Welcome to another installation of me teaching myself about crypto by writing about it! In past posts, I have discussed topics like Bitcoin mining and proof-of-stake. I’m not an expert on crypto, but I like learning about technology, and these posts are an attempt to share what I have learned at a level that is not too basic, but not too advanced, for readers who are curious, like me. Actually, this topic has a lot to do with contract law, so I am more comfortable writing about it than those prior posts.
The thing I hear repeatedly about smart contracts is that they are neither smart nor contracts. Let’s figure out why people say that, and whether it is correct.
What is a Smart Contract?
A smart contract is a transaction that executes automatically on a blockchain, according to a set of programmatic rules. The most commons kinds of smart contracts today are trading, investing, lending, and borrowing–financial transactions. Also, non-fungible tokens (NFTs) are created via a minting process embodied in a smart contract.
The term smart contract was coined by Nick Szabo in 1998. He wanted to apply the principles of distributed ledgers to executing transactions.
Not all blockchains support smart contracts. The most popular one that does is Ethereum. On Ethereum, smart contracts are executed via the Ethereum Virtual Machine (EVM). The EVM is isolated, in the sense that it has no access to network, file system or other processes on which the blockchain is running. That is important so that bugs in smart contracts cannot affect the entire blockchain, or other transactions.
Are they Smart?
Not in the lay sense. The quintessential example of a smart contract, suggested by Szabo, is a vending machine. If you put in the money, and press a selection button, the snack drops down. That is not very smart, but it is automatic, and eliminates the need for a human to fulfill the transaction on the seller side.
Smart contracts are smart in that they are self-executing without human intervention. In contrast, traditional legal contracts are almost always promises to do things in the future, so they need to be performed by humans, and tracked, to be sure the parties actually perform them.
Actually, smart contracts are usually nowhere near as complicated as most traditional written contracts, which often have pages of terms and conditions. At this point, smart contracts contain rules that are “fairly rudimentary.” Here is an example of a simple smart contract:
This example creates an Ether wallet. As you can see, the language looks similar to C++. The first lines of the program name the license for the code, and the language it is written in. The program logic after that is quite simple. There are many other examples here.
Smart contracts work because the EVM can send a transaction from one account to another account, and that transaction can include binary data (the payload) and Ether (the cryptocurrency). If the receiving account contains logic (the smart contract), that logic is executed with the payload as input data.
To execute a smart contract requires the payment of a transaction fee, called a gas fee. (Because it’s Ether.) A smart contract that is more complex will cost more gas to execute. The maximum gas price is set by the creator of the transaction. If the authorized gas is insufficient, the transaction will not execute. If some gas is left after the execution, it is refunded to the creator.
You can see some examples of smart contracts on Ethereum here.
Are they Contracts?
Yes, but the bar for formation of a contract is pretty low. And smart contracts are usually not what lawyers call executory contracts. Under law, a contract is formed when there is an offer, acceptance, and consideration (an exchange of value). Once the contract is formed, the parties must perform the terms of the contract, and until they are done performing, the contract is called an executory contract.
Smart contracts are often touted has having the advantage of not requiring a third party to authorize them. But in fact, in most modern economies, traditional contracts do not require a third party to authorize them, exactly. Or perhaps only by implication, because parties perform contracts because of the threat of a third party’s involvement. If one party to a contract breaches, the other party can sue for damages, and a neutral third party (like a court or arbitrator) can enforce the contract, based on contract law. But most contracts are never litigated. So, while traditional contracts can be executed between the parties with no third party intervention, the more accurate accurate distinction is to say that smart contracts are concluded on the blockchain with no additional human effort.
Smart contracts happen immediately–or at least, as soon as the blockchain can process them. Of course, traditional contracts can be executed quickly, too. If you walk up to a fruit stand, hand over a dollar and take an apple, that’s a contract, and it executes immediately. But those kinds of contracts are not usually written in advance.
Unlike traditional contracts, smart contracts are transparent and irreversible, because they execute on a blockchain. Everyone can see the smart contract if they look at the blockchain. In contrast, the terms of traditional contracts are often confidential, and they can be amended or voided by the parties.
Also, traditional contracts are rarely pseudonymous. In fact, it’s important, in a traditional contract, to clearly identify the parties–which is why we include corporate names, addresses, and other identifying information when we define parties in a contract. That’s to help enforce the contract against the right person, if necessary. But blockchain transactions are by definition pseudonymous. The contracting parties do not have to know each other’s true identities. Depending on your viewpoint, this is a benefit or a drawback.
Smart contracts can stand on their own, or be paired with a traditional contract and execute only some of its provisions. For lawyers who are accustomed to traditional contracts, it may be easier to think of a smart contract as the execution of an escrow or a closing process. Money is paid upon the occurrence of a specific trigger. And like escrow agents, smart contracts need specific and unambiguous direction as to what is to be done to effectuate the transaction. And complicated instructions are generally not a good idea.
Like traditional contracts, smart contracts can suffer from ambiguity or “bugs.” Any program can fail to account for contingencies in the real world. But smart contracts are mostly quite simple, at this point. In comparison, traditional contracts are complicated, and the reason people hire lawyers to write them is that they need lawyers to consider the myriad things that can go wrong, and whether and how to account for them in the contract.
What’s Next for Smart Contracts?
First of all, they will not be replacing traditional contracts any time soon. But they may make inroads into replacing escrows or closing processes. However, pseudonymous contracting is probably insufficient for some transactions, such as when the parties have know-your-customer (KYC) requirements or require complex closing conditions.
The applications of smart contracts are likely to to expand over time. While today, smart contracts mostly involve payments and similar financial transactions, they are already being used for investment transactions, automated asset management, and self-paying loans. In the future, they might be used to establish pseudonymous digital identities, transfer assets such as land title, manage capitalization tables, verify supply chains, or conduct public elections.
It’s also likely that new blockchains will support smart contracts. The market for different blockchains and cryptocurrencies is highly competitive, and the additional functionality of smart contracts can help make a blockchain more popular.
Here are some additional resources, if you want to learn more about smart contracts: