Smart contracts are computing programs that automatically self-execute the terms of a contract following the fulfilment of certain conditions. These forms of contracts represent a digital evolution in contracts and are most commonly used by financial institutions to authenticate repetitive and high-volume transactions. Smart contracts are written and coded in a way that no single party can stop a smart contract’s operation as no single party controls its operation. Smart contracts are now becoming synonymous with blockchain technology and bridging the gap between existing legal and commercial arrangements.

So, What Are Smart Contracts?

Strictly speaking (and by legal definition), smart contracts are not contracts. Rather, they are unilateral promises that execute once a computing program receives a certain instruction (such as a script). Smart contracts are considered ‘smart’ as they are machine readable and executable, and they interact with various IoT (Internet of Things) systems simultaneously. It mirrors a normal contract in that obligations are set out, and there are breaches for non-conformance. Today, the advent of blockchain technology has enabled smart contracts to increase in popularity with banks and financial ledger platforms, as well as users of cryptocurrencies such as Bitcoin.

What are Their Features?

A distinctive feature of a smart contract is its ability to minimise risk through “non-discriminatory execution”. This feature means that contracts are executed and performed automatically so long as it fulfils the full criteria of the transaction. A vending machine is a real-life example of a smart contract. The machine takes in coins in exchange for a good. The transaction is self-automated and does not require any third party intervention. Nick Szabo, a legal scholar and cryptographer, known for his research in digital contracts, gave the example of the vending machine. For more on smart contracts, read his 1997 paper, “The Idea of Smart Contracts”.

A loan is a common example of how a smart contract can be codified. The terms of the loan are set up and stored in the blockchain. When the terms of the loan are met, and the conditions are fulfilled, the token for the digital asset will be released (similar to the vending machine example above). The performance of the smart contract does not depend on any outside intervention or monitoring. Similarly, if a loan defaults, a smart contract would revoke access to a digital asset. Smart contracts extend beyond digital assets. They can also be established for financial securities such as swaps, options, forwards and futures.

Today, smart contracts codify and automate simple contracts or processes. Over the next few years, we will see more commercial entities begin to automate and adopt more complex smart contracts. This progress will mean integration with IoT systems and increasing multi-party interaction. For example, failure to pay a car mortgage on time could mean your car, connected to the IoT, does not start.

The nature of blockchain technology in decentralising the settlement of transactions means that parties can execute contracts with greater efficiency. Individuals can now contract with one another without the middleman. As these arrangements are automated, there is little wriggle room to allow parties to amend their agreements. This may result in fewer disputes as parties agree to a clear set of terms at the start of the contract.

Key Takeaways

At its core, smart contracts are just software scripts. It is unlikely we will see smart contracts substitute legally binding agreements. For now, smart contracts will be difficult to enforce in court as “contracts” as it is difficult to establish the terms of a complex commercial contract in code. In the near future, clients may require lawyers to read the code to confirm the terms of a smart contract.

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Anthony Lieu

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