Smart Contracts
Posted on Nov 5, 2021Edward McDonald
I. Introduction
Amidst skyrocketing cryptocurrency prices[1] and NFTs selling for astronomical prices,[2] uses of blockchain technology have been on many people’s minds, but there is another use of the blockchain that may be of particular interest to lawyers: smart contracts. Smart contracts are agreements, written in code, that are stored on the blockchain, often on the Ethereum[3] blockchain.[4] The concept has existed since the 90’s,[5] but has only started to take off recently.[6] There is much speculation on how smart contracts’ use will expand; while there are doubters, smart contracts have the potential to become an important part of the future of business transactions in our global high-tech world.
II. Features of Smart Contracts
There are various features that make smart contracts different from their traditional counterparts. The first feature, and maybe the largest selling point of smart contracts, is their self-executing nature. Once the conditions within the code of the smart contract are met, whatever the coded for result, it will automatically be performed if possible.[7] For example, this self-execution allows for escrow accounts in payment transactions without using intermediaries or instant acceleration and repayment of a loan upon default.[8]
Being self-executing and written in code leads to a second feature, they are inherently unambiguous. A smart contract can rely only on its code and the available data,[9] and based on that data it will either execute or not.[10] This makes it unambiguous in that anyone who has the expertise to read a contract’s code will be able to know ex ante the outcome it prescribes for any set of circumstances. This makes it (nearly)[11] impossible to insert clauses that rely on qualitative judgements calls.[12] There are benefits and drawbacks to having a contract that is inherently unambiguous. A lack of ambiguity can reduce the possibility of litigation[13] and can lead to quicker execution.[14] On the other hand, there are clauses and default rules that do not work within smart contracts, like good faith clauses.[15]
A third feature of smart contracts is their immutability. Due to the nature of the blockchain, once a smart contract is written, it cannot be changed. It is stored on the blockchain and continuously verified by the decentralized network of users of the blockchain on which it is stored.[16]
The final feature of smart contracts is their accessibility. Unlike many traditional contracts, smart contracts can easily be formed, with little transaction costs,[17] even when the two parties reside on separate continents without having any in person meeting or documents being mailed, or even without knowing who is on the other side of the contract.[18]
III. Current Uses of Smart Contracts
Smart Contracts are still in their infancy, but they are in use. As of January 2020, there were over 1,000,000 smart contracts on the Ethereum blockchain.[19] Smart contracts are primarily used in decentralized finance, or DeFi; as of September 2021, US$92 Billion of assets were in DeFi protocols.[20] DeFi uses smart contracts to replicate traditional financial transactions like loans, derivatives, and exchanges without the need for third party intermediaries.[21] These transactions can be conducted with speculative cryptocurrencies, or “stablecoins” whose values are pegged to the Dollar.[22] DeFi has started to be used to allow non-sophisticated parties to easily participate in otherwise inaccessible financial transactions using “DApps” or decentralized applications.[23] Parties can use these DApps to lend money, pool money to invest in assets, or even get insurance.[24]
IV. Legal Treatment of Smart Contracts
While there are many questions that remain regarding the legal treatment of smart contracts, some questions are well settled. First, smart contracts can be[25] legally enforceable contracts. To be legally enforceable, they must still meet all the requirements of contract law such as offer, acceptance, and consideration.[26] The fact that they are written in code without a physical signature does not prevent their enforceability due to the E-SIGN Act and the UETA.[27] This is also likely true under UCC Article 2[28] and Article 9.[29] The Uniform Law Commission and the American Law Institute created a committee tasked with investigating how smart contracts should be treated under the UCC.[30] That being said, there are many open questions about the legal treatment of smart contracts, including difficult jurisdiction and choice of law questions, their asset type under Article 9, and whether they conform with each state’s statute of frauds.[31] Some states, including Tennessee,[32] Wyoming,[33] and Nevada[34] that have passed laws to make the treatment of smart contracts clearer, but these are exceptions.
V. The Future of Smart Contracts
While smart contracts currently are limited in their use cases, many experts are cautiously optimistic about their potential to change the way we do business. Many payment transactions that use a financial intermediary could be done without one, either by transferring stablecoins directly between parties or creating digital escrow accounts where funds are released upon proof of delivery. [35] This is also the case with financing transactions, potentially allowing lending, borrowing,[36] and even raising capital[37] without an intermediary involved. Derivative smart contracts could automate payouts and margin calls.[38] Using smart contracts for these financial transactions not only could reduce transaction costs, but also make it easier for individuals to participate in these transactions. Other industries are open for disruption as well. With the growth of smart energy grids and household renewable energy sources like solar panels, the energy industry could implement smart contracts to allow for consumers to instantly pay for energy or sell excess energy back to the grid.[39] The insurance industry could use smart contracts to create products that instantly payout when events happen without the need for a lengthy and costly claim validation processes. [40] Global supply chains could also be changed by smart contracts; smart contracts can automatically record when each step of the supply chain is carried out without risk of fraud or needing manual recordation. [41]
Even asset ownership or the nature of business entities could be changed. Asset tokenization could allow ownership interests in real assets to be recorded and traded on the blockchain using smart contract DApps.[42] Smart contracts can be used to create business entities and control their governance structure, these are called Digital Autonomous Organizations (“DAOs”), which have tokens that act as proof of ownership and provide governing rights to the entity; some states are starting to adopt laws to formalize DAOs and give them similar legal treatment to LLCs.[43]
These use cases require advancements in the infrastructure around smart contracts, primarily through the expansion of “oracles.” Since smart contracts cannot directly take input data from the real world, they must get that data from sources already on the blockchain.[44] Oracles are the solution to this problem; they are data feeds record real-world data and store them on the blockchain for use by smart contracts.[45] These could be software oracles that find data online, like stock prices or temperature data, and record that data on the blockchain, hardware oracles, using the internet-of-things and sensors to record real-time data from the world, like the location of a shipment, or even human oracles that could be a trusted third party who inputs whether some condition has been met onto the blockchain.[46]With the expansion of a more comprehensive system of oracles, which will become easier to implement as the internet-of-things expands and growth in smart contract use spreads their costs, many of the functions of traditional contracts could be performed using smart contracts.
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[1] Billy Bambrough, $1 Trillion Crypto Price Boom, Forbes (Oct. 30, 2021, 6:30 AM EDT),
https://www.forbes.com/sites/billybambrough/2021/10/30/1-trillion-crypto-price-boom-bitcoin-braced-for-further-supply-shocks-as-ethereum-suddenly-surges/?sh=5ebf856418b2
[2] Jacob Kastrenakes, Beeple sold an NFT for $69 million, The Verge (Mar. 11, 2021, 10:09 AM EST),
https://www.theverge.com/2021/3/11/22325054/beeple-christies-nft-sale-cost-everydays-69-million
[3] Smart contracts are most used on Ethereum, as opposed the more popular Bitcoin, because they can store and run code within their blocks. This is necessary for the use of smart contracts and Bitcoin does not have this ability, and due to Bitcoin’s decentralized nature, it is impossible to add this feature to it.
[4] Stuart D. Levi and Alex B. Lipton, An Introduciton to Smart Contracts and Their Potential and Inherent Limitations, Harv. L. Sch. F. on Corp. Governance (May 26, 2018), https://corpgov.law.harvard.edu/2018/05/26/an-introduction-to-smart-contracts-and-their-potential-and-inherent-limitations/
[5] Fabian Schär, Decentralized Finance: On Blockchain- and Smart Contract-Based Financial Markets, Fed. Rsrv. Bank of St. Louis Rev. 153 (2021), https://files.stlouisfed.org/files/htdocs/publications/review/2021/04/15/decentralized-finance-on-blockchain-and-smart-contract-based-financial-markets.pdf
[6] Ivan Kot, 6 Use Cases for Smart Contracts in Decentralized Finance, Finextra (Jan. 18, 2021),
https://www.finextra.com/blogposting/19770/6-use-cases-for-smart-contracts-in-decentralized-finance
[7] Ethereum Developers, Introduction to Smart Contracts, Ethereum.org (Sept. 21, 2021), https://ethereum.org/en/developers/docs/smart-contracts/
[8] Diego Geroni, Top 12 Smart Contract Use Cases, 101Blockchains.com (Sept. 16, 2021),
https://101blockchains.com/smart-contract-use-cases/
[9] As a technicality, smart contracts cannot directly reference real-world data. They reach real world data through oracles that record real world data on the blockchain. Once the data is on the blockchain smart contracts can use this real-world data. Ethereum Developers, Oracles,Ethereum.org (Oct. 1, 2021), https://ethereum.org/en/developers/docs/oracles/
[10] Jeffrey D. Neuburger et. al, Smart Contracts: Best Practices, Proskauer Rose Blogs: Practical Law (2019), https://blockchainandthelaw.proskauerroseblogs.com/wp-content/uploads/sites/9/2019/11/Smart-Contracts-Best-Practices-w-022-2968.pdf
[11] There are ways to include qualitative clauses by using trusted third parties called (human) oracles, to do so creates transaction costs and results in the contract no longer being “trustless,” i.e. not relying on any party to ensure the contract is correctly carried out, thus nullifying many of the reasons a party would choose to use a smart contract over a traditional contract. See Richard H. Casper et. al, Smart Supply Chains Using Smart Contracts, Nat’l L. Rev. (Sept. 23, 2021), https://www.natlawreview.com/article/smart-supply-chains-using-smart-contracts; Ethereum Developers, Oracles, Ethereum.org (Oct. 1, 2021), https://ethereum.org/en/developers/docs/oracles/
[12] Stuart D. Levi and Alex B. Lipton, An Introduciton to Smart Contracts and Their Potential and Inherent Limitations, Harv. L. Sch. F. on Corp. Governance (May 26, 2018), https://corpgov.law.harvard.edu/2018/05/26/an-introduction-to-smart-contracts-and-their-potential-and-inherent-limitations/
[13] There are possibilities a smart contract to still be litigated, such as claiming a contract was never formed for lack of capacity, offer, acceptance, or consideration, alleging that there was fraud, misrepresentation, or lack of disclosure, or claiming that the data the contract was using was incorrect. But, the possibility that the two parties having drawn out litigation based solely on disagreement about the meaning of its text is impossible. Stuart D. Levi and Alex B. Lipton, An Introduciton to Smart Contracts and Their Potential and Inherent Limitations, Harv. L. Sch. F. on Corp. Governance (May 26, 2018), https://corpgov.law.harvard.edu/2018/05/26/an-introduction-to-smart-contracts-and-their-potential-and-inherent-limitations/
[14] Diego Geroni, Top 12 Smart Contract Use Cases, 101Blockchains.com (Sept. 16, 2021),
https://101blockchains.com/smart-contract-use-cases/
[15] Jeffrey D. Neuburger et. al, Smart Contracts: Best Practices, Proskauer Rose Blogs: Practical Law (2019), https://blockchainandthelaw.proskauerroseblogs.com/wp-content/uploads/sites/9/2019/11/Smart-Contracts-Best-Practices-w-022-2968.pdf
[16] Ethereum Developers, Introduction to Smart Contracts, Ethereum.org (Sept. 21, 2021), https://ethereum.org/en/developers/docs/smart-contracts/
[17] There is some initial cost with creating a smart contract from scratch, but once a form smart contract is coded out, it can be cheaply adjusted and replicated for subsequent similar transactions. Additionally, decentralized applications can make this process easier and more accessible to non-sophisticated or non-technical parties.
[18] Coinbase, What is Ethereum?, coinbase.com (2021), https://www.coinbase.com/learn/crypto-basics/what-is-ethereum
[19] James Barton, How many Ethereum smart contracts are there?, coindiligent (Jan. 27, 2020), https://coindiligent.com/how-many-ethereum-smart-contracts
[20] See Lewis Cohen, Angela Angelovska-Wilson & Greg Strong, Decentralized Finance: Ready for its “close-up”?, in Global Legal Insights, Blockchain & Cryptocurrency Law and Regulations 2022 (2021), https://www.globallegalinsights.com/practice-areas/blockchain-laws-and-regulations/08-decentralized-finance-ready-for-its-close-up; Fabian Schär, Decentralized Finance: On Blockchain- and Smart Contract-Based Financial Markets, Fed. Rsrv. Bank of St. Louis Rev. 153 (2021), https://files.stlouisfed.org/files/htdocs/publications/review/2021/04/15/decentralized-finance-on-blockchain-and-smart-contract-based-financial-markets.pdf
[21] Id.
[22] Id.
[23] See Fabian Schär, Decentralized Finance: On Blockchain- and Smart Contract-Based Financial Markets, Fed. Rsrv. Bank of St. Louis Rev. 153 (2021), https://files.stlouisfed.org/files/htdocs/publications/review/2021/04/15/decentralized-finance-on-blockchain-and-smart-contract-based-financial-markets.pdf; Pablo Cibrano, 101 Smart Contracts and Decentralized Apps in Ethereum, auth0 Blog (July 7, 2021), https://auth0.com/blog/101-smart-contracts-and-decentralized-apps-in-ethereum/; Ethereum Developers, Ethereum-powered tools and services, Ethereum.org (Oct. 1, 2021), https://ethereum.org/en/dapps/
[24] See Fabian Schär, Decentralized Finance: On Blockchain- and Smart Contract-Based Financial Markets, Fed. Rsrv. Bank of St. Louis Rev. 153 (2021), https://files.stlouisfed.org/files/htdocs/publications/review/2021/04/15/decentralized-finance-on-blockchain-and-smart-contract-based-financial-markets.pdf; See e.g., Ethereum Developers, Ethereum-powered tools and services, Ethereum.org (Oct. 1, 2021), https://ethereum.org/en/dapps/
[25] Smart contracts are not always even meant to function as contracts. Smart contracts can be used for other functions such as recording data on public, decentralized ledgers.
[26] Jeffrey D. Neuburger et. al, Smart Contracts: Best Practices, Proskauer Rose Blogs: Practical Law (2019), https://blockchainandthelaw.proskauerroseblogs.com/wp-content/uploads/sites/9/2019/11/Smart-Contracts-Best-Practices-w-022-2968.pdf
[27] Id.
[28] Richard H. Casper et. al, Smart Supply Chains Using Smart Contracts, Nat’l L. Rev. (Sept. 23, 2021), https://www.natlawreview.com/article/smart-supply-chains-using-smart-contracts
[29] Heather Hughes, Blockchain and the Future of Secured Transactions Law, Stan. J. of Blockchain L. & Pol’y (2020), https://stanford-jblp.pubpub.org/pub/blockchain-secured-transactions/release/1
[30] Richard H. Casper et. al, Smart Supply Chains Using Smart Contracts, Nat’l L. Rev. (Sept. 23, 2021), https://www.natlawreview.com/article/smart-supply-chains-using-smart-contracts
[31] Stuart Levi, Alex Lipton & Cristina Vasile, Legal Issues Surrounding the Use of Smart Contracts, in Global Legal Insights, Blockchain and Cryptocurrency Regulation (Josias N. Dewey ed., 2d. ed., 2020)
[32] Tenn. Code. Ann. § 47-10-201, 47-10-202
[33] William K. Kane and Zachary Golda, Wyoming Takes the Lead With Decentralized Autonomous Organizations, Nat’l L. Rev. (May 25, 2021), https://www.natlawreview.com/article/wyoming-takes-lead-decentralized-autonomous-organizations
[34] Jeffrey D. Neuburger et. al, Smart Contracts: Best Practices, Proskauer Rose Blogs: Practical Law (2019), https://blockchainandthelaw.proskauerroseblogs.com/wp-content/uploads/sites/9/2019/11/Smart-Contracts-Best-Practices-w-022-2968.pdf
[35] Richard H. Casper et. al, Smart Supply Chains Using Smart Contracts, Nat’l L. Rev. (Sept. 23, 2021), https://www.natlawreview.com/article/smart-supply-chains-using-smart-contracts
[36] Fabian Schär, Decentralized Finance: On Blockchain- and Smart Contract-Based Financial Markets, Fed. Rsrv. Bank of St. Louis Rev. 153 (2021)
[37] David Lopez, Colin Lloyd & Laura Daugherty, Raising Capital: Key Considerations for Cryptocurrency Companies, in Global Legal Insights, Blockchain & Cryptocurrency Law and Regulations 2022 (2021), globallegalinsights.com/practice-areas/blockchain-laws-and-regulations/15-raising-capital-key-considerations-for-cryptocurrency-companies#chaptercontent2
[38] Luis Alejandro Estoup, Smart Contracts and Smart Derivative Contracts: Legal Guidelines, Thomson Reuters: Practical Law (Sept. 1, 2019), https://uk.practicallaw.thomsonreuters.com/w-021-9121?transitionType=Default&contextData=(sc.Default)#co_anchor_a325950; Jonathan Gilmour and Vanessa Kalijnikoff Battaglia, Smart Contracts in the Derivatives Space, in Global Legal Insights, Blockchain & Cryptocurrency Law and Regulations 2022 (2021), https://www.globallegalinsights.com/practice-areas/blockchain-laws-and-regulations/16-smart-contracts-in-the-derivatives-space
[39] Connor O’Neil, From the Bottom Up: Designing a Decentralized Power System, Nat’l Renewable Energy Laboratory, Department of Energy, https://www.nrel.gov/news/features/2019/from-the-bottom-up-designing-a-decentralized-power-system.html; Ivan Kot, 6 Use Cases for Smart Contracts in Decentralized Finance, Finextra (Jan. 18, 2021),
https://www.finextra.com/blogposting/19770/6-use-cases-for-smart-contracts-in-decentralized-finance
[40] Hasib Anwar, The Importance of Blockchain in Insurance Industry, 101Blockchains.com (Nov. 17, 2020), https://101blockchains.com/blockchain-in-insurance/
[41] Diego Geroni, Top 12 Smart Contract Use Cases, 101Blockchains.com (Sept. 16, 2021),
https://101blockchains.com/smart-contract-use-cases/
[42] Mihai Malașevschi, Asset Tokenization & Legal Implications, Malashevsky’s Law Blog (Nov. 27, 2018), https://malasevschi.wordpress.com/2018/11/27/asset-tokenization-legal-implications/; David Uzsoki, Tokenizing Real Assets: Examples from Switzerland, in Tokenization of Infrastructure: A blockchain-based solution to financing sustainable infrastructure 18 (2019), https://www.jstor.org/stable/resrep22004.6
[43] See William K. Kane and Zachary Golda, Wyoming Takes the Lead With Decentralized Autonomous Organizations, Nat’l L. Rev. (May 25, 2021), https://www.natlawreview.com/article/wyoming-takes-lead-decentralized-autonomous-organizations;
[44] Ethereum Developers, Oracles, Ethereum.org (Oct. 1, 2021), https://ethereum.org/en/developers/docs/oracles/
[45] Id.
[46] Richard H. Casper et. al, Smart Supply Chains Using Smart Contracts, Nat’l L. Rev. (Sept. 23, 2021), https://www.natlawreview.com/article/smart-supply-chains-using-smart-contracts