Smart Contracts Primer for NJ Businesses

The Use of Smart Contracts to Execute Legal Agreements is Expected to Increase Dramatically…

The use of smart contracts to execute legal agreements is expected to increase dramatically. While smart contracts can make transactions faster, cheaper, and more transparent, they are also based on a relatively new technology that remains a work in progress.

What Are Smart Contracts?

Smart contracts, also called self-executing contracts, blockchain contracts, or digital contracts, are currently based on blockchain technology. While a standard contract outlines the terms of the parties’ relationship in a written document, a smart contract enforces the relationship by securing the terms in cryptographic code. Because smart contracts exist across a decentralized, distributed blockchain network, they allow transactions to take place among unrelated, anonymous parties and in the absence of any central authority, legal system, or external enforcement mechanism.

Even though they are high-tech, smart contracts share some basic elements with traditional contracts. They reflect an agreement between two or more parties, which are usually referred to as signatories. The smart contract must also spell out the terms (although using math rather than words) that the signatories have agreed upon, including the requirements and obligations of each party, the rewards for meeting the requirements, and the penalties for non-compliance. 

What Might be the Benefits of Smart Contracts?

Although still being tested, smart contracts have the potential to revolutionize the way business is conducted. If the technology works as intended, below are several potential advantages:

• Autonomy: Blockchain contracts may eliminate the need for a third-party intermediary, such as notaries, brokers, and other effecting agents, substituting the reliability of third-party verifiers with the reliability of secure code. This potentially allows the parties to have greater control over the transaction and tailor it to their exact needs.
• Transparency: Because smart contracts are encrypted and stored on a secured, shared ledger, the parties can rely on the system as a check on the worthiness of reliance of the counter-party.
• Cost-effectiveness: The elimination of intermediaries could, once the technology is wide-spread adopted, make smart contacts less expensive than their non-digital counterparts.
• Security: If coded properly, smart contracts are extremely secure. In addition, because they are stored in a decentralized registry, they can’t be lost or physically stolen.
• Efficiency: Eliminating the time and expense of sending documents back and forth during the execution phase, smart contracts can also be automatically enforced.

Are Smart Contracts Secure?

While smart contracts are designed to be more transparent and reliable than standard contracts, they are also built using software. Like any technology, they are susceptible to problems, like software bugs and hacking.

Last year, a user mistakenly froze approximately 514,000 ETH (purported to be valued at the time at $155 million) in Parity, a popular Ethereum wallet. The issue was traced to a Parity software bug. In another incident, a software bug allowed hackers to steal 150,000 ETH (valued at $30 million). In the 2016 DAO hack, cybercriminals got away with 3.6 million ETH, which represented 15 percent of all Ether in circulation at the time. The hack lead to a hard fork, resulting in two versions of the famous cryptocurrency.

What’s Next?

While smart contracts are currently being tested in several industries, banking and finance companies account for many of the early adopters. Last year, Bank of America Merrill Lynch, Citi, Credit Suisse, J.P. Morgan, and the Depository Trust & Clearing Corporation (DTCC) successfully traded credit default swaps using blockchain. Smart contracts are also being explored by government bodies, as well as the real estate, healthcare, and insurance industries.

While smart contracts hold a lot of promise, they won’t be replacing attorneys or legal departments anytime soon. Blockchain remains a new technology, and it will take time for businesses and regulators to catch up. The development and use of Smart Contracts requires the participation of attorneys familiar with the technology.

If you have any questions, please contact us

If you have any questions or if you would like to discuss the matter further, please contact the Scarinci Hollenbeck attorney with whom you work, at 201-806-3364.