Smart(er) contracts in 2020
Blockchain well and truly entered into the vernacular during the ‘ICO boom’ of 2017, and yet for many the term has become synonymous with cryptocurrency. Although very much still in development, blockchain technology has the potential to move beyond simply recording and verifying transactions. In particular, there has been a renewed interest, and increased experimentation, in codifying legal agreements on blockchains through the use of smart contracts.
This article discusses some of the current opportunities and challenges facing the adoption of blockchain technology, and in particular smart contracts.
WHAT IS A BLOCKCHAIN?
Blockchains are tamper resistant digital ledgers implemented in a distributed fashion, usually without a central authority. This distributed ledger system essentially takes a number of records and bundles them into data sets or ‘blocks’. That block gets chained to the next block using a cryptographic signature or ‘key’. The blockchain then acts as a ledger and the keys control who can do what within the ledger. Each user owns a full copy of the ledger, and plays an important role in automatically and continuously agreeing on the current state of the ledger and all of the transactions recorded in it. Blockchains can be public (i.e. anyone can become part of the network) or private (i.e. only approved participants can become part of the network).
At their most basic level, a blockchain enables a community of users to record transactions in the ledger that is public to that community, such that, effectively, no transaction can be changed once published. It is the data transparency between all users in the network, and underlying cryptography, that removes the need for a trusted intermediary.
WHAT ARE SMART CONTRACTS?
The term smart contract is something of a misnomer. As Ethereum founder Vitalik Buterin tweeted in 2018, they should have been called “something more boring and technical, perhaps something like persistent scripts”. A smart contract is a self-executing, self enforcing protocol which is governed by its explicit terms and conditions. To enter into a blockchain based smart contract, the parties first negotiate and agree to the terms of the agreement before memorialising the terms (either in part or entirely) in smart contract code.
Matters which utilise clear rules and quantifiable terms of engagement are well suited to implementing smart contracts. For example, blockchain and smart contract technology is already being utilised:
- in the logistics sector – to shorten the chain of third party agents, shorten delivery timeframes, track the transportation of goods and potentially reduce the price to consumers and chances of theft ;
- in the food and wine sector – to track the provenance of products to better prevent food fraud; and
- in the financial services sector – the opportunities are almost endless for financial services and include, for example, payment processing (including cross-border payments), clearing and settlement of financial instruments, trade finance and automated over the counter (OTC) derivatives contracts, as well as regulatory technology such as streamlined ‘know your customer’ certification.
Advantages of using smart contracts
There are a number of common advantages which smart contracts can offer. These include:
Accuracy and transparency: As the codified terms are fully visible and accessible to all relevant parties, there is no way to dispute them once the smart contract is established. This facilities complete transactional transparency and removes (or, at the very least, reduces the likelihood) of any manipulation, bias or error which in turn encourages greater confidence in the execution of the smart contract. This, in turn leads to decreased monitoring costs and risks of opportunistic behaviour.
Efficiency: Smart contracts are able to improve the efficiency with which commercial arrangements are carried out due to:
- automated execution;
- the bypassing of bureaucratic mechanisms;
- the high speed of execution thanks to the use of mathematical algorithms in blockchain applications instead of bureaucratic mechanisms;
- there being no requirement to process documents manually; and
- a lack of miscommunication due to the explicit nature of the codified terms.
Many smart contract-proposed use cases assume that the smart contract will receive information or parameters from ‘off-chain’ resources. This can cause two major issues. Firstly, smart contracts do not have the ability to pull data from off-chain resources; rather, the information must be ‘pushed’ to the smart contract. Secondly, if the data at issue is in constant flux, and since the code is replicated across multiple nodes, different nodes across the network may be receiving slightly different information. As consensus is required across the nodes for a transaction to be validated, these fluctuations may prevent the condition from being satisfied. Contracting parties can, however, solve this issue in a streamlined and transparent way by using an ‘oracle’. Oracles are trusted third parties (which may be software or actual people) that retrieve off-chain information and then push that information to the blockchain at predetermined times.
Security: Smart contracts are afforded the reliability and tamper-resistant nature of the decentralised data storage which underpins blockchain technology. In particular, because of the distributed nature of a blockchain, along with consensus mechanisms and hashing algorithms, once information has been recorded to a blockchain, it becomes incredibly hard to change or delete. A party does not have the ability to modify or roll back information stored on a blockchain, or halt the execution of a smart contract once it has been deployed, unless provided for in the code.
LEGAL AND REGULATORY CHALLENGES OF SMART CONTRACTS
Despite the opportunities the adoption of smart contracts can offer, there are still a myriad of issues, including, in particular, legal and regulatory challenges, which are preventing the more widespread utilisation of smart contracts. These include:
Interpretation and enforceability: If there is a dispute about whether a smart contract accurately memorialised the parties’ intentions or whether one party has breached the contract, the parties may still bring legal proceedings or engage in alternative dispute resolution processes. As contract law varies between different jurisdictions, so too will the enforceability of smart contracts depending on any formal requirements required in a particular jurisdiction.
Assuming the smart contract is enforceable, how then do the parties to the contract, a judge or a regulator interpret the terms that are written in code? While judges may not look to sources external to the contract to interpret the code, natural language clauses can be linked to the digital clauses for interpretation purposes. These hybrid contracts are referred to as ‘Ricardian contracts’. Coding within the blockchain ledger contains a reference to the natural language clause thereby incorporating it into the digitised contract. If all goes smoothly, it may be that the natural language clauses will not need to be referred to.
If a different outcome was mandated by law, how would a smart contract transaction on the blockchain be unwound? And what would that mean for the downstream transactions that have already formed on the blockchain? Will there be a need to legislate for ‘kill switches’ in times of stress?
Liability and risk allocation: Smart contract ‘purists’ take the view that the smart contract code should simply resolve issues of liability through performance. However, this is a simplistic view. There will always be interests that differ between two counterparties, regardless of the assumptions on which the technology is built and runs. This is a reality of trade and commerce, and means that it is not possible to escape the fact that there may need to be adjudication on matters of liability.
Smart contracts also introduce a completely novel risk that the contract will be hacked or that the code or protocol simply contains an unintended programming error. In relation to blockchain technology, these concepts are closely aligned as most hacks associated with blockchain technology eventuate from exploitations of an unintended coding error. Parties to a smart contract will need to consider how risk and liability for unintended coding errors and resulting exploitations ought to be allocated between the parties, and possibly with any third party developers or insurers of the smart contract. For example, the parties may seek written representations from the programmer that the code performs as contemplated.
Confidentiality, security and privacy: Although the transparent nature of smart contracts is potentially advantageous, some smart contracts may exhibit a degree of transparency that is undesirable to some parties. Unlike traditional contracts, all transactions executed via a smart contract, are propagated across all of the nodes in the network, which creates privacy issues, particularly when the accounts of the parties are associated with known entities. Even when the parties are not identified (e.g. they rely on pseudonymous accounts), certain identification techniques can be used to discern the identities of parties who transact with a particular smart contract.
Interestingly, the flip side to the confidentiality/privacy debate is that the availability of the data provides an audit trail and a much more efficient way for regulators to view the information they need to ensure regulatory compliance – essentially, acting as a “regulatory app”.
Jurisdictional issues: Smart contracts also raise interesting jurisdictional issues. Because blockchain operates as a decentralised ledger, it means that smart contracts can be formed and accessed anywhere across the globe. They do not reside in any one location, but exist across multiple locations at the one time. Yet our laws are jurisdiction-based.
The differences in laws across jurisdictions – including matters as basic as ownership – can be highly problematic, resulting in incongruent rights and responsibilities, and confusion regarding the consequences if there is a contract violation.
Evidentiary matters: As smart contracts begin to proliferate, they will be subject to examination. This means there will be a need for new types of cryptography experts, and forensics experts, to verify software code and to translate the code into human-readable form.
Regulated contracts: Smart contracts sit uneasily with certain types of regulated contracts. Take, for example, Australian unfair contract terms legislation. A contract written in code is probably not going to be sufficiently transparent for the purposes of informing a consumer or small business.
Regulatory and policy settings: Existing regulatory and policy settings will need to be considered in greater detail. How are regulators to police smart contracts? And what opportunities exist for parties to use the technology to potentially side-step the law by hiding the identity of the parties and the governing jurisdiction of the contract? How are cross-jurisdictional issues of taxation, national security and anti-money laundering to be managed?
WHERE TO FROM HERE FOR AUSTRALIA?
In addition to the release of the National Blockchain Roadmap in February 2020, several Australian Government agencies have sought to clarify the regulatory issues that affect the implementation and use of blockchain. For example:
- the Australian Securities and Investments Commission has released guidance in relation to when the use of blockchain technology may attract regulation under Australian financial services regulatory laws (for example, when an initial coin offering may constitute an offer of shares or interests in a managed investment scheme);
- the Australian Taxation Office has also released guidance in relation to the tax treatment of digital assets;
- following legislative changes in 2018, digital currency exchange operators with a geographical link to Australia are now required to comply with Australian anti-money laundering and counter-terrorism financing laws;
- the Federal Government has provided funding to Standards Australia to develop, in concert with the International Organization for Standardization, international blockchain standards; and
- IP Australia co-leads the Committee on World Intellectual Property Organization Standards Blockchain Task Force, which is exploring the potential of blockchain technology for the IP Rights ecosystem.
The Australian Government has acknowledged that there are many opportunities blockchain technology and particularly smart contracts can facilitate across various sectors, however, Australia’s ability to capitalise on these opportunities will depend (at least in part), upon effective, efficient and appropriate regulation and standards.
This publication covers legal and technical issues in a general way. It is not designed to express opinions on specific cases. It is intended for information purposes only and should not be regarded as legal advice. Further advice should be obtained before taking action on any issue dealt with in this publication.