In this article, Sarah Kenshall and Santos Hau discuss the meaning of smart contracts, their benefits and potential applications, and issues businesses should consider when implementing and/or agreeing to such contracts.
What are smart contracts?
In their most basic form, smart contracts are computer programs which embody contractual conditions. The program monitors performance of the conditions and will self-execute once the conditions are fulfilled (if A happens, B will result). Smart contracts are used to accommodate the myriad of ‘handshakes’ between machines that take place behind the scenes to enable automation within, for example, smart factories, smart cities and on smart roads. The lack of human intermediaries means they are almost instantaneous in execution, reducing scope for delay and human error.
Benefits and potential applications of smart contracts
The fact that human intermediaries are not required to execute smart contracts means they are perfectly positioned to handle repetitive and process driven tasks e.g. payment of customs levies, recognition of number plates, inventory management, etc. In the future, they may replace more complex but nevertheless standardised and repetitive agreements such as counterparty agreements in financial services and interconnection agreements in telecoms. They are also useful for transactions between anonymous (or pseudonymous) parties, for example in the context of cryptocurrencies.
As smart contracts can operate in an encrypted and decentralised system, there are less risks from infiltration. Following news of a health service ransomware attack which shocked the Irish psyche in May 2021, organisations in the healthcare sector are increasingly interested in the use of smart contracts and blockchain technologies to ensure that the transfer of patient data is secure, confidential and can be restored in the event of any data loss.
Smart contracts may be cheaper to operate than standard contracts. For instance, AXA has a flight delay insurance product which automatically pays customers compensation, should their flight be delayed by more than 2 hours. As this eliminates the need for a human representative to confirm flight delays of more than 2 hours, costs savings could result.
Furthermore, the lack of human intermediaries involved in smart contracts means that there is a reduced risk of human errors, thereby increasing the accuracy of contract execution. On the other hand, there is little room for handling nuances in contractual terms e.g., what is ‘reasonable’?
Issues to consider when implementing and / or agreeing to smart contracts
While the potential anonymity of parties is a benefit of smart contracts and facilitates confidentiality, there is an issue of how to identify an individual who breaches a smart contract, for an aggrieved party to take legal action.
Furthermore, even if a perpetrator was identified, it may be difficult to consider which jurisdiction applies to the dispute, given that digital transactions are commonly cross-border and do not necessarily occur in one geographical area for the purposes of determining jurisdiction (e.g. the servers involved may be anywhere in the world).
Additionally, there is uncertainty in determining liability in the event of third-party externalities, such as system bugs, failures, or ambiguities in code which lead to unintended consequences.
Furthermore, while smart contracts are marketed as cost-saving, some third parties will still be needed to set up the smart contract, such as lawyers to negotiate the contract, and developers to write the code. For one-time, bespoke and negotiated transactions, smart contracts may not be suitable.
However, the potential problems with smart contracts are not insurmountable. Risks may be mitigated, by providing express contractual terms which:
- provide certainty in the allocation of risks (e.g. in the event of faulty code);
- clarify the relationship between natural language and code (e.g. which prevails in the event of conflict); and
- halt the performance of a code in certain circumstances (e.g. on breach of a contract) - ‘kill switches’ may be implemented.
If you are considering utilising smart contracts in your business or within your service offering, BPE’s Technology team is well placed to help you navigate through this rapidly developing field, to ensure you are reaping the benefits of smart contracts, while mitigating your risks.
Recommended reading
The Law Commission has recently published a report on the ability of English and Welsh law to accommodate smart contracts and is available here.
The LawTech Delivery Panel have published a legal statement on smart contracts with the aim of increasing market confidence in their use, available here.
These notes have been prepared for the purpose of articles only. They should not be regarded as a substitute for taking legal advice.
