How to make smart contracts actually useful?

Or why smart contracts also require smart law

Note: this is the first article in my upcoming series on smart contracts; should you want to provide any feedback or contribute to the debate, please feel free to contact me by e-mail to ivo.grlica@gmail.com.

As a lawyer, I have been fascinated about smart contracts ever since I have first been introduced to them. Just as smartphones have forever changed nearly every single facet of our daily lives (from dating apps to business communication tools), an idea of “smart” contracts seemed to be a game changer for the whole legal industry.

Under the concept of a smart contract, I envisaged a world of seamless, efficient and self-enforcing business and consumer transactions.

I imagined a world:

  • Where a signed contract is not some forgotten piece of paper lying in a drawer, but rather a user-friendly, living instrument;
  • Where a contract is not merely a tool that helps parties regulate their transactions, but also to enforce them.

In not so distant future and with the help of artificial intelligence, smart contracts might become even self-amending programs. In case of a dispute, fully autonomous (artificially intelligent) digital courts may step in, in order to reach a decision — which could then be even automatically enforced.

Whereas possibilities, in theory, seem practically unlimited, the current reality of smart contracts is, at best, rather bleak.

Currently, there are numerous ICOs out there promising progress in the field of Legal Tech. Their respective digital products, however, seem rather technically impractical and of a very limited capacity:

  • In essence, the basic functionality of existing (unduly called so) “smart” contracts usually comes down only to providing escrow mechanisms for most simple payments;
  • Often, some “arbitration” mechanism to solve potential disputes is also envisaged. However, all implementations so far are in reality very rudimentary (users as arbitrators to assess potentially complex legal questions), costly (expensive double fees — both for the use of the platform AND as a remuneration for arbitrators) as well as legally questionable (non-existent arbitration clauses, unknown rules of such arbitration and problematic enforceability);

As such, current smart contracts are often quite unfriendly to all users who are not programming specialists or are for whatever reason technically not enough savvy.

Also, numerous legal questions remain unresolved. To list just a few:

  • How to ensure compliance with applicable AML / KYC legislation, especially in a cross-border context?
  • How to comply with relevant tax legislation (VAT, withholding taxes, sales tax, etc.)?
  • How to resolve the issue of the validity of the contract when one (or both) of the parties remain anonymous?
  • How to assess the content of the contract and rights of each party in case of breach of an obligation that was not explicitly foreseen (but is implied) in the contract (due to its oversimplification and non-inclusion of otherwise standardized clauses)?
  • Which law is to be applied for the assessment of the contract and which judicial authority shall have jurisdiction in such a case?

It is unquestionable that such smart contracts (in their present stage of development) have a much-limited scope of application and usability. As shown above, this is true both in technical as well as in legal sense.

Users, however, need smart contracts which will be easy to create by average people without the need of special skills in either programming or in law.

So how to achieve this?

First of all, all development teams need to realize that they should not operate in some technical programming limbo but involve real lawyers in their work instead.

Contracts are, at the end of the day, legal instruments creating rights and legally binding obligations of the parties.

In that sense, contracts are the law for their parties (or in terms of centuries-old legal principle — pacta sunt servanda). Smart contracts should therefore not be understood just as a piece of enforceable code — such as traditional, written contracts are not to be seen merely as pieces of signed paper.

Ignoring this fundamental underlying legal nature of smart contracts can leave serious legal issues unresolved and can expose users to considerable legal risks, thus hampering very core functionality of this Legal Tech product. In such circumstances, it should not come as a surprise when users would feel discouraged from using digital smart contract apps.

Secondly, smart contracts need to be put in a proper context. In that way, “virtual law” need to be somehow connected with the sphere of traditional law and legal remedies. By doing that, much of the above questions (regarding compliance with AML / KYC, tax legislation, jurisdiction in case of disputes, legal loopholes or ambiguous clauses, etc.) can be solved. However, such “bridge” between the two spheres should be only built in a way which will ensure that smart contracts retain both their distinct nature as well as functionality offered by the blockchain technologies.

Thus, mediocre compromises should be avoided. Instead, synergies between traditional and “virtual” law need to be sought.

There are many ways how this could be achieved (be it via proper standardized general terms, or specific clauses to be developed and used in such contracts); and some of them will be analyzed in my following article.

Lastly, similarly to cars which are rather useless without reliable roads to drive them on; proper infrastructure should be developed for smart contracts as “legal vehicles” in need of proper underlying framework to run on.

Similarly to smart contracts themselves (as discussed above), however, one should not forget that also such proper infrastructure is of a twofold nature.

While much attention is usually given to the technical base (blockchain), the legal component is often either neglected or completely ignored.

In that sense, we could speak of the need to develop appropriate “smart law” — a normative framework on which smart contracts will be able to smoothly, efficiently and transparently run.

Such smart law normative (infra)structure needs to be built by developing the following core elements:

  1. Ready-to-use, ready-to-combine and simple-to-adapt standardized modules for structuring and building smart contracts by not technically savvy (average) users;
  2. Standardized boilerplate smart law contracts for the different types of B2B, B2C and C2C transactions (e.g., lease agreement, sale purchase agreement for different type of assets, loan agreement, marketing agreement, service agreement, distribution agreement, agency agreement, etc.);
  3. “Smart law specific” legal rules and principles to be applicable in case of any loopholes or mismatches in smart contracts;
  4. Artificial intelligence based modules and tools for self-amendment of smart contracts;
  5. Autonomous decentralized arbitration (based artificial intelligence);
  6. Smart case-law (to be consulted in case of disputes).
These are also the elements which will be further discussed in my following article.

As the process of building legal infrastructure will, of course, not happen overnight, the above components will need to be developed step-by-step (with 1–3 preceding 4–6).

Once the smart law is established even in its most basic form (and subsequently evolved in correspondence with ever-changing realities), smart contracts and any other Legal Tech products (smart litigation, smart private and public registries, smart courts, etc.) will finally be able to realize their full potential.