Back to basics: digital assets Part 4 – Smart contracts

In 1994, the inventor of the ‘smart contract’, Nick Szabo, defined the term as a ‘computerised transaction protocol that executes the terms of a contract’. The transaction protocol works with algorithms following an ‘if-then’ logic.

When we talk about smart contracts now, we refer to a computer protocol run on a decentralised blockchain system, usually the Ethereum blockchain, which allows automated (i.e., self-executing) contract execution between two or more parties with previously coded data. As with all data on a blockchain, the distinct features and current legal limitations of smart contracts are theoretical immutability, perpetuity, decentralisation and encryption.

A smart contract is not a contract in the legal sense but rather a computer ‘technology’ or a software for contract execution and storage of data on the blockchain that takes on the function of a transaction register. This understanding is mostly shared by legal doctrine throughout the world.

Current fields of application for smart contracts include: borrowing/lending, escrow or trading transactions in decentralised finance (DeFi); creation and sale/purchase of non-fungible tokens (NFTs) in the gaming industry; and building and managing decentralised autonomous organisations (DAOs).

Smart contracts come with legal challenges and limitations. For example, the decentralised and immutable nature of smart contracts poses questions concerning jurisdiction and governing law. As these contracts are hosted on blockchain networks that are globally distributed, it becomes difficult to establish which national laws apply in the event of a dispute.

Another challenge is the legal recognition and enforcement of smart contracts. For now, smart contracts (in most jurisdictions) rely on ex ante formal legal contracts.

Moreover, the immutability of smart contracts raises concerns about rectification and dispute resolution. Once a smart contract is deployed on the blockchain, it cannot be changed, which poses difficulties when programming, when other errors occur or in the event of unforeseen circumstances.

Finally, building a legally binding contract on a blockchain, even if it was possible under the law, could become a complex endeavour. Since it is, by definition, self-executing, all eventualities would have to be taken into account ex ante and would have to be pre-programmed.

Legislators worldwide are actively exploring smart contracts’ potential implementation and integration within legal frameworks. It promises to be a captivating journey to observe the forthcoming developments in this domain.