Smart contracts – intelligent contracts of the future?

Bitcoin, ether, and other cryptocurrencies are becoming more and more popular means of payment. These digital means of payment offer an advantage over classic bank transactions in that no central processing needs to take place anymore. The payment transaction is organized through blockchain, meaning that it is handled by the use of ledgers between computers. The accounts and transactions are documented by the decentralized data bank blockchain. The ledger entry regarding the bank transaction is received by each participant in the transaction in identical form. This ledger is not centrally saved and administered. Blockchain offers many more possibilities than just using it for banking operations. Numerous FinTechs are betting on the future of smart contracts that function with blockchain technology. U.S. legal scholar Nick Szabo had the idea for smart contracts about twenty years ago.

Smart contracts are not the same as legal contracts. Rather, smart contracts are computer programs or ledgers in which contractual terms are entered. These contractual terms are independently executed and monitored. Smart contracts are not smart in terms of artificial intelligence, however.

How smart contracts are working

The example of the vending machine is often chosen to explain the functionality of smart contracts. The buyer chooses the desired drink product, puts the amount of the indicated purchase price into the machine and, as a final step, obtains the desired drink product. Smart contracts work in a similar manner. The exchange of services is carried out automatically under precisely defined conditions.

The investigation of whether the contractual conditions have been satisfied is completed by the software. The parties to the contract do not have to concern themselves with this. That is particularly an advantage when the parties do not know each other personally, as is often the case in e-commerce. With the use of smart contracts, it is no longer necessary to trust the other party to the contract.

Execution and documentation of smart contracts works with blockchain technology. Because of the pseudonymous IDs used, it will also be possible to exchange services anonymously in the future.

Sample applications

Smart contracts could very easily be used for the leasing of automobiles. The vehicle’s onboard computer software could be programmed so that it can only be started and used upon payment of the leasing rate.

Smart contracts could replicate derivatives. A wager, an interface to the stock exchange, an underlying asset, maturity and a knock-out threshold could be programmed so that the bank would not need to monitor or control the price wager reflected in the smart contract. Any win would be paid out automatically.

Bonds could trigger automatized interest payments using smart contracts.

It would also be conceivable to conclude insurance contracts on the basis of smart contracts. Claims could be investigated automatically and, in the event that the conditions are satisfied, the insurance sum could be paid out directly.

A collaboration between RWE and FinTech slock.it (https://blog.slock.it/partnering-with-rwe-to-explore-the-future-of-the-energy-sector-1cc89b9993e6) already uses smart contracts for the charging of electric cars.

Smart contracts are possible everywhere digital goods are exchanged or digital transactions are carried out. In each case, the prerequisite is that the satisfaction of contractual terms can be digitally verified. In order to make provision for real events, such as the actual transfer of a product, an interface to the real event, an “oracle,” would have to be programmed. Then, the transfer of the product can be communicated via the oracle.

Smart contracts are fundamentally only possible with defined arrangements that are unambiguous. Uncertain legal terms, such as “reasonable in scope,” “without undue delay,” “as quickly as possible,” can only be entered with difficulty.

Legal issues

From a legal point of view, smart contracts themselves are not contracts. The transactions that take place on the basis of smart contracts, however, can lead to the conclusion of a contract by reason of external circumstances. Basically, the smart contract fulfills what has been agreed to in a contract.

Legally speaking, the use of smart contracts raises many questions. It has not yet been clarified whether general terms and conditions can effectively be included in the concluded contract and whether the individual clauses of the general terms and conditions oversight of Sections 305 et seqq. German Civil Code hold up and are applicable. It is also unclear whether the programming language can be selected as the contract language.

Additionally, there remains a question of what happens in the event of smart contract programming errors. The contract is automatically executed all the same. It is not possible to correct the interpretation of “erroneous” clauses or program codes. The smart contract can neither establish the actual will of the parties within the meaning of Section 133 Civil Code nor coordinate actions according to the good faith principle of Section 242 Civil Code. Such coordination questions cannot be programmed or take place automatically.

It is said that a big advantage of smart contracts is that the contractual parties do not know each other and do have to place trust in the other party. But against this background, the question arises, especially with programming errors, how a rescission of the contract takes place or against whom warranty claims can be made. The conclusion of a contract based on smart contracts does not concomitantly mean that warranty rights should be waived. A rescission would be possible as a new contract on the basis of smart contracts. It is also being discussed that a rescission could take place via programmed ombudsmen, the “oracles” (see above). In this way, a neutral third party would be appointed that may rescind the contract because a programming error existed. The condition entered for this would be: whenever a programming error exists, the contract will be rescinded.

All of this applies to jurisdiction in Germany. It remains to be seen, however, which law applies. For every contract that is concluded based on the substructure of smart contracts, it must be determined which law is applicable.

Opportunities and risks

Overall, there are still numerous open legal questions relating to smart contracts. One of the biggest opportunities of smart contracts lies in no longer having to verify contractual partners’ compliance with the terms of the contract oneself. This means that contracts can be processed quickly, efficiently, and with low transaction cost. It is another advantage that smart contracts are considered very secure against falsification and fraud through the use of the blockchain technology. As soon as one of the contractual parties undertakes changes to the contracts or the terms and conditions, the remaining contractual parties are warned due to the blockchain technology and can take appropriate action. Arguably, these advantages promise a big future for smart contracts, even if smart contracts still hold numerous risks at the present time. Especially in the FinTech scene, smart contracts promise great opportunities, because here, digital monetary transactions take center stage in the provision of services.