Smart contracts – transacting in the digital era

26 November 2018

Since the launch of Bitcoin in 2009, more and more people have become aware of blockchain technology, and its potential to revolutionise payments systems. However, blockchain has many applications beyond cryptocurrency. ‘Smart contracts’ – computer code which execute the terms of an agreement have the potential to revolutionise commercial transactions.

The basics

A ‘smart contract’ is basically a standard agreement, converted into code, which is then placed on a blockchain – a decentralised encrypted distributed ledger. The blockchain removes the need for traditional intermediaries because the agreements are self-executing. In other words, the terms of the agreement are written into the code, and are automatically enforced once the relevant conditions are met.

In manufacturing

Take, for example, a manufacturing business managing debtors. At the moment, such a business would have a variety of contracts with debtors with, potentially, a variety of payment terms. Currently, an accounts receivable department must maintain a record of deliveries to debtors, a record of payments and must pursue ageing debtors, which is a time-consuming process. Furthermore, debtors may have a conflicting account of the timing of deliveries, and both parties must take into account the time taken for payments to clear and centralised payment systems.

A smart contract with a debtor could resolve many of these problems. Here, a delivery could be logged on the distributed ledger, and timestamped. This would preserve an immutable, shared record of the delivery. This would automatically trigger a payment in accordance with the agreement, which would clear instantaneously in cryptocurrency at the contractually agreed upon time. Failure of the payment to clear could be met with an instant suspension of trade, which could also be logged in the distributed ledger. In this case, the smart contract has created a central ledger which informs both parties when the invoice was raised, when the delivery was completed and when payment was made, eliminating many sources of dispute.

In transport

Alternatively, take the example the collection of demurrage debt for transport businesses. Demurrage is a charge incurred by shipping companies for shipping delays, or by consignors or consignees for loading or unloading delays. Currently, recording and chasing demurrage debt is a complicated and complex process, and many businesses write off unpaid debts, given the expense involved with pursuing them.

A smart contract could be designed to which shipping data was provided, and if delays occurred, demurrage payments could automatically be cleared in a cryptocurrency. Both parties could have access to the data in real time, and the distributed ledger would provide a record of all transactions for audit purposes. Again, failure of the payment to clear could also be logged and automatically trigger a suspension of services. The clear benefit in this case of a central register of information and an automatic payment system helps both debtors and creditors to meet the terms of their agreements.

The key benefits

These examples demonstrate just some of the advantages of smart contracts. In summary, the key benefits of smart contracting are that they:

  • are automatic and precise
  • are irreversible, transparent
  • are trackable
  • eliminate need for third-party
  • reduce fees due to lack of third-parties
  • offer a number of efficiencies
  • ensure security via encryption
  • ensure documents are backed up and safe
  • minimise errors
  • maintain data safety & transaction history

Smart contracts offer an opportunity for parties to transact with confidence, even with anonymous parties, given the transparent and self-enforcing nature of the agreement.

Challenges for smart contracting

While smart contracts offer businesses and individuals a more transparent and efficient transaction process, the transition to smart contracting is not without challenges. Given it is a relatively recent development in the law, there are questions in relation to the legal enforceability of code. Law makers will need to keep pace with the technology, in order to ensure that smart contracts are treated the same as paper agreements.

Finally, as with all computer based transactions, smart contracts are at risk from cyber-attack. The blockchain is inherently secure, in the same way that the blockchain which underpins cryptocurrencies like bitcoin is inherently secure, given its level of encryption. However, bugs and loopholes in code have the potential to be exploited by hackers (eg through software updates) so it is essential for programmers of smart contracts to guarantee the integrity of the code.

Lessons for businesses

Despite the challenges, smart contracts clearly present businesses with the opportunity for a more efficient means of transacting. However, as with any agreement which purports to be legally binding, businesses need to have confidence that they are receiving the right advice, from solicitors with a depth of experience in blockchain technology. Furthermore, businesses need to have confidence that their solicitors understand the nuances of smart contracting.