Technical developments challenge the legal community

Smart contracts are an important element of the blockchain revolution, even though they precede the blockchain. According to most sources, it was Nick Szabo who coined the term “smart contract” in the 1990s. Since then, the mechanism of a machine has often been cited as an example of a simple smart contract based on if-then logic. Depositing into a machine triggers an irrevocable automated action from withholding the money to the delivery of an item.

The advent of blockchain technology made it possible to implement such if-then logic in decentralized networks to enable autonomous, self-executing, self-fulfilling smart contracts, also known as computerized scripts, smart code, computerized protocols, or decentralized business logic. Since they have gained popularity, there has been debate and questioning whether they are smart or contracts at all.

The basics of smart contracts

That debate aside, smart contracts offer many advantages. One of them is efficiency, which is mainly achieved through automation, its lean design, unambiguous interpretation and efficient performance. Efficiency gains lead to cost savings that are achieved by removing intermediate layers and reducing ambiguity and opportunistic behavior.

The transparency of smart contracts offers verifiability and strengthens trust. Technology-guaranteed performance facilitates transactions not only between parties who do not know each other, but also between parties who would be reluctant to do business with each other without guaranteed performance. The ex-ante performance guarantee through automation and self-execution of smart contracts also helps to avoid institutional enforcement and costly breaches of contract. Smart contracts can enable more efficient and cost-effective business processes, supply chain management, corporate governance and much more. We are only just beginning to research their possible uses.

It has to be said, however, that smart contracts also require a certain level of technical skill to code, implement and understand, and these skills outside of the blockchain community remain relatively low. Smart contracts are also not free from technical challenges and weaknesses in all phases of their life cycle, from creation to deployment, execution and completion. There are also ex ante costs of implementing smart contracts and costs of switching to smart contract networks that shouldn’t outweigh the benefits of realizing efficiency gains.

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Technology and law

Smart contracts represent the interface between technology and law and therefore challenge practitioners, scientists and legislators – many legal questions were discussed. Smart contracts were neither referred to as smart nor as a contract. First, there is neither a common definition nor a uniform, structured and systematic classification of smart contracts. There is no agreement or common understanding about the relationship between smart contracts and traditional legal contracts. Some scholars question the ability to create valid, binding legal contracts through a smart contract.

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Discussions are ongoing about the applicable legal framework and how the immutability of blockchain data records can be reconciled with contractual errors or flaws. Similar concerns have been raised about the change in the terms of smart contracts recorded on an immutable ledger. Applicable law and applicable jurisdiction are also particularly relevant topics for borderless, decentralized blockchain networks on which smart contracts are used. Questions of consumer protection and information requirements are also addressed.

There are also growing significant concerns about anti-money laundering (AML) / counter-terrorism financing (CFT) requirements, data protection and confidentiality issues. Immutability and automated, unstoppable execution are also potential legal pitfalls for using smart contracts.

This analysis is made more difficult because there are different types and models of smart contracts depending on the legal relevance (if any), context and technical characteristics. They range from simple, uncomplicated and standardized payment instructions to sophisticated instruments that are able to carry out a complex sequence of actions autonomously. The advent of blockchain-based smart contracts also brought a new dimension to the notion of cyberspace self-regulation. Discussions about “Code is Law” and “Lex Cryptographica” also flared up.

When it comes to lawmakers and regulators, however, they have largely remained silent about smart contracts. Despite fierce scientific debates about the legal status, recognition and enforceability of smart contracts, their normative legitimacy and legal implications, the legislators seem neither worried nor are they inciting any prohibitive measures. While there is some legislative activity in select jurisdictions, so far only a handful of countries have formulated a regulatory response and passed laws that were usually modest.

Smart contracts vs. USA

For example, most smart contracts legislative initiatives in the United States are relatively narrow, regulating only a select number of issues, mostly limited to the definition of smart contracts, the recognition of their electronic form and signatures, and sometimes their admissibility as evidence. These include states like Arizona, Tennessee, North Dakota, Nevada, Wyoming, and Illinois. Some critics have argued that such legislative initiatives are premature, incomplete, and merely aim to promote a particular jurisdiction. This harbors the risk of regulatory fragmentation between the US states and piecemeal smart contract legislation, which could potentially make harmonization at the federal level more difficult in the future.

U.S. federal regulators and regulators, such as the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC), have looked into their research, clarification, and guidance on smart contracts, which have some of the legal implications of using smart contracts in the United States. The CFTC has issued an introduction to smart contracts claiming that a smart contract could be a binding legal contract and could be subject to a variety of existing legal frameworks, depending on the facts and circumstances. The CFTC also highlighted several risks arising from the use of smart contracts, including operational risks, technical risks, cybersecurity risks, fraud and tampering risks, and risks arising from governance protocols.

Similar to the CFTC, the SEC applies existing legal frameworks in its enforcement measures in connection with blockchain and smart contracts. As a sign of increasing regulatory scrutiny, the SEC recently announced the acquisition of intelligent contract analysis tools to analyze and detail code in blockchains and other distributed ledgers in order to enhance its efforts to monitor risk, improve compliance, and inform SEC guidelines regarding digital assets to support.

Smart contracts vs. the world

In other parts of the world, countries like Belarus, Italy, and Russia have done a limited amount of smart contracts. The UK Jurisdiction Taskforce made an important legal statement concluding that smart contracts can form valid, binding and enforceable contracts between the parties and stressing the adaptability and flexibility of the common law that is capable is to keep pace with technological advances such as smart contracts. The European Union has also raised consumer protection concerns related to the use of smart contracts, but so far no regulatory action has been taken at EU level.

The existing legislative initiatives seem to align on the recognition of smart contracts within the existing legal framework; However, they differ in the definition of smart contracts. It is only a matter of time before issues related to smart contracts reach the courts so that the judiciary can resolve legal issues, especially in common law jurisdictions.

Conclusion

Meanwhile, the proliferation of different definitions and the potentially legal treatment of smart contracts can lead to legal uncertainty and regulatory arbitrage. The legislature should therefore closely monitor developments in smart contracts and only intervene if this is necessary in order to create legal certainty, reduce risks and protect endangered contracting parties. Such a measured and risk-based regulatory approach would support innovations, seize opportunities and integrate innovations of smart contracts into existing legal systems. Appropriate regulatory guidance could also help remove legal uncertainty and increase market confidence for the industry, investors and consumers.

The market size of global smart contracts is growing rapidly. It is projected to have an average annual market growth rate of 17.4% in the forecast period of 2020 to 2025 and to reach $ 208.3 million by 2025. Smart contracts are increasingly being used in a wide variety of sectors including the financial, public, supply chain management, and automotive, real estate, insurance, and healthcare industries. They are also the backbone of a growing Decentralized Financial Area (DeFi). Regulators are increasingly challenged to respond to and address smart contracts, but previous legislative initiatives suggest that there are no major obstacles to the use of smart contracts; no major legal reforms appear to be required to adopt them.

The views, thoughts, and opinions expressed herein are solely those of the author and do not necessarily reflect the views and opinions of Cointelegraph or Warsaw Technical University or their affiliates.

This article is for general informational purposes and is not intended and should not be construed as legal advice.

Agata Ferreira is an assistant professor at Warsaw University of Technology and visiting professor at a number of other academic institutions. She studied law in four different jurisdictions, under common and civil law. Agata practiced law in the UK financial sector for a leading law firm and investment bank for over a decade. She is a member of an expert committee of the EU Blockchain Observatory and Forum and a member of an advisory board for Blockchain for Europe.