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An introduction to smart contracts

In a previous article, we have written about Artificial Intelligence (AI) and contracts. AI is having an impact in three areas when it comes to contracts: 1. contract review, 2. contract management and automation, and 3. smart contracts. While smart contracts are automated contracts, what sets them apart from other automated contracts is the usage of Blockchain technology.

What are smart contracts? We’ll combine elements from the definitions Tech Republic and the Investopedia to explain: A smart contract is a software-based contract between a buyer and a seller. The software automates the business processes and the conditions of fulfilment contained within the contract. The code programmed into the contract actually makes the contract self-executing so that it takes action whenever a specific condition is triggered within the contract. The code and the agreements contained therein exist across a distributed, decentralized Blockchain network. Smart contracts permit trusted transactions and agreements to be carried out among disparate, anonymous parties without the need for a central authority, legal system, or external enforcement mechanism. They render transactions traceable, transparent, and irreversible. Because the smart contract is software capable of automating business processes and contract fulfilment automatically, it eliminates the need for managers and middlemen supervision.

Let’s give an example: A is a supplier of products for B. Every month, B places an order with A. It makes sense to automate this process. The smart contract is a piece of software that, e.g., would contain the code that says if an order is received by A from B, and B is not in arrears, then that order must be executed. Now, with smart contracts these transactions are typically registered in a distributed, decentralized Blockchain network of ledgers. In a previous article we explained that Blockchain is a technology that registers transactions in a ledger, where everybody in the network has a copy of that ledger. Transactions are secured by using a verification code that is calculated based on all previous transactions in the ledger. In essence, to forge a transaction, one would therefore have to forge all registrations of all transactions in all ledgers.

The benefits of smart contracts are clear: the whole process of transactions between parties can be automated, and by using Blockchain technology one has virtually irrefutable proof of the transactions. Add to that that programming code tends to be less ambiguous than the generic legalese of traditional contracts, so the chances of disputes about the interpretation of smart contracts are smaller.

The usage of smart contracts is expected to grow fast. A survey published in Forbes Magazine predicts that by 2022, 25% of all companies will be using them. Basically in any market where Blockchain technology is useful, one can expect smart contracts to be useful, too.  Smart contracts can also be the perfect complement to E.D.I. At present, smart contract applications are already being used in – or developed for – supply chains and logistics, in finance and securities, real estate, management and operations, healthcare, insurance, etc.

Still, one has to be aware of the limitations of smart contracts, as there are a number of legal issues to take into account. The name ‘smart contracts’ is misleading in that they aren’t really contracts but software. As such, there are legal concerns with regard to:

  • Offer and acceptance: is there even a binding contract, if there is no human interaction or supervision, and the transaction is completely executed automatically?
  • The evidentiary value: smart contracts are not written evidence of agreed rights and obligations because they encapsulate only a portion of any rights and obligations that is related to contractual performance
  • Jurisdiction: is the area of jurisdiction clearly defined in case of a conflict or dispute?
  • Dispute Resolution: are there any dispute resolution mechanisms in place?

When considering working with smart contracts, it is therefore a good idea to first come to a framework agreement in which these issues are addressed. And those will preferably still be written by lawyers.