By: Robert C. Hackney
A term thrown around a lot lately is “smart contract.” This blog post will help you, as a business owner, to evaluate whether or not smart contract technology makes sense for your particular business and/or your industry. There is great potential, but as in all things, there is also great risk, and lots of potential pitfalls. Lawyers know what contracts are and have been over the years. Now we are faced with a variation that is different in many ways from what we have become accustomed to in the practice of law, so while the concept sounds great, make sure you have a comfort level before jumping in.
What is a Smart Contract?
In the most basic generality, a smart contract is simply a computer program. A particular program would become part of a distributed ledger by being layered over the distributed ledger. That program, as a smart contract, would automate the execution of the terms of the contract. For example, if interest payments are called for, it could automate the payments, and monitor any preconditions in the contract.
By using smart contracts, the need for a third party intermediary could become unnecessary, or limited. The most interesting part of a smart contract arrangement may be its ability to handle dispute resolution. This situation would involve a third party, but in a limited way. Let’s say we have two parties who want to contract for services for a particular project. They agree upon a certain price and terms. They enter into a smart contract, and appoint an arbitrator in advance. Party A, who is hiring Party B to do the work, deposits the payment in an account that can be viewed, but not accessed for transfer by Party B. Party B knows that the payment is available when the work is done. Party B then completes the work. If Party A accepts the work and is satisfied, then Party A give Party B a computer key to access the funds. If Party A thinks the work is deficient under the terms of the agreement and does not want to pay, Party A contacts the arbitrator, who also holds the key to release the funds. The arbitrator can review the situation and either decide to release or not release the funds to Party B.
All of that really sounds pretty simple, so why would you need a smart contract to do that? Couldn‘t you just pick the arbitrator in advance and confirm payment in a more traditional way? Of course, but think about this in a multi-party situation with multiple trigger points and benchmarks and it becomes a better solution than the traditional protocol. With multiple computers running on a blockchain and all participants being able to verify multiple payment streams over a distributed ledger it becomes easier to understand how you can eliminate some of the complexity of monitoring and enforcing a complex contract.
The Question of Interoperability
In the computer world, as we all know, there are frequently interoperability issues between different systems, and to address those issues a group has been formed known as the Smart Contracts Alliance. This group was formed by a trade association which itself was created solely for the blockchain industry, the Chamber of Digital Commerce.
The avowed purposes of the Smart Contracts Alliance are to educate the business community about smart contracts and their benefits, and to promote the adoption of technology standards. The website for the Alliance can be found at: http://digitalchamber.org/initiatives/smart-contracts-alliance/
Security Issues with Smart Contracts
On the issue of security, Microsoft has formed a working group that it calls “Kinakuta.” As secure as smart contracts are, or are supposed to be, there have been security failures in early projects. To address this issue, Microsoft has brought together a community of experts. The Kinakuta nickname is a reference to a fictional island nation that is featured in Cryptonomicon, a 1999 novel set in two different time periods, and relates to computer technology and the Internet.
For lawyers involved in business transactions, keeping track of their paper trails is critical. By digitizing the paper trail using the Blockchain, then everything changes. A prime example of this application is a firm named Stampery. Stamperty says it is a leader in blockchain based data certification. In essence, Stampery is a digital notary. The company focuses on proof of ownership of assets; proof of existence at a given point in time, ie: a time stamp; proof of integrity so data is secure; and proof of receipt to show that a communication was in fact received at a particular time.
Want to prove that a marriage actually took place? Want to prove that two parties actually signed a contract? Want to prove you owned that expensive painting when you need to file an insurance claim? Digital proof though smart contracts will even assist in administering litigation. Recording these kinds of transactions on the blockchain connects them to the blocks before and after, and time stamps when it all occurred.
Who are the three biggest categories of users of Stampery? The answer to that is easy, first, lawyers looking to certify documents, two, artists, authors and playwrights protecting their creative products, and businesses time stamping their intellectual property.
Smart contracts go hand in hand with smart assets. There are millions of pieces, parts and components traveling through the supply chains of the world. What if they were being recorded in near real-time on a shared ledger? At this point in time, bills of lading and letters of credit have to be recorded and documented against asset movements. If these were digitized on a blockchain, the entire existing system would be turned upside down. Under this scenario, supply chain management becomes a whole different animal.
A leader in this space is WAVE. The company says that it “connects all members of the supply chain to a decentralized network and allows them a direct exchange of documents. WAVE’s application manages ownership of documents on the blockchain eliminating disputes, forgeries and unnecessary risks.” WAVE operates a decentralized network that connects all carriers, banks, forwarders, traders and other parties of the international trading supply chain.
Systems like the one that WAVE uses are not limited to recording basics such as serial numbers and value, but a lot of other information about that asset. The information on their blockchain can tell who is sending it, where it is going, how it is connected to other assets in the supply chain, the forwarding agent information, tax and government clearance information and any other pertinent information about the asset. This smart asset tracking system, residing on the blockchain, cannot be tampered with, changed or destroyed. The international supply chain process could undergo a massive disruption.
What about hard assets like diamonds? A company named Everledger catalogs diamonds. Their website proclaims “We collect an asset’s defining characteristics, history, and ownership to create a permanent record on the blockchain.” Founded in April 2015, they have already catalogued over 1,000,000 diamonds, which can now be traced in the future. This way the ownership can be traced like real estate titles, and insurance companies can be assured of what assets they are insuring. Along with the standard serial numbers and four Cs of diamonds, the system catalogs them by 40 metadata points, so there is a digital footprint of each diamond. Everledger has visions of applying this process to other luxury items like expensive watches, designer handbags and fine art.
Speaking of fine art, or any art, Ascribe uses a blockchain protocol for artists and creators of other intellectual property to upload a digital image and store it on the blockchain, which creates a record of when it was uploaded and by whom. Once you have registered it with Ascribe, it can be loaned to people or even transferred to another user. Ascribe refers to itself as a “notary and timestamp for intellectual property and creative works.”
Legal Issues in Smart Contracts
For lawyers, smart contracts provide lots of issues. While a smart contract can provide for automatic payments, proof of breach, and mathematical certainty (did you make 120 payments or 119?), will it result in more or less litigation? As a more efficient system, you would assume it would be less, but that may not be true. Today about 75-80% of contract breaches don’t result in litigation because the expense is viewed as too great, and the evidence versus the levels of proof create uncertainty. With certainty based on the blockchain, will more people sue or less? How will the court systems relate to blockchain? Will the courts accept the mathematical certainty provided by the blockchain? Since blockchain technology will undoubtedly increase the number of cross-border transactions (since the trust issue will be solved), will that create jurisdictional issues, service of process issues and venue issues for the courts to determine?
Problems and Pitfalls
There are huge differences between public blockchains and private blockchains, and some of the biggest differences are in the infrastructure and in the energy consumed in the process. The original concept of the blockchain involved a transparent system open to everyone, ie: a public blockchain. That means that a massive amount of computing power is needed to run this system so that it is available to all. Along with computing power comes the issue of electricity usage, no small issue when you are talking about thousands of computers. As a blockchain grows, the need for more computing power and more energy to keep it going grows with it. This is not a minor problem and researchers are working to overcome this issue.
Government intervention could also be a major stumbling block. Again, this may become an issue that emphasizes the difference between public and private blockchains. When you are dealing with public access to any system, it becomes more susceptible to government intervention and interference. One thing lawyers like me know from our experience is that legislators love to legislate and regulators love to regulate. While it gives them something to do and appears to justify their existence, they do not always know or comprehend the effect of their actions. The law of unintended consequences runs rampant among this group. Could they kill, delay or disrupt blockchain technology through regulation? Will there be competing regulation throughout the world? While computer programmers talk about interoperability of systems, the legal issue is regulatory interoperability. Blockchain technology is a square peg, and regulators only have round holes. How will they try to make this technology fit? Will they drill some square holes or just try to jam it into the round ones and really create a mess?
Who are the Winners in Smart Contract Technology?
Will the benefit go to major corporations at the expense of the public? While the concept of the blockchain is designed to be ubiquitous, transparent and open to the world at large, the creation of private blockchains keeps the power in the hands of the large companies. We have seen many small start up companies vying for space in this sector, but we also see the IBMs, JPMorgans, and similar massive companies who have recognized the importance of the blockchain and are battling for their piece of the action. Since they are bigger, stronger and richer than their competitors, will they completely privatize blockchain technology and usurp it for their own purposes?
Will the blockchain create more jobs, or deprive the world of the old jobs? Will the efficiencies of the blockchain have a negative effect upon employment? Will the blockchain make those companies that control private systems much more wealthy at the cost of loss of work for middle and working class families? Will the blockchain create more opportunities for employment than exist now?
Today there are a number of working groups, consortiums and companies that are attempting to create a consensus as it relates to operating standards. In the old days, when we had these things called videotapes, the big standards debate was which one would win, which is better, VHS or BetaMax? Most people of a certain age agree that BetaMax was a better quality product, but VHS became the standard. (Today, of course, most people alive would ask what videotape means, since no one left in the world uses these systems.)
To tame a little bit of the wild west, and promote a lack of chaos, the internet dealt with similar issues by coming up with ICANN (Internet Corporation for Assigned Names and Numbers). At this point there are a number of groups trying to become the standard setters in the blockchain world. Will one be successful or will there be a hodgepodge of standards? Time will tell.