Smart contracts and the law: Tech developments challenge legal community

Smart contracts are an important element of the blockchain revolution, although they predate blockchain. According to most sources, it was Nick Szabo who coined the term “smart contract” in the 1990s. The mechanism of a vending machine has since been frequently given as an example of a basic smart contract based on if-then logic. The payment into a vending machine triggers an irrevocable automated action from when money is retained to when an item is supplied.

The emergence of blockchain technology enabled the implementation of such if-then logic on decentralized networks to facilitate autonomous self-executing, self-performing smart contracts, also called computerized scripts, smart code, computerized protocols or decentralized business logic. Ever since they gained popularity, it has been debated and questioned whether they are at all smart or contracts.

The basics of smart contracts

Setting this debate aside for the moment, smart contracts offer many benefits. One of them is efficiency brought mainly by automation, their streamlined formation, unambiguous interpretation and efficient performance. Efficiency gains bring forth cost savings, achieved through the removal of intermediary layers and the reduction of ambiguities and opportunistic behavior.

Transparency of smart contracts provides auditability and enhances trust. Technology-guaranteed performance facilitates transacting not only between parties that do not know each other but also between parties that would be reluctant to transact with each other without guaranteed performance. Ex-ante guarantee of performance through automation and self-execution of smart contracts also helps to avoid institutional enforcement and costly contract breaches. Smart contracts can enable more efficient, cheaper business processes, supply chain management, corporate governance and much more. We are only starting to explore their potential use.

However, it has to be said that smart contracts also require a certain degree of technical literacy to code, implement and understand them, and outside of the blockchain community, such skills remain relatively low. Smart contracts are also not free from technical challenges and vulnerabilities throughout all stages of their lifecycle, from creation through to deployment, execution and completion. There are also ex-ante costs of smart contract implementation and costs of switching to smart contract networks, which should not outweigh the benefits to realize any efficiency gains.

Related: The promise of smart contract adoption is held back by crypto silos

Technology and law

Smart contracts represent the intersection of technology and law, and therefore challenge practitioners, scholars and legislators — many legal issues have been debated. Smart contracts have been called out as neither smart nor a contract. First, there is neither a commonly agreed-upon definition nor a unified, structured and systematic classification of smart contracts. There is no common agreement or understanding about the relationship between smart contracts and traditional legal contracts. Some scholars question the ability to create valid, binding legal contracts through a smart contract.

Related: Hybrid smart contracts will replace the legal system

Discussions are ongoing in regard to applicable legal frameworks and how to reconcile the immutability of blockchain records with contractual mistakes or contractual deficiencies. Similar concerns have been raised about amending smart contracts’ terms recorded on an immutable ledger. Also governing law and applicable jurisdiction are particularly relevant issues for borderless, decentralized blockchain networks on which smart contracts are being deployed. Consumer protection and duty of information issues are also being raised.

Increasingly, there are also considerable concerns related to Anti-Money Laundering (AML)/Combating the Financing of Terrorism (CFT) requirements, as well as privacy and confidentiality issues. Immutability and automated, unstoppable execution are also potential legal pitfalls for smart contract use.

This analysis is made more difficult since there are different types and models of smart contracts, depending on their legal relevance (if any), context and technical properties. They vary from simple, straightforward and standardized payment instructions, to sophisticated instruments capable of the autonomous performance of a complicated sequence of actions. The emergence of blockchain-based smart contracts also brought a new dimension to the notion of cyberspace self-regulation. Moreover, discussions about “code is law” and “Lex Cryptographia” ensued.

However, when it comes to legislators and regulators, they have been largely silent on smart contracts. Despite vigorous scholarly debate about the legal status, recognition and enforceability of smart contracts, their normative legitimacy and legal implications, legislators do not seem to be alarmed nor are they rushing into any prohibitive action. Even though there is some legislative activity in selected jurisdictions, thus far only a handful of countries have formulated a regulatory response and enacted legislation, which has usually been modest.

Smart contracts vs. United States

For example, the majority of the legislative initiatives on smart contracts in the United States are relatively narrow and govern only a select number of issues mostly limited to defining smart contracts, recognition of their electronic form and signatures, and sometimes their admissibility as evidence. This includes states like Arizona, Tennessee, North Dakota, Nevada, Wyoming and Illinois. Some critics have claimed that such legislative initiatives are premature and incomplete, and amount to no more than a promotion of a particular jurisdiction. This creates the risk of regulatory fragmentation among the U.S. states and piecemeal smart contract legislation, potentially complicating the harmonization at the federal level in the future.

The U.S. federal regulatory and supervisory agencies, such as the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC), addressed smart contracts through their investigations, statements and guidance, which clarify some legal implications of smart contract use in the United States. The CFTC issued a primer on smart contracts in which it claims that a smart contract could be a binding legal contract, depending on the facts and circumstances, and could be subject to a variety of existing legal frameworks. The CFTC also highlighted several risks stemming from smart contract use including operational risks, technical risks, cybersecurity risks, risks of fraud and manipulation, and risks arising out of governance protocols.

Similar to the CFTC, the SEC applies existing legal frameworks in its enforcement actions related to blockchain and smart contracts. As a sign of increasing regulatory scrutiny, the SEC recently announced procurement for smart contract analysis tools to analyze and detail code within blockchains and other distributed ledgers, in support of its efforts to monitor risk, improve compliance and inform SEC policy concerning digital assets.

Smart contracts vs. the world

In other parts of the world, countries like Belarus, Italy and Russia have addressed smart contracts to a limited extent. The United Kingdom Jurisdiction Taskforce issued an important legal statement, concluding that smart contracts are capable of forming valid, binding and enforceable contracts between parties, emphasizing the adaptability and flexibility of common law that is capable of catering to technological advancements such as smart contracts. The European Union has also expressed consumer protection concerns related to the use of smart contracts, but so far there has been no regulatory action taken at the EU level.

The existing legislative initiatives seem to align when it comes to the recognition of smart contracts within existing legal frameworks; however, they differ on defining smart contracts. It is just a matter of time before issues related to smart contracts reach the courts, allowing the judiciary to address legal questions, particularly in common law jurisdictions.

Conclusion

In the meantime, the proliferation of diverging definitions and potentially legal treatment of smart contracts may give rise to legal uncertainties and regulatory arbitrage. Legislators should therefore closely follow developments in smart contracts and step in only when necessary to provide legal certainty, mitigate risks and protect vulnerable contracting parties. Such a measured and risk-based regulatory approach would support innovation, harness opportunities and integrate smart contracts innovation within existing legal systems. Adequate regulatory guidance could also help to remove legal uncertainties and uplift market confidence for the industry, investors and consumers.

The market size of global smart contracts is rapidly growing. It is predicted to gain a compound annual market growth rate of 17.4% in the forecast period of 2020 to 2025, and is expected to reach $208.3 million by 2025. Smart contracts are increasingly being deployed across a broad range of sectors, including the financial sector, public sector, supply chain management, and the automobile, real estate, insurance and healthcare industries. They are also the backbone of a growing decentralized finance (DeFi) space. Regulators will be increasingly challenged to respond to and address smart contracts, but legislative initiatives so far indicate that there are no major obstacles for smart contract use; it does not seem that any substantial legal reforms are necessary to embrace them.

This article is for general information purposes and is not intended to be and should not be taken as legal advice.