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Smart contracts: An approaching legal revolution

One of the possible applications of the Bitcoin protocol is smart contracts—legal relationships created, monitored and enforced automatically using the Bitcoin protocol.

The growing popularity of Bitcoin has contributed to an increasing interest in the fundamental source of the success of the virtual currency: the Bitcoin protocol. It turns out that the IT and cryptographic solutions used for Bitcoin may be successfully used for other more advanced purposes, such as smart contracts.

The concept of “smart contracts” dates back to the 1990s, when the possibility of using the internet to create automated contracts in the form of algorithms which could be enforced automatically began to be considered. It was not until the Bitcoin protocol was developed, however, that a realistic possibility of forming such contracts was created.

In simple terms, the Bitcoin protocol is a solution enabling the creation of a cryptographically secure public register of transactions, functioning within a decentralised peer-to-peer network. Transactions made using Bitcoin are verified automatically by users of the network. Because the network is decentralised, it may be used by anyone, regardless of location. The decentralised control over transactions and the cryptographic solutions employed make the Bitcoin protocol one of the most secure IT solutions currently being used (for example, it effectively prevents the creation of fictitious Bitcoins or spending the same Bitcoins multiple times). It should be stressed that the scandals involving Bitcoin (such as the collapse of the Mt. Gox exchange) have not involved the Bitcoin protocol itself—so far no one has undermined its security—but actions by intermediaries in Bitcoin trading.

The Bitcoin protocol is currently used primarily for purposes connected with virtual currencies. But its possibilities are much greater. It is only through a certain convention that users assign the meaning of virtual currency to digital records verified through the Bitcoin protocol. Imagine that a different meaning were ascribed to the same digital record. For example, assume that it is not a currency, but a share vesting the holder with the right to payment of a dividend. The Bitcoin protocol could then be used as the foundation for building entirely new solutions based on the concept of a decentralised platform for exchange and verification of digital content. The first attempts to build such new solutions have already appeared, such as Colored Coins and Ethereum.

Script containing the content of a contract recorded in digital form may also be the subject of verification through a decentralised network. At the current stage of development, such contracts will probably involve primarily digital assets. The parties might, for example, enter into a loan of Bitcoin while at the same time pledging virtual shares as collateral. The decentralised protocol will enable verification of whether the loan is being properly performed. If not, then thanks to the previously established script, the security will be automatically enforced, with verification through the decentralised network, by transfer of the pledged shares to the lender. The whole process would be designed to occur automatically. The intent of the parties to the contract is expressed only at the stage of creation of the script for the contract which is then entered into the decentralised network.

Supporters of smart contracts also foresee the possibility of further growth of this concept and creation of connections between virtual reality and the real world. An example sometimes given is the idea of applying such script to automobile leasing contracts. The vehicles would be connected to the internet, and if a leasing payment were missed the operation of the vehicle would be automatically blocked.

The possibilities for use of the Bitcoin protocol and smart contracts are practically limitless. Further development of such solutions may lead to the creation of an alternative, virtual economy functioning outside state borders on the basis of a decentralised network. (The seeds of such an economy may be seen for example in the latest crowdfunding models, which provide for creation of virtual shares in real commercial entities.)

The challenges presented to the law by the concept of smart contracts are similar to the challenges presented by Bitcoin. First and foremost, smart contracts function in a decentralised network which cannot be assigned to a specific jurisdiction and thus cannot be governed by a specific legal system. Traditional legal systems are founded on the existence of territorial limits of operation. This shows that traditional thinking about the law does not really work when it comes to digital reality, as is already apparent from the difficulties that the law has today in regulating various functions of the internet. Attempts to impose a mindset based on territorial limitations of jurisdiction onto a globalised network can lead to grotesque consequences.

The same dilemma applies to smart contracts. One might attempt to adapt them to existing legal structures and assumptions. For example, the general rules concerning the law applicable to contractual obligations might be applied to the issue of choice of law for smart contracts. But this approach could prove extremely difficult because of the technical aspects of how such contracts operate. It could also be difficult to enforce the law in a decentralised and automated network. On the other hand, the notion that smart contracts are governed by an autonomous legal order, independent of existing traditional systems, may also prove difficult to accept. The reality of a decentralised network has no sovereign who could intervene when needed. Any lawyer who has ever participated in litigation is aware of the nuances surrounding commercial dealings. Because of these nuances, state intervention in commerce is sometimes essential.

Without doubt, the growing popularity of smart contracts will open up a fascinating debate about the nature and future of law, as new IT solutions create a utopian vision of fully automated legal relationships, where algorithms replace the state and the court, and the professions of notary, advocate, judge and bailiff give way to computer scientists.

Krzysztof Wojdyło, New Technologies and Payment Services practices, Wardyński & Partners