What are smart contracts?

In simple terms, a smart contract is a self-executing contract, containing electronically drafted provisions which have the ability to automate a variety of processes, in accordance with the terms of the contract.

Through the use of code underlying its clauses, a smart contract is able to verify the performance of contractual obligations and subsequently ensure the performance of corresponding obligations – in essence, it confirms and enforces the performance of its own terms.

This process of automation and verification is possible due to blockchain technology. For smart contracts, the blockchain provides a solution to the issue of trust and certainty, by providing an authoritative and multi-verified database of transactions. This database is continuously maintained and updated by a network of participants who must verify amendments or additions in order for them to be incorporated into the contract.

How can smart contracts and the blockchain be used in practice?

Below we set out the use of the blockchain in the context of financial services smart contracts. Read more about the Blockchain and it's uses.

Conditional performance – automation, speed, and clarity

The clauses of smart contracts are capable of being electronically drafted such that the effect of a contractual clause will be autonomously triggered, for example:

  • contingent upon the occurrence of a specific event (“if X happens, then action Y”)
  • on a specific date or at the expiration of a period of time (“at X date, action Y”)
  • dependent upon which event occurs (“if X happens, then action Y, whereas if A happens, then action B”).

A vending machine may be used as a rudimentary example of the application of such automated conditional performance. Upon the purchaser satisfying the defined consideration (by inputting money), the vending machine is designed to automatically transfer ownership of goods (eg a chocolate bar) by physically releasing them to the purchaser.

By using blockchain technology, however, the need for the physical retention of goods until consideration is satisfied (as in the vending machine example above) is eradicated, and instead, a record of the transfer of ownership is maintained by multi-party verification on the blockchain. The blockchain allows the ownership of real assets to be controlled digitally.

From a wider business perspective, this could assist legal and financial services in the transfer of settlement funds between parties, upon the performance of a defined obligation. It was recently announced that Mizuho Financial Group and IBM are currently testing the use of blockchain technology to facilitate instantaneous swapping of payments, avoiding delays and ensuring adherence with contractual obligations. This idea could be applied similarly to the sale of land or the licensing of intellectual property.

As well as automation and speed, smart contracts are capable of providing contracting parties with greater certainty as to the terms of the agreement. Smart contracts’ terms are written in code (avoiding ambiguity in the interpretation of legalese) and can be determined by a mutually agreed data source (anything accessible on the internet) which provides any information which the contract is contingent upon. This might be used in trading “over-the-counter” derivatives, where the source of data for the asset (eg currency), the value of which the contract is contingent upon, can be agreed, and the data provided by that source is determinative of the terms of the contract. When the data becomes available to the smart contract via its agreed source, it will immediately execute the contract or specific provisions therein, in accordance with the data provided to it. To take the above example of derivatives trading a step further, conceivably, the bank details of the traders could be linked to the code of the contract, allowing for immediate transfer of funds when payments become due.

Recording and reporting

Another advantage to smart contracts is its record-keeping potential. This is due to the identical and dynamic copies of the contract being kept across the blockchain, with amendments having to be unanimously verified by the computers of all participants, in accordance with a ‘consensus algorithm’. This ensures synchronisation of the contracts on the network and in practice should lead to alleviating complications of version-control and remove the need to endlessly run comparison software over documents to avoid subtle, yet potentially damaging, amendments to the terms by other parties. It also means that no one party need be assigned as custodian of the ‘master’ contract, as this responsibility is distributed thanks to the blockchain’s network. This also provides a log of amendments, which are stored electronically on the blockchain.

As well as providing assurances as to the veracity of a contract or a status under it, a further benefit of contracts being drafted electronically is the ability to 'view' or 'track' the status of the contract. Conceivably, with the status of certain provisions capable of being viewed in real-time, if the obligations extended to multiple parties for instance, the parties could monitor the progress of obligations being adhered to. It is envisaged that this could lead to contracts being viewed as their own ‘web-page’, improving transparency and allowing, for example, lawyers to report to their clients or for those clients to report to their board more easily and with greater certainty.

Does this mean we can get rid of lawyers?

The short answer is, probably not, or at least not for now. Indeed, the consensus appears to be that smart contracts will never fully replace traditional legal contracts and, as such, the need for human involvement shall remain. In spite of the benefits to certainty and clarity, there will invariably remain contractual provisions that require legal interpretation, both in advising clients, and by the courts in litigation. Reference to legal terms and concepts (eg “negligence” or “reasonableness”) shall continue to require cerebral interpretation, and transactions which require human performance, rather than the transfer of money, or a chocolate bar, cannot be contained in code.

Further smart contracts will still require lawyers’ involvement in the construction of these contracts, namely in advising on the interaction of contractual obligations and also potentially by identifying litigation-prone areas that could benefit from being incorporated more robustly in electronic language. So, for now, even if smart contracts become widely adopted, lawyers will likely still be required to help. But hopefully in a more cost-effective and efficient manner.