Smart contracts: What lawyers need to know

Smart contracts are the new frontier for lawyers and the global smart contracts market is predicted to reach USD$345.4 million by 2026.^[1] Despite this, the discourse surrounding smart contracts is frequently convoluted and confusing to understand. This introductory piece aims to unpack the notion of smart contracts and the key points to remember when utilising smart contracts.

Smart contracts in a nutshell

While smart contracts come in all shapes and sizes, the typical modern day definition of a smart contract is a contract that is represented in code and executed by computers. Traditionally, a contract is where parties enter into an agreement and each party is committed to fulfilling certain conditions. Cryptographer and legal scholar, Nick Szabo, first introduced the term ‘smart contract’ in 1994 which slightly altered the traditional notion of a contract. He defined the term as ‘a computerised transaction protocol that executes the terms of a contract’ or ‘a set of promises, specified in digital form, including protocols within which the parties perform these promises’.^[2]

With the invention of Decentralised Ledger Technology (‘DLT’), the definition of smart contracts has continued to be modernised. Smart contracts are typically formed online where they are enabled and guaranteed by blockchain, a type of DLT. Blockchain is a decentralised public ledger consisting of networks of co-operating computer nodes. This is accessed through digital identities called ‘keys’. Through keys, parties can enter and update records into the ledger, which generates a new ‘block’ that is added to the ‘chain’.^[3] The cryptography aims to prevent any other alterations that would invalidate the whole register. To develop the register, users called ‘miners’ work to develop consensus algorithms, which store and validate the blocks and nodes. In this process, proof of works and proof of stakes are created, where miners also receive a full copy of the blockchain.

Smart contracts are implemented on top of blockchains. This is where approved contractual clauses, like those found in a traditional contract, are converted into executive computer programs. Subsequently, the mechanics of a smart contract operate on an ‘if/then’ basis. For example, if Event A occurs, then the DLT will automatically trigger the enforcement of Clause B. Thus, if parties wish to initiate a smart contract, they will often require a third-party, trusted, technical expert with whom they communicate to capture in code the nuances of the agreement.^[4]

The trajectory and current usage of smart contracts

In recent years, smart contracts have been growing in their rate of adoption. The appeal of smart contracts is the multi-faceted ways in which they can be used. With the versatile and adaptable ‘if/then’ basis which can be applied to many situations, there are a wide variety of fields and industries that currently utilise smart contracts and the list continues to grow. As a result, the practical, day-to-day functioning of smart contracts is ever evolving. For example, supply chain management systems use smart contracts to facilitate the exchange of goods. In the financial services sector, smart contracts can be used in data synchronisation and securities. Many large companies deploy some form of self-executing contract in their operations, such as computerised order systems, which are now responsible for more than 60 per cent of the trading volume of US-listed stocks. With the increased usage of smart contracts by corporations, this has begun to alter the ways in which lawyers contract and serve their clients to ensure any agreement entered into is commercially viable.

The recognition of smart contracts varies across different regions. Some countries like Belarus have explicitly legislated to allow smart contracts to be legally binding and enforceable. Other jurisdictions such as Australia and the UK have allowed smart contracts to function in their regions so far.^[5] However, they have not specifically addressed blockchain or smart contracts in legislature or case law except in industry guidelines.^[6] In Australia, smart contracts are legally binding and enforceable so long as they follow traditional contract law principles such as consideration and the contract was not created under duress. Other countries, such as Bangladesh, have not accepted the premise that smart contracts are legally binding and have gone so far as to ban types of smart contracts such as Ethereum.