‘Smart contracts’ have not yet taken off as a common commercial tool in Australia. In light of this, consideration of the legal, compliance and regulatory implications of smart contracts involves a lot of guesswork. However, with the proliferation of digital currencies, and blockchain technologies, you may soon be asked to use this technology or may wish to trial such a product yourself. In today’s piece, we look at smart contracts definitions, their legal status, and reflect on some recent regulatory changes that might affect your use of smart contracts.
Photo by Matt Barrett on Unsplash
By Dr Drew Donnelly, Compliance Quarter
Smart contracts and vending machines
Smart contracts are not (thus far) creatures of regulation or law, and thus do not admit of a universal definition. In recent times, the term has been used for a computer program, using ‘blockchain’ or distributed ledger technology that replicates many of the features of a conventional contract (for more information, see https://compliancequarter.com.au/understanding-smart-contracts/).
But there are broader definitions too. Sometimes the term simply refers to any mechanism that executes a contract automatically. An oft-used example is the humble vending machine:
The simple electronic mechanism of a vending machine performs two critical functions. First, it directly effectuates performance, by taking in money and dispensing products. Second, it incorporates enough security to make the cost of breach (breaking into the machine) exceed the potential rewards[1]
This feature of a smart contract, to automatically execute contract terms, creates a legal, philosophical and regulatory headache. What if things go wrong with a smart contract? If the vending machine doesn’t spit out your Mars Bar, $2.20 is gone; in the case of a famous Ethereum smart contract bug, tens of millions was siphoned off an investment fund[2].
Legal questions for smart contracts
Without existing case law or legislation, the legal classification and treatment of smart contracts is a matter of academic debate. One interpretation is that, rather than bona fide contracts, ‘smart contracts’, are a form of self-help whereby a party enforces contractual terms themselves[3].
A recent article in the NSW Law Society Journal emphasises some of the challenges for the law[4], including:
- Can parties agree to contractual terms that they can’t themselves read but are specified in computer code?
- How might the courts deal with negligence in the coding of the contract?
- What if the parties to the contract are anonymous and unidentifiable (as in the case of the Ethereum contract mentioned earlier).
Smart contracts and compliance
Leaving to one side the legal questions, how might smart contracts figure in some of the regulatory changes and compliance obligations we have discussed lately?
- The Fintech regulatory sandbox[5]: This could be used to develop and trial an innovative smart contract product without being subject to all the usual licensing requirements for a financial or credit product.
- Innovative energy sale, purchase and metering[6]: In considering any smart contract which automatically terminated energy supply, extreme care would need to be taken to fulfil life support obligations under the National Energy Rules.
- Anti-money laundering:[7] How might you build identification mechanisms into a blockchain and smart contract system to fulfil your anti-money laundering obligations?
- Data Protection: You must ensure with any smart contract that customer data involved or connected to that contract is processed in accordance with the EU General Data Protection Regulation and new data breach notification requirements.[8]
[1] See Werbach, Kevin D. and Cornell, Nicolas, “Contracts Ex Machina” (March 18, 2017). 67 Duke Law Journal, Forthcoming. Available at SSRN: https://ssrn.com/abstract=2936294, p9.
[2] See https://www.bloomberg.com/view/articles/2017-11-16/smart-contracts-are-still-way-too-dumb, for a good summary of the case.
[3] For example, see Raskin, Max, “The Law and Legality of Smart Contracts” (September 22, 2016). 1 Georgetown Law Technology Review 304 (2017). Available at SSRN: https://ssrn.com/abstract=2959166 or http://dx.doi.org/10.2139/ssrn.2842258.
[4] See https://www.lexology.com/library/detail.aspx?g=3747bb11-18ec-4a6a-9182-ac7f84fc7ebe.
[5] See https://compliancequarter.com.au/october-fintech-update-new-fintech-services-products-trialled-regulatory-sandbox/.
[6] See https://compliancequarter.com.au/innovative-demand-response-initiative/ for a summary of some upcoming product trials.
[7] See https://compliancequarter.com.au/austrac-risk-management-tool/.
[8] See https://compliancequarter.com.au/gdpr/ and https://compliancequarter.com.au/tag/notifiable-data-breach/.
