If you’ve paid any attention at all to news about Web3, the metaverse, non-fungible tokens (NFTs), or cryptocurrency, you’ve probably heard of smart contracts. You’re also probably intrigued by how they work from a legal perspective and what they could mean for the future of your business.
Smart contracts are a foundational 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 their competitors as Web3 matures.
What Is a Smart Contract?
A smart contract isn’t your typical legal contract. It’d be more accurate to say it’s a computer program that ensures things get done according to the agreement between parties, something akin to automated digital escrow agents.
Smart contracts are applications containing lines of code that trigger certain actions when you meet predefined conditions. This automatic execution mechanism ensures that all parties involved deliver on their promises. Many smart contracts are legally binding like traditional contracts so that if one party is no longer able to fulfill their obligations, they may face legal consequences.
Smart contracts 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 after the smart contract is deployed to the decentralized network, no contracting party can go in and alter the terms or conditions without the agreement 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 might 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 upon these items, you can create the contract. Many businesses use an in-house developer to do the programming, or they might outsource the task to a third party.
How Do Smart Contracts Work?
Smart contracts are fairly simple to understand. When a predefined condition or set of conditions is met, the smart contract automatically executes the actions in 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.
Upon 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.
Once the transaction is complete, the oracle informs the smart contract and the blockchain updates to reflect the completed transaction. So, for example, someone might use Bitcoin to buy a car. As soon as it receives the signal that payment is complete, the smart contract could ping an IoT system within the car to unlock the door.
The Benefits of Smart Contracts
In many ways, smart contracts are both disruptive and helpful for business across almost all industries. Some of the top business benefits of smart contracts include:
- Security: Due to the immutable nature of blockchain technology, hacking into a smart contract is incredibly difficult. A malicious actor would be unable to alter one record without having to go through the whole chain, which would require hacking a majority of the 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 executes the agreed-upon action. This works best for one-off, discrete transactions rather than complicated, ongoing business relationships.
- Accuracy: Because smart contracts are completely automated, the risk of human error after implementation is low.
- Transparency: Because smart contracts are distributed across 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 intermediaries, you can save money on service fees and delays.
Like any technology, though, smart contracts have their drawbacks. For one thing, their permanence means you can’t go back and change the code if you find errors. You’re also completely reliant on the developer who programs the contract, which can make it difficult to verify if the code includes all the terms and conditions.
Additionally, it is also possible to program loopholes into smart contracts. An experienced Web 3.0 lawyer can help you protect your business from ending up on the wrong side of a bad-faith crypto deal.
How Can Businesses Use Smart Contracts?
Smart contracts can be useful for many applications. Here are some real-world examples of applications for smart contracts 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 programs aren’t connected to a blockchain.
Combining smart contracts with workflow automation can allow businesses to harness the full power of this software. For example, when one smart contract expires, the software could automatically create a new one or provide a notice that the current contract is about to expire and needs to be renegotiated.
2. Intellectual Property Protection
Smart contracts can help creators protect their IP, which is becoming increasingly important due to concerns over digital commodities like NFTs. Creators can use smart contracts to transfer or retain their ownership over a piece of content during a transaction.
For example, an NFT creator might want to retain ownership over their artwork while transferring ownership of the token to the buyer. In the NFT’s smart contract, they could outline clear ownership and payment terms protecting their rights.
Artists can also receive royalties using smart contracts. Any time an NFT or copy of their artwork sells, a smart contract could trigger an automatic payment from the distributor to the artist.
3. Supply Chain Management
Supply chains are incredibly complex, especially for large companies managing thousands of transactions per day. Automating record keeping using smart contracts and blockchain technology creates a robust, reliable audit trail of all supply chain activities. This can make it easier to trace issues back to their origins and resolve them, as well as provide transparency to downstream partners regarding the source and status of their goods in transit.
Smart contracts can automatically:
- Assess and verify transaction status
- Issue payments
- Record 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 applications for this technology are widespread.
In the meantime, though, it’s best to do your due diligence when making smart contracts. Just like with traditional contracts, working with a licensed attorney can help you dodge some of the pitfalls of bad faith agreements. Contact the legal experts at Harris Sliwoski to explore your options.
