If you’ve been paying any attention at all to news about Web3, the metaverse, non-fungible tokens (NFTs), or cryptocurrency, you’ve probably heard about smart contracts. You’re probably also intrigued by how they work from a legal perspective and what they could mean for the future of your business.
Smart contracts are a fundamental element of Web3, the evolving decentralized internet that many say is on the horizon. Businesses (including lawyers) that understand how to use smart contracts can gain an edge over the competition as Web3 matures.
What is a smart contract?
A smart contract is not your typical legal contract. It would be more accurate to say that it is a computer program that ensures that things are done according to the agreement between the parties, something similar to automated digital escrow agents.
Smart contracts are applications that contain lines of code that trigger certain actions when you meet predefined conditions. This automatic enforcement mechanism ensures that all parties involved keep their promises. Many smart contracts are legally binding like traditional contracts, so if a party is no longer able to fulfill their obligations, they can face legal consequences.
Smart contracts are run using blockchain technology, which is a cryptographically based, decentralized, digitally distributed ledger that records transactions. It exists on a network of computers rather than on a single server. And it is immutable, meaning that after the smart contract is deployed to the decentralized network, no contracting party can step in and change its terms or conditions without the consent of the network.
Components of a smart contract
Although most smart contracts run on the Ethereum blockchain, there are many competing blockchains such as EOS, Polkadot or Tron. Contracts on the Ethereum blockchain use the Solidity programming language, while others may use Vyper, Yul or Rust, among others.
When creating a smart contract, all parties should agree on the following:
- How the blockchain will represent transactions and data
- How and when to make manual exceptions, if desired
- The conditions for triggering an action
- A dispute resolution framework, including choice of law
Once you have agreed on these elements, you can create the contract. Many companies use an in-house developer to do the programming, or they can outsource the task to a third party.
How do smart contracts work?
Smart contracts are quite easy to understand. When a predefined condition or set of conditions is met, the smart contract automatically performs the actions of the agreement. These actions can be anything from transferring funds between parties to sending a notification to your phone. One of the simplest examples is a vending machine.
In implementation, the smart contract “listens” for updates from an input oracle, which connects the blockchain to external inputs. Output oracles allow smart contracts to send signals to other systems to trigger actions.
When the transaction is complete, the oracle informs the smart contract and the blockchain is updated to reflect the completed transaction. So, for example, someone can use Bitcoin to buy a car. As soon as it receives the signal that the payment is complete, the smart contract can ping an IoT system in the car to unlock the door.
The benefits of smart contracts
In many ways, smart contracts are both disruptive and helpful to businesses across nearly every industry. Some of the biggest business benefits of smart contracts include:
- Safety: Due to the immutable nature of blockchain technology, it is incredibly difficult to hack into a smart contract. A malicious actor would not be able to change one record without going through the entire chain, which would require hacking the majority of computers participating in the network.
- Efficiency: Smart contracts eliminate the need to go through third parties such as physical custodians and asset servicers, removing delays in execution. Immediately after the conditions are met, the smart contract performs the agreed action. This works best for one-time, discrete transactions rather than complicated, ongoing business relationships.
- Accuracy: Because smart contracts are fully automated, the risk of human error after implementation is low.
- Transparency: Because smart contracts are distributed over a network, all parties involved have access to a copy of the contract. All participants can trace updates back through the blockchain to their source.
- Financial savings: By eliminating the need to bring in middlemen, you can save money on service fees and delays.
However, like all technology, smart contracts have their drawbacks. First, their duration means you can’t go back and change the code if you find errors. You are also completely dependent on the developer programming the contract, which can make it difficult to verify that the code includes all the terms and conditions.
In addition, it is also possible to program loopholes in smart contracts. An experienced Web 3.0 attorney can help protect your business from being on the wrong side of a bad-faith crypto deal.
How can companies use smart contracts?
Smart contracts can be useful for many applications. Here are some real-world examples of smart contract applications across different industries:
1. Automated workflows
Many forward-thinking businesses today use workflow automation software to improve their operational efficiency. Workflow automation is similar to smart contracts in that it also follows an “If X, then Y” process. However, unlike smart contracts, most workflow applications are not connected to a blockchain.
By combining smart contracts with workflow automation, businesses can harness the full power of this software. For example, when a smart contract expires, the software can automatically create a new one or provide a notification that the current contract is about to expire and needs to be renegotiated.
2. Protection of intellectual property
Smart contracts can help creators protect their IP, which is becoming increasingly important due to concerns over digital goods such as NFTs. Creators can use smart contracts to transfer or retain their ownership of a piece of content during a transaction.
For example, an NFT creator may wish to retain ownership of their artwork while transferring ownership of the token to the buyer. In NFT’s smart contract, they could outline clear ownership and payment terms that protect their rights.
Artists can also receive royalties using smart contracts. Every time an NFT or copy of their artwork sells, a smart contract can trigger an automatic payment from the distributor to the artist.
3. Supply Chain Management
Supply chains are incredibly complex, especially for large companies that manage thousands of transactions per day. Automating record keeping using smart contracts and blockchain technology creates a robust, reliable audit trail for all supply chain activities. This can make it easier to trace issues back to their origin and resolve them, as well as provide visibility to downstream partners regarding the source and status of their goods in transit.
Smart contracts can automatically:
- Review and verify transaction status
- Issue payments
- Register ledger entries
- Flag exceptions for manual intervention
Automating these tasks can significantly simplify supply chain management for companies of all sizes.
The future of smart contracts
Will smart contracts become mainstream in business transactions? It’s hard to say for sure. We’ll have to see what happens as Web3 matures over the coming years, but the potential uses for this technology are widespread.
In the meantime, however, it’s best to do your due diligence when creating smart contracts. Just as with traditional contracts, working with a licensed attorney can help you avoid some of the pitfalls of bad faith agreements.
