• Matthew Johnston

Smart Contracts in a Regulated World

Updated: Apr 6

Smart Contracts in a Regulated World

On the 28th October, The Legal Chain hosted their second webinar, which explored smart contracts, along with guest speaker Tara Waters, a partner at Ashurst and head of Ashurst Advance Digital, who was named in The Lawyer’s Hot 100 (2020) and included in Innovate Finance’s Women in FinTech Power List 2017. If you missed our webinar on smart contracts, do not worry! You can access a live recording of a webinar as well as a summarising article after each event via our website and LinkedIn page.

A smart contract is a piece of code contained in a blockchain that carries out a contract between a buyer and seller. Unlike regular contracts between two parties, smart contracts are self-enforcing. Parties to the contract are unable to alter the smart contract blockchain. This means that smart contracts are protected from the usual problems of parties’ unwillingness to carry out their obligations. This would ideally replace the need for an institutional enforcement mechanism such as the courts. Smart contracts are limited to information self-contained within the blockchain, therefore they receive their inputs through “Oracles”, sources which are trusted to provide accurate information. Smart contracts embody Lawrence Lessig’s idea that “code is law”, being enforceable not only because of an agreement between parties but because its code is immutable.

This rigidness, however, creates problems within smart contracts. The first and largest problem is a conflict between systems, any flaw within the original code would not be able to be corrected and so would consequently roll through into creating a flawed end result. As there is no mechanism for a “roll back” or reallocation of assets through the smart contract system, it is likely that this correction role would return to the courts. The problem is that the threat of ex-ante litigation seriously threatens some of the benefits of smart contracts, making the outcome of the contract no longer fixed and certain. It is plausible, that this will simply create a norm of lawyers and computer scientists working in tandem to create both efficient and legally compliant smart contracts, less vulnerable to flaws or litigation.

Similarly, a second problem with smart contracts is that “Oracle” provided information can be faulty. At the minute, smart contracts are reliant on trusted providers such as meteorological websites. While blockchain driven smart contracts are immune to tampering, Oracle provided information has no such resistance. This can further reduce faith in the smart contract and can leave effects vulnerable to manipulation. A theorised solution to this problem, is using a wider set of data than a single website and requiring an algorithm to verify this data against other sets in order to protect against manipulation.

A third and final problem with smart contracts is their inflexibility. Whereas through mutual agreement, parties can agree to cancel contracts or have them amended due to changing circumstances, smart contracts are entirely automated. Especially where the good or service employing the smart contract is necessary for life, there will be opportunities for problems to arise, such as public relations issues. Human discretion allows for both some degree of perceived benevolence, while also preventing unfavourable contracts.

So, what benefits do they have? One benefit is that of certainty. A large part of the financial system is in the business of dealing with risk. Smart contracts provide an almost fully risk-free system, beyond possible litigatory risk and technological failure as I have outlined above, smart contracts will fulfil their task and carry out the agreement. This should result in smart contracts being more popular and sort after as the technology becomes normalised and the techniques become more advanced.

Smart contract systems can also be independent of institutions. It is questionable to what extent business agreements can ever be beyond the reach of regulation and the courts, but, at surface level, their nature limits the power of the courts to impose biased rulings and instead prioritise the parties' original intentions. However, this advantage is weak as the courts will most likely continue to consider the relevant bargaining powers of the parties with regards to the application of smart contracts especially in its age of novelty.

A major benefit of the smart contract system is that it is resistant to corruption. The code in blockchains and smart contracts is transparent and automatically executed. This suggests that smart contracts may be favoured and supported by regulators due to the complete transparency of the procedures and agreements. Another benefit for regulators would be the prevention of changes to the execution of the contract, which depending on the impact of the contract could theoretically lead to market manipulation and insider trading. By contrast, the transparency of smart contracts allows and prioritises freedom of information within the market, creating an even playing field for financial speculation around these contracts and their outcomes.

Application

Conceptualising smart contracts and their effects is easier when viewed with a contextual example of what smart contracts currently are and also what they feasibly could be. A conservative estimate of the capacity of smart contracts would focus on their relevance to financial contracts between individuals. You can imagine a situation where several investors buy a property and proceed to extract rent from it. Smart contracts could be used to split the income between the parties automatically when an account is paid. This not only streamlines the process but also removes any chance of fraud or financial impropriety from a party who would be managing the capital distribution.

A similar system to this hypothetical scenario was The DAO in 2016. The DAO was an attempt to have an entirely virtual venture capital fund. It was started on the Ethereum blockchain and coded on solidity. Both of these facts are important, as Ethereum has full functionality for smart contracts and solidity was a language with a syntax very similar to JavaScript that was created to code smart contracts. The DAO lacked any board of directors or management hierarchy and was functionally stateless. Ownership of the DAO came from Digital Share Tokens, which were used by investors to vote on projects for the overall organisation to fund. In June 2016 the DAO was subject to an attack, which managed to reroute 1/3 of the overall assets of the organisation (held in Ethereum coins). This shows not only the power of smart contracts to create an incredibly decentralised, innovative structure, but also open the door for unforeseen technological threats.

Another real life smart contract company (and a favourite for DAO funding in 2016) was slock.it, a company which provides a smart contract enabled entry system based on swipe cards. Once the seller has received payment, the smart contract would activate and allow the buyer to use their card to open a specific door. This technology could feasibly be used for services like Airbnb and reduce the amount of owner oversight necessary for property access.

In a similar way, smart contracts not only allow transfer of access to property but also property itself. So called “smart property” allows the transfer of title deeds, be it for vehicles or real estate. This can allow a really streamlined and certain system where for instance once payments have concluded on a car, the title can be transferred instantaneously to the consumer.

Our recent webinar went into the specific legal and business impacts of smart contracts, a talk necessary for anyone who wants to go into tech law or simply be prepared for emerging trends in e-commerce.

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