Smart(er) contracts in 2020 – Technology – Australia – Mondaq News Alerts

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Blockchain well and truly entered into the vernacular during the ‘ICO boom’ of 2017, and yet for many the term has become
synonymous with cryptocurrency.  Although very much still in
development, blockchain technology has the potential to move beyond
simply recording and verifying transactions.  In particular,
there has been a renewed interest, and increased experimentation,
in codifying legal agreements on blockchains through the use of
smart contracts.

This article discusses some of the current opportunities and
challenges facing the adoption of blockchain technology, and in
particular smart contracts.

WHAT IS A BLOCKCHAIN?

Blockchains are tamper resistant digital ledgers implemented in
a distributed fashion, usually without a central authority. 
This distributed ledger system essentially takes a number of
records and bundles them into data sets or ‘blocks’. 
That block gets chained to the next block using a cryptographic
signature or ‘key’.  The blockchain then acts as a
ledger and the keys control who can do what within the
ledger.  Each user owns a full copy of the ledger, and plays
an important role in automatically and continuously agreeing on the
current state of the ledger and all of the transactions recorded in
it.  Blockchains can be public (i.e. anyone can become part of
the network) or private (i.e. only approved participants can become
part of the network).

At their most basic level, a blockchain enables a community of
users to record transactions in the ledger that is public to that
community, such that, effectively, no transaction can be changed
once published.  It is the data transparency between all users
in the network, and underlying cryptography, that removes the need
for a trusted intermediary.
 

WHAT ARE SMART CONTRACTS?

The term smart contract is something of a misnomer.  As
Ethereum founder Vitalik Buterin 
tweeted in 2018
, they should have been called “something more boring and technical, perhaps something like
persistent scripts”.  A smart contract is a
self-executing, self enforcing protocol which is governed by its
explicit terms and conditions.  To enter into a blockchain
based smart contract, the parties first negotiate and agree to the
terms of the agreement before memorialising the terms (either in
part or entirely) in smart contract code.

Matters which utilise clear rules and quantifiable terms of
engagement are well suited to implementing smart contracts. 
For example, blockchain and smart contract technology is already
being utilised:

  • in the logistics sector – to shorten the chain of third
    party agents, shorten delivery timeframes, track the transportation
    of goods and potentially reduce the price to consumers and chances
    of theft ;
  • in the food and wine sector – to track the provenance of
    products to better prevent food fraud; and
  • in the financial services sector – the opportunities are
    almost endless for financial services and include, for example,
    payment processing (including cross-border payments), clearing and
    settlement of financial instruments, trade finance and automated
    over the counter (OTC) derivatives contracts, as
    well as regulatory technology such as streamlined ‘know your
    customer’ certification.

Advantages of using smart contracts

There are a number of common advantages which smart contracts
can offer.  These include:

Accuracy and transparency:   As the
codified terms are fully visible and accessible to all relevant
parties, there is no way to dispute them once the smart contract is
established.  This facilities complete transactional
transparency and removes (or, at the very least, reduces the
likelihood) of any manipulation, bias or error which in turn
encourages greater confidence in the execution of the smart
contract.  This, in turn leads to decreased monitoring costs
and risks of opportunistic behaviour.

Efficiency:  Smart contracts are able
to improve the efficiency with which commercial arrangements are
carried out due to:

  • automated execution;
  • the bypassing of bureaucratic mechanisms;
  • the high speed of execution thanks to the use of mathematical
    algorithms in blockchain applications instead of bureaucratic
    mechanisms;
  • there being no requirement to process documents manually;
    and
  • a lack of miscommunication due to the explicit nature of the
    codified terms.

Many smart contract-proposed use cases assume that the smart
contract will receive information or parameters from ‘off-chain’ resources.  This can cause two major
issues.  Firstly, smart contracts do not have the ability to
pull data from off-chain resources; rather, the information must be ‘pushed’ to the smart contract.  Secondly, if the data
at issue is in constant flux, and since the code is replicated
across multiple nodes, different nodes across the network may be
receiving slightly different information.  As consensus is
required across the nodes for a transaction to be validated, these
fluctuations may prevent the condition from being satisfied. 
Contracting parties can, however, solve this issue in a streamlined
and transparent way by using an ‘oracle’.  Oracles are
trusted third parties (which may be software or actual people) that
retrieve off-chain information and then push that information to
the blockchain at predetermined times.

Security:  Smart contracts are
afforded the reliability and tamper-resistant nature of the
decentralised data storage which underpins blockchain
technology.  In particular, because of the distributed nature
of a blockchain, along with consensus mechanisms and hashing
algorithms, once information has been recorded to a blockchain, it
becomes incredibly hard to change or delete.  A party does not
have the ability to modify or roll back information stored on a
blockchain, or halt the execution of a smart contract once it has
been deployed, unless provided for in the code.

LEGAL AND REGULATORY CHALLENGES OF SMART CONTRACTS

Despite the opportunities the adoption of smart contracts can
offer, there are still a myriad of issues, including, in
particular, legal and regulatory challenges, which are preventing
the more widespread utilisation of smart contracts.  These
include:

Interpretation and enforceability:   If
there is a dispute about whether a smart contract accurately
memorialised the parties’ intentions or whether one party has
breached the contract, the parties may still bring legal
proceedings or engage in alternative dispute resolution
processes.  As contract law varies between different
jurisdictions, so too will the enforceability of smart contracts
depending on any formal requirements required in a particular
jurisdiction.

Assuming the smart contract is enforceable, how then do the
parties to the contract, a judge or a regulator interpret the terms
that are written in code?  While judges may not look to
sources external to the contract to interpret the code, natural
language clauses can be linked to the digital clauses for
interpretation purposes.  These hybrid contracts are referred
to as ‘Ricardian contracts’.  Coding within the
blockchain ledger contains a reference to the natural language
clause thereby incorporating it into the digitised contract. 
If all goes smoothly, it may be that the natural language clauses
will not need to be referred to.

If a different outcome was mandated by law, how would a smart
contract transaction on the blockchain be unwound?  And what
would that mean for the downstream transactions that have already
formed on the blockchain?  Will there be a need to legislate
for ‘kill switches’ in times of stress?

Liability and risk allocation:   Smart
contract ‘purists’ take the view that the smart contract
code should simply resolve issues of liability through performance.
 However, this is a simplistic view.  There will always
be interests that differ between two counterparties, regardless of
the assumptions on which the technology is built and runs. 
This is a reality of trade and commerce, and means that it is not
possible to escape the fact that there may need to be adjudication
on matters of liability.

Smart contracts also introduce a completely novel risk that the
contract will be hacked or that the code or protocol simply
contains an unintended programming error.  In relation to
blockchain technology, these concepts are closely aligned as most
hacks associated with blockchain technology eventuate from
exploitations of an unintended coding error.  Parties to a
smart contract will need to consider how risk and liability for
unintended coding errors and resulting exploitations ought to be
allocated between the parties, and possibly with any third party
developers or insurers of the smart contract.  For example,
the parties may seek written representations from the programmer
that the code performs as contemplated.

Confidentiality, security and
privacy:  
Although the transparent nature of
smart contracts is potentially advantageous, some smart contracts
may exhibit a degree of transparency that is undesirable to some
parties.  Unlike traditional contracts, all transactions
executed via a smart contract, are propagated across all of the
nodes in the network, which creates privacy issues, particularly
when the accounts of the parties are associated with known
entities.  Even when the parties are not identified (e.g. they
rely on pseudonymous accounts), certain identification techniques
can be used to discern the identities of parties who transact with
a particular smart contract.

Interestingly, the flip side to the confidentiality/privacy
debate is that the availability of the data provides an audit trail
and a much more efficient way for regulators to view the
information they need to ensure regulatory compliance –
essentially, acting as a “regulatory app”.

Jurisdictional issues:   Smart
contracts also raise interesting jurisdictional issues. 
Because blockchain operates as a decentralised ledger, it means
that smart contracts can be formed and accessed anywhere across the
globe.  They do not reside in any one location, but exist
across multiple locations at the one time.  Yet our laws are
jurisdiction-based.

The differences in laws across jurisdictions – including
matters as basic as ownership – can be highly problematic,
resulting in incongruent rights and responsibilities, and confusion
regarding the consequences if there is a contract violation.

Evidentiary matters:   As smart
contracts begin to proliferate, they will be subject to
examination.  This means there will be a need for new types of
cryptography experts, and forensics experts, to verify software
code and to translate the code into human-readable form.

Regulated contracts:   Smart
contracts sit uneasily with certain types of regulated
contracts.  Take, for example, Australian unfair contract
terms legislation.  A contract written in code is probably not
going to be sufficiently transparent for the purposes of informing
a consumer or small business.

Regulatory and policy settings:  
Existing regulatory and policy settings will need to be considered
in greater detail.  How are regulators to police smart
contracts?  And what opportunities exist for parties to use
the technology to potentially side-step the law by hiding the
identity of the parties and the governing jurisdiction of the
contract?  How are cross-jurisdictional issues of taxation,
national security and anti-money laundering to be managed?

WHERE TO FROM HERE FOR AUSTRALIA?

In addition to the release of the 
National Blockchain Roadmap
 in February
2020, several Australian Government agencies have sought to clarify
the regulatory issues that affect the implementation and use of
blockchain.  For example:

  • the Australian Securities and Investments Commission has
    released 
    guidance
     in relation to when the use of
    blockchain technology may attract regulation under Australian
    financial services regulatory laws (for example, when an initial
    coin offering may constitute an offer of shares or interests in a
    managed investment scheme);
  • the Australian Taxation Office has also released 
    guidance
     in relation to the tax treatment
    of digital assets;
  • following legislative changes in 2018, digital currency
    exchange operators with a geographical link to Australia
    are 
    now required to comply
     with Australian
    anti-money laundering and counter-terrorism financing laws;
  • the Federal Government has provided funding to Standards
    Australia to develop, in concert with the International
    Organization for Standardization, international blockchain
    standards;  and
  • IP Australia co-leads the Committee on World Intellectual
    Property Organization Standards Blockchain Task Force, which is
    exploring the potential of blockchain technology for the IP Rights
    ecosystem.

The Australian Government has acknowledged that there are many
opportunities blockchain technology and particularly smart
contracts can facilitate across various sectors, however,
Australia’s ability to capitalise on these opportunities will
depend (at least in part), upon effective, efficient and
appropriate regulation and standards.

The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.

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