Written by Jonny Fry
Writers linkdin: https://www.linkedin.com/in/jonnyfry/

IBM’s definition of smart contracts is: “Smart contracts are digital contracts stored on a blockchain that are automatically executed when predetermined terms and conditions are met”. Interestingly, the use of smart contracts has been heralded as a factor in the potential decline in the use of some legal services. After all, we seem to be increasingly surrounded by algorithms and machines replacing humans in the execution of transactions, whereby making business process more efficient, faster and hence potentially less risky for companies which have historically relied on their staff. Yet, when smart contracts were first being widely discussed many lawyers would often quip: “Smart contracts, they are not smart nor are they contracts”. 

Smart contracts were first used by Nick Szabo in 1994, but it was not until 2015 when Vitalik Buterin launched Ethereum that smart contracts become better known. Vitalik and his developers built smart contracts on the Ethereum Blockchain to be processed on the Ethereum Virtual Machine (EVM). Smart contracts on the Ethereum Blockchain use ether, otherwise known as ‘gas’, hence the expression ‘gas fees’ to execute a transaction. Indeed, Ethereum’s description of smart contracts reads: “A smart contract is simply a program that runs on the Ethereum blockchain. It's a collection of code (its functions) and data (its state) that resides at a specific address on the Ethereum blockchain”. Up until recently, people drew a difference between smart contracts and Ricardian contracts (which were proposed in 1996 by Ian Grigg and Gary Howland). A Ricardian contract can be seen as a bridge between paper/text contracts and digital/code with the following parameters: 

  • “a contract offered by an issuer to holders 

  • for a valuable right held by holders, and managed by the issuer 

  • easily readable by people (like a contract on paper) 

  • readable by programs

  • digitally signed

  •  carries the keys and server information

  •  allied with a unique and secure identifier.”

Initially, smart contracts were seen as a way to automate transactions on a blockchain-powered platform so were not treated as being a legal document or potentially enforceable. On the other hand, Ricardian contracts were designed to define the contractual relationship between various parties and could be used outside a blockchain. As Limechain has summarised, the difference between a smart and Ricardian contract is that: “A smart contract is essentially a set of instructions on how to execute certain actions based on whether certain requirements have been met. A Ricardian contract also provides the legal framework that underpins all subsequent transactions that may occur under the contract. It defines the parties in the agreement, the possible legal implications, and the relevant legislation that can be used in case of a dispute.” 

In the UK, the legal position of smart contracts has now been clarified. The Law Commission has issued a report confirming that, in order for smart contracts to be legally enforceable, only “an incremental development of the common law is all that is required to facilitate the use of smart legal contracts within the existing legal framework'. Furthermore, Professor Sarah Green, Law Commissioner for the commercial and common law team, has added to this and said: “Smart legal contracts could revolutionise the way we do business, particularly by increasing efficiency and transparency in transactions. We have concluded that the current legal framework is clearly able to facilitate and support the use of smart legal contracts; an important step in ensuring increased recognition and facilitation of these agreements.”

The legal uncertainty of smart contracts, in the UK at least, has been clarified. Meanwhile, the Bitcoin Blockchain has recently undergone an update, called Taproot. As reported by Reuters: “the upgrade introduces a new digital signature scheme called Schnorr that will help bitcoin transactions become more efficient and more private. Schnorr can also be leveraged to let bitcoin users execute more complex smart contracts”. Clarifying the legality of smart contracts will help many existing businesses which have, to date, been reluctant in the adoption of Blockchain technology due to its uncertainty. In view of this, maybe one sector to keep an eye on is derivatives, given this sector is one of the biggest assets globally. As at June 2021, the value of the derivatives market was $610 trillion, compared to the total value of all quoted equities of $95trillion. Worldwide, derivatives impact the entire economy. The International Swaps and Derivatives Association (ISDA) has been consulting on the use of smart contracts for a while and has, presumably, been waiting on the type of legal clarity now evident in the UK. Given the number of jurisdictions historically which have relied on English law when conceiving their own laws, will we now see other countries equally providing legal guidance as to the enforceability of smart contracts and so ushering-in greater use of these digital and machine-programable instructions?