In this series of blog posts, we take a look at the current state of play regarding blockchain technology as well as the legal setting with a European and German focus.

How smart are smart contracts? With this question, we take a look at the next topic. After dealing with the bitcoin virtual currency in our last post, so-called “smart contracts” is another widely discussed application of blockchains.

Particularly in the financial sector, the advantages and disadvantages as well as the possibly disruptive nature of the use of smart contracts are currently being weighed-up fairly intensively. In the area of FinTech, not only are start-ups trying to use this digital technology profitably, but the “established” financial institutions alre also testing very precisely in which areas the application of smart contracts is possible and advantageous. Still, the financial industry is just one business segment in which business processes and transactions could increasingly be depicted and processed through smart contracts in the course of advancing digitization. Ultimately, this technology provides options for simplified, decentralized business transactions throughout the field of e-commerce. The trick is to use the advantages of the smart contracts and at the same time have solutions ready to deal with their disadvantages.

What are Smart Contracts?

First of all, it must be clarified that, unlike the term “contract“, a smart contract is not a contract in the civil law sense. It is a software code, more precisely, a very specific expression of a blockchain. Automatic machines – that are able to grasp the insertion of a coin and the selection of a brand of confectionery, enabling the desired product to land in the dispenser – can be considered predecessors of the smart contracts.

Modern smart contracts are designed to define what should happen when a certain predefined event occurs (if-then-logic) between two or more contract partners in one network in a decentralized manner. If, for example, a previously agreed payment is made, the delivery of goods ordered on the Internet can be triggered via the smart contract. On the other hand, actions such as payment or investment can also be triggered by the fact that a certain number of participants declare their agreement. With smart contracts, it is also easy to map complex network decisions – an advantage that should not be underestimated. Due to the decentralized storage of the blockchain, the decision processes is largely guarded from unauthorised manipulation.

One can therefore imagine a smart contract as a database, in which the most diverse events are predefined and aligned. A review of whether a particular event has occurred, enabling the next “domino” to fall is takes place in the network in a decentralized manner. This is commonly referred to as the “Smart Contract Due Diligence” (SCDD) process.

What legal aspects need to be considered?

Smart contracts, of course, have the known disadvantages of blockchain. They are unchangeable as such. This distinguishes them from the general rule of civil law that treaties have to be subject to an evaluative consideration. There is an infinite number of reasons why a contract or a business action to fulfil a contractual obligation can be void, suspended or contestable. It is important to assess whether actual exchanged material or monetary values ​​must be returned. This cannot usually be achieved by an automated software code. It is just not possible to consider and program all eventualities in advance. For this, “artificial intelligence” (AI) would be required. Even if the development of smart contracts goes in this direction – as it must – one must accept the fact that smart contracts do not currently have this intelligence.

From a legal point of view, the discussion about the use of so-called “hard-forks” is of particular interest. Hard forks are retrospective interventions in the existing protocol of a blockchain. The principle of invariability is thus broken. This, on the one hand, means a departure from the basic principle of each blockchain, but on the other hand, it permits the representation of a legally caused disturbance in the performance relation. If smart solutions are developed here, the range of applications of smart contracts will be inevitably widened.

As a conclusion, it can be said that parts of the processing of contractual business relationships can already be done very well by means of smart contracts. However, current system-immanent due diligence cannot replace legal examination of the validity of the contractual actions. Smart contracts therefore have considerable potential for simplifying the digital handling of mass transactions, but they are not yet an autonomous “stand-alone” solution.