context, one widely discussed potential use is the charging and billing of electric cars at charging stations. To make this cutting-edge idea a success story, proper standardization is needed — which, so far, is not in sight.

Smart contracts and ICOs

At the moment, however, the most discussed potential use for smart contracts is token sales, or ICOs (“initial coin offerings”). ICOs are a means for companies to collect money. Instead of writing long business plans and conducting endless pitches, companies can simply create their own “token” (on the basis a smart contract), gather a community behind their project, do some marketing, and write a white paper. There is no generally recognized classification of ICOs. The Swiss Financial Market Authority (FINMA) uses the following terminology, acknowledging there are also hybrid forms:

Payment tokens or currency tokens: These do not give rise to claims on their issuer. Rather, they are intended to be used — now or in the future — as a means of payment for goods or services, or as a means of money or value transfer.

Utility tokens: These are tokens in­tended to provide digital access to an application or service, usually by means of a blockchain-based infrastructure.

Asset tokens. These represent assets such as a debt or equity claim on the issuer. Asset tokens promise, for example, a share in future company earnings or future capital flows. In terms of their economic function, these tokens are therefore analogous to equities, bonds or derivatives. Tokens that en­able physical assets to be traded on the blockchain also fall into this category.

Thanks to the blockchain hype, approximately $4 billion was raised by a blockchain start-up in 2017. After a difficult start, ICOs are now becoming more and more professional and are also attractive to companies that have previously raised and earned money by traditional means. This is not just hype — legislators and financial authorities have started to publish their opinions on ICOs. The BaFin warned consumers against investing in ICOs and issued a paper on the legal qualification of ICOs, though at heart the financial authority has not yet provided clear guidance on the matter and mainly states that each case has to be assessed individually.

Smart contracts: A serious threat to lawyers?

Smart contracts were developed to eliminate the need for expensive lawyers and slow court decisions, in accordance with the dogma “code is law.” Sticking to the facts, it’s obvious that this dogma is without legal foundation and that smart contracts cannot liberate us from legal issues. In fact, programmers of smart contracts need lawyers more than ever if they are to avoid loopholes in smart contract code, and lawyers need programmers more than ever if they are to understand the source code of smart contracts. We cannot have the one without the other. Ideally, this will lead to the birth of a new profession that combines the advantages of both the legal and IT spheres. Until then, it will be a long journey — but it will be worth every step to attain the best of both worlds.

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