Smart Contracts: Creation and Utilisation
Smart contracts have the potential to revolutionise how contracting parties can increase efficiency within contracts and streamline process-related terms in their contracts. What are they? Smart contracts are lines of computer code that automatically execute all or parts of an agreement and are stored on a blockchain-based platform. These contracts are also named in the literature as ‘smart legal contracts’ due to the legally enforceable nature of the obligations within the agreement. Quite simply, when ‘x’ occurs, which the contract can determine using data sources which it is linked to, automatic processes occur via the blockchain and the result of ‘y’ is achieved. The unique element of smart contracts, which are especially appealing to commercial agents, is the autonomous functioning of the contract without either party being able to interfere or tamper with the performance.
A use case for smart contract technology would be in the context of insolvency. It is time-consuming for lawyers to search thousands of databases regularly to check whether the suppliers firms are bankrupt. Instead, lawyers and technologists can design a smart contract with a ‘smart clause’ which programmes the protocol to continuously check external data sources and terminate the contract if a certain event occurs (e.g., the company files for administration). This saves time, money and the use of a blockchain which encrypts information adds safety to the transactions. Lawyers at Freshfields Bruckhaus Deringer see the future of smart contracts involving transfer of property ownership upon receipt of cleared funds and trading of securities without the need for central securities depositories.
In order to understand the full complexity of this technology, it is important to look at the creation of smart contracts in detail.
The creation of a smart contract can be broken down into 5 key steps.
1. Agree use
The first stage of creating a smart contract involves the parties having discussions as to which clause within the contract will be digitised and made ‘smart’. A common misconception is that entire contracts are digitised within the ‘smart contract model’ but in reality, parties find the most utility from making ‘smart’ a few key mutually beneficial terms.
Terms which are incorporated into smart contracts are usually process-driven operation-based terms in a contract. Notifications (e.g., of insolvency), invoicing, delivery of goods and such. This is due to the discrete nature of the obligation and the lack of a need to apply subjective knowledge to determination of whether the obligation has been completed. Terms such as ‘reasonableness’ or ‘good faith’, invite uncertainty and cannot be certified by the smart contract protocol on the blockchain and therefore such terms will not be made ‘smart’.
Clauses are then ‘mapped as code on the blockchain’. This is when lawyers and technologists turn natural language into computer code. This is termed ‘mapping’ as it involves getting from natural language (e.g. ‘if X happens then Y must be transferred’) into a code compatible with the blockchain. This also involves identifying the data source which is connected to the smart contract which allows constant monitoring of the variable.
The practical process of mapping involves lawyers breaking down the clause and steps within the obligation into easily understandable boxes which can be put together to make up the entirety of the smart clause. Often this takes place using ‘Unified Modeling Language’ (UML), which is a standardised modeling language that uses diagrams and helps software developers to construct software. Consequently, these algorithms need to be turned into ‘pseudocode’ by lawyers who construct the terms. Pseudocode sounds somewhat sci-fi esque but in reality it is a ‘text-based’ detail design tool (in layman’s terms - a language) that bridges natural language and computer code to allow the algorithm to be turned into code.
The next step involves uploading the code to a digital platform which is going to be used to house the smart contract. Blockchain-enabled platforms, such as OpenLaw, are used due to the issues with a centralised platform where there is the potential for a bad actor to change the obligation or down-time which temporarily disables the contract. Blockchain is a distributed ledger which is immutable and secure. Parties are comforted by the fact that all information on the blockchain is recorded and validated by separate nodes at the same time and the immutability of the information also adds legal certainty. Any change to the code once uploaded will result in the hash being changed and this can be easily identified, remedied and resolved by parties.
The final step in the creation process involves the parties finalising the agreement and signing the contract. Unlike a traditional contract where, once signed, a contract is filed away and not re-visited unless there is a dispute or point of contention. Smart contracts, once signed and executed, immediately begin to perform the functions which are coded and monitor data sources.
Thus, the creation of smart contracts is a complex and organised process which requires the meeting of minds of highly intelligent lawyers and equally brilliant technologists. Over time, the creation of smart contracts is likely to become easier and more standardised as dominant codes and platforms become established. The innovation in this space is vast. Platforms, such as OpenLaw and DLT Co., are being rapidly developed and iterated upon. Legal bodies such as the Law Commission and the Financial Conduct Authority are regularly CONDUCTING research and publishing thought-leadership on the topic. It is only a matter of time before smart contracts become commonplace within the repertoire of lawyers and staying ahead of the curve is essential.
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Article written by Shruthi Madhusudan