Financial services companies, software developers and governments alike are exploring opportunities to automate a wide range of legacy processes using smart contracts and blockchain technology.

What are smart contracts?

Smart contracts are “computable” legal contracts that execute automatically (without verification by a third party) when a set of pre-programmed conditions are satisfied.  Unlike traditional legal contracts, smart contracts are written in source code.  They can be stored on distributed ledger platforms and secured using cryptographic keys to make them immutable and tamper resistant.

One example of a smart contract is a simple derivatives contract that settles automatically upon certain specified changes in a reference financial index. When the financial index undergoes specified changes, pre-programmed rules in the smart contract automatically trigger contract settlement (for example, a payment from one account to another).  This automatic settlement of smart contracts in accordance with pre-programmed rules eliminates the need for a trusted intermediary (such as a lawyer or escrow agent) to verify that the conditions precedent to settlement have been satisfied.  As a result, smart contracts have the potential to eliminate third party intermediaries, and to reduce transaction costs, in certain commercial arrangements that today are managed and settled manually.

Legal Issues to Consider

Although smart contracts platforms and programming languages are at an early stage of development, as the technology matures and gains greater commercial adoption, contract counterparties will face a number of legal risks. Smart contracts that rely on real-time data feeds to trigger contract settlement have dependencies that do not exist in traditional legal contracts that require manual review or event verification before settlement.  The potential manipulation of underlying data feeds and indices that trigger real-time contract execution is a risk that regulators such as the U.S. Commodity Futures Trading Commission are likely to watch closely.  Coding errors and software bugs, as well as cybersecurity attacks (such as the one experienced by The DAO, a decentralized autonomous organization designed to function as an autonomous venture capital fund, earlier this year), pose risk of financial loss and business interruption and could negatively impact companies that are early adopters of smart contracts (as well as their cybersecurity insurance carriers).

State and federal governments — and regulators — will need to address a number of novel legal issues as smart contracts technology gains broader adoption, including the admissibility of time-stamped evidence recorded in distributed ledger databases under state rules of evidence, burdens of proof regarding contract authenticity, and the enforceability of smart contracts that involve assets or contract settlement steps in multiple jurisdictions.

The State governments of Vermont and Delaware are currently at the forefront of addressing these novel legal issues. In 2016, Vermont enacted a new law which creates a rebuttable statutory assumption that digital records that are electronically registered in the blockchain are authentic.  In addition, in June 2016, Delaware’s governor announced the creation of the Delaware Blockchain Initiative which, among other things, seeks changes to Delaware law to accommodate distributed ledger shares.  Outside the United States, a number of governments have been actively engaged in researching the applications of smart contracts.  See, for example, the UK government’s report on blockchain technology released earlier this year.

Smart contracts could also disrupt the legal industry by automating certain functions that today are performed by lawyers. At the same time, the adoption of smart contracts will likely generate demand for legal advisors who can “code” in smart contract programming languages and ensure these computable contracts accurately reflect the underlying business deal.