Are Smart Contracts the future?

How industry can implement blockchain-backed agreements

By Justin Ellis and Allan Murray of iLaw

The use of blockchain technology has increased substantially in the last five years and it is now being adopted in a number of ways across different markets to transact, store data and automate certain processes.

The most common and well-known use of blockchain by far is Bitcoin, which uses a secure but publicly accessible distributed ledger system to create and store a form of digital currency.

Blockchain is unique in that unlike traditional forms of data storage it does not rely on a single server or bank of servers, but instead stores the data on multiple machines to create a highly secure, decentralised network of encrypted data that verifies and records each new block of data within a longer chain of data.

This means that data further down the chain cannot be deleted or amended without deleting or amending an earlier part of the chain, which both increases transparency and prevents fraud.

It is clear why this technology is popular for digital currency, but its application in the world of contracts may not be as obvious.

However, whereas the Bitcoin blockchain stores financial transactions, blockchain can also be used as a programmable platform – the most notable example being Ethereum – on which new applications can run and new use cases found.

One example is Smart Contracts, which although a relatively new phenomenon, are seeing increased use as a way of moulding and executing a contract digitally in a secure manner.

Legal Clarity

The Government is currently consulting with the help of the LawTech UK delivery panel on the status of Smart Contracts under English law and it is anticipated that they will issue an ‘authoritative legal statement’ at the end of the Summer outlining their use and legal status.

In anticipation of this, it is useful to look at the rise of Smart Contracts and how they may be implemented and used commercially in the future.

Smart Contracts are typically made up of a special software code running on the blockchain. They are not legal contracts, but can be used as a substitute, or sometimes alongside, a traditional legal document.

At the moment it is not clear under what circumstances a Smart Contract becomes ‘legally binding’, or how parties’ rights might be enforced if there is a software failure. The LawTech panel has stated that their legal statement will provide clarity on this.

It is the involvement of automation via the blockchain that makes it unique. When created, a Smart Contract may be a simple agreement with certain manually executed mechanisms, but as it evolves through the blockchain it may be self-executing so that as certain terms are met the agreement changes.

An easy way to explain it is by looking at the most simplistic form of automation, which states that “if this happens, then that should happen next”. A Smart Contract runs on the individual connections within a chain and will automatically execute certain tasks once pre-agreed conditions are met, or an obligation is performed.

By using the blockchain, the code for which is public, the extensive network of computers that make up the chain can monitor external, real world data via trusted, third-party feeds which send information into the Smart Contract, which then executes changes and stores them securely and irreversibly within the chain.

Smart Contracts running on the blockchain are likely to find wide adoption in the finance and insurance sectors, as well as in property market due to the promise of almost instantaneous transactions, together with the increased security and transparency that the technology promises. And because of the automatic execution of key contractual provisions, with no intermediaries required, there will also be significant costs savings to parties.

Smart Contracts are currently being employed in the solar industry for insurers so that when bad weather creates a shortfall in energy generation, and therefore income, the company receives a compensation payment.

They can also be used to set other conditions in an agreement for when funding should be released, for instance in a supply chain when goods reach their destination.

Another example could be a system that makes automated compensation payments to telecoms customers if their broadband remains down for a set period of time, or to airline customers if their flight is cancelled.

What’s more, should commercial conditions change the contract can be managed in such a way that parties can agree to changes that are automatically implemented.

This flexibility, something not typically associated with traditional contracts, is likely to be very appealing to companies as it allows for easy life cycle management of an agreement.

Types of Smart Contract

When looking at the future adoption and implementation of Smart Contracts, businesses will typically face three common models to choose from, Solely Code, Internal and External (although other models and hybrids do exist).

The Solely Code Model is a contract based exclusively around a code, with no natural contractual architecture or language. These are typically used for simple transfers or conditional payments between parties.

The Internal Model is a Smart Legal Contract which should be seen as a document containing software code, but is not exclusively code. This makes use of natural contractual language to set out rules by which the code should be executed when conditions are met.

Finally, the External Model, which is often referred to as a traditional contract supported by code. In this case the relevant code is not included directly within the contract, but is instead paired with code that is stored and executed outside of the written document and performs certain functions agreed to in the written contract.

The possibilities for these types of arrangements in commerce are vast. The implication for lawyers is also significant, with traditional ‘off-chain’ written contractual clauses having to be incorporated into agreements with ‘on-chain’ code.

With a variety of models on offer, each offering a different level of blockchain integration, and with legal clarity on the horizon, we are likely to see a growing variety of agreements and transactions trialling the use of increasingly complex and sophisticated Smart Contracts in the near future.