HomepageBitesize CoursesSmart contracts5 Principles to Know

5 Principles to Know

7 mins

Smart contracts are deterministic programmes that automate the performance of specified actions. They consist of self-executing smart contract code that automatically performs once predefined conditions (or triggers) are met (see Principle 2). While smart contracts can be (but are not always) legally enforceable, parties to a legally enforceable contract may be able to automate the performance of some (or all) of its terms through the use of smart contract code (thus forming a 'smart legal contract').

The classic analogy (or ‘primitive ancestor’) for a smart contract is that of a vending machine. Once money is deposited into the machine, the product is automatically dispensed. The process does not require human intervention and cannot be terminated once started. Moreover, the machine itself provides adequate security against theft (a locked cash container), meaning it can be reliably deployed in a range of environments.

06 TA01 01

It is the characteristics of automation and self-execution that allow parties to trust that a smart contract transaction will be performed, without the need for a centralised gatekeeper or external enforcement mechanism. Instead, trust is generated by the underlying smart contract code. This trust can reduce the transaction costs and risk of human error that are otherwise associated with monitoring and managing contractual performance, a benefit that can be realised at scale with highly repeatable agreements (e.g. standard insurance contracts).

SEE LESS

A key benefit of smart contract code is that it provides ‘automaticity’. That is, agreements between parties (whether or not legally enforceable) are automatically performed in the event that predefined conditions occur. In the context of smart legal contracts, this use of conditional logic (if X, then Y) provides computational guarantees that contractual obligations are, in all practical terms and absent of any technological mishaps, performed. For example, smart contract code can automate an agreement that the digital lock to a rental property will automatically be released if a specified amount of currency is transferred by a given date.

06 TA02 01

The distinguishing feature of the automaticity provided through smart contract code (as opposed to other automated technologies or payment systems) is that the code is self-executing. Once a condition has been satisfied, the programme will automatically perform. This gives the parties to a smart legal contract a greater degree of confidence that the automated terms of the contract will be performed (it being a separate question whether any legal claims may still arise).

For smart legal contracts, the use of conditional logic means that smart contract code is better suited to operational provisions that do not require discretion e.g. payment terms. This can include terms that rely on external data sources, known as oracles, such as exchange rates (Principle 3). In contrast, provisions that require judgment (e.g. ‘reasonable’ endeavours) are more difficult to codify. As a result, smart legal contracts will often include a mixture of natural language terms and automated 'smart' terms (Principle 4).

SEE LESS

Determining whether predefined conditions have been met may require information to be fed into a smart contract or smart legal contract. For example, an insurance payment may be triggered automatically when a flight is delayed by a specified period of time. To meet this need, smart contract code can be connected to data sources external to the contract, known as 'oracles'. In this example, a database of flight departure times can tell the contract whether the flight was delayed by more than the permitted time specified in the contract.

06 TA03 01

Oracles are essential for the effective operation of many smart contracts and smart legal contracts, providing critical input data that allows the contract to operate. However, they also give rise to something known as the ‘oracle problem’ as they introduce a single point of failure that creates potential challenges of trust, reliability and security. In particular, if an oracle fails to provide the necessary data, or provides inaccurate data, the smart contract or smart legal contract will fail to perform as expected.

There are several ways that oracle risk can be mitigated. For example, contracting parties can undertake thorough due diligence to ensure that any oracle is reliable and has satisfactory data quality, redundancy and governance controls in place. In addition, technical solutions are emerging to address oracle concerns, including the development of decentralised (blockchain-based) oracle solutions.

SEE LESS

Smart legal contracts do not need to adopt any particular structure. One possible approach uses the 'natural language model' (sometimes called the 'external model'). Here, the terms of the contract are written entirely in natural language and the automated performance of some (or all) of those terms is executed by smart contract code that is documented separately (externally) to the contract. The smart contract code does not record the parties’ contractual obligations but simply acts as a mechanism for performance.

Another approach is the 'solely code model', where the terms of a contract are recorded solely in smart contract code and no natural language version of the contract exists. Between these models sits a 'hybrid model', where some terms of a contract are recorded in natural language and others in smart contract code. This model encompasses a spectrum of approaches. At one end are contracts written primarily in natural language with only one term written in smart contract code. At the other are contracts where most terms are written in smart contract code with only one term written in natural language (e.g. the governing law clause).

NEW 06 TA04 01

The variety of models provides parties with the flexibility needed to satisfy their risk appetite and requirements (legal and otherwise). It also allows for use of smart legal contracts in a greater range of circumstances, for example by allowing parties to cherry-pick terms that will deliver the most benefit through automation while using natural language to document the remainder (see Principle 1).

SEE LESS

There is no specific way to write and deploy smart contracts or smart legal contracts. The approach will depend on the parties' relationship and terms they wish to make 'smart'. Once the parties have agreed to automate an 'agreement' (or certain parts of it), the process will usually begin with the parties representing relevant terms of that agreement in smart contract code. This may involve the use of flowcharts and pseudocode to ensure that the smart contract code accurately reflects the intention of the 'agreement'.

Given their use of computer code, smart contracts and smart legal contracts need to be tested and run on a digital platform. Those platforms most often use distributed ledger technology (DLT), such as blockchain, the decentralised, immutable and cryptographically secure nature of which makes it especially well-suited for use with smart contracts and smart legal contracts. These blockchain-based platforms provide parties with comfort that a contract on the platform is the single source of truth (you can learn more about DLT here).

NEW 06 TA05 01

For smart legal contracts, parties will likely want to include natural language terms in the contract to address potential risk and liability associated with the use of smart contract code. This may include terms that apportion liability for bugs in the code or oblige a party to maintain oracles. As legal terms often document processes that occur multiple times during the life of the contract, the parties may also include a right to suspend smart contract code in certain circumstances, defaulting instead to natural language terms.

SEE LESS

Terminology

Previous
Next

Thank you for signing up for LawtechUK news and updates

You will now be notified of all our latest updates.

Thank you for contacting LawtechUK

We will get back to you as soon as we can.

Thank you for your interest in the Open Legal Data project.

The LawtechUK team will be in touch with you shortly.

Thank you for signing up for LawtechUK news and updates

You will now be notified of all our latest updates.