Loading...

Smart contracts vs Traditional contracts

topic

In our days, there is an abundance of opinion that blockchain technology could spark a revolution. The blockchain is fast becoming a symbol of the Fourth Industrial Revolution which is a fusion of advances in technologies that are becoming indispensable in our modern life. Therefore, the Fourth Industrial Revolution is paving the way for transformative changes on how we live and radically disrupting business sectors. Everything is happening at an unprecedented, whirlwind pace.

Core to this revolution is the idea of entering into smart contracts based on blockchain technology. Yet, it is believed that this escape from law is a mere illusion. Szabo famously defined smart contracts as ‘any computerised transaction protocol that executes contract’s terms’. ‘If x then y’. Smart contracts are recorded in a computer-readable code placed on blockchain, an open, distributed ledger that runs on the computers of thousands of users, having no central authority. They are characterized as ‘smart’ because of their self-executing and self-enforcing elements, needing, usually, neither intermediary nor human intervention.

Contract formation

Unsurprisingly, computers are not the first non-human actor to be involved in contract formation, as for example, vending and ticket machines have been in our lives for decades.

The flexibility and adaptability of contract law allows smart contracts to be formed as legally valid contracts since the contract elements (offer, acceptance, consideration, intention to create legal relations) are satisfied. However, it is advised to affirm the existence of the intention to create legal relations by ‘wrapping the code up’, by introducing a paper contract acknowledging that the smart contract is valid.

Considering smart contracts, the counterparties are not people but cryptographic private keys representing individuals as instructed by humans. As they do not provide a ‘capacity test’, they can be entered into by minors, persons who are incapacitated, such as under the influence of drugs or alcohol, or mentally incapacitated. This is problematic because in the realm of pseudonymous users, it is difficult to identify who to sue. Therefore, people who in real life lack the capacity to enter into a contract could do it on blockchain. This ‘uncontrolled freedom’ possesses risks that are not apparent in traditional contracts.

Smart contracts and Traditional contracts in conflict

Lack of human element

Smart contracts are attractive because they eliminate the human fallibility since they are executed by machines. Lawyers will only identify non-boilerplate clauses that should be implemented into code and allocate their time on more intellectually demanding matters. They de facto take enforcement out of the courts’ hands and remove their reliance on paper. Also, since they are operated on a ledger, counterparties can enhance the speed of executing the contract and avoid resorting to the court because of linguistic interpretations which are immutable, thus saving costs. Consequently, the court will be rendered obsolete since smart contracts serve the same function with greater efficiency.

Humans can deal with ambiguity as opposed to machines. It is known that contract terms and law are usually uncertain, complex, vague, ambiguous and cannot be replicated by code. The jurisdiction’s apathy can be justified by the existence of implied terms and the lawyers and courts’ competence to fill in gaps. Whereas, a coding contract lacks human qualities, as machines cannot develop empathy, fairness or justice.

By eliminating the human involvement, the transaction and verdict might be more impartial. Humans are characterized as fallible and untrustworthy, merely aiming to increase their profit compared with technology which acts without the influence of opinions, emotions or money. Yet, this is problematic. We are humans, we have sympathy and we can understand each other, whereas code operates on a heartless machine.

Tamper-proof

Once the smart contract enters the blockchain, its performance cannot be stopped, breached, amended or revoked by a court, a coder or an institution. They record the transaction(s) making it tamper-proof and unchangeable.

Consequently, a claim rendering contract terms unenforceable would possibly be ineffective since the contract has already been performed, creating tensions with doctrines like frustration and rectification which cannot be applied. Consequently, it is paramount to ensure that the code contains no error because a single error may harm the transaction in its entirety as it is operating on a chain. Hence, it is absurd to believe that they guarantee perfect performance. They are rigid, not permitting any adjustments to changing events or party’s preferences as they are incapable of coping with vague contractual terms, unlike traditional contracts which in dispute, parties can resort to courts. Arguably the term ‘smart contracts’ is a misnomer since they are not smart.

Additionally, if a third party creates the smart contract, there might be a discrepancy between what the parties were told the smart contract would do and what it really does. The coder may fail to reflect the parties’ intention due to a misunderstanding, his incompetence or malice. Consequently, the majority of persons having no coding knowledge cannot verify or refute the code.

Unattractively, smart contracts are required to anticipate up front all events that may occur during their lifetime which could affect their operation. This is impossible. This justifies why the law introduced implied terms and force majeure clauses aiming to limit unpredicted and uncontracted events and to fill in gaps when the parties’ contractual intention is ambiguous.

Computer Code v Natural Language

The language of smart contracts is a thread. Technology’s ability has not reached the level of understanding, enforcing and translating a natural language contract precisely into code, and it seems unlikely that it ever will. The majority of contracts are long, complex and ambiguous, containing gaps, requiring implied terms or the courts’ intervention to make them workable. Smart contracts cannot correspond to this situation.

Conversely, computer language is more reliable than human language as humans tend to act in their own interest. It is believed that code is much less ambiguous and therefore clearer. Also, given that human-negotiation is not necessary, performance is faster.

However, it is stressed that even computer experts have problems understanding the code. Failure of grasping the term’s meaning, which is common, results in an undesirable outcome. Hence, it is a fallacy to believe that all obligations in a contract can be expressed in code.

Can smart contracts replace traditional contracts?

It is debatable whether smart contracts can replace traditional contracts as both serve different aims.

Traditional contracts are performed in the complex and unsettled real world and it is extremely difficult to include smart contracts in it. If the motivations of replacing traditional with smart contracts are economy, certainty and ease, the latter may be more costly and possibly less efficient. Further, machines are susceptible to errors, exploitation, hacking and ambiguities.

Scholars are confident that although smart contracts might transform the world and enjoy adoption over time, they will not replace contract law. They just represent a technological alternative to the legal system. Further, given the tremendous economic potential of this new method of conducting business, regulators may feel compelled to intervene prematurely with new regulations. At best, smart contracts may reduce the need for litigation, without implying that they serve the same function in a superior manner. Rather, shifting to smart contracts would mean a shift to a different interaction mode.

Concluding thoughts

Academics suggest blending code, smart contracts, with natural language, traditional contracts. The agreement would be recorded on the blockchain and would be immutable. The traditional contract will set out the terms which are undeterminable and should be prioritized in case of conflict. This marriage will not eliminate commercial litigation, but it will give the opportunity to parties to modify terms and to address the contractual implications of an unforeseeable event.

Arguably, a smart contract can exist in a virtual world, but it gets complicated when connecting to the real world. In summary, smart contracts act as a supplement to traditional contracts and the approach towards replacing traditional contract is gaining momentum.

The content of this article is valid as at the date of its first publication. It is intended to provide a general guide to the subject matter and does not constitute legal advice. We recommend that you seek professional advice on your specific matter before acting on any information provided. For further information or advice, please contact Stavriani Sofroni, Legal Consultant at the Limassol Office, email stavriani.sofroni@kyprianou.com