Smart contracts

This article is written by Shivani Singh, pursuing Diploma in Cyber Law, FinTech Regulations, and Technology Contracts from LawSikho. The article has been edited by Prashant Baviskar (Associate, LawSikho) and Smriti Katiyar (Associate, LawSikho).

Introduction

Blockchain is a term that almost every person has become familiar with and it’s mainly because of cryptocurrency. Both of these terms go hand in hand with each other. However, very few people are aware of the fact that Blockchain technology has applications that extend beyond the world of cryptocurrency. One of the most revolutionary applications of this phenomenal technology, other than cryptocurrency, is the ‘Smart Contracts’. This article will endeavour to throw some much-needed light on this aspect of Blockchain technology. 

What is blockchain technology?

Blockchain or Distributed Ledger Technology (DLT), is a record-keeping technology that stores the information provided in a block (each of the blocks has a storage capacity), and once that block is filled to its capacity, it is then added to the chain that already has a number of information blocks in the chronological order. The following are the unique features of this technology.

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Distributed or decentralized

Blockchain technology stores data very differently from the other databases, as the computers that store the data are not under the control of one individual or group, the information or data is distributed across various computers, all of which are operated by different individuals or groups. So it is a decentralized ledger for the storage of data or information, which makes it very transparent and the information stored is less vulnerable to attacks. 

Immutable

Another distinctive feature of Blockchain technology is that the information that is stored in it cannot be reversed or changed. This feature almost guarantees the authenticity of the data stored in it, as no one can manipulate the data even if they want to. If any person would endeavour to tamper with the data stored in one block then all the other blocks will cross-reference, as each block has a cryptographic hash of its previous block to point out the block with the incorrect data.

Transparent

The data stored in a Blockchain can be easily accessed by anyone either having a personal node or via Blockchain explorer. It does not have one central point where all the data is stored like databases. Therefore the level of transparency is pretty high in this technology.

What are ‘Smart Contracts’?

‘Smart Contracts’ are self-executing contracts that use Blockchain technology to store the terms of the contract in the form of codes. The terms stored in the blocks act as triggers or pre-determined conditions, so when any of the terms is fulfilled then the part of the contract that is dependent on its fulfilment for execution, gets automatically executed. This eliminates the role of an intermediary to oversee the execution of the contract and therefore, saves a lot of time as well as money. All the participants of the contract remain ensured that the contract will get executed the moment the conditions precedent are met, as the workflow is automated. 

How does a ‘Smart Contract’ work? 

In 1994, Nick Szabo (an American computer scientist, who invented virtual currency called ‘Bit Gold’ in 1998) suggested that Blockchain technology could be used for smart contracts because of its decentralized nature. A Smart Contract works on the algorithm or statements of ‘if/when/then’, which are written as codes on the Blockchain. It is simply a program that runs mostly on Ethereum Blockchain and is stored in a specific address on it. Ethereum has developed the Solidity language to write smart contract applications. All the transactions with respect to the contract are deployed on the network, instead of being controlled by a user. The smart contracts can be interacted with by a user account by submitting a transaction which will then execute a term defined on the smart contracts. A smart contract, as Nick Szabo says, is like a vending machine, where if there is the right input, a certain output is assured. The same logic is employed in smart contracts. The whole working of smart contracts can be laid out in the following steps.

Determination of terms

The parties will firstly negotiate and decide the terms of the contract.

Translation of terms

The final terms of the contract are then translated into codes. The codes constitute all the variables or conditions that could be posed by the transactions undertaken by the participants and its designated output for the future transaction. 

Test and review of the codes

The logic used in the codes are then tested by the person writing the codes. The codes are then sent for review by the internal experts of the parties.

Storing of codes in Blockchain network

The translated codes are then stored on the Blockchain network and distributed or replicated among all the participants on the said network so that each one then has identical access to the terms of the contract and the further activities with respect to it.

Execution of codes

Once all the participants receive the codes, then their respective systems run the codes. The system is configured in a manner that it can listen to any update in the transaction from a cryptographically secured streaming data source, which in common terms is called ‘Oracle’.

Verification of the terms

Now if any of the terms of the contract is realized, then its verification by all the participants on the network is required. Therefore, when the fulfilment of a term is verified by all the participants on the network then that particular transaction corresponding to the term satisfied, will automatically get executed.

Let’s take an example if two parties enter into a contract for the supply of medical equipment. The terms are written in the form of codes and stored on Blockchain. The smart contract will track the delivery of the medical equipment to the ‘buyer’. Once the delivery is fulfilled, the smart contract will automatically release the payment to the ‘supplier’, without any intermediary interference. 

What is the legal validity of a Smart Contract?

A smart contract can be legally valid if it fulfils all the requirements of a valid contract under the contract law of the said country. If we are to take the example of India then, under Section 10 of the Indian Contract Act, 1872, the following requirements are given for an agreement to become legally binding: a) competent parties, b) free consent, c) lawful consideration, d) lawful object, and e) not expressly declared void.

Therefore, if we analyze a smart contract based on the prerequisites mentioned above, it can be legally binding as long as it fulfils all the requirements. Moreover, it must comprise an offer and acceptance between the parties. A smart contract typically stores the obligation and consideration part of the contract because it has been designed for execution.  So, the other standard and boilerplate clauses can be mentioned in a paper-based contract. The paper-based contract and the smart contract can together form a valid contract. Although it is not mandatory to have a text-based contract attached to the smart contract, it is an ideal scenario.

Are Smart Contracts conceivable without Blockchain? 

The answer is ‘yes the smart contracts are conceivable without Blockchain’, but it requires a little more elaborate explanation. There are smart contracts already in existence that are up and running but the only difference is that they are run on a centralized system. The advantage of this type of smart contract is that it reduces the cost and energy consumption as it does not require all the information to be recorded on all the systems present on a particular Blockchain network. However, it is pertinent to keep in mind that the smart contracts created on Blockchain technology offer security and transparency which the smart contracts deployed on a centralized system can never ensure. Therefore, the question an organization or individual needs to ask before choosing between either of them is; what is their priority? Cost or security? The choice will really depend on the priority and the requirements of the parties. 

Conclusion

The application of Blockchain or Distributed Ledger Technology in smart contracts is, without doubt, phenomenal and ingenious. This technology not only automates the entire process, thereby reducing time loss and cost of intermediary, but at the same time provides a double layer of security that ensures transparency in the transactions involved in the contract. It presently remains in the experimental phase in most industries, for the complications involved in deploying and managing a smart contract acts as the deterrent. Also, the smart contracts are created in the form of codes so the non-technical parties will require the assistance of an expert in order to confirm that the translation of terms of the contract into codes is accurate. This may create reluctance among parties to endeavour to move from traditional contracts to smart contracts. 

The solution here might be to start using the smart contracts based on Blockchain in bits and pieces, without trying to leverage this technology to completely capture a contract arrangement. The potential use of this technology in real-time auditing and risk management is revolutionary and therefore, will be beneficial for the purposes of compliance. This technology is here to stay and no area is going to stay untouched. Smart contracts are definitely going to transform the role of lawyers and other intermediaries involved in the process of contract formation and execution, beyond the traditional boundaries. The sooner we realize this, the sooner we can start adapting to this change. 

References

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