In this article, Syeda Muneera Ali of KIIT School of Law discusses what are smart contracts and how do they work.
What are smart contracts?
- Unlike most legal or semi-legal concepts, the idea of a ‘smart contract’ is a fairly modern and undefined one. However, one might choose to simplify the understanding of a smart contract as, ‘a form of digital contract, that is able enough to implement itself, without the help of a middleman’.
- Basically, a smart contract is in the form of a software, that stores the rules for the negotiations of a contract, checks the contract to automatically verify it, and then executes it, based on what was agreed upon. It, therefore, eliminates the reliance of the transacting parties on a subsequent third party. This leads to an easy and quick way of transacting.
- It is coded as a programme, rather than a conventional legal document. However, what makes a smart contract similar to a traditional legal contract, is that both of these are capable of defining stricter rules and the consequences of a non-performance or undesired deviations.
- Smart contracts use information as input, process it by using certain codes of conduct and regulation, and take necessary action, that may be required to procure a result.
- There is a common misconception that a smart contract is not a legal one, as it does not involve lawyers at any point. This, however, is a myth. As long as there is a right, a duty, an obligation and a remedy, it is a legal contract.
- A smart contract fulfils all the conditions of contract law, and is, therefore, undisputedly legal. It works efficiently with the combination of a blockchain and cryptocurrencies, that act as a major part of the smart contract.
What are blockchains and cryptocurrencies?
To understand the concept of smart contracts, one must first understand what blockchains and cryptocurrencies are.
- A blockchain is a digital database that publicly records all the transactions that take place. It forms a backbone for cryptocurrencies, as ensures transparency and authenticity, without the risk of malpractice, theft or illegality.
- A blockchain is basically managed by a peer-to-peer network, that collectively adhere to a protocol that validates new blocks.
- By virtue of their design, a blockchain is implicitly resistant to any modification of data. Once recorded, the data in any given block cannot be altered, without the alteration of all subsequent blocks and the collusion of the network.
- Functionally, a blockchain can serve as “an open, distributed ledger that can record transactions between two parties efficiently and in a verifiable and permanent way. The ledger itself can also be programmed to trigger transactions automatically.”
- A cryptocurrency is a form of currency that uses cryptography as a way of securing its transactions and thereby validating it.
- One of the most popular cryptocurrency at the moment is Bitcoin. Bitcoin became the first decentralised cryptocurrency in 2009, and subsequently, there have been several other cryptocurrencies that have developed.
- Though Bitcoin is legal in countries like the United States of America, Canada, Japan, Germany, etc., some countries such as Bolivia, Ecuador, Bangladesh, Malaysia, etc., have chosen to ban the same.
A smart contract can function by virtue of a cryptocurrency or a blockchain. Therefore, a successful contract can be executed by the means of the two, and one without the other renders useless.
How does a smart contract work?
A smart contract provides for an extremely simple and quick way of going through transactions or contracts, that are interdependent. To explain in a simplified manner, suppose that there is a car whose ignition is automatically stopped from starting if the owner fails to pay the monthly instalment. Such a situation, where one instance of the contract is interdependent on the other, without the chance of any disruption, is the example of a smart contract. Here, the running of the car is directly dependent on the payment of the instalment. Therefore, this minimises the risk of a breach of contract or an intended malpractice.
- A smart contract functions as a computer code. There are computer programs that are written, in the form of an executable code, that follows the principle of ‘do this, if that happens’. To explain this further, let us look at the following example:
Steve promises to pay $10000/month as rent for Anastasia’s condo, which has a code generated lock system. Following a smart contract, Steve would be able to access Anastasia’s condo with a unique code that is generated on the first day of each month. So, he could only enter his home, if Anastasia has been paid. In this example, it may be seen that there is a co-dependent relationship. If even one part of the contract is unfulfilled, the other is too. So, if Steve fails to pay the rent, he cannot access his condo.
Are smart contracts better than Traditional contracts?
A smart contract differs from traditional contracts because of several reasons.
- To start with, a smart contract is easily understandable and guarantees that no part of the contract remains unfulfilled. It ensures authenticity and prevents frauds.
- In a traditional contract, there is always a risk that the person who is getting into the contract with you, may not keep his/her end of the deal.
- There is always a risk that there would be unfulfilled promises and the struggle of dragging the matter to court, followed by years of litigation and losses. A smart contract ensures that this would not be the case. This is primarily because a smart contract follows their own system of security, whereby there is almost never a chance of fraud or cheating.
- Due to the simple fact that there is nearly never a chance of there being mistakes in terms of computer codes, there is rarely a chance of mistake in a smart contract. It is generally complete and free of loopholes.
- A traditional contract, on the other hand, is manually executed and drafted by another human being. Being physically drafted, there is always a chance of error or ambiguity that may lead to diverse forms of interpretations, with a high chance of manipulation. There is always a chance that a traditional contract would have a loophole that may be eventually used as an advantage for one of the two parties.
- Moreover, smart contracts are self-regulated, whereas a traditional contract may be regulated in court. A dispute arising out of a traditional contract has a greater chance of taking a longer time to get resolved, in comparison to smart contracts. This is primarily because a smart contract has its own way of ensuring fulfilment of the contract, whereas a traditional contract relies on the morality and character of the parties.
- It is also a known fact that a smart contract is cost effective and does not cost a fortune. On the hand, a traditional contract is often excessively expensive, given the fact that it involves lawyers, who are more often than not, expensive. The lack of third party involvement in a case of smart contracts leads to it being a cost effective mechanism.
- A traditional contract is usually time taking and its execution, as well as its remedy, may take time. On the other hand, a smart contract is one that ensures a speedy execution as well as a speedy remedy. One of the main reasons behind this is the fact that a smart contract is self-executive and therefore, the question of a time taking process is null and void.
What is the current scenario of smart contracts in India?
- The concept and idea of a cryptocurrency and a smart contract are still vague. This is because they do not have a legal status in India. There is no definite definition of cryptocurrencies in FEMA, RBI Act or Coinage Act. There is also a long-standing ambiguity as to how a cryptocurrency may be taxed, and who may tax it.
- The ambiguity in terms of taxation, is one of the reasons, as to why smart contracts are not completely recognised in India.
- Furthermore, considering the fact that a smart contract is self-regulated, and takes place on the internet, it also raises questions on the jurisdictions of courts.
- There is also a prevalent fact that traditional contracts often release certain people of liability. In the case of a smart contract that becomes difficult. It is therefore desired that a legal smart contract consists of coded as well as natural language.
- The RBI, in recent news, has issued several warnings, stating that it will not be responsible for frauds or other crimes with regard to cryptocurrencies. It further stated that those transacting via the same shall be responsible for their own risks. This leads to an increased scepticism within the minds of people, who choose to transact using the same.
In a country like India, it is difficult to accept a smart contract as people are more inclined towards the use of verbal language and personal promises. It becomes difficult to execute a contract that is completely devoid of such desires. It will still take a while for people to adjust to the idea that a verbatim relationship is not necessary for a contractual transaction. And, even though it is still a far-fetched reality for people to switch from traditional to smart contracts, we can hope for it to happen sometime in the near future. Undeniably so, it would lead to a greater chance of successful contract executions and lessen the load of the Judiciary.