What are Smart Contracts, and What Can We do with Them?

This ancient area of law is ripe for automation by cryptocurrency. Read what lawyers should learn about the technology and what the technology will need to learn about lawyering.

The Internet of Money

One of the great promises of cryptocurrency networks such as those underlying Bitcoin and Ripple is enabling a new paradigm of transactions that go far beyond transferring digital currency. The “Internet of money” refers to the capability of these decentralized ledger networks to create transactions and agreements that do not involve banks, courts, and other traditional players.

Smart contracts are a potentially revolutionary type of application using decentralized ledger networks. The idea underlying smart contracts is that software can automate much of the contracting process. This could allow for the performance, monitoring, and enforcement of contractual promises without human involvement. Like other types of automation, contract automation can lower the costs of operating a business and make mistakes less likely to happen. Another potential benefit is enabling parties to more efficiently structure their relationships. For example, automatic verification of a contractor’s work could allow the contractor to be paid more quickly and prevent unnecessary delays.

The most attractive feature of smart contracts may be the potential to greatly reduce or even eliminate the need for litigation and courts. By using a smart contract, parties commit themselves to be bound by the rules and determinations of the underlying code. Doing so in principle removes the potential for parties to have a dispute: both parties are held to whatever outcome the smart contract determines. In his seminal 1997 article, legal scholar and technologist Nick Szabo described what may happen to someone that breaches a smart car lease: “if the owner fails to make payments, the smart contract invokes the lien protocol, which [automatically] returns control of the car keys to the bank.”

Smart contracts could therefore reduce the need for litigators, judges, and arbitrators. However, by requiring parties to strictly commit, at the outset, to decisions of a smart contract, the need for transactional attorneys and others to structure smart contractual relationships may increase. Parties would most likely want to specify a more detailed range of contingencies and outcomes ahead of time before committing themselves to abide by the decisions of a software-driven contract.

Smart Contracts in Development

Today, a wave of companies and organizations are developing smart contract platforms and applications. Bithalo, for example, offers a platform that uses a joint account system whereby contracting parties deposit funds or work product into a secure account. Hedgy is developing smart derivatives contracts that reduce counterparty risk and increase settlement speed with straight-through-processing. Swarm, which uses the Counterparty platform, allows a company to crowdsource capital using “cryptoequity” contracts that give holders a variety of potential rights such as those relating to voting, sharing in profits, controlling executive decisions, and making further investments as the company reaches certain milestones.

Multi-Signature and Oracles

Certain features have come to typify smart contracts. One is the use of multi-signature (or “multi-sig”) to improve and assure performance. With a multi-sig feature, two or more parties are required to approve a transaction before funds can be released or some other aspect of the contract can move forward. Another is the use of an “oracle” to monitor prices, performance, or some other aspect of the real world. A smart loan agreement may, for example, automatically deposit funds in a borrower’s bank account once an oracle obtains information that the borrower’s loan application has been approved. A major obstacle to the development of smart contracts is embedding complex decision making into a cryptocurrency platform, something Ripple’s Codius software attempts to overcome.

Which Chain? What Coin?

A fundamental issue currently dividing smart contract developers is whether to build on top of the Bitcoin network (also known as a blockchain) or to use a different cryptocurrency. Ethereum, for example, uses a blockchain distinct from Bitcoin. Using its own blockchain allows Ethereum to implement a wider variety of smart contracts, according to its founding white paper. The Clearhinghouse blockchain likewise considers not using Bitcoin to be a major advantage that enables faster transactions and no risk of being held up by choices made by Bitcoin developers.

Counterparty, by contrast, builds contracting software on top of the Bitcoin blockchain. In 2014, Counterparty developers struggled with an update to the Bitcoin protocol that rendered their method of embedding message data useless. That problem has since been resolved.  Counterparty insists that any costs associated with integrating their software into a changing protocol outside of their control are outweighed by the benefits of utilizing Bitcoin’s more secure, well-established blockchain and ecosystem.

Many of these smart contract platforms utilize their own unique cryptocurrency to develop and operate smart contract applications. For example, Ethereum uses Ether while Counterparty uses XCP. Appropriate mechanisms for creating and fairly distributing these novel tokens is another source of debate amongst smart contract developers. Counterparty created its XCP by automatically granting their tokens to any Bitcoin user who provably destroyed some Bitcoin by sending it to an address with no known private key. Counterparty calls the method proof of burn. Ethereum sold access to its platform through a pre-sale of Ether tokens. The cryptographic Ether tokens have yet to be generated and those purchasing them are implicitly trusting Ethereum’s developers to deliver once the protocol is up and running.

Choosing between Bitcoin and another blockchain may not be either/or, however. In November 2014, the Counterparty developers effectively made the Ethereum smart contract platform compatible with Bitcoin.

How to Improve Smart Contracts

Smart contracts using cryptocurrency protocols could revolutionize the world of contracting. Automated performance, however, does not guarantee that parties will always, or even often, be capable of determining all aspects of their bargain at the outset of the transaction. In the real world, things aren’t so simple.

Contracts often end up being ambiguous and imprecise. This is because what happens after parties strike a deal is often unpredictable. Parties also don’t have the time or interest in attempting to detail every possible eventuality up front.

Parties accordingly want some level of flexibility and seek to avoid locking themselves into rigid commitments and outcomes. What developers of smart contracts may overlook is that both parties can benefit from renegotiating their contract in response to changed circumstances. For example, CBS and stars of The Big Bang Theory both benefited when some of the actors’ contracts were renegotiated in response the show’s immense rise in popularity—something not entirely predictable when the actors first signed on. Smart contracts should have mechanisms to allow parties to amend their agreements when mutually desired instead of being stuck based on old assumptions.

Contracting parties also desire built-in mechanisms that adjust the terms of an agreement without the need for renegotiation. Commercial loans often use performance pricing provisions that adjust the interest rate based upon the performance of the borrower. Asset-based loans can be particularly valuable because they automatically adjust the amount of credit available to borrower based on the value of its assets. Smart contracts should likewise have protocols that adjust the terms of an agreement to the advantage of both parties.

Smart contracting proposals should also learn from the automation that is already taking place in the contract world but outside of cryptocurrencies. In the context of international trade, banks have been trying to convince corporate clients to adopt bank payment obligations that effectively act like smart contracts: a seller is paid only if she transmits the correct data to a bank showing that the goods were shipped to the buyer. Companies have largely failed to adopt the system, however, due to not being sold on its benefits or wanting to convert to a new system.

And it is not as if the world of business contracts is completely paper based. Oracle’s PeopleSoft platform automates much of the contracting process and related business operations. In the loan context, companies like ABLSoft and Ftrans enable lenders to continually monitor borrowers using their software. Much of promise of smart contracts may have already been captured.

If smart contracts using cryptocurrency networks are going to succeed, much less usher in a transactional revolution, they will have to overcome the problems of existing contract automation initiatives. They will also need to deliver features over and above those already being offered by companies that sell contract-enhancing software.

Smart contracts implemented over a cryptocurrency blockchain do, however, have important advantages over incumbent services. First, they function on a decentralized, open network where trust is established using deterministic software rather than reputation or law. In addition, because a blockchain publicly records transactions on a single ledger, it allows economic activity to be coordinated more easily. This could increase how well markets operate globally by, for example, enabling companies that are part of the same supply to chain to coordinate production in response to market conditions. Should smart contract technologies catch on, they’ll provide a robust means of establishing trust and integrating markets without having to join or trust a company or other intermediary that is focused on selling its own services and that could serve as a single point of failure.

Houman Shadab is professor of law at New York Law School and a Coin Center Fellow. 

Based in Washington, D.C., Coin Center is the leading non-profit research and advocacy center focused on the public policy issues facing cryptocurrency and decentralized computing technologies like Bitcoin and Ethereum. Our mission is to build a better understanding of these technologies and to promote a regulatory climate that preserves the freedom to innovate using permisionless blockchain technologies.