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Smart contracts - How smart are they, and how much smarter can they become?


Author: Marin Karuza

January 2023


Let's imagine for a moment that we live in a fully automated world where code dictates what we can and cannot do, where technology is used to enforce the rules, and where we don't need lawyers to interpret contractual provisions for us (or at least not to such an extent). How close (or far) we are from that futuristic scenario is what I will try to explain in more detail in this article.

I believe many of you know or have at least heard of the term "smart contract", but for those who haven't, the term was first coined by computer programmer and cryptographer Nick Szabo in the mid-90s. At the time, Szabo explained that he referred to these contracts as smart because they were far more functional than their "inanimate paper ancestors" - classic contracts. One example of a smart contract given by Szabo is the vending machine where, once the customer has satisfied the terms of the "contract" (i.e. putting money into the machine), the machine automatically honors the terms of the unwritten agreement and delivers the product.

Smart contracts have come a long way since then. Today, they exist as a string of code which is stored on the blockchain and can be executed automatically and in a determinate manner. Smart contracts mostly follow the "if-then" protocol, which makes them, in essence, quite simple to program, and aims to remove the human factor from decision-making as it is this factor that often proves to be the most error-prone and unreliable element of traditional contracts. However, in order to implement a single smart contract, the participation of dozens or hundreds of third-party computers is required, for which each receives compensation in the form of cryptocurrency. So, the more complicated a smart contract is, the higher the fee for its execution and storage will be. But surely you are more interested in how a smart contract is created in the first place, or even better, how to write one yourself? The answer to that question is not quite straightforward. Namely, anyone can gain access to programming languages for writing smart contracts, but without programming knowledge and skills, it is almost impossible to write even the most basic "if-then" smart contract as even the slightest error could create a bug and render the contract vulnerable to being hacked. For that reason, we wouldn't advise anyone try it without first consulting a skilled programmer.

How can the "smart contract" be even "smarter"?

One of the key attributes of smart contracts is their ability to automatically execute pre-defined contractual provisions without the need for human intervention. In translation, this means that once written and stored on the blockchain, the contract cannot subsequently be modified or canceled, and is completely beyond the reach of the contracting parties or any third parties. The fact that human intervention is not required once a smart contract is placed on the blockchain means that the costs of contract execution can potentially be significantly reduced.

Paradoxically, the advantages of a smart contract are also its disadvantages. Why? Well, one reason is that in practice there is often a need for a subsequent amendment of a contract or further interpretation of ambigous terms and conditions, which smart contracts cannot, by their very nature, accommodate. Since smart contracts necessitate that everything be accurately predefined in order for the contract to be automatically fulfilled, there is no room for gray areas. In essence, the terms of a smart contract need to be set out in black and white in order for the contract to be executed.

Another disadvantage related to smart contracts is that the blockchain itself is a closed system which, without the help of an external provider (for example - Oracle), cannot verify whether a fact has occurred or not, and thus whether a contractual condition has been fulfilled or not. This external intermediary is integrated with a specific blockchain in such a way that it provides real-time information from the outside world regarding the contractual conditions, all in order to be able to determine whether a certain contractual condition has been fulfilled or not. For example, if in the smart contract one of the conditions for the payment of money from person A to person B on 01.01.2023 is that the sea temperature in the city of Hamburg must be 5 Celsius or more, the blockchain does not have the ability to check the sea temperature in Hamburg on that day, but must rely on Oracle or another such provider.

Likewise, it should be pointed out that smart contracts are not free. In order for them to be deployed on the blockchain, a so-called "gas" fee is paid in the form of cryptocurrency, which in the case of more complex contracts can lead to considerable costs because it takes a lot more time and energy to verify and store a contract on the blockchain, making it perhaps even more expensive than the creation of a traditional contract.

In order to improve the functionality of smart contracts and extend their scope of use outside the fields of finance and trade, it is absolutely necessary that, in addition to the code itself, the textual part of the contract can be integrated into the blockchain, which will provide additional clarification of terms or contractual provisions that cannot simply be converted into computer code. Likewise, it is necessary to improve on programming languages in order to simplify the composition of smart contracts and allow them to be drawn up without necessitating the knowledge or help of a code programmer. Finally, the harmonization of private international law is necessary, especially in relation to the place of conclusion of such a contract, which would consequently determine the jurisdiction of the court and the specific law that would be applicable to these transactions, thereby increasing legal certainty.

Legality and enforceability of the "smart contract"

Smart contracts are equated with traditional contracts and are therefore legally permissible in a large part of the world, however, legal certainty is still at a low level. This is mainly due to the fact that enforceability is an integral part of legal certainty, so a legally permissible contract is not worth much if there is no firm guarantee that its provisions will be able to be fairly interpreted or to prevent immoral or null and void legal transactions. At the same time, due to the nature of a smart contract, which can be concluded between any two parties, there exists a legal gap as to which law would be applicable and which court would be competent to hear the matter in the event of a dispute, hacking, or system error, if nothing in this regard is specifically provided for in the provisions of the contract.

The EU has recently passed a proposal for the Data Act („the DA“) with the aim of regulating, among other things, the field of smart contracts in order to increase the level of legal certainty given the fact that more and more smart contracts are being concluded every day without any supervision or regulation. One of the ways in which the DA attempts to legally regulate smart contracts is by aligning them as closely as possible to traditional contracts. In doing so, the DA has introduced four essential requirements of smart contracts. Firstly, it prescribes that smart contracts must ensure a high degree of protection against functional errors and manipulation by third parties. Secondly, it mandates that smart contracts include the possibility of cancelation or termination of the contract which, however, contradicts one of the fundamental characteristics of a smart contract. Thirdly, it provides that there must be a possibility to archive transactional data and keep records of all past operations of terminated smart contracts. Lastly, it requires that access control mechanisms be implemented.

Although the requirements set out in the DA are, in principle, a welcome development, it is unclear how and by whom they should be implemented, nor how effective they will be in practice. These are all questions that will be answered once the DA is finalised and a legal practice around smart contracts established.

A smart contract in IP?

There is no question that the application of smart contracts in IP is the future, mostly in the sphere of copyright, but also in relation to other IP rights. As many authors know, it is very difficult for to keep track of when, how, and by whom their work is being used, making it often impossible for them to stop IP violations or to successfully monetize their works, while third parties find it equally difficult to determine from whom they should obtain a license to use such work. This where smart contracts come in hand as some blockchain-based platforms allow authors to record copyright ownership, which they can then use to see where and how their work is being used online, while simultaneously enabling third parties to identify from whom they should seek licenses to use such rights.

The possibility of authors registering and verifying their rights using blockchain-based platforms means that they can then search a variety of different sources to determine who is using their work, enabling them to identify and stop infringements, and facilitate the licensing of their IP works. In this sense, blockchain can serve as an enforcement tool. With a blockchain-based registration system, checking whether a new work (be it a song or an image) infringes on an existing IP address of a previously registered work will be much simpler. Pretty amazing, right?

Conclusion

At this moment, it is difficult to recommend the conclusion of smart contracts to parties without warning them of all the shortcomings and legal loopholes that surround this legal tool. However, we can conclude without a doubt that smart contracts are part of our future and that with the progress of blockchain technology, the sphere of their application will be larger and wider. How far we are from that future is difficult to say, but with the daily effort and money invested in blockchains and programming languages, it seems that this new reality is approaching much faster than we expect. The best, and maybe only, thing to do would be to keep up-to-date with the progress of blockchain technology and the relevant legislation governing this sphere in order to prepare ourselves for the inevitable future in which smart contracts will become the norm when it comes to concluding legal transactions.