The smart contract definition is a self-executing computer program that controls the terms and documents the transactions of an agreement between two or more parties. Creating smart contracts has been discussed since the mid 1990s but are currently being popularized by Web3 enthusiasts. Web3 is a current social term for the idea of what comes next for the internet. Smart contracts are a current topic of consideration among blockchain, NFT (non-fungible token), and cryptocurrency implementors. It is important to note that smart contracts are not necessarily smart legal contracts.
Smart contracts are an automatic means of performing the obligations of the contract, but depending on where you live, smart contracts are not necessarily enforceable agreements under the law. Smart contracts can be legally binding agreements, but enforcement under the law is not an automatic part of such agreements. This article discusses the basics of smart contracts and the issues involved in enforceability of smart contracts under the law. Read more about how to make one in our article about smart contract formation.
How do Smart type Contracts Work
Smart contracts are self-executing agreements in the form of computer programs that work by automatically enforcing the terms of an agreement. Here is a simple example to illustrate the concept: imagine Alice agrees to buy Betty’s widget packing machine, and Betty agrees to ship the machine to Alice. They can use a smart contract to automate the sale. The terms of the agreement, such as the price and delivery date, are coded into the smart contract.
Here’s how the purchase transaction would work as a smart contract:
- Alice and Betty encode the terms of the agreement, including delivery date and price, into a computer program to monitor and verify the delivery of the machine, and upon delivery, transfer the money and verify receipt of payment.
- Betty sends the widget packing machine to Alice, and the smart contract monitors and reports on the shipping and delivery to Alice.
- Alice accepts delivery of the widget packing machine, and the smart contract processes payment, reports payment to Betty, and monitors receipt of payment.
The smart contract automatically verifies that the delivery deadline has not been exceeded and that the payment has been received. In this example, the smart contract is acting as an intermediary (such as a lawyer or escrow service), automatically enforcing the terms of the agreement and ensuring that both parties fulfill their obligations. Supply chain management smart contracts like this example are frequently implemented today using blockchain implementations. Purportedly, by using a blockchain, the transaction is secure and tamper-proof thus offering a high degree of trust in the outcome. Read more about smart contracts at Wikipedia.
Are Smart Contract Applications Legal?
Whether or not implemented on a blockchain, a smart contract like Alice and Betty’s may or may not be legal under the law depending on where Alice and Betty live. The current (February 2023) legal status of smart contracts varies by geography (legal jurisdiction). In some countries, smart contracts are recognized as legally binding agreements. In some countries, smart contracts are recognized as legally binding agreements only for some uses. In other countries, the legal recognition of smart contracts is still not determined and/or is in development making legal enforceability uncertain.
If the agreement is legal under the laws of the jurisdictions of the parties and if it was in writing signed by the same parties, then it would likely also be legally enforceable in smart contract form. Implementing smart contracts is still a relatively new technology. Consequently, the legal framework for general recognition and enforcement is still evolving. More jurisdictions are establishing guidelines for their recognition and enforcement. Obviously, it is always recommended to seek consult from a lawyer to understand the legal implications of using smart contracts in any specific situation.
Are there Smart Legal Contracts?
Currently (February 2023) for smart legal contracts, there is the idea that if a distributed ledger technology was implemented along with blockchain, that smart contracts therein would be smart legal contracts. However, regardless of any specific technology implemented to enable smart contracts, there is not really a separate “smart legal contract” that is any different than the smart contract. There are smart type contracts at least potentially available for legal services. For example, we could offer our patent application services, trademark registration, and copyrighting using a smart type of contract vehicle.
Whether any contract, a smart one for example is legal is determined by jurisdiction. Like any other contract it must be legal in the jurisdiction(s) where it provides services in order for it to be legal. Smart contracts are smart legal contracts if the smart contract is legal. Arguably, it does not even make sense to create another term like smart legal contracts for smart contracts that are legal. It makes more sense to get the smart contracts moved into legal status.
Important Tip: Be sure to check with an attorney to understand the legal implications of using smart contracts in any specific use case or situation where the legality of the agreement is or may be questioned. Our patent attorney is well-versed in technology.
Potential Advantages of Smart Contracts
There are some potentially big advantages to the use of smart contracts for all kinds of agreements. Smart contracts can offer a more efficient, secure, and transparent way of executing agreements for a wide variety of agreement applications in most industries. Given the use of blockchain, distributed ledger, and non-fungible token technologies that are presently available and thus being developed, smart contracts can offer several potential advantages over traditional contracts.
Potential advantages of smart contracts over traditional contract vehicles include automation, efficiency, unchangeable agreements, no intermediaries, transparency of contract terms and agreements, and transaction security. With appropriate use of blockchain, distributed ledger, and non-fungible token technologies, nearly any contract could potentially be converted into a smart one. Advantages of smart contracts over traditional contracts:
- Automatic Contract Compliance: Smart contracts automate the execution of the terms of the agreement and monitor contract performance by tracking and/or verifying the transactions performed. Obviously this reduces or eliminates the potential for errors and compliance monitoring costs.
- Efficiency and Accuracy of Contract Performance: Smart contracts reduce transaction times and errors thus improving the compliance of all parties to the agreement, and eliminating contract performance monitoring costs.
- Unchangeable Terms and Conditions: Once a contract is deployed, the terms of the agreement cannot be altered, and the program can only run what was coded into the executable. This ensures that the agreement remains as initially agreed to and it is executed only in compliance with the encoded terms and actions. Note that this can also be a disadvantage.
- No Lawyers or Escrow Services: Smart contracts can be implemented without the use of intermediaries which reduces costs and improves speed of execution.
- Transparency of Contract Terms and Conditions: The terms of the agreement are encoded in the smart contract, which can be stored on a blockchain and/or decentralized ledger technologies. This could then make the terms of the agreement transparent and accessible to all parties involved.
- Contract Transaction and Performance Security: Smart contracts can use cryptographic algorithms to secure the transactions and enforce the terms of the agreement. This can reduce the risk of fraud and help ensure that the agreement is executed as intended.
- Decentralization: Smart contracts can be stored on a decentralized ledger, making them accessible from anywhere in the world and reducing the dependence on centralized authorities.
Potential Disadvantages of Smart Contracts
While smart contracts can offer many advantages, they also currently have several disadvantages that need to be considered when deciding whether to use them for a particular agreement application or use case. While the unchangeability of smart contracts may be the biggest disadvantage, the lack of legal recognition, limited sources to use in them, limited interoperability between sources, complexity of creation, and dependence on computer network connectivity should be considered.
Current challenges include:
- Unchangeable Terms and Conditions: Once deployed, the code cannot be altered. This can be problematic if there is a bug in the code or if the terms of the agreement change over time.
- Potential Lack of Legal Recognition: In many jurisdictions, smart contracts are not yet recognized as legally binding agreements. This can create uncertainties and legal challenges in the enforcement of smart contracts.
- Limited Programming Languages: Currently, options for smart contract programming languages are limited which can make them inaccessible to some developers. This limits the number of potential sources of smart contracts.
- Interoperability Between Implementation Platforms is Limited: Different blockchain platforms use different programming languages and protocols. In other words, smart contract languages used for programming may be different on different implementations. This makes it difficult or impossible for smart contracts on one platform to interact with smart contracts on another platform.
- Complexity of Contract Creation: Writing and deploying a secure and error-free smart contract can be complex. In addition to knowing the contract language, knowing how to make the conversion may require a deep understanding of cryptography, blockchain technology, decentralized ledger technology, and programming.
- Dependence on Network Connectivity: The execution of a smart contract is dependent on the availability and reliability of the underlying computer networks it is implemented on. If the network experiences congestion or failures, the execution of the smart contract may be delayed or hindered.
5 Examples of Smart Contract Use Cases
Smart contracts are growing in popularity and are a part of the Web3 evolution. There are more kinds of agreements implemented as smart contracts all the time. This is a very actively developing technology being implemented in a variety of ways. Presently, there are at least these five example use cases of smart contracts:
- Supply Chain Management: Smart contracts can be used to automate the tracking of goods and materials as they move through the supply chain. This can help to increase transparency and reduce the risk of fraud and counterfeiting.
- Real Estate Transactions: Smart contracts can be used to automate the transfer of ownership of real estate properties. This can simplify and streamline the process, reduce the need for intermediaries, and increase the speed and efficiency of real estate transactions.
- Crowdfunding Campaigns: Smart contracts can be used to automate the process of raising funds from a large number of people for a specific project or cause. This can help to increase transparency, reduce the risk of fraud, and ensure that the funds are only released when specific conditions are met.
- Insurance Contracts: Smart contracts can be used to automate the payment of insurance claims based on the terms of the policy. This can help to reduce the need for intermediaries, increase transparency, and ensure that claims are paid promptly and accurately.
- Online Gaming Systems: Smart contracts can be used to automate the process of buying, selling, and trading in-game items and assets. This can help to reduce the risk of fraud, increase transparency, and allow players to securely and easily trade digital assets without the need for intermediaries.
