A recent report by the European Parliamentary Research Service (EPRS) explores how blockchain technology could continue to develop and impact on a number of key areas of everyday business and life in general. One area explored by the EPRS report relates to the use of blockchain for so-called smart contracts.

How does blockchain work?

Blockchain first came on the scene through Bitcoin. In basic terms it is a decentralised, distributed electronic ledger which allows for the creation and maintenance of authentic, tamper-resistant records. This is done by essentially cutting out the middlemen (for example, central registries such as banks and governments) to bring record creation and verification into the realms of peer-to-peer control. Blockchain is so special because once a record has been created and verified, it cannot be altered. It is a great way of tracking prior activity/transactions and verifying their provenance and validity. In many contexts, blockchain is proving to be faster, cheaper, more transparent and safer than traditional ledgers. Digital currency is not the only context for its use; there are many other ways in which the technology can potentially be deployed.

Smart contracts

As well as recording the basics of a transaction such as its date, time and participants, blockchain technology can be used to create contracts with embedded code. These smart contracts can be self-executing. Their embedded code also allows for specific contractual actions or instructions to be triggered automatically, for example, making payment upon delivery of goods or services. This mechanism could simplify and speed up business and improve contractual standardisation, leading to gains such as improved efficiencies. This further layer of customisation for transactions in the blockchain would bring much more certainty for contracting parties and less risk.

No doubt, smart contracts will be useful for certain types of transaction but there are some potential drawbacks. For one, the unalterable nature of blockchain technology means that once code is entrenched in the blockchain, contracts completed in this way can only be cancelled or modified under terms set out in that particular code, as it exists in the blockchain. Whilst contractual certainty is important for many reasons, the commercial realities of business are not fixed. This means that the lack of malleability in a smart contract could cause problems should a dispute arise between the contracting parties, for example, if one party believes it has reason to withhold payment.

The EPRS report refers to a radical interpretation of smart contracts where embedded code could be perceived as substituting the law itself. This would be on the basis that the code in the blockchain would entirely govern the contract. In such instances, smart contracts could be regarded as "self-contained, self-performed and self-enforced." Such interpretation is not without its risks, however. For instance, mistakes in the code could be exploited without consequence (as they would be part of the contract). Also, smart contracts could include provisions that are illegal in the chosen jurisdiction.

The report suggests that a more realistic interpretation of smart contracts is to place them within the wider legal system by imposing additional requirements and controls on top of the embedded code, in accordance with the relevant law. This could include the application of traditional judicial processes, such as arbitration, to deal with any disputes.

It is important to note that smart contracts by their very nature could undermine some of the key benefits inherent in blockchain technology. Incorporating embedded code within smart contracts sets them apart from the routine transaction recording that has lent itself so well to blockchain technology. Therefore, smart contracts will likely require greater effort to process and verify which could lead to more cost. This risks cancelling out some of the efficiency gains of traditional blockchain use. Also, the extra complexity required for smart contracts could increase the risk of security vulnerabilities arising. According to the EPRS, when combined with the "'code as law' ideology" this could cause serious practical challenges for smart contracts.

A copy of the EPRS report is here.

Comment

This is an area that has sparked the interest of many organisations. Contract management and automation often go hand in hand when looking at improving efficiencies. Smart contracts could sit very nicely in this sphere to earn a place in the mainstream business world, particularly for more routine, repetitive types of transaction.

However, blockchain technology in this context is not without its limitations, particularly where parties' plans can alter and disputes may lurk. The inflexibility of the blockchain could work against this reality. As the EPRS report acknowledges, the enforceability of smart contracts and the adjudication of disputes to which they relate may present challenges in the future. It is unlikely that such contracts would ever be above the law but incorporating additional controls to aid enforceability and adjudication will be a careful balancing act. It will be interesting to see how this area continues to develop.