Smart contracts have the ability to disrupt the legal industry over the years to come. Enabled by blockchain technology, they can be quite complex and challenging to understand. Similarly to the Internet in the 1990s, some commentators think it is just a trend and won’t last very long. Due to their complexity, few legal practitioners and businesses have widely adopted using them. In this beginner’s guide to smart contracts, we look at what smart contracts are and how you can use them to benefit your legal practice.

What is Blockchain Technology?

Computer scientist Nick Szabo originally described the idea of blockchain technology in 1993, as a kind of digital vending machine. In his famous example, he described how users could input data and receive a specific item from a vending machine, like a snack or a soft drink.

In simple terms, a blockchain is a chain of blocks that contains information. Each block contains:

  • data – the type of data will depend on the kind of blockchain;
  • a hash – this is like the fingerprint of the block and is, therefore, unique to that block; and
  • the hash of the previous block on the chain – this is one of the reasons why blockchain technology is so secure. If someone alters the data on one of the blocks, the hash of that block will be modified and will no longer coincide with the hash of the next block in the chain.

Then we have a node. A node is an electronic device, such as a computer or a phone. This device is connected to a blockchain network. The role of the node is to support the system by:

  • maintaining a copy of the blockchain; and
  • processing transactions.

What Is a Smart Contract?

In practice, a smart contract is a computer program stored in a blockchain. It contains specific inputs and executes a set of instructions to come to one of the many outcomes that have been predetermined by its programmer.

They can help you exchange:

  • money;
  • property;
  • shares; or
  • anything else that is of value.

It does this exchange in a transparent way that avoids the services of a middleman. This is because someone codes the terms of the contract in a computer language that makes the terms automatically enforceable by a protocol that all nodes in the network follow.

Bitcoins are a basic type of smart contracts where the network can transfer value from one person to another. The system of nodes will only validate transactions if certain conditions are met.

A simple example of how smart contracts can be used in a different context is crowdfunding. Let’s say a startup would like to raise $100,000. This startup might determine that if the amount that they end up raiding is below the threshold of $100,000, the investors get their money back. Subsequently, the protocol that the smart contract will follow is that if the goal of $100,000 is:

  • reached then the money goes towards the startup; or
  • not reached then the money goes back to each investor.

Are Smart Contracts Legally Enforceable?

To be enforceable in Australia, a smart contract must meet the requirements of a normal contract:

  • offer;
  • acceptance;
  • consideration; and
  • intention to be bound.

If the entire process of a smart contract is fully automatic and a party to the transaction is not aware that it is taking place, they might not have the intention to be bound by the transaction. However, because parties understand the code’s rules, they are bound by the transactions that take place from that code.

How Can I Use Smart Contracts in My Law Firm?

At the moment, much of the focus around smart contracts is related to its use in the trading of financial instruments such as:

  • shares;
  • bonds; or
  • derivatives contracts.

For example, the International Swaps and Derivatives Association (ISDA) has taken significant steps in automating its standard form contracts in the derivatives market. They have been developing a framework on how to implement the use of automated contracts.

However, there are many more opportunities for the use of smart contracts within different industries. Smart contracts are particularly helpful in areas where many transactions begin because of specific events. For example:

  • supply chain management, where a smart contract can track products and manage the workflow of approvals, then automatically transfer payment;
  • real estate transactions and land registration, where once the purchase price is paid, the buyer receives the deed;
  • payment of insurance claims, where a certain event or incident triggers the payment of a claim to the insured; and
  • management of intellectual property rights, where a smart contract can calculate royalties and distribute payment to artists.

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Are Smart Contracts Better Than Normal Contracts?

The main benefits of using a smart contract are:

  • automated performance: once someone has coded the terms of the contract, they are automatically enforced;
  • transparency: the terms of the contract are visible to all parties;
  • secured transactions: smart contracts use the highest level of data encryption currently available;
  • speed: as smart contracts live on the Internet, they can execute transactions very quickly;
  • storage: the details of the contract are permanently stored in a digital database.

Are There Disadvantages of Smart Contracts?

It can be challenging to write large amounts of code to create a smart contract without making any mistakes. Therefore, if the contract is not producing the desired outcome, developers will need to amend the code.

However, one of the characteristics of smart contracts is that they cannot be altered. This comes as a significant advantage in most cases because it means that parties can rely on the contract itself, without having to rely on the trustworthiness of the other party. But, if there is an issue in the code, not being able to stop the performance of the contract will become an issue.

One way of addressing this risk is to ensure that the contractual parties agree on a process for how a smart contract can be overridden by a “new version” of that smart contract. The replacement smart contract would then sit alongside the original smart contract with additional code. This code will ensure that any input to the original smart contract would automatically flow to the replacement contract.

Will Smart Contracts Put Lawyers Out of Their Jobs?

Lawyers will always need to be involved during the process of drafting and amending contracts. Smart contracts are no exception to this need for lawyers. Developers of the contracts need to interact with lawyers to understand how to code appropriately. Lawyers will also facilitate the negotiation and assist their clients in understanding the consequences of the contract.

One of the most challenging areas for the development and evolution of smart contracts is when a smart contract references a real-life event as a milestone for activation.

For example, when a breach of contract may be severe enough to warrant the termination of the contract.

When the milestone is a piece of information that can be obtained on the Internet, this is straightforward. But, if the event happens privately, how will the smart contract know whether it has occurred? Here, the parties will need the assistance of lawyers to assess and determine whether or not the event warrants the activation of a contract term.

What’s Next for Smart Contracts?

Smart contracts are already increasing in number and in sophistication, but there is still some uncertainty around them. To set smart contracts up as a serious alternative to natural language contracts, we need some fundamental changes:

  • more trained experts in the field: as smart contracts increase in popularity and training is tailored to this technology, there will be a need for more developers;
  • recognition by courts: as smart contracts are used more, there will be more court decisions addressing them. This will increase clarity around how smart contracts are used and may encourage other industries to use smart contracts;
  • a focus from the regulators: regulators will pay increasing attention to how smart contracts can operate in a variety of contexts and provide the framework necessary for the success of smart contracts.

Key Takeaways

A smart contract is an automated contract designed to increase efficiencies within the legal industry. The terms of the contract are encoded in a computer language and are then automatically enforced by a protocol that the network follows. The main benefit of smart contracts is that they can automatically execute a set of instructions in a transparent environment. However, a number of crucial changes need to occur before smart contracts can be considered a serious alternative to natural language contracts. If you have any questions about implementing smart contracts within your business, contact LegalVision’s Legal Transformation lawyers on 1300 544 755 or fill out the form on this page.

About LegalVision: LegalVision is a tech-driven, full-service commercial law firm that uses technology to deliver a faster, better quality and more cost-effective client experience.
Melanie Gilbert

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