Unravelling Traditional Contracts v. Smart Contracts: Exploring Legal Frontiers
Table of Content
∘ Who Invented Smart Contracts?🤓
∘ What is a Smart Contract, in Simple Terms?
∘ Salient Features and Functionalities of Smart Contracts
∘ Self-execution
∘ Immutability
∘ Transparency
∘ Cost Savings
∘ How Do Smart Contracts and Regular Contracts Compare?
· Legal Issues with Smart Contracts
∘ Validity and Enforceability
∘ Regulatory Compliance
∘ Jurisdictional Issues
∘ Are Smart contracts Legally Binding?
∘ Final Thoughts
Market friction makes transactions costly and time-consuming. Traditional contracts are time-consuming, and often result in expensive disputes. Parties must meet to draft, negotiate and execute them.
Parties rely on intermediaries to execute these contracts, making them costly and time-consuming.
Enter smart contracts.
Smart contracts provide viable solutions to these challenges. They enable faster transactions, remove third-parties, and enhance transparency. Smart contracts help you reduce costs, and streamline operations.
Despite their revolutionary potential, smart contracts face various legal challenges. For instance, the validity of smart contracts is a source of widespread debate.
As smart contract use rises, disputes are bound to rise. How do courts regard smart contracts, as far as contract law is concerned?
Traditional contracts provide parties a sense of clarity and security. Blockchain-based technologies enable peer-to-peer transactions, eliminating the need for trust.
This article discuses various aspects of smart contracts in comparison with traditional contracts, and highlights the legal limitations that smart contracts face.
🤓How are transactions in a blockchain executed without third-parties? The answer is….., you guessed it, smart contracts!
Who Invented Smart Contracts?🤓
Smart contracts have been around longer than most people know. The term smart contract was first coined by Nick Szabo in 1994. Nick Szabo is an American cryptographer, and computer scientist.
For instance, he created Bit Gold, a virtual currency, a decade before Bitcoin. Below is the definition Nick Szabo gave to smart contracts.
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‘’I call these new contracts “smart”, because they are far more functional than their inanimate paper-based ancestors. No use of artificial intelligence is implied. A smart contract is a set of promises, specified in digital form, including protocols within which the parties perform on these promises.’’
Nick Szabo.
What is a Smart Contract, in Simple Terms?
Smart contracts are self-executing agreements contained in a blockchain like Ethereum. The terms and conditions of a smart contract are hard-coded into the agreement. Smart contracts self-execute, part or all of the agreement, when a triggering event occurs.
The triggering event may be the payment of an agreed amount of money, or the performance of a specific thing.
Simple ‘’if/when…then’’ statements guide the operation of smart contracts.
For example:
If Jeff writes 10 articles from 1st April to 5th April, then pay him 0.6 ETH.
Another common example of smart contracts in action is the vending machine. This is how it works:
To get a soda from a vending machine:
soda selection + Money = soda dispensed
Like a vending machine, a smart contract has a logic programmed into it. Other modern forbearers of smart contracts include:
- Electronic data interchange (EDI):
Organizations no longer exchange information via paper. EDI allows them to exchange information electronically. Examples of EDI include shipping statuses, purchase orders, and payment confirmations.
- Point-of-sale cards and terminals (POS):
Retailers use POS hardware systems to process card payments. This device is commonly found in busy restaurants and supermarkets.
💡Also Read: 6 Ways Smart Contracts are Revolutionizing Copyright Protection
Salient Features and Functionalities of Smart Contracts
Smart contracts translate agreements into code. The code tracks all terms and conditions in an agreement and automates execution once they are satisfied.
Below are five key features of smart contracts:
Self-execution
As previously stated, smart contracts are self-executing agreements in a blockchain.
Smart contracts execute autonomously when a triggering event occurs.
That is, when certain predetermined conditions are met. The self-executing nature of smart contracts eliminates the need for intermediaries.
Immutability
Information stored in a smart contract is tamper-proof, or immutable, ensuring the efficacy of contractual terms.
Immutability is an essential feature of smart contracts, as tampering with smart contract data is readily apparent to the contracting parties.
Traditional contracts can be modified easily.
It is impossible to modify smart contracts once the code is embedded into the blockchain.
Parties may need to draft another contract to modify the previous one.
Transparency
Blockchain technology is celebrated for its transparent nature.
Through decentralization, blockchain-based technologies, including smart contracts, provide users with enhanced security, trust, and transparency.
Blockchain cryptography ensures smart contracts remain immutable.
Cost Savings
Reliance on intermediaries increases the cost of doing business. By eliminating intermediaries, parties reduce enforcement and administrative costs, major causes of market friction.
Security
Advanced cryptographic methods secure smart contracts. Advancements like zero knowledge proofs (ZKPs) add an extra layer of security to smart contracts. ZKPs protect the privacy of the data and logic used in their execution.
How Do Smart Contracts and Regular Contracts Compare?
As far as purpose is concerned, there is no much difference between traditional contracts and smart contracts.
They perform the same function. That is, they enable the formalization of agreements. There are, however, a few notable differences that are worth mentioning.
The table below outlines the key differences between regular contracts and smart contracts.
Despite technological advancements, contract law plays a critical role in business.
As such, it is important that parties cultivate a firm understanding of the principles of contract law even when dealing with smart contracts.
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Distributed ledger technologies show us how to create cryptographically secured consensus over shared facts, and give us exciting new ways to construct what some have called the golden copy of records. Not only do these technologies promise great savings through the life cycle of financial transactions, but the ability to reach shared consensus serves as a fundamental building block for smart contracts, which will set the scene for the next twenty years of finance. Yet technology solutions alone cannot realize the promise of smart contracts. They must be designed to ensure legal enforceability, with the strength of contractual law, globally, between all our members. I put it to my team to construct a legally defensible global shared record, and they are delivering.
Legal Issues with Smart Contracts
Contracts have existed for centuries. While smart contracts have the potential to revolutionize the conduct of business globally, their legal status remains questionable.
The relationship between smart contracts and the prevailing legal regimes is somewhat complicated. Indeed, the law, in most parts of the world, is silent on the validity and enforceability of smart contracts.
What are the main legal issues that affect smart contracts? Read on!
Validity and Enforceability
Smart contracts can be likened to digital lockboxes. Like a paper contract, the code (or the key) is needed to unlock and execute the contract. However, things get tricky when conflicts arise over the validity of the contract.
Consider the following scenario:
The DAO Hack of 2016 resulted from a flaw in a smart contract, causing tremendous financial loss. The hack highlighted several critical issues regarding the legality of smart contracts. Jurisdictions like the US, for instance, grappled with whether existing legal regimes could handle such incidents.
The hack attracted more scrutiny due to the lack of investor protection and oversight. There were debates whether smart contracts ought to be considered bidding, despite their code harbouring vulnerabilities.
💡Learn More: Decentralized Autonomous Organizations (DAOs) and Legal Personhood
Regulatory Compliance
Compliance in smart contracts is a tricky affair. Why? There is a disconnection between automated processes and traditional regulations. They don’t mesh seamlessly.
The rapid growth of smart contracts, coupled with their novelty, invokes suspicion from regulators and users, causing numerous conflicts and loopholes in the law.
Consider the following scenario:
The Security Exchange Commission’s (SEC) concern regarding token sales and Initial Coin Offerings (ICOs) demonstrates the difficulty of aligning smart contracts and digital assets with securities laws. The disconnection between digital assets, smart contracts and securities laws calls for updated regulatory frameworks.
💡Read More: The Intersection of Blockchain Technology and Securities Laws
Jurisdictional Issues
Smart contracts are signed in one jurisdiction and executed on a global network.
The decentralized nature of blockchain technology causes conflicts of laws.
The decentralized nature of smart contracts makes determining which courts and laws have authority in a matter hectic.
The process is akin to assembling a puzzle whose pieces are scattered across the globe.
Consider the following scenario:
The Ethereum Classic reorganization case of 2020 raised serious jurisdictional issues, as the blockchain rollback attempt demonstrated the absence of legal avenues for remedying similar occurrences globally.
Are Smart contracts Legally Binding?
The answer to this question depends on the jurisdiction the question is asked from.
The legality of smart contracts and other blockchain-based technologies remains unanswered in many jurisdictions across the globe.
However, jurisdictions like England and Wales have legislation that supports smart legal contracts.
Smart contracts can be legally binding. Like traditional contracts, smart contracts must satisfy all legal requirements to be valid.
These requirements are: offer, acceptance, consideration, capacity, and consensus (meeting of minds).
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Because most states and nations are still in the process of determining how they will enforce smart contracts, businesses should consider taking a hybrid approach to complex agreements, at least until we see clearer legislation. In addition to the blockchain execution code, both parties should maintain a text version of the terms that they can refer to. They may also want to include a wraparound agreement that contains additional language to address unforeseeable consequences. It will feel redundant to some extent, but it is also common to utilize a master agreement to govern ongoing relationships.
💡Further Reading: How Can Businesses Navigate the Legal Complexities of Smart Contracts?
Final Thoughts
Contracts play a crucial role in commerce, especially in this rapidly evolving digital ecosystem. Regular contracts, written on paper and governed by well established legal regimes, are the norm. The emergence of blockchain-powered smart contracts challenge convectional practises.
By adopting a holistic and proactive approach to risk management and compliance, it is possible to navigate the legal complexities that plague blockchain-based technologies. This approach ensures you and your business leverage this cutting edge technology in a secure and compliant manner.
