Understanding smart contracts

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By Dr Drew Donnelly, Compliance Quarter.

Continuing in our series of posts on blockchain and related financial technology, today we look at how blockchain might facilitate a new legal instrument; smart contracts. We define smart contracts, provide an explanatory example and look at some of the inherent limitations of the instrument.

A smart contract is…

To understand smart contracts, it is useful to think about blockchain again and how it facilitates the transfer of digital currency (sometimes called ‘cryptocurrency’). Blockchain is a distributed ledger or network with an inbuilt process for validating transactions and permanently recording them. Through its inbuilt verification process, the blockchain can validate the transfer of a currency such as bitcoin or ethereum from one person to another.

Consider, however, that the transfer of money (or other items of value) often occurs in return for something else, and under certain conditions. I.e. it happens according to the terms of a contract. A smart contract is a computer program, using blockchain technology, which replicates many features of a conventional contract.

…a blockchain application with some key advantages…

Last month we talked about changes to the Personal Property Securities Act 2009 (see Hire and Rental Businesses take note: PPSR changes), to exempt certain businesses from compliance requirements under that Act. Imagine a case though, where a business wanted to sell an item while retaining a security interest in the item. In our example today, that item is a ‘smart’ or ‘internet’ refrigerator, with payments to be made in installments. Here is how a smart contract could capture this transaction.

A small computer program would be ‘inserted’ into the blockchain with the following features:

  • Payment (in digital currency) is automatically transferred to the vender at a certain time fortnightly.
  • The security interest in the refrigerator is automatically registered on the Personal Property Securities Register (PPSR).
  • The refrigerator is programmed to automatically turn off five days after a missed payment.
  • A history of missed payments would automatically update the individual’s credit history on the blockchain.

 

Such a contract would have certain advantages over a conventional contract:

The security interest would be not only validated by the PPSR, but by the blockchain itself making it almost impossible for others on the blockchain to register a fraudulent security interest.

Enforcing some contractual terms would be far easier and less costly. For example, the refrigerator automatically turning off would presumably reduce the likelihood of needing to repossess the item.

…and limitations, compared to conventional contracts.

One practical problem for implementing smart contracts, illustrated in the refrigerator example, is the sheer number of different players that would need to become users or ‘nodes’ on the blockchain. For example, the buyer, the seller, the manufacturer (to program the refrigerator in accordance with the contract), credit agencies and the Australian Financial Security Authority (as administrator of the PPSR) would all need to be involved.

Furthermore, smart contracts, like the one in our example, do not eliminate the need for lawyers and other professionals for contract negotiation, creation or enforcement. Just as with a conventional contract, legal advice will be essential in negotiating the terms of the contract. The smart contract simply executes some of the terms that the parties are already willing to agree to.

Furthermore, there are a range of contractual terms and enforcement actions that, by their nature, cannot be automatically executed. For example, enforcing a force majeure clause in a contract requires interpretation of what is an unforeseeable circumstance preventing the enforcement of the contract; this requires actual human judgment.

In our next article on blockchain, we will continue our discussion of its various applications by addressing the complexities of regulatory compliance for blockchain.

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