Technological developments challenge the legal community
Smart contracts are an important part of the blockchain revolution, although they predate blockchain. According to most sources, it was Nick Szabo who coined the term “smart contract” in the 1990s. The mechanism of a vending machine has since been frequently cited as an example of a basic smart contract based on the if- logic. then. Payment in an ATM triggers an irrevocable automated action from the time the money is held until the time an item is delivered.
The emergence of blockchain technology has enabled the implementation of such if-then logic on decentralized networks to facilitate autonomous and self-executing smart contracts, also known as computerized scripts, smart code, computerized protocols or decentralized business logic. . Since they gained popularity, we have debated and wondered if they were smart or contractual.
The basics of smart contracts
Leaving this debate aside for now, smart contracts offer many advantages. One of them is the efficiency brought mainly by automation, their streamlined training, their unambiguous interpretation and their efficient performance. Efficiency gains lead to cost savings, achieved by removing middle layers and reducing ambiguities and opportunistic behavior.
The transparency of smart contracts provides verifiability and improves trust. The performance guaranteed by technology facilitates transactions not only between parties who do not know each other, but also between parties who would hesitate to transact between themselves without performance guarantee. Ex-ante performance assurance through the 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 cheaper business processes, supply chain management, corporate governance and more. We are only beginning to explore their potential use.
However, it must be said that smart contracts also require a certain degree of technical culture to code, implement and understand them, and outside of the blockchain community these skills remain relatively weak. Smart contracts are also not free from technical challenges and vulnerabilities at all stages of their lifecycle, from inception to deployment, execution and completion. There are also ex ante costs of implementing smart contracts and costs of moving to smart contract networks, which should not outweigh the benefits to achieve efficiency gains.
Related: Promise of smart contract adoption is held back by crypto silos
Technology and law
Smart contracts represent the intersection of technology and law, and therefore challenge practitioners, academics and lawmakers – many legal questions have been debated. Smart contracts have been characterized as neither smart nor contract. First, there is neither a commonly accepted definition nor a unified, structured and systematic classification of smart contracts. There is no agreement or common understanding on the relationship between smart contracts and traditional legal contracts. Some researchers question the ability to create valid and binding legal contracts through a smart contract.
Related: Hybrid smart contracts will replace the legal system
Discussions are ongoing regarding the applicable legal frameworks and how to reconcile the immutability of blockchain records with contractual errors or contractual loopholes. Similar concerns have been raised about changing the terms of smart contracts recorded in an immutable ledger. Applicable law and applicable jurisdiction are also matters of particular relevance to decentralized and borderless blockchain networks on which smart contracts are deployed. Questions of consumer protection and the duty to inform are also raised.
Increasingly, there are also considerable concerns related to anti-money laundering (AML) / counter-terrorist financing (CFT) requirements, as well as confidentiality and privacy issues. Immutability and automated, unstoppable enforcement 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 their legal relevance (if any), context and technical properties. They range from simple, straightforward and standardized payment instructions to sophisticated instruments capable of autonomously executing a complex sequence of actions. The emergence of blockchain-based smart contracts has also brought a new dimension to the notion of cyberspace self-regulation. In addition, discussions of “code is law” and “Lex Cryptographia” followed.
However, when it comes to lawmakers and regulators, they have remained largely silent on smart contracts. Despite a vigorous academic debate on the legal status, recognition and enforceability of smart contracts, their normative legitimacy, and legal implications, lawmakers do not appear to be alarmed or rushing into prohibitive action. Although there is some legislative activity in some jurisdictions, so far only a handful of countries have formulated a regulatory response and enacted legislation, which has generally been modest.
Smart contracts against the United States
For example, the majority of smart contract legislative initiatives in the United States are relatively narrow and govern only a small number of issues primarily limited to the definition of smart contracts, recognition of their electronic form and signatures, and sometimes their admissibility as evidence. This includes states like Arizona, Tennessee, North Dakota, Nevada, Wyoming, and Illinois. Some critics have argued that such legislative initiatives are premature and incomplete, and represent nothing more than the promotion of a particular jurisdiction. This creates a risk of regulatory fragmentation between US states and fragmented smart contract legislation, potentially complicating federal harmonization in the future.
U.S. federal regulatory and supervisory agencies, such as the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC), have dealt with smart contracts through their investigations, statements, and guidance, which clarify certain legal implications of the use of smart contracts in the United States. The CFTC has released a smart contract primer in which it states that a smart contract could be a binding legal contract, depending on the facts and circumstances, and could be subject to a variety of existing legal frameworks. The CFTC has also highlighted several risks associated with the use of smart contracts, including operational risks, technical risks, cybersecurity risks, risks of fraud and manipulation, and risks related to governance protocols.
Like the CFTC, the SEC enforces existing legal frameworks in its enforcement actions related to blockchain and smart contracts. As a sign of growing regulatory oversight, the SEC recently announced the purchase of smart contract analysis tools to analyze and detail code in blockchains and other distributed ledgers, in support of its efforts to monitor risks, improve compliance and inform the SEC’s policy regarding digital assets.
Smart contracts against the world
In other parts of the world, countries like Belarus, Italy and Russia have addressed smart contracts to a limited extent. The UK Jurisdiction Task Force issued an important legal statement, concluding that smart contracts are capable of forming valid, binding and enforceable contracts between parties, highlighting the adaptability and flexibility of common law which is able to respond to technological advancements such as smart contracts. The European Union has also expressed consumer protection concerns related to the use of smart contracts, but so far no regulatory action has been taken at EU level.
Existing legislative initiatives appear to align with regard to the recognition of smart contracts in existing legal frameworks; however, they differ on the definition of smart contracts. It is only a matter of time before smart contract issues reach the courts, allowing the judiciary to deal with legal issues, especially in common law jurisdictions.
In the meantime, the proliferation of divergent definitions and the potentially legal treatment of smart contracts can give rise to legal uncertainties and regulatory trade-offs. Lawmakers should therefore closely monitor developments in smart contracts and intervene only when necessary to provide legal certainty, mitigate risk and protect vulnerable contracting parties. Such a measured and risk-based regulatory approach would support innovation, exploit opportunities and integrate smart contract innovation into existing legal systems. Adequate regulatory guidance could also help remove legal uncertainties and strengthen market confidence for the industry, investors and consumers.
The size of the global smart contract market is growing rapidly. It is expected to achieve a compound annual market growth rate of 17.4% during the forecast period of 2020 to 2025, and is expected to reach $ 208.3 million by 2025. Smart contracts are growing. deployed in a wide range of industries, including the financial sector. , the public sector, supply chain management and the automotive, real estate, insurance and health sectors. They are also the backbone of a growing decentralized finance (DeFi) space. Regulators will increasingly be challenged to respond to and address smart contracts, but legislative initiatives so far indicate that there are no major barriers to the use of smart contracts; it does not appear that substantial legal reforms are necessary to adopt them.
The views, thoughts and opinions expressed here are those of the author alone and do not necessarily reflect or represent the views and opinions of Cointelegraph, the Warsaw University of Technology or its affiliates.
This article is for general information purposes and is not intended to be and should not be construed as legal advice.
Agata Ferreira is Assistant Professor at Warsaw University of Technology and Visiting Professor at several other academic institutions. She studied law in four different jurisdictions, common law and civil law. Agata practiced law in the UK financial sector for over a decade in a leading law firm and in an investment bank. She is a member of an expert panel at the EU Blockchain Observatory and Forum and a member of an advisory board for Blockchain for Europe.