How far are smart contracts from real-world laws?

Rage Comment : The author of this article, Josh Stark, is a lawyer and the head of operations and legal affairs at Ledger Labs. He uses this article to explain his understanding of the application of blockchain technology in the legal field. He believes that blockchain technology will definitely subvert the legal and business fields, and it has great advantages over traditional contracts. However, the two major defects of smart contracts currently make it just an idea, but the development of blockchain technology makes it possible to solve these two defects. Therefore, the subversion of traditional fields by smart contracts is actually not far away from us.

Translation: Annie Xu

Josh Stark is an attorney and the head of operations and legal affairs at Ledger Labs, a consulting firm and research and development group.

This article presents Stark’s personal opinion, focusing on “smart contracts” as an alternative form of legal agreement and its expected impact on the legal field in the future.

Over the past year, the concept of “smart contracts” has received renewed attention in both the legal and business communities.

The development of blockchain technology has led some to believe that smart contracts will soon replace traditional business and financial agreements, bringing about a huge change in the legal and financial industries. Although this exciting prediction is still immature, most people in the legal profession are still ignorant of this important emerging technology and its long-term impact on the legal profession.

In this context, "smart contracts" refer to the use of computer code to explain, verify and execute contracts between parties; while typical contracts are drafted in natural language, the terms of smart contracts are expressed in code, similar to programming languages ​​such as javascript or HTML.

The contract is then “executed” by a computer; given the terms of the agreement and a set of defined inputs, the smart contract automatically executes the terms.

Readers familiar with blockchain technology will know that the concept of "smart contracts" is generally used to refer to any program or script running on a blockchain; however, for the purpose of this article, we will focus on the narrow interpretation mentioned above: replacing traditional contracts with contracting parties with code.

The origin of smart contracts

Nick Szabo

The concept of "smart contracts" was first popularized by computer scientist Nick Szabo, who said in his 1997 article "The Idea of ​​Smart Contracts" that vending machines are the simplest form of "smart contracts", which are mechanical devices that transfer ownership of goods after receiving certain defined inputs (US$1.5). Because the machine controls the property itself through physical sealing, it can execute the terms of the "contract".

To further explain the concept, Szabo pointed out that computer code can replace mechanical devices to conduct more complex digital property transactions; instead of transferring ownership of physical goods, smart contracts transfer physical assets, equity and intellectual property. The program will define the "inputs" required for the execution of the contract, such as payments, board votes or anything else that can be represented by code.

Take a basic option contract as an example. A call option contract allows the holder to buy a certain amount of securities at a certain price. For example, Alice buys our "smart option contract" from Bob, which allows Alice to buy 100 shares of Bob's stock in Acme Inc at $50 per share. This contract has a certain expiration date, and after it expires, Alice can no longer buy shares at the defined "strike price".

Here we show you in pseudocode what a simple "smart options contract" looks like:

contract Option {

strikePrice = $50

holder = Alice

seller = Bob

asset = 100 shares of Acme Inc.

expiryDate = June 1st, 2016

function exercise ( ) {

If Message Sender = holder, and

If Current Date < expiryDate, then

holder sends($5,000) to seller, and

seller send(asset) to holder

}

In the first part, the smart option contract defines the relevant terms, the contract assets, the exercise price, the identity of the contract parties, the validity period of the contract, etc. Then, the function we call "exercise" allows the holder to buy shares at the exercise price before the contract expires.

This function first checks whether the person initiating the transaction is the stock holder (Message Sender), and then checks whether the contract is within the validity period.

If both check out to be correct, the contract is immediately executed, transferring cash from the holder to the seller and assets from the seller to the holder according to the terms of the contract.

Two major challenges

Until recently, smart contracts have been little more than theoretical, and generally speaking, there are two major challenges that need to be addressed before smart contracts can be used in the real world.

First: How can smart contracts actually control physical assets to ensure effective execution of contracts? Back to Szabo’s example, vending machines control property ownership by storing goods inside, but how can the code do that? In the above options contract, the “exercise” function transfers assets and cash between contracting parties; but how can a computer program control real-world assets such as cash and shares?

Second: How can computers enforce these terms to gain the trust of the parties? The parties should not need to approve the contract code and the computers that interpret and execute the code. So, at least there should be a shared standard that the parties can use in a verifiable way. Ideally, the parties should not need to personally inspect the problematic computer.

The emergence of blockchain technology

In the past few years, solutions to these two problems have begun to appear in people's sight, and emerging research and development around blockchain technology may provide the basis for the future realization of smart contract applications.

The first application of blockchain technology was the digital currency Bitcoin, which became famous for the anonymity of its creator and its sudden appreciation in value at the end of 2013. In the past few years, its underlying blockchain technology has been frequently studied and improved for use in areas other than digital currency. Startups, open source communities, large financial institutions, etc. have begun to improve and expand the technology in order to one day enable the trading of fully digital assets.

Blockchain is an authorized database that is maintained and upgraded in a way that gives it a high degree of credibility. Blockchain is not controlled by any single group, and no enterprise, individual or organization has supreme control over the blockchain.

The blockchain is maintained, updated, and secured by a network of participating computers.

Each computer holds a complete copy of the blockchain database, and a cryptographic execution rule system called a consensus algorithm synchronizes and saves the database of each computer.

Most importantly, blockchain is an append-only database, which means that once information is added, it cannot be removed. A cryptographic process called hashing keeps blockchain updates secure because it allows the network to detect and prevent any attempt to modify the database.

In this way, blockchain lays the foundation for the recording and transfer of fully digital assets.

Because the information stored in the blockchain is always synchronized, there is only one true record of ownership, which effectively prevents the double payment problem of assets that has been rampant before. Because the blockchain is immutable and the mathematical algorithm makes the interested parties believe that their ownership records will always be kept intact.

New solutions are emerging

Although blockchain technology is still in its early stages of development, many people believe that if blockchain can create a secure digital asset trading platform, the two major challenges facing smart contracts will be solved.

First: Smart contracts require computing code to control real assets. Through fully digital assets, blockchain enables computer code to control assets. On the blockchain, the control of assets is the control of the key corresponding to the asset, not any physical object.

Therefore, in the above case, the option contract can control the assets associated with the contract without the need for a custodian. Once the "exercise" function is activated, the code execution can complete the asset transfer without any human involvement.

Second: Smart contracts require a "trusted computer" to execute the terms of the contract, and blockchain can play this role. Today's blockchain is no longer limited to the function of a database, but also a distributed computer that can execute code and record asset ownership.

Our "smart options" can be uploaded and stored in the blockchain and executed according to instructions.

The blockchain’s unique ability to record asset ownership also makes it suitable for executing smart contracts. Once the blockchain records the contract code, the parties can be sure that the contract cannot be changed.

The impact of smart contracts is coming

Blockchain smart contracts may not be as far away as we think.

Banks, exchanges and other financial institutions are actively developing blockchain technology, hoping to record and trade real assets in the blockchain system. Nasdaq has partnered with blockchain startup Chain to develop and test a private market options trading platform.

The next-generation open-source blockchain called Ethereum hopes to become the cornerstone of non-traditional decentralized commerce. A blockchain consortium of 43 banks and blockchain company R3 have begun working together to develop a blockchain-based industry-shared platform in an effort to revolutionize the way financial contracts are executed.

In the next few years, we may see fully digital assets traded on blockchain networks, with the terms of the transactions executed by code.

This impact is not limited to financial contracts, although finance is the most obvious use case. The technology to record and trade different types of assets on the blockchain is still under development, and the potential applications of smart contracts will continue to increase.

If smart contracts become widely used, the nature of business and commercial transactions will change. The software advantages that have transformed many industries (automation, speed, predictability) will eventually benefit the legal field.

Writing contract terms in code rather than natural language brings predictability and clarity to contracts. Smart contracts can be tested with any input information, that is, with any important facts that become information input. This allows lawyers on both sides of the transaction to know how the contract will be executed and its possible calculation results.

For example, in the smart option example above, each Alice and Bob can run the contract in a simulated environment and test any possible input. Although such a simple case does not require a smart contract, imagine a contract with thousands of inputs, not to mention that many complex financial contracts have a large number of nested "if-then statements".

These complex contracts can also be tested using code-defined inputs. Software developers test their code with various possible scenarios to find loopholes; lawyers can do the same and reduce their legal fees if both parties to the contract are more aware of their trade risks.

It is subversion, not replacement

Of course, smart contracts will not completely replace natural language laws.

Many types of contracts cannot be fully expressed in code or executed by computers, such as those that involve human performance rather than the exchange of dematerialized assets.

Even fully self-executing contracts will very much need to refer to legal text and concepts that define the rights of the parties to the contract, as the parties may encounter litigation. The emergence of smart contracts will bring about a re-evaluation of common practices, as lawyers and clients discover the types of contracts and terms that code is most suitable for; and ultimately decide which contracts are suitable for natural language and how to combine the two to achieve the best results.

Smart contracts are still science fiction at the moment.

But for the first time, the technology is emerging that could enable the commercial use of smart contracts; and while that day is still years away, legal professionals would be wise to consider the impact of these innovations on their business.

When smart contracts are truly applied one day, I hope there will still be lawyers available in law firms.