Smart contracts for finance parties
03 May 2017
WHAT IS A SMART CONTRACT?
"Smart contracts are neither particularly smart nor are they strictly speaking, contracts." – Monax.io
A smart contract is a set of promises, agreed between parties and encoded in software, which, when criteria are met, are performed automatically. The concept of a smart contract is used to cover a spectrum of scenarios – ranging from a contract which is completely encoded (ie the entire contract is contained in the code and there is no separate natural language agreement) to a contract which is encapsulated in natural language form but where performance is digitised.
Smart contracts were written about in the 1990s by Nick Szabo, and have received renewed interest recently as a result of the "blockchain revolution" stemming from the technology underlying Bitcoin. Smart contracts do not need a blockchain to work, but they do need an underlying trusted network or mechanism, which blockchains provide conveniently and efficiently.
SMART CONTRACTS IN A FINANCE CONTEXT
There are a number of possible uses to which smart contracts could be put in the finance context, eg: proxy voting, the settlement of securities, payments under a derivatives contract and the recording of financial data. However, smart contract technology is still in its infancy and is unlikely to be deployed for complex and elaborate agreements yet. In the immediate future, smart contracts will most likely be used for relatively simple, standardized tasks, such as straightforward payment flows, identity verification or index pricing. Agreements that contain necessary ambiguity (eg "best endeavours") or contingencies that cannot be easily coded should remain in traditional written form. However, for parties who require certainty of performance, smart contracts represent a great opportunity for process innovation.
To demonstrate, consider the example of a trade financing contract. Under a basic trade financing agreement, an import company’s bank will provide a letter of credit for the benefit of the exporter. This provides the exporter with payment assurance, following the satisfaction of certain evidentiary requirements of shipment (such as the presentation of a bill of lading). There may also be related financing arrangements, such as the exporter’s bank providing a loan on the basis of the export contract, or underlying insurance contracts.
This existing trade financing process contains its own difficulties and inefficiencies, such as verification by correspondent banks in the export bank’s country, and broader issues of timing, veracity and documentary trust. The reliance on documentary evidence can lead to fraud and inefficiencies, such as duplicative financing. These inefficiencies have been cited as a leading example of a use case where smart contracts can assist. In fact, a trial of a cotton trade agreement has already been completed successfully.
With a smart contract, the financing process can be streamlined by hardwiring the various elements of the agreement into code which executes automatically. For example, the goods could be scanned upon arrival at the destination, which would automatically send a signal to the smart contract which would, upon receipt of that confirmation, automatically authorise the release of funds to the exporter. In addition, if the parties wanted further assurance of delivery, the goods could also be geo-tagged so that the smart contracts would only trigger the release of the funds upon receipt of two confirmations: (a) the scan of the goods upon arrival, and (b) the geo-tag signalling its location is correct.
SMART CONTRACTS REVERSE THE LITIGATION BURDEN
A key distinction with a smart contract is the reversal of the burden of litigation – a "wronged" party under a smart contract will have to sue to reverse performance and claim damages, instead of suing for failure of performance and a claim for damages.
This is because a smart contract entails the automated execution of an agreement. A key question for parties is whether the automatic performance of certain contractual terms is appropriate for their circumstances. To demonstrate, consider the following three outcomes for our trade financing contract – in all of them both goods and delivery have already been made under the smart contract.
The smart contract has worked as both parties intended: No dispute as the parties are satisfied and do not require legal recourse. This mirrors the outcome in a trade financing documented under a traditional written form.
The smart contract has worked as only one, but not both, parties intended: This differs from a trade financing documented under a traditional written form as the burden of litigation has now been shifted. Under a traditional written form, an exporter would have not complied with the terms of the contract if such delivery did not accord with the exporter’s understanding of the contract (or perhaps the exporter may rely on a contingency clause, such as a material adverse change clause). As a result, the importer would sue to enforce the contract seeking damages in lieu of performance (or in rare cases, specific performance). However, under a smart contract scenario, performance has occurred. Thus, if the exporter wishes to challenge the result, it is now the exporter who must sue to reverse the performance or seek damages for its loss.
The smart contract has worked as neither party intended (whether through a mistake in the code, a misunderstanding of the code, or any other reason): Under a traditional written form, it is highly unlikely the parties would reach this outcome as they simply would not have performed in a manner adverse to their own understanding. In addition, the remedy of contractual mistake would be available to the parties to rescind the contract. However, under a smart contract scenario, the trade financing has been performed regardless. Thus, the parties would have to engage in returning the delivery and reversing the transaction as best they can, with all the complexities and difficulties that such a process may entail. They may have a cause of action against the developer of the smart contract, depending on the relevant law and factual circumstances, or they may seek to void their contract on the grounds of mistake, as well as seeking recourse against their counterparty. It is worth noting that this potential risk that smart contracts introduce, the risk of coding error, is by and large novel territory for contract law.
HOW THE LAW VIEWS SMART CONTRACTS
A smart contract is not necessarily a contract at all – it depends on the relevant applicable law to determine whether a contract has been made, just as with any other type of alleged contract. Contract law in many jurisdictions has proved adept at evolving to cope with different ways of forming contracts (eg by email) and smart contracts are unlikely to be any different. Key contractual concepts vary by jurisdiction but concepts such as capacity, offer and acceptance, consideration, intention to create legal relations, certainty of terms etc can all be moulded to adapt to the new world of smart contracts.
Most legal systems will require the answer to the following questions, or a variation of them, in order to ascertain whether a smart contract has been made:
- Does the smart contract code purport to be the complete record of the parties’ agreement (ie the smart contract is the contract in toto) or is the purported smart contract code part of more traditional natural language documentation?
- Has the contract been legally formed? This will depend on the formalities required in each jurisdiction, and will depend on factors such as:
- Can the parties be identified? Identifying the parties could be an issue if the parties are only identified by public/private key cryptographic technology, as is usually the case in a blockchain environment.
- Do the parties have capacity and have they consented?
- Is there an intention to create legal relations?
- Is there an offer and an acceptance?
- Are the terms of the contract sufficiently certain and lawful?
- What consideration has been provided (common law)?
In addition to contract law issues, parties may also need to consider regulatory requirements specific to their industry or jurisdiction.
Smart contracts that purport to agree further agreements
A smart contract can either be initiated by the parties, or be the result of a "follow-on" contract, namely one that has been brought about by the original smart contract itself (ie the smart contract purports to cause the parties to enter into further agreements). But does a piece of code have the capability to contract on its owner’s behalf? Would a blockchain node have the requisite legal capacity to enter into a contractual arrangement with another autonomous system (eg a smart home hub entering into a smart contract with a home security system on the internet of things)? These circumstances have not yet been explored in depth.
Smart contracts may also give rise to new factual scenarios that would constitute a termination event. For example:
- frustration – the contract becomes incapable of performance under the circumstances, such as a coded reference price index no longer being available;
- impossibility – the contract becomes impossible to perform due to underlying circumstances;
- mistake – the parties being mistaken as to the underlying law or facts applicable to their agreement, such as an unintended coding error;
- hardship (civil law) – parties could try to challenge the application of the contract on the grounds of hardship (ie performance of the contract is excessively onerous for a party);
- misrepresentation – one party misrepresents relevant facts to the other, inducing them to enter into the contract, such as a misrepresentation of the effect of the smart contract’s coding; or
- illegality – a jurisdiction bans the use of smart contracts or the basis of the agreement is illegal.
For a party who terminates their agreement, remedies are traditionally limited to the undoing of the contract (ie voiding or rescission of the contract), and a claim for damages. As noted above, the key distinction with a smart contract is the reversal of the burden of litigation. This shift is an important one, as although courts are empowered, in certain circumstances, to force “specific performance” by a party, it is a remedy that is rarely imposed. It is this fundamental innovation which promises to tie contractual agreements closer to their real world execution, and in the process provide parties with greater certainty of outcome than existing contract law can provide.
Smart contracts create significant opportunities for business but also create new risks. On the one hand, they will automate processes, reduce human intervention error and fraud, and provide outcome certainties. On the other, coding complex agreements to ensure that all contingencies have been captured represents a significant challenge. The stakes for such a challenge are raised by the automation element and the reversal of the litigation burden that results. It is likely therefore that smart contracts will walk before they run, and initial proofs of concept and trials will automate simple processes, before more complex agreements are attempted.
Parties who are considering the use of smart contracts should take practical steps to limit risk where possible, such as providing for renegotiation or automatic termination upon certain thresholds or timing, fallback plain-language terms and conditions, and a security audit of the underlying code.
Smart contracts demonstrate great promise for parties who understand their purpose, but it is important that parties recognize their limitations before they deploy them, and ensure their counterparty does likewise. While the development of contract law may have reduced the importance of the traditional “buyer beware” and “seller beware” maxims, they remain the most sensible advice for users of smart contracts.
For a pdf version of this article, please click here.
Authors: Conor O'Hanlon, Eric Roturier, Jason Rix
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