• Advokat Jeppe R. Stokholm

What is a smart contract - and how is it regulated?

Updated: Feb 1, 2018

#Cryptolaw


From a technical point of view, a verified #smartcontract is a symbiosis between nodes, blocks and chains of blocks:


  1. A node (i.e. any device, that is connected to the network) runs a smart contract by facilitating, verifying, executing and/or enforcing the contract as data into a block.

  2. A block (i.e. a block of transaction data that is permanently recorded by all the nodes in the network) stores multiple data, including information related to the smart contract. Every block contains a hash of the previous block. When validated by miners using mathematical algorithms, the block is a part of the chain of blocks.

  3. A chain of blocks (i.e. the blockchain) is a transaction database shared by all the nodes participating in the network on the same protocol. Each block in the chain is guaranteed to come after the previous block chronologically, because the previous block’s hash value would otherwise not be known.

This symbiosis between the participating nodes, blocks and chain of blocks secures the permanent storage and validation of the smart contract. It is extremely difficult to manipulate such contracts on a distributed ledger, since each block is timestamped and referring to previous blocks in the chain. But a smart contract is more than a peer-to-peer protocol on the #blockchain. It is an application, that “makes things happen”.


Smart contracts may be entered between two persons (P2P), person to machine (P2M) and/or person to organization (P2O). None of the parties have to trust each other, but they have to trust the code and the computer language to build a dependable ledger.


Due to the code and computer language, contract clauses can be made partially or fully self-executing, self-enforcing or both. This gives a certain level of trust inter partes without the need for a third-party intermediary to govern the contract. When a smart contract is entered, all parties involved can rely on the fact, that when the smart contract is honoured, the result will be recorded in the ledgers and accounts of all the parties to the agreement.


In the following, a smart contract is defined as:


  • A transaction protocol converted into code that facilitate, verify, execute and/or enforce the performance of a contract between two or more parties on a distributed ledger.


Smart contracts can be found in multiple functions representing rights and obligations, including tokens etc.


Nick Szabos dream from 1996, now a Blockchain reality


Computer scientist Nick Szabo, who invented the concept in 1996, described his idea as follows:


New institutions, and new ways to formalize the relationships that make up these institutions, are now made possible by the digital revolution. I call these new contracts "smart", because they are far more functional than their inanimate paper-based ancestors. No use of artificial intelligence is implied. A smart contract is a set of promises, specified in digital form, including protocols within which the parties perform on these promises”[1].

Two years later, Nick Szabo designed a mechanism for a decentralized digital currency called “bit gold” in 1998, but it was never implemented. He simply needed a trustworthy platform to accelerate the concept. This happened in 2008, when Satoshi Nakamoto, presented the distributed ledger technology to be run as an open and decentralized record of peer-to-peer transactions with no central server. With this new protocol, a trustworthy platform for smart contracts was created, and Nick Szabos dream from 1994 became a reality.

The difference between coins and tokens


When talking smart contracts, we talk #tokens and not #coins. The reason is, that coins and tokens are not the same. Coins represents a store of value, a medium of exchange and a unit of account and can be defined by their use:


A) Coins can be used as a payment

B) Coins can be traded between parties


Tokens can also perform as coins, i.e. be used as payment and be traded between parties, but tokens are more than just coins: They can also perform as #contracts, that represents rights and obligations


How are smart contracts regulated?


When dealing with Smart Contracts, life is less complicated: If all parameters are met, binding agreements can be executed in real time, and all trails in the transaction can be found in the distributed ledger.


However, if something goes wrong, what to do?


From a legal perspective, drafting a Smart Contract is not different from drafting an ordinary commercial contract. A contract is a legally-enforceable promise (or set of promises) between one or more parties, and the legal regulation depends on the jurisdiction(s) involved.


When drafting a smart contract, the parties must carefully consider their choice of governing law and dispute resolution, including the following questions:


  1. To which legal system should the contract be drafted: Common law or civil law?

  2. Which governing law and forum should be applied to the contract?


The enforceability of smart contracts


As a starting point, smart contracts are code driven contracts, that can be enforced.

The legal challenge is, that smart contracts are facilitated, verified, executed and/or enforced in a decentralised peer-to-peer environment between different nodes, blocks and chains of blocks. This does most-likely create a cross-border related issue when investigating the governing law and forum.


Inspiration may be found in the applicability of international accepted standards, such as the United Nations Convention on Contracts for the International Sale of Goods (the "CISG").


If the parties have not expressly chosen governing law and forum, the answer must be found in the international “conflict of law” rules. In the European Union, the rules are harmonized for determining the applicable law to contractual obligations.


Legal risk management: How to exit a smart contract?


The flipside of contract clauses, that are made partially or fully self-executing, self-enforcing or both is obvious: What to do if something goes terrible wrong?


It can be the coding, it can be the computer language or it can be unforeseen events like force majeure or hardship, that fundamentally alter the equilibrium of the contract resulting in an excessive burden being placed on one of the parties involved?


Legal protection against unforeseen events can be implemented in a smart contract by:


  1. the use of multi-signature (or “multi-sig”) functionalities, where an approval is required, and/or

  2. the use of a trusted third-party to monitor and verify prices, performance, events etc., before the contract can be executed.

Never forget: Legal risk management is a critical issue, that must be dealt with before crossing the Rubicon. When a fully self-executing and self-enforcing smart contract is entered, the armies are marching and the die is cast: Alea iacta est!



Advokat Jeppe R. Stokholm is based in Zürich, Switzerland. The area of expertise is corporate affairs, including M&A, Venture Capital, Private Equity and Crypto Law. Advokat Jeppe R. Stokholm represents several international oriented Law Firms, Auditors and Family Offices on a case-by-case basis and provide discretionary counselling to global operating companies and private UHNW clients. 



NOTES:


[1] Nick Szabo: ”Smart Contracts”, (1996), found at http://www.fon.hum.uva.nl/rob/Courses/InformationInSpeech/CDROM/Literature/LOTwinterschool2006/szabo.best.vwh.net/smart_contracts_2.html




​Zürich, Switzerland