Blockchain technology is often associated with digital currencies, notably bitcoin, which has gained widespread use for purchasing goods and services online. However, the blockchain protocol is also useful in other applications, notably smart contracts, to provide a secure means of securing agreements and transferring funds between parties. The technology behind blockchain-based smart contracts does not require third party oversight, making this a convenient, cost-effective mechanism for supply chains, banks, and contracts.
Blockchain technology was initially developed for bitcoin but is an open-source platform that is free to use and customizable to suit other functions. Blockchain functions on a decentralized or peer-to-peer digital ledger, where data is globally stored on many servers at once. Each node or participant in the network stores a copy of the data and communicates with one another.
The blockchain technology functions in this order when a transaction occurs:
Upon realizing the value of decentralized ledgers, legal scholar and cryptographer, Nick Szabo tied in the concept of smart contracts to blockchain in 1994. As in digital currency, contract data is converted to computer code, which is then stored, replicated, and supervised in the same decentralized manner.
Ethereum, another type of cryptocurrency, facilitated the development of the smart contract. The Ethereum protocol powers the code to execute the transaction. The contract is essentially a program running on the Ethereum blockchain.
Vitalik Buterin, a cryptocurrency programmer, best describes how a smart contract works with the blockchain protocol. The underlying asset or payment is transferred into a program that uses code to determine who receives the asset or if it should be refunded. A decentralized ledger stores and replicates the document, effectively securing it. He goes on to compare the transaction to that of a vending machine. The logic programmed into the machine grants the buyer the purchased item upon receipt of the money, much like the code in a smart contract works between parties.
As all other contracts, smart contracts are agreements between parties that are legally enforced. However, unlike traditional written agreements, smart contracts are more precise and explicit. No longer is there room for interpretation of vague wording that leads to disputes and claims. Instead, data specifics must be agreed upon, which may include matching time zones and other variables.
In their report, the Smart Contracts Alliance states how a smart contract’s elements satisfy contractual law in the U.S. These consist of an offer, consent, and consideration.
Some concerns still need clarification for smart contract execution and legal recognition. These include the extent to which smart contracts are legally recognized and how blockchain data is recognized as evidence.
The state of Illinois is one of the first states to clarify any legal issues by enacting the Blockchain Technology Act (BTA), effective January 1, 2020. This act clarifies that a smart contract cannot be denied any use in legal settings only because blockchain is used to create, store, or verify the contract, record, or signatures. Other states have also enacted similar regulations.
Smart contracts provide several advantages to both the client and the law firm.
That is not to say that lawyers are no longer needed. While smart contracts provide the above benefits, legal professionals will continue to be involved.
There are several areas where blockchain and smart contract applications are in use today.
From start to finish, a smart contract transaction consists of four main steps.
While smart contracts are hailed for the above advantages, there are many challenges and risks that are inherent in their use.
In 2016, hackers exploited a vulnerability in the Ethereum platform on which smart contracts are processed. The losses amounted to $150 million to the decentralized pool that funded and governed the platform. However, the flaw was in the smart contract itself that enabled hackers to trigger a vulnerability with repeated “send funds” requests. While this was a rare, one-time occurrence, this breach demonstrates that imperfect coding could essentially expose the platform to intrusive threats.
Despite the above-reported breach, according to Gartner, smart contracts will be used by more than 25% of global organizations by 2022.
Before considering smart contract solutions, organizations should pose the following questions to creators and vendors of this technology.
Gartner recommends that when choosing smart contracts, to ensure that the code has been thoroughly tested to avoid exposure to risks.
While smart contracts can never replace the legal professionals’ services and experiences, they are having a tremendous and positive impact overall in many areas. Despite any risks, Gartner strongly supports using the contract technology and recommends that organizations deploy them in simple contract agreements.
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