Smart Contracts and Businesses

Smart Contracts and Businesses

I. Preamble

“Verba volant, scripta manent” (: “spoken words fly away, written words remain”) Romans used to say.  It is similar to a Greek saying, roughly translating: “when there is something in written, no one can dare question it”.  Both phrases obviously refer to the need (our need) for written proof of what is agreed upon.

This Greek saying depicts the “relationship” between the older among us and written documents entailing what is agreed upon. And, also, the insecurity the absence of written documents brings along.

Most of us grew up having well engraved in our subconscious the need to “hold” tight a “piece of paper”, usually proof of an agreement, a trait or a title.

Different times back then.

Different times indeed! But the “engraving” in our subconscious is, more or less, still somewhere there.

Today, in the age of technology, tangible documents have started to, gradually, lose their value.

 

II. Smart…

Smart phones, smart house, smart appliances, smart car, smart factory…

The use of the adjective “smart” is getting wider by the day. We could say that it gives a new meaning to traditional concepts. Especially in the context of the 4th Industrial Revolution and the technological leaps that come with it.

This is where we also stumble upon “Smart Contracts”. But this is not a new term or concept. The discussion on smart contracts had already begun in the mid 90’s.

 

III. A little bit of history

Nicj Szabo, in his early youth, made some exceptional choices and investments in himself. He chose to study law, informatics and cryptography. This combination is, to this day, remarkably innovative. Even more so for his time. Those specific studies gave him the ability to make a double (but simple in its content) ascertainment: (a) human societies are structured around the use of paper-documents as means of proof of an agreement, an event, a certification, and that (b) it was (technically) possible to  change that, by using computer software -“protocols”, to be more precise.

Based on those, he highlighted the potential to utilize a wide variety of new protocols.  Their Purpose?

(a) the digital registration of promises/commitments of both parties – he called this registration “smart contracts”,

(b) the monitoring of whether the requirements set were met, and

(c) the automated execution of the obligations the contracting parties undertook (both in case the requirements were met or in case they were not)

The vending machine is considered to be an ancestor of smart contracts. Their early forms: ATM and POS machines.

 

IV. The characteristics and applications of Smart Contracts

Nick Szabo defined smart contracts as a computer trading protocol (in the form of: “what will happen if…”), which allows for an automated execution of the terms of a contract.

But the conversation regarding smart contracts spread during the past few years. And this is due to the opportunity which arose, to combine smart contracts and blockchain technology.

This technology is practically what made smart contracts possible. We already saw that smart contracts are nothing more than a program code. When the conditions that have been agreed upon are met, then smart contracts can self-execute. The clauses and the terms of the contract are registered in the code. The code then verifies whether they were delivered, or it detects any violation that may occur. Finally, it automatically executes what has been agreed upon, taking into consideration whether the agreed upon clauses and terms where delivered. Every movement, every term of the contract that is kept or violated is registered in the blockchain, rendering the data unchangeable and unquestionable.

Therefore, smart contracts are completely safe. Consequently, more useful.

This is why their use by businessmen and businesses is widened. And not just by them.

 

Smart contracts and blockchain

While approaching blockchain technology from the business perspective we ascertained that:

“…Smart contracts can most effectively operate in a blockchain environment. Smart contracts are concluded between two or more parties, but they are not reflected on pieces of paper. They are “written” and “signed” digitally by the contracting parties, in encrypted algorithm software codes.

They are self-executed contracts and contain terms agreed upon by the contracting parties. It is obvious that businesses can replace most, if not all, contracts (i.e. employment contracts) with a smart contract.

The usefulness of smart contracts has proven (and will be further proven in the future) to be extremely important in business transactions. For example, businesses that trade with geographically remote buyers and suppliers, are able, by using blockchain technology and the traceability it provides, to certify the origin, integrity and agreed upon quality of their intermediaries or final products. Respectively, they can verify the same characteristics for products they acquire from the global market.

It is very important to stress that any violation in a smart contract is automatically identified. Such violation cannot be disputed. The consequences of both the execution of the contract (i.e. the payment of its price) and the violation of the obligations deriving from the contract (i.e. no execution of the contract) occur immediately.  These facts lead to the rapid decrease of the cost of transactions, the avoidance of conflicts and of the necessity of extensive involvement by humans. The decrease of the relating costs if self-evident…”

The benefits from the utilization of smart contracts in business transactions-especially in international ones are, therefore, a fact. Other possible applications are: in transferring movables, real estate, securities and rights. In insurances, healthcare, in patenting and capitalizing copyrights. In creating certificate registries, in energy. Also, in providing guarantees, exchanging and transferring money. The possible applications are literally unlimited…

We are before an imminent, but real, revolution in transactions and contracts.

 

V. Advantages and disadvantages

Smart contracts offer several of advantages. Due to blockchain’s decentralized structure, there is no need for a mediator. Instead of a mediator, there is digital trust. Every smart contract is executed securely, fast and with transparency. Exactly as agreed. There is no need for the contribution, intervention or mediation of a central authority, bank or lawyers. More precisely: a third party like that has no place. That way, the costs of transactions are significantly reduced.

However, this new technological opportunity involves some risks.  Some of which are very significant.

Smart contracts have already been proven inseparably linked to blockchain technology. This means that it is impossible to modify and registered information. This specific trait (as stated above) provides security and trust in the execution of smart contracts. But the same trait, viewed by a different angle, causes significant concerns.

It possible, for example, one of the contracting parties to change their mind. In case the choice of withdrawing was not provided for when designing the code, withdrawal is not an option. At least at a first glance. The final and unchangeable code, on which a smart contract “runs”, leaves no room for error and does not allow modifications. Something like that would bring into question the above-mentioned advantages.

It is a fact that there is no legislation on smart contracts. In contract law, there are certain rules that apply. Rules sufficient enough for managing and dealing with problems like the ones already mentioned. Given the lack of legislation on smart contracts, there is no provision for dealing with similar, potential, problems. Smart contracts have an absolute nature, which may possibly (under certain conditions) to be proven problematic.

 

VI. Dealing with smart contracts on a legal level

A smart contract seems to not be recognized as a contract by law. At least not yet. A contract (for us lawyers) is a promise legally executed. It can be written or verbal, explicit or silent, to be, or not, of a specific type (deed). Contracts, according to the predominant opinion, cannot be identified as the automated execution of a code. (It would be possible, of course, to present strong counter-arguments to that position- but let’s leave this discussion to take place on a scientific level).

But exactly this lack of legislation is what makes the need of finding a way to regulate them imperative. It is a fact that smart contracts are starting to be used, replacing traditional contracts. This makes the legislation securing the rights of the contracting parties absolutely necessary.

The questions, though, arising is very interesting: Which is the competent authority to adopt the proper legislation? And who will be competent for enforcing its application?

The applicable law is usually chosen by the national legislative framework within which a contract is developed. Especially when it does not have any cross-border elements. However, blockchain technology favors cross-border contracts and trading. The legislative framework that will possible be created, must take into consideration the rules of private international law. The applicable law will, each time, be chosen based on those rules.

Another issue that must be regulated, regards the execution of smart contracts. A smart contract, as already mentioned, self-executes. In case the option of withdrawal was not provided for in the first place, withdrawal is impossible. This characteristic does sound quite attractive. On the other hand, it can possibly create serious problems. And this is because there are already provisions in place (i.e. consumer law) that provide for the right of withdrawal.

 

VII. The need for a regulatory environmentthe example set by Cyprus

In this regard, there is a project running for the utilization of Distributed Ledger Technologies (DLT) and especially blockchain. Cyprus has already issued the National Strategy for “Distributed Technologies (Blockchain)”, with the main goal being the creation of the proper environment for businesses, companies, services and investments, in order to welcome the new technologies.

In Cyprus the relevant legislation is in the works; a legislation that will regulate those technologies. Of course, smart contracts included. They have already accepted that such a legislation must be based on the principal of technological neutrality. The regulation of the proper use of smart contracts is also expected.

The relevant legislation about to be drafted is expected to acknowledge (and manage) the negative impacts (legal-wise) of, among others, smart contracts in Cypriot law. Among the issues expected to be tackled are the binding nature of smart contracts and its consequences.

 

VIII. In conclusion

Smart contracts are a true revolution in transactions. They offer safety, speed, financial advantages -and many more.

Given those facts I will not hesitate to assume that smart contracts will gradually substitute conventional contracts. And not only that, but that they will also (sooner or later) completely replace them.

In the not so far future, the phrase “when there is something in written, no one can dare question it” will no longer apply in contracts…

Nick Szabo made the right choice to pair up legal, informatics and cryptography studies and he made it at the right time.

In the following decades, legal studies will no longer suffice for a lawyer. Legal practice, clearly affected by the force of technological advancements, is rapidly changing.

For the time being: it is necessary to speed up the discussions between the business and the science community concerning the creation of the proper regulatory environment for smart contracts.

It is not important who will initiate the much-needed dialogue: Chambers of Commerce, Institutions, Universities or the State.

The only thing certain is that it needs to start.

Cyprus is already showing us the way.

stavros-koumentakis

Stavros Koumentakis
Senior Partner

P.S. A brief version of this article has been published in MAKEDONIA Newspaper (November 24th, 2019).

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