The Potential Dangers of Smart Contracts

Although smart contracts have been hailed as a revolutionary technology that has the capacity to disrupt the legal industry and business arrangements, smart contracts still face several challenges that need to be reconciled if widespread adoption is to become the norm. This article will explore why. 

What are Smart Contracts? 

Smart contracts are self-executing contracts that are programmed on decentralised, immutable blockchains. The smart contract is programmed so the code automatically executes certain actions when particular conditions are met, thereby eliminating the need for intermediaries to enforce the contract between both parties. 

Smart contracts have many extensive use-cases, whether it be from executing an agreement for the sale of goods between two parties or automating property deals. A further example of where smart contracts are employed includes vending machines. Here, the rules of purchasing items from the vending machine are pre-set whereby the vending machine only gives you the product after you have entered the correct amount of money. 

The automated nature of smart contracts is significant in mitigating the potential for parties to not fulfil their side of the agreement. Ultimately, a party's decision to not honour their contractual obligations is outside their control because their performance is automated. In this way, aggrieved parties avoid the expense and risk of having to enforce contracts by pursuing dispute resolution or litigation. 

The Dangers of Automation

While automation may be seen as a blessing, smart contract schemes are not entirely immune from their problems. There is of course the possibility that the contractual terms were unlawful to begin with and that a remedy needs to be provided to the aggrieved party. Doing so will prove more difficult than what it normally would have been for a traditional paper contract because the computer code executes automatically, making the contract more difficult to 'unwind'. 

Moreover, the costs of having a self-executing smart contract that contains a coding error can be substantial. For example, the smart contract code for the DeFi platform 'Compound' was found to have had an error which mistakenly awarded $90 million worth of COMP tokens to some of its users. Rectifying these errors can be costly, time-consuming and even impossible. 

A further issue with self-executing smart contracts is that they afford little flexibility between parties in terms of their subjective dealings. The COVID pandemic has heightened the need for subjective judgement when it comes to contractual dealings, whether it be that of making a commercial decision to waive mortgage repayments for several months or to change agreed deadlines.

Smart contracts make it difficult for parties to pivot as required by unforeseen circumstances because the code is immutable (and cannot be 'altered') with any terms self-executing. Any slight changes to the contract would require the parties to cancel their existing smart contract and agree upon a new set of a code. 

Difficulties with Understanding Programming Languages

You may have read a lengthy contract and scratched your head at all the legal terms and jargon that was used, wondering who on earth would understand any of it. Similar things can be said of coding (given your level of expertise of course!). 

This poses several issues at both the 'client' and 'lawyer' levels of smart contract interactions. At the client level, most people would potentially find smart contracts difficult to understand and evaluate on their own. So while smart contracts promise clients greater transparency in their dealings with other parties, this is ultimately of little value if the client cannot understand the code for themselves and therefore cannot determine whether it will perform as intended. 

One might then suggest that the solution lies with the lawyers properly explaining the code to their clients. However, this has its issues as well. Since most lawyers (and judges) are not avid coders, lawyers may be limited in terms of their capacity to explain the contractual implications of their code to their clients.

Ultimately this will depend on the lawyers bringing in coding experts to advise them on material issues. While this has merit, it will serve as an imperfect solution as it is the lawyers who understand complex legal contractual jargon. Lawyers needing to translate this to coders, and coders needing to translate this back to lawyers, raises the very real possibility of important legal information being lost in translation (and vice versa). 

Final Thoughts

Although smart contracts offer significant benefits in terms of automation, efficiency and transparency, they still face significant obstacles that could implicate their efficacy. However, this does not mean that the issues facing smart contracts are insurmountable. A great start would be for digital literacy to become a priority in law schools and within the legal profession itself. Governments can also start thinking of regulation in terms of how to regulate enforceability issues arising out of smart contract arrangements.

References

[1] Jaliz Maldonado, '10 Ways Blockchain Technology Will Change the Legal Industry', The National Law Review (online, 19 November 2018) <https://www.natlawreview.com/article/10-ways-blockchain-technology-will-change-legal-industry>. 
[2] Jesus Cedeno, '5 Use Cases for Blockchain in the Legal Industry', LRZ Legal (online, 22 July 2020) <https://lrz.legal/de/lrz/5-use-cases-for-blockchain-in-the-legal-industry>.
[3] Alice (Fei) Chen, Zun Hu and Keyu Shi, 'Blockchain in The Legal Industry', Sydney University Law Society (online, 25 September 2020) <https://www.suls.org.au/citations-blog/2020/9/25/blockchain-in-the-legal-industry>. 
[4] Aidan Hookey, 'How Blockchain and Smart Contracts are Driving a Legal Revolution', Australian National University (online, 1 September 2021) <https://law.anu.edu.au/news-and-events/news/how-blockchain-and-smart-contracts-are-driving-legal-revolution>. 
[5] Brian Laverdure, 'The Challenges and Risks of Smart Contracts', Independent Community Bankers of America (online, 12 November 2021) <https://www.icba.org/newsroom/blogs/main-street-matters/2021/11/12/the-challenges-and-risks-of-smart-contracts#:~:text=High%2DStakes%20Flaws,tokens%20due%20to%20faulty%20coding.>. 
[6] Jonathan Herpy, 'Smart Contracts and the Law: What You Need to Know', Forbes (online, 17 March 2022) <https://www.forbes.com/sites/forbesbusinesscouncil/2022/03/17/smart-contracts-and-the-law-what-you-need-to-know/?sh=14e40df13d03>.