Implementing Blockchain Technology: Understanding Smart Contracts

The term “blockchain” has become ubiquitous in recent months, garnering headlines and social media attention. It also tends to be a source of confusion.

I am often asked whether blockchain is different from bitcoin or whether it has anything to do with the recent explosion of activity in the initial coin offering space. The answer to both these questions is yes, but blockchain technology has applications far beyond these uses, including the creation of “smart contracts”. Many commentators have predicted that, over the next several years, blockchain technology will disrupt industries and transform the way that many commercial transactions are carried out.

What is Blockchain?

Simply put, it is a digital ledger on which transactions can be recorded that is maintained in a decentralized manner rather than in a central location. This ledger is maintained across a network of unrelated computers, called nodes, which are connected via the Internet and which run the particular blockchain software protocol. Transactions recorded to the blockchain are grouped into blocks for processing, with each block containing a cryptographic reference, called a hash, to the previous block of transactions. A block is only added to the chain if the nodes reach consensus on the next valid block. Cryptographic tools used in blockchain software protect the system against hacking, fraud, and alteration.

Smart Contracts

Bitcoin was the first, and is the most well-known, implementation of blockchain technology. However, the technology is still in its infancy and many new applications have been identified, including “smart contracts”. This term can cause confusion, especially among lawyers, such as myself, for whom the word “contract” has a specific meaning and significance.

Essentially, smart contracts are instructions written in computer code that automatically execute when certain criteria are met, using blockchain technology to record and execute the transaction. No intermediaries are necessary to confirm the transaction. For example, a smart contract could be coded to cause funds placed into escrow to be automatically released to a seller of land upon confirmation of filing of the land title documents transferring the property title to the buyer. There are several use cases for smart contracts, such as in the insurance industry, supply chain management, and in the maintenance of certain records, such as real estate and medical records.

These code-based smart contracts are not contracts in the traditional legal sense, which require the elements of offer, acceptance, and consideration. While legal contracts are written and interpreted by people operating within the rules of a legal system, smart contracts are written in code and interpreted by computers. However, a legal contract could be implemented using smart contract technology, which would self-execute the series of actions required to complete the terms of the legal contract. In this scenario, a traditional legal contract would exist alongside the code-based smart contract.

Benefits and Legal Implications of Smart Contracts

A major benefit of smart contracts is automation. Since little to no human action is required, execution of smart contracts should be cheaper, more efficient, and leave less room for human error. On the other hand, this automation leads to interesting ramifications. For example, an error in the code could cause an irreversible erroneous result.

In addition, the use of blockchains and smart contracts in the context of our existing legal system raises new legal issues. For example, as the blockchain is digital and decentralized, parties to a contract and nodes in the blockchain can be located across multiple jurisdictions, raising the question of where a transaction executed on the blockchain occurred. It is therefore important for parties to stipulate the governing law in the smart contract and to be confident this will be honoured by the courts of the various jurisdictions.

Although it is early days, smart contracts have the potential to change the way companies conduct business, allowing for flexible, decentralized, and (hopefully) secure arrangements. Companies ranging from startups to global financial institutions have already begun exploring the possibilities of this brave new world, where computer code can autonomously manage money and execute deals. The ramifications of smart contracts are difficult to predict, but it is safe to say that we are in for some interesting times.