How smart are Smart contracts in 2019?

Lawyers often enjoy making the “joke” that smart contracts are neither smart nor represent legally binding contracts. Smart contracts are self-executing business automation applications that run on a decentralised network, such as a blockchain. Smart contracts complete pre-determined conditions. Such a merging of law and technology requires lawyers and technologists to find new ways to work together. Therefore the real question seems to be – how “smart” are smart contracts?

Smart contracts are neither smart nor legally binding contracts!

Smart contracts appear, for the moment, to be suited to implement simple legal contracts or transactions that have clear parameters or requirements on the relevant parties/users and clear termination or exit provisions.

Sample uses:

• Slock.it: Working with the German Share&Charge project, which utilises smart contracts to automate the process of paying to rent electric vehicle charging stations, enabling private individuals to rent their home charging station in a peer to peer fashion.
• Fizzy by AXA: If your flight is more than two hours late, and your airline details are loaded into the app, you will be automatically notified with compensation options. This use of smart contracts is based on parametric insurance.

A smart contract relies upon rules which it follows exactly, and as such can lead to unsuitable results. It is difficult to envisage all variants that can arise in a contract or the implementation of a contract. For example, it is often argued that in its current state smart contracts cannot react to secondary considerations in the off-chain world. They require detailed considerations of all applicable variables in execution and this can be daunting from a legal and programming perspective. Viewed through this prism, smart contracts are not actually smart; they are deterministic.

The accuracy of data entered into a smart contract is essential as once smart contract rules are in place, they are unalterable. Neither the user nor programmer can amend a contract once it has been written. This gives rise to the question, is this actually smart?

Additionally, a blockchain cannot directly gather data. The blockchain network relies on an external data feed (aka an Oracle) to provide the information being passed to the smart contract.

Whilst in theory the ledger is secure, a contract could be subject to the risk of cyber-attacks, such as a “man in the middle attack” where a hacker passes fake data into a smart contract. The operation of the platform can cause security risks and bugs or defects may not be promptly highlighted and resolved by the users or developers.

There are also potentially high implementation costs and the general risk of human error could result in heavy financial losses. In June 2016, a hacker exploited a weakness in the code of the DAO obtaining $50 million of digital money. The incident conveys how coding can be just as vulnerable to human mistakes.

Each step in building a smart contract needs close attention to detail. Even at the business level, you are programming your business model into an executable program let loose on the internet. When a smart contract is translated into machine code,  even if written perfectly, there is a risk that the executed machine code might differ in a slight way from how the the smart contract code was written (due to differences in how a compiler was designed to interpret the code given to it).

A recent paper published in ACSAC 2018(1) examined the prevalence and types of risks in smart contracts on the Ethereum network. It labelled vulnerable contracts with three categories — greedy, prodigal and suicidal — which either lock funds indefinitely, leak them to arbitrary users, or are susceptible to by killed by any user. Roughly 3% of all contracts referenced were deemed vulnerable in some way.

It is important to note that we are in the early days of smart contract adoption and the pace of development is rapid. It is entirely conceivable that these risks and limitations will be appropriately addressed. Smart contracts are part of an abundance of emerging technology which could create a world where human abilities are amplified. They could assist mankind to implement separate normal legal contracts. As a result, it would be possible for people to spend more time engaged in high-level thinking, creativity and decision-making.

Smart contracts are not currently regulated in Ireland, but that is not to say that they are not being carefully considered. The Law Society of Ireland and the Department of Finance are monitoring developments in this area, as is industry. Kevin O’Brien, head of Consumer Protection – Policy and Authorisations at the Central Bank of Ireland, stated “If we cannot understand [blockchain], we cannot supervise it, and if we cannot supervise it, we cannot authorise it”. Accordingly we have worked with clients to implement appropriate risk, control and governance frameworks which requires lawyers to work closely with the relevant stakeholders.

Other EU countries, such as Italy, have recently taken steps to implement a legal framework for smart contracts with Law Decree No. 135/2018. I note that industry in Ireland is considering these issues carefully both at a domestic and international level and is well positioned to address the growing demand in this area.

If smart contracts are to fulfil their potential, it is essential that we mitigate the highlighted risks. There is a need for working groups to address such risks and join with developers. It is my view that any regulation and guidance will need significant input from industry.

I do not wish to overshadow the potential of smart contracts but it is vital to address the risks involved. To conclude, utilisation of smart contracts is an area which is evolving rapidly. If the market intends to fully exploit their potential it is necessary to take appropriate steps in mitigating their associated risks.

For further information, please contact:

Deborah Hutton, Partner and Head of Asset Management & Regulation

+353 1 6644 273

+353 86 184 9114

[email protected]

Deborah is a partner and head of the asset management and regulatory team in Eversheds Sutherland and specialises in investment funds and financial services regulation.

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