The beginning of the 21st century has been characterized by multiple innovative technologies that have had a substantial impact on the new data-driven economy; the most important of these are: Cloud Computing, Big Data, Internet of Things, and blockchain. The latest technology, which was initially introduced as the technological backbone of Bitcoin, has begun to take on meaning in its own right. However, governments and companies around the world are mostly perplexed about the possible implementation of blockchain in many areas of life, not associated with the use of cryptocurrency. One of the most promising areas of blockchain application is the creation of fully automated contracts i.e. agreements that are executed without human involvement. These, in the IT environment, are called “smart contract”.
There is no universally agreed upon definition of a “smart” contract; this is due to both its innovative nature and its complex technological basis.
According to the simplest definition, a smart contract is a contract whose execution is automated.
For Nick Szabo, one of the pioneers in the analysis of self-executing automated agreements, the smart contract is a computerized transaction algorithm that executes the terms of the contract.
However, this definition can hardly capture how smart contracts differ from some already well-known contractual constructs that implement automated execution, e.g., vending machines. The latter are defined as autonomous automated machines that dispense goods or provide services when coins are inserted or payment is made in other forms (e-cash, credit card). Vending machines are programmed with certain rules that might be defined in a contract and operate based on those rules.
The degree of novelty and the presence of certain special features in smart contracts becomes particularly relevant in exchange markets, where automated trading systems are widely used. For example, in exchange markets, trading operations are often executed not by the trader, but by a computer system based on a trading strategy calculated through an algorithm.
As of 2014, over 75% of the stocks traded on U.S. exchanges came from orders from automated trading systems, so automated contracts, in and of themselves, are nothing new.
It is worth referring to another definition of smart contract provided by Gideon Greenspan: “A smart contract is a piece of code that is stored on a blockchain, triggered by transactions on the blockchain, and that reads and writes data to that blockchain’s database.”.
This definition is more concrete, as it emphasizes the blockchain as one of the key features of the smart contract. The blockchain can be considered a “paradigm shift” in contracting because it allows both parties to automate the contract performance process. Vending machines automate the performance of only one party, requiring at least some personal involvement from the other party (e.g., the insertion of coins or a credit card).
When the performance of both parties can be fully automated, the question arises as to whether there is still a contract in the legal sense or not another type of phenomenon.
Organizational theorist Arthur Stinchcombe once wrote that contracts are just miniature organizations and, by extension, all organizations are just complexes of contracts. Companies are created using a variety of contractual arrangements, ranging from employment contracts for employees, to relationships with suppliers, to obligations to its customers, to leases, to the sale and purchase of equipment. Traditionally, these contractual obligations are quite costly because they must be enforced through a reliable legal system and through law enforcement.
With a blockchain-based smart contract, however, much of these costs are greatly reduced or eliminated. This allows blockchain-based organizations to be more efficient, cost-effective, and competitive with traditional companies in the marketplace.
All of this shows that smart contracts go far beyond existing contracting models and represent a new paradigm for interaction in a cyberspace. Smart contracts make it possible to create pools of resources and allocate them according to previously agreed criteria, which can be particularly relevant for crowdfunding activities or insurance contracts.
In the first case, smart contracts can keep track of the amount of funds belonging to a crowdfunding project and, once the required amount is reached, the same is transferred to the beneficiary. Otherwise, the funds are returned to the donors.
In the second case, a group of farmers might put together a pool of resources as insurance against drought, flooding, or other natural disasters. Once such a disaster occurs, the contract would ascertain it according to the procedure specified in the contract (e.g. by checking the weather or news in predesignated sources) and allocate the resources. Needless to say, smart contracting provides the highest degree of transparency and verifiability, mitigating the risks associated with intermediary decision-making and the “human factor,” as well as time delays.
Although the execution of the smart contract is automated, it still requires the presence of the will of the contracting party to become effective. The person expresses his or her consent to the terms of the contract and the manner of its execution at the time of its conclusion.
Taking into account the fact that such a person will not be able to influence the execution of the contract once it is entered into, there should be a certain amount of trust, which gives rise to a kind of “fiduciary” relationship in the smart contract. But unlike the classic contract, in which trust is placed in the counterparty, in smart contracts this trust is placed in the computer algorithm that underlies the contract (“trust without trust”).
Based on the current understanding of smart contracts, it is possible to outline the following characteristics of them:
- exclusively electronic nature
- software implementation
- higher certainty
- conditional nature
- self-application
- self-sufficiency
1.​ Exclusively electronic nature: classic contracts can exist in various forms, for example, oral or written. Of course, the development of e-commerce has greatly increased the number of agreements concluded in electronic form, the most obvious examples of which are the various “clickwrap” agreements (A clickwrap agreement is a digital prompt that gives individuals the opportunity to accept or reject a digitally-mediated policy). However, even in the case of e-commerce contracts, some classic paper documents, such as invoices, receipts, or delivery certificates, may still be necessary, especially when such electronic contracts cover the purchase of goods or services offline.
Sometimes, these documents are the only evidence or manifestation of the existing contract in electronic form.
In contrast, smart contracts can only exist in electronic form and any other form of contract cannot be used. It is also characterized by a specific object, which can be a digital asset (e.g., a cryptocurrency) or a digital manifestation of an offline asset registered on the blockchain. This differentiates the smart contract from most “clickwrap” contracts, which also exist in electronic form, but only impose certain negative obligations on the user (e.g., not performing certain activities while using the service or not objecting to certain activities performed by the service provider). In addition, smart contract by its nature requires the use of electronic digital signatures, based on cryptography.
2.​ Software implementation: the smart contract has a dual legal nature; it serves as a “document” governing the contractual relationship between the parties and is also the subject of intellectual property rights. Therefore, the programming of some smart contracts according to the customer’s needs can be treated as a software development process, while the distribution of rights following the smart contract must be done as part of the licensing/assignment of intellectual property rights.
3.​ Higher certainty: Since the software code represents the essence of the intelligent contract, the terms of the latter are expressed in one of the computer languages characterized by a strictly defined semantics and syntax. The computer language does not allow for discretion in its interpretation.
Intelligent contract terms are interpreted by a computer based on Boolean logic, unlike the classical contract, where the interpretation of terms is performed by the human brain based on subjective criteria. Therefore, the precision of programming languages is able to mitigate the possible problems associated with the unpredictable interpretation of contract terms by the contracting party. Consequently, existing rules on contract interpretation do not apply to smart contract. Smart contracts are intended to be stand-alone agreements that are not subject to interpretation by outside entities or jurisdictions. The code itself is understood to be the final arbiter of the “agreement” it represents.
Given the technical complexities and the need for advanced programming skills, in many cases smart contracts will be created by specialist companies based on client demand. Because of the separation between those who program the code and those who intend to use it in their business activities, there is a risk of misunderstanding the terms of the future agreement.
Moreover, since it is only the computer code that governs the smart contract, the latter automatically becomes prone to various flaws and bugs. The recent hacker attack on one of the Ethereum platform’s smart contracts is a prime example of this: in June 2016, attackers exploited a vulnerability in the software and drained millions of ethers. In an open letter to the Ethereum community, the attacker claimed that they had not done anything illegal, but were “using this explicitly coded feature under the terms of the smart contract.”
Thus, it can be argued that smart contracts are still vulnerable to coding errors, something that likely needs to be addressed by the new rules for interpreting such contracts.
4.​ Conditional nature: previously it was argued that the smart contract is written in one of the programming languages. Conditional statements are fundamental to computer science: computer code relies on statements such as “if x then y” that allow the contract to be executed.
5.​ Self-application: once the smart contract is concluded, its execution no longer depends on the will of the parties or third parties, nor does it require further approval or action on their part. The computer verifies all the conditions, transfers the assets and enters the data related to these transfers into the blockchain. Therefore, the smart contract is technically binding for all parties, no longer depending on the human intermediary, who is subject to errors and subjective discretion.
6. ​Self-sufficiency: the smart contract does not need legal institutions to exist, nor does it need the body of legal rules, as is the case for classic contracts. Self-sufficiency is particularly important in international transactions, as it makes language differences, national laws and their interpretation irrelevant: the same rules are applicable worldwide. Based on these characteristics, it is possible to define the smart contract as a software code, implemented on blockchain platform, which guarantees self-sufficiency and autonomy of its terms based on conditions defined in advance and applied to the assets that are on blockchain. Among the benefits of smart contracts is their ability to reduce many of the transaction costs that accompany normal contracts.
Costs associated with the involvement of the intermediary in the execution of the contract (e.g., bank or insurance organization) are also excluded in smart contracts due to their disintermediating nature. However, it would be incorrect to conclude that smart contracts are cheaper than regular contracts: the infrastructure required to implement them and the costs associated with developing (“drafting”) their terms are still quite high.
Smart contract platforms have already emerged and gained popularity and recognition. The most obvious example is Ethereum, which is a blockchain-based open-source computing platform with smart contract creation capabilities. Unlike the Bitcoin ecosystem, which does not allow for the exchange of anything other than the cryptocurrency itself, Ethereum allows for the exchange of any asset class that can be transferred over the Internet.
