Going toward a full-scale smart contracting revolution?

Maybe not

by Mirta Cavallo

  1. From the information society to the value society.

The technological landscape is constantly evolving, with a pervasive and disruptive ([1]) impact on the economic, social and legal sphere. A transition currently taking place is from an “information society” – based on transfers of information via the transmission control protocol/ internet protocol (TCP/IP) – ([2]) to the “value society” – based on transfers of value through the blockchain – ([3]). In other words, blockchain is leading the shift from the “Internet of Information” to the “Internet of Value” ([4]).

Blockchain, together with other emerging technologies, such as big data and artificial intelligence, has the potential to regulate individuals’ behavior ([5]), but also to raise questions about the fundamental of law itself. The latter is exactly what’s happening with smart contracts – digitally enforced agreement based on the distributed ledger technology – and contract law, to the point that “[e]nthusiasts of various stripes believe that smart contracts offer the potential to displace the legal system’s core function of enforcing agreements” ([6]), that they “will obviate the need for contract law, revolutionize business arrangements, and restructure property ownership”. In addition to cost savings and efficiency gains resulting from contract automation, it is claimed that technology could indeed replace the role of law in ensuring that the counterparts to a contract trust one another to perform (this reveals a high degree of distrust vis-à-vis humans, who are seen as generally biased and unreliable) ([7]). In contrast, a number of skeptics believe smart contracts to have nothing to do with actual contracts ([8]).

Smart contracts trigger tricky questions about their legal and practical applicability. These will be explored in section 3 of this article, after an overview of blockchain and smart contracts from a technical standpoint (section 2).

 

  1. Understanding the technology: cryptography and trust

In order to fully understand the implications of smart contracts, it should be first clarified what smart contracts and, before that, blockchain actually are. As any other foundational technology, blockchain and smart contracts support transformative services and applications with the potential to redefine the economic, social, and legal ecosystems ([9]). This potential is strictly linked to the technical features of blockchain (sub-section 2.1) and its implementation known as smart contracts (sub-section 2.2). In fact, efficiency, trust, accountability, and security – which all make smart contracts so promising – are all dependent on the inner functioning of this distributed ledger technology (DLT).

 

2.1. Blockchain: if code is trust, code is law

Blockchain is a distributed ledger based on cryptography and a peer-to-peer network of computers, where users’ trust is placed in the technology itself and its inner working, rather than in a central authority supervising the proper functioning of the system.

More specifically, in this cryptographically secured chain, each transaction – may that be the sale of cryptocurrencies or the transfer of a real estate asset – is duly recorded in a ledger (or list of records, called “blocks”) with a cryptographic hash – acting as unique digital fingerprint –, a timestamp – to provide chronological certainty – and all relevant transaction details. An exact and synchronized copy of the ledger is kept by each computer in the system and updated only subject to a “consensus mechanism” ([10]), whereby the community members are informed near real time of each transaction and check all relevant information before approving the new block and adding it to the chain, so that “legitimate transactions are irreversibly recorded, illegitimate transactions can be spotted and rooted out” ([11]).

All this enables transactions to be recorded efficiently, in an open, verifiable and transparent way. Since this permanent trusted record does not have a single-point-of-failure and tampering or revisions are impossible, security, reliability and authenticity are also guaranteed. This combination of elements also enhances accountability ([12]).

Furthermore, this “mixture of mathematical subtlety and computational brute force” ([13]) makes it unnecessary to have a third, impartial party (like banks, tax authorities and central agencies) to supervise, record and validate transactions or, more generally, to guarantee the correct and smooth functioning of the system. The consensus mechanism replaces any trusted third party. This makes blockchain at the same time “trustless” ([14]) and a “time machine” ([15]). In other words, code is trust.

In addition, with blockchain, code is law ([16]), given that it validates the transactions by itself, thus removing the problem of noncompliance ex ante([17]).

These distinctive features of blockchain are the reason why this distributed ledger technology should be taken “as seriously as [one] should have been taking the development of the Internet in the early 1990s” ([18]). It has even been defined as “the sustainable and secure way to develop the future” ([19]).

Accordingly, some years after its appearance in the white paper by Sathoshi Nakamoto ([20]) and its first implementation for Bitcoin ([21])([22]), it has taken the private sector by storm: there is significant optimism among businesses and opportunities of increasing economic relevance are spreading in a number of different sectors – ranging from securities and financial services  to sharing economy and e-commerce platforms – for a number of different goals – from replacing administrative and notary functions to authenticating individuals’ identity, from preventing voting fraud to tracking products origin and safety ([23]).

Not surprisingly, there are concerns as well, with regulators, especially in the financial sector, rearming to “fight the last war” ([24]) against any threat of a “crypto-anarchy” ([25]).

 

2.2. Smart contracts

The role of trust is crucial in smart contracts. Smart contracts, as conceived by Nick Szabo in 1994 ([26]), are self-executing agreements captured in computer code. More specifically, once the parties agree on the terms and conditions of the contract, the latter is translated into code and saved into the blockchain, thus becoming unchangeable and auditable. When the terms specified in the agreement are met, the smart contract executes automatically, without the need for an intermediary ([27]). The operation of smart contracts is based on the transfer of crypto-tokens, which are mutually accepted by the parties as part of the exchange.

In contrast to traditional contracts, the code itself incorporates the obligations of the parties, without leaving room for interpretation. Not only transactions are all-or-nothing and enforced by the network itself, but they cannot be amended or stopped even by its creator. In this way, it is argued that smart contracts enable a shift of paradigm in contract practice from ex postauthoritative judgment – typical of traditional contracts –  to ex anteautomated assessment ([28]).

These contracts ex machina have the potential to become crucial business tools in the near future, but also raise doctrinal concerns ([29]). On the one hand, “allegedly, smart contracts can streamline the contracting process, reduce transaction costs by eliminating intermediaries and, most importantly, simplify enforcement by obviating the need to seek protection from traditional legal institutions” ([30]). On the other hand, thereheare a number of doubts on te technical and legal feasibility of automated contracting.

 

3. Some misconceptions about smart (and self-driving) contracts

Some of the main features of smart contracts – validation mechanism, self-enforcement, tamper-proof nature, inflexibility – are worth a reflection.

First of all, trust in smart contracts largely derives from their validation mechanism. However, blockchain provides evidence of completion of a transaction, but does not provide indications on the legality of the transaction itself ([35]). Therefore, even if blockchain validates transactions, it does so technically only, without guaranteeing its legal validity.

Self-enforcement – which entails the transfer of tokens upon occurrence of pre-determined conditions – ensures execution of the contract without deviations (since neither party can interfere with it) and without the risk of breach. In addition, equating (self-) enforcement with guaranteed performance, smart contracts not only make breaches technically impossible, but also exclude – ex ante – the need to recur to state-sanctioned systems of adjudication and the set of remedies awarded by courts in case of breach. The fact that performance is technically guaranteed is believed to bring legal and commercial certainty, but it may not always be the case ([36]).

Self-enforcement deprives the debtor of the possibility to breach the contract when it would be economically efficient to do so (i.e., efficient breach), and deprives the creditor of the possibility to disregard a minor breach when economically insignificant or when preserving the contractual relationship is deemed more important. The lack of these possibilities decreases the commercial desirability of smart contracts.

Self-enforcement, combined with the tamper-proof nature and the impossibility to modify smart contracts in any way, means that the code shall contain no errors. However, it is statistically unconceivable to have a computer program without bugs, meaning that a perfect performance cannot always be guaranteed and that the risk of any malfunctioning should be assessed and allocated ex ante.

Moreover, in order to have a smart contract to self-execute as intended, the code shall reflect the parties’ agreement perfectly. However, reflecting the parties’ intention into computer-readable instructions is not a straightforward process, especially considering the variety of interests, peculiarities and clauses involved in each transaction.

There is no standardized legal language capable of being reduced into an algorithm, and it is currently impossible to automatically convert natural language into code, so human intervention is still needed. In order to avoid the problems related to translation, one could bypass drafting in legal prose and write in code from the very beginning; however, this would require the parties (or at least lawyers) to learn how to code. Similarly, the possible solution of using an unambiguous “controlled legal natural language” comprehensible to all parties involved neglects that not all obligations can be reduced in code (e.g., the concept of good faith or reasonableness). All this means that smart contracts do not remove human intervention, but just change the role humans are expected to perform!

Programmers who write smart contracts are not skilled in contractual interpretation and may fail to properly understand and translate into code the intention of the parties; at the same time, the parties – unless programmers – cannot verify the accuracy of smart contracts. So, an additional interpretative problem would be generated: not only the risk of disagreement between the parties on the interpretation of a clause, but also the risk of discrepancies between what was agreed and what was actually implemented by the programmer.

Moreover, not each and every possible circumstance is predictable. And putting all the predictable ones into code would require very long contracts and, consequently, a higher risk of coding errors. In addition, changed circumstances cannot be accommodated by smart contracts. Indeed, “smart contract is based on a binary zero-sum logic that does not appear in all real-life contract cases” ([37]).

The inherently imprecise nature of natural language, combined with the impossibility to have fully complete and unambiguous agreements, leaves to the parties room for interpretation, thus enabling flexibility. This cannot be achieved by smart contracts, which remain rigid and somewhat disconnected from the transactional reality in which they operate. “Rigid determinism […] will not necessarily breed certainty but destroy adaptability” ([38]).

The inability of smart contracts to protect the parties from code errors and changed circumstances triggers the need to recur to traditional legal protections if necessary – which is exactly what smart contracts promise to remove, together with human involvement. After all, smart contracts could never insulate a transaction from the legal system of a given jurisdiction: contracts can be automated by a decentralized system intended to minimize humans’ and courts’ intervention, but still have to fully comply with the law ([39]).

All the above-mentioned problems would be exacerbated in the context of self-driving contracts. As self-driving cars drive their passengers to their desired destination, making autonomous decisions during the route, in self-driving contracts parties would just have to specify their objectives in broad terms, leaving to the self-driving contracts to automatically fill in the specifics on the basis of real-time contingencies. It is claimed that in this would be achieved through the predictive capabilities enabled by big data and artificial intelligence. In this way, the ex post gap filling function – which is a crucial function of contract law – would be performed by the technology itself ([40]). However, it is not clear how this could be done in practice, given the difficulties related to the language of the contract and the issues relating to the intention of the parties and consent.

 

  1. Concluding remarks

Smart contracts, similarly to all blockchain-implemented technologies, have a great potential and certainly could redefine transacting, especially in the financial sector. At the same time, the enthusiasm surrounding this new emerging technology should not lead to neglecting altogether the legal and technical difficulties connected to smart contracts, which certainly need addressing: “technology cannot replace what is fundamentally a human activity. Smart contracting certainly proposes exciting new changes to the way transactions might take place […]. But a full-scale smart contracting revolution would introduce costs far more extreme and intractable than the ones it seeks to solve” ([41]).

 


([1]) The theory of disruptive innovations was first developed in BowerJ.L., ChristensenC.M., Disruptive Technologies: Catching the Wave, in Harvard Business Review, 1995, 43 ss.

([2]) The expression “information society” is commonly used in literature to refer to the massive use of information and communication technologies (ICT), and, accordingly, the pivotal importance of information in all contemporary affairs, determining a shift away from an economy of goods into an economy of information.

([3])AinsworthR.T., ViitasaariV., Payroll Tax & The Blockchain, in Tax Notes International, 2017, 1007 ss., 1008, specifying that “[v]alue can be money (Bitcoin, or the rights to fiat currency), but it can also be titles, deeds, music, art, scientific discoveries, or intellectual property”.

([4]) On this, TapscottA., TapscottD., Blockchain Revolution: How the Technology Behind Bitcoin and Other Cryptocurrencies is Changing the World, Penguin Books, 2016.

([5]) Lessig

([6]) Werbach, 315, mentioning Matt Byrne, Do Lawyers Have a Future?, LAW. (Sept. 20, 2016), https://

www.thelawyer.comlissues/online-september-2016/do-lawyers-have-a-future-2 [https://perma.cc/H2P4-BC94] and Alan Cunningham, Decentralisation, Distrust & Fear of the Body-The Worrying

Rise of Crypto-Law, SCRIPTED 237 (Dec. 2016), https://script-ed.org/wp-content/uploads/ 2016/

12/13-3-cunningham.pdf [https://perma.cc/PAP2-VWVA].

([7]) “[s]mart contracts don’t [need] a legal system to exist: they may operate without any overarching legal framework. De facto, they represent a technological alternative to the whole legal system.” Alexander Savelyev, Contract Law 2.0. <Smart> Contracts as the Beginning of the End of Classic Contract Law 21 (Nat’I Research Univ. Higher Sch. of Econ., Working Paper No. BRP 71/LAW/2016, 2016), https://papers.ssrn.com/sol3/papers.cfm?abstract-id=2885241 [https://perma.cc/HS7F-PF3W].

[8] Matt O’Brien, Bitcoin Isn’t the Future of Money-It’s Either a Ponzi Scheme or a Pyramid Scheme, WASH. POST: WONKBLOG (June 8, 2015), http://www.washingtonpost.com/blogs/wonkblog/wp/2015/06/08/bitcoin-isnt-the-future-ofmoncy-its-either-a-ponzi-scheme-or-a-pyramid-scheme/ [https://perma.cc/7BRH-Y7VE];

([9]) For an analysis of blockchain as “foundational technology” see AinsworthR.T., ViitasaariV., Payroll Tax & The Blockchain, in Tax Notes International,2017, 1007 ss., 1009.

([10]) The most popular consensus method is known as “Proof of Work” (PoW) and is used for Bitcoin (see infra§2.2). According to PoW, for each transaction the members of the Bitcoin network (called “miners”) compete to add the new block to the chain by solving a cryptographic puzzle and the winner is rewarded with a fee. An overview of the mechanisms used to rule on validity in CastorA., A (Short) Guide to Blockchain Consensus Protocols, Coindesk, 4 March 2017, https://www.coindesk.com/short-guide-blockchain-consensus-protocols/.

([11])SvikhartR.T., Blockchain’s Big Hurdle, in 70 Stanford Law Review Online, 2017, 100 ss., 101. On the functioning of blockchain see also Swan M., Blockchain: Blueprint for a New Economy, O’Reilly Media, 2015.

([12])SvikhartR.T., supra, 101.

([13])The Economist, Blockchains: The Great Chain of Being Sure About Things, 31 October 2015, https:// www.economist.com/news/briefing/21677228-technology-behind-bitcoin-lets-people-who-do-not-know-or-trust-each-other-build-dependable.

([14]) AinsworthR.T., AlwohaibiM., The First Real-Time Blockchain VAT – GCC Solves MTIC Fraud, in Boston University School of Law, Law & Economics Paper No. 17-23, 2017, 1 ss., 21.

([15])The Economist, The Promise of Blockchain: The Trust Machine, 31 October 2015, http://www.economist.com/news/leaders/21677198-technology-behind-bitcoin-could-transform-how-economy-works-trust-machine.

([16])LessigL., Code and Other Laws of Cyberspace. Version 2.0, Basic Books, 2006.

([17])AinsworthR.T., AlwohaibiM., Blockchain, Bitcoin, and VAT in the GCC: The Missing Trader Example, in Boston University School of Law, Law & Economics Paper No. 17-05, 2017, 1 ss., 18.

([18]) This is a statement by Blythe Masters, ex-head of Global Commodities, JP Morgan Chase, as referred in Deloitte, Blockchain in the food chain, 2016, https://www2.deloitte.com/content/dam/Deloitte/nl/Documents/consumer-business/deloitte-nl-cb-blockchain-in-the-food-chain.pdf, 2.

([19])BotosH.M., A blockchain “intelligence” analysis, in International Relations, 2017, 42 ss., 42.

([20])NakamotoS., Bitcoin: A peer-to-peer electronic cash system, 2008, https://bitcoin.org/bitcoin.pdf. The true identity of the programmer(s) behind the pseudonymous Satoshi Nakamoto is yet to be revealed.

([21]) So far, the distributed ledger technology has been mainly implemented in the financial sector, with cryptocurrencies challenging the existing regulators with a number of issues, ranging from their very legal nature, to the applicable law regime. Cryptocurrencies are digital currencies – i.e., currencies without physical form – built on blockchain and accepted both as mean of payment and tool for financial speculation. Their acceptance and value derive from the trust and value placed by each individual member (or “node”) of the network, which in turn relies on the functioning and security of the underlying blockchain technology. As “paper” currency does not have any intrinsic value to the holder but works due to the trust placed on the central bank authority, cryptocurrencies are just strings of (digitally unique) code exchanged among users who trust the system to verify each transaction and record it on blockchain, in a permanent, transparent, tamper-proof and secure way.

More specifically, when a user wishes to make a payment, he triggers a transaction by signing it with his private key (which works as unique digital signature), and this is then broadcasted to the entire peer-to-peer network. In order to validate the transaction, all the peers, acting as miners, compete to process complex algorithms: the first one to solve it adds the new block of data to the blockchain – which is simultaneously replicated throughout the network – and obtains a fee in return for his efforts.

Among cryptocurrencies, Bitcoin is the one that has achieved astonishing popularity. More precisely, “bitcoin(s)” without capitalized letters refers to units of the virtual currency, while “Bitcoin” with a capitalized “B” denotes the underlying software program used to generate (“mine”) them and audit bitcoin transactions. Being an open-software program, any individual can review the raw programming to check compliance with the protocol, while cryptography prevents tampering and preserves security.In this way, bitcoin, similarly to “altcoins” like Ethereum or Ripple ([21]), marginalizes the role of trust, by detaching it from banks and other central institutions. On this: Deloitte, The future of exchanging value. Cryptocurrencies and the trust economy, 2015, https://www2.deloitte.com/content/dam/Deloitte/au/Documents/technology/deloitte-au-technology-exchanging-value-cryptocurrencies-trust-economy-210116.pdf.GambleC., The Legality and Regulatory Challenges of Decentralised Crypto-Currency: A Western Perspective, in 20 International Trade & Business Law Review, 2017, 346 ss. HolcombI.A., Bitcoin’s Standing within the Global Regulatory and Economic Marketplace, in 23 Currents: International Trade Law Journal, 2016, 56 ss.

([22]) As explained in AinsworthR.T., ViitasaariV., Payroll Tax & The Blockchain, supra, 1013-1014, “A Google Trend analysis of global searches for the term “blockchain” shows no search activity from the 2008 publication of Satoshi Nakamoto’s white paper on Bitcoin until April 2013. The great Bitcoin Bubble came and broke and still there were no searches for blockchain. Two more years go by in silence. The foundational technology behind the single-use case (bitcoin) was functionally invisible, even though its single-use was anything but invisible. This all changed when Bitcoin’s value reached US$100. Suddenly, there is very measurable interest in Blockchain”.

([23])Williams-GrutO., Goldman Sachs: 5 practical uses for blockchain — from Airbnb to stock markets, in Business Insider UK, 28 May 2016, http://uk.businessinsider.com/goldman-blockchain-beyond-the-hype-practical-uses-2016-5?IR=T/#electricity-market-letting-houses-generate-and-sell-their-own-electricity-2. See also MougayarW., The Business Blockchain: Promise, Practice, and Application of the Next Internet Technology, Wiley, 2016.

([24])LeonardC., Blocking the Blockchain, in 35 International Financial Revolution, 2016, 58 ss.

([25])MayT.C., The Crypto Anarchist Manifesto, in LudlowP., Crypto Anarchy, Cyberstates, and Pirate Utopias, The MIT Press, 2001, 61 ss.

([26])SzaboN., Smart Contracts, 1994, http://www.fon.hum.uva.nl/rob/Courses/InformationInSpeech/CDROM/Literature/LOTwinterschool2006/szabo.best.vwh.net/smart.contracts.html, explaining smart contracts in the following terms: “A smart contract is a computerized transaction protocol that executes the terms of a contract. The general objectives of smart contract design are to satisfy common contractual conditions (such as payment terms, liens, confidentiality, and even enforcement), minimize exceptions both malicious and accidental, and minimize the need for trusted intermediaries. Related economic goals include lowering fraud loss, arbitration and enforcement costs, and other transaction costs”.

([27])O’ShieldsR., Smart Contracts: Legal Agreements for the Blockchain, in 21 North Carolina Banking Institute Journal, 2017, 177 ss., 179.

[28]HsiaoJ.I.H., Smart Contract on the Blockchain. Paradigm Shift for Contract Law, in 14 US-China Law Review, 2017, 685 ss., 690.

[29]On this, WerbachK., CornellN., Contracts Ex Machina, in 67 Duke Law Journal, 2017, 313 ss.

[30]MikE., Smart Contracts: Terminology, Technical Limitations and Real-World Complexity, in 9 Law, Innovation & Technology, 2017, 2, 2.

[31]MikE., Smart Contracts: Terminology, Technical Limitations and Real-World Complexity, supra,14-15.

[32]Judge Hand in Hotchkiss v. Nat’l City Bank, 200 F. 287, 293 (S.D.N.Y. 1911).

[33]Ethereum White Paper, A Next-Generation Smart Contract and Decentralized Application Platform, https://github.com/ethereum/wiki/wiki/White-Paper

[34]Werbach 342

[35]MikE., Smart Contracts: Terminology, Technical Limitations and Real-World Complexity,supra, 9.

[36]The relationship between smart contracts and enforcement is also explored in KouluR., Blockchains and online dispute resolution: smart contracts as an alternative to enforcement, in 13 SCRIPTed, 2016, 41 ss.

[37]HsiaoJ.I.H., Smart Contract on the Blockchain-Paradigm Shift for Contract Law, in 14 US-China

Law Review, 2017, 685 ss., 694.

[38]MikE., Smart Contracts: Terminology, Technical Limitations and Real-World Complexity, supra, 20.

[39]MikE., Smart Contracts: Terminology, Technical Limitations and Real-World Complexity, supra, 5-21.

[40]On this, CaseyA.J., NiblettA., Self-Driving Contracts, in 43 The Journal of Corporation Law, 100 ss.

[41]SklaroffJ.M., Smart Contracts and the Cost of Inflexibility, in 166 University of Pennsylvania Law Review, 2017, 262 ss., 303.


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