Are Smart Contracts Really Smart? (2024)

Sanhita Chauriha*

Smart contracts are self-executing contracts with the terms of the agreement directly written into code. Operating on blockchain technology, they automatically execute and enforce contractual clauses, eliminating the need for intermediaries. Smart contracts enhance transparency, security, and efficiency in various decentralised applications that have their shortcomings.This article delves into the characteristics and operational intricacies of smart contracts. Additionally, it examines the legal frameworks in India and other jurisdictions such as the USA, UK, and Singapore that address the regulation of smart contracts. Anticipation surrounds the inclusion of provisions related to smart contracts in the forthcoming Digital India Act.

Introduction

Smart contracts rose to prominence following the advent of blockchain technology, notably after the seminal release of Satoshi Nakamoto’s paper on Bitcoin. As jurisdictions increasingly embrace technology-friendly approaches, the agreement on the European Union’s Artificial Intelligence Act, regulating and leveraging new technologies for societal improvement, a thoughtful examination of smart contracts becomes imperative. This study delves into the historical context of smart contracts, aiming to pinpoint their primary uses and features. It explores the diverse types of contracts and their respective use cases, drawing a clear distinction between traditional and smart contracts. Additionally, an in-depth analysis of smart contracts within the Indian legal framework and the cross-jurisdictions is undertaken.

What are Smart Contracts?

Smart contracts, often hailed as the next frontier in automation, have emerged as a promising solution to streamline transactions, reduce intermediaries, and enhance security. Are these contracts truly as “smart” as they appear? What legal support do they possess? Smart contracts are self-executing agreements with the terms of the contract directly written into code. They run on blockchain technology, which offers transparency, immutability, and security. The idea behind smart contracts is to automate the execution of agreements, cutting out the need for intermediaries such as lawyers, notaries, or banks. This automation is expected to reduce costs and minimise the potential for human error, making transactions more efficient and trustworthy. Smart contracts are applicable in various sectors, including finance, real estate, supply chain management, etc. For instance, they can facilitate automatic payments when specific financial conditions are met.

Setting the context

The concept of smart contracts traces its roots back to the early 1990s when computer scientist and legal scholar Nick Szabo first introduced the idea. Szabo envisioned self-executing contracts with the terms of the agreement directly written into code, automating the execution of contractual clauses. Despite the early conceptualisation, it was not until the advent of blockchain technology that smart contracts were practically implemented.

The breakthrough came with the creation of Ethereum, a decentralised blockchain platform, by Vitalik Buterin in 2015. Ethereum introduced a programming language called Solidity, designed specifically for creating smart contracts. Ethereum supported smart contracts by providing a decentralised platform for enforcing self-executing contracts through blockchain technology. This development marked a pivotal moment, enabling developers to write complex agreements and deploy them on the Ethereum blockchain.

With its ability to support decentralised applications (DApps) and smart contracts, Ethereum’s blockchain revolutionised the landscape of digital transactions. Smart contracts on Ethereum gained widespread attention, facilitating various applications beyond simple financial transactions, such as decentralized finance (DeFi), token sales (ICOs), and non-fungible tokens (NFTs).

Since then, other blockchain platforms have also incorporated smart contract functionality, each with its unique features and capabilities. As technology continues to advance, smart contracts are poised to play a central role in reshaping how agreements and transactions are executed in the digital era.

Features of the Smart Contract

Smart contracts exhibit several key attributes. First and foremost, they are distributed, ensuring that all network participants possess an unalterable copy of the contract’s conditions, as replication occurs across connected nodes. They are deterministic, as they execute only predefined functions when specific conditions are met, ensuring consistent outcomes regardless of the executing party. Immutable once deployed, a smart contract cannot be altered, and autonomy is maintained as no third parties are involved, granting authority directly to the involved parties. Customisable before launch, smart contracts adapt to user preferences, and transparency is inherent, as they are stored on a public blockchain ledger, visible to all participants. These features underpin the capabilities of smart contracts, including accuracy, automation, speed, and backup functionality. Moreover, their cryptographic security ensures the safety of assets, making unauthorised modifications practically impossible. With the elimination of intermediaries, smart contracts bring cost savings, manage information efficiently, and support multi-signature accounts for secure fund distribution upon agreement confirmation. The below figure delineates the possible innumerable features of smart contracts.

According to the Law Commission of England, a smart legal contract possesses three key characteristics. Firstly, it involves the automatic execution of some or all contractual obligations through a computer program, a feature known as “automaticity.” This means that specific tasks within the contract are carried out automatically, streamlining processes and reducing manual intervention. Secondly, a is the “legal enforceability” of the contract. The outcomes generated by the automated processes hold legal weight and can be upheld in a court of law. Lastly, the computer program that governs the smart “legal contract operates on a distributed ledger.” This decentralised nature, often facilitated by blockchain technology, ensures that the contract’s records are maintained across a network of nodes, enhancing transparency, security, and reliability. Together, these characteristics define the innovative and secure nature of smart legal contracts in the digital age.

Types of smart contracts

There are different kinds of smart contracts as they exhibit diverse functionalities within the blockchain realm.

1. Basic smart contracts, like those employed in cryptocurrency transactions, autonomously execute predefined terms once specific conditions are met.
2. Escrow smart contracts, serving as intermediaries, release funds when predetermined conditions are verified -a common practice in real estate transactions.
3. Multiparty smart contracts facilitate complex agreements among multiple entities, making them ideal for intricate supply chain engagements.
4. Oracle-based smart contracts incorporate external data, such as weather-dependent insurance contracts relying on oracles for payout conditions.
5. Tokenisation contracts manage digital assets within blockchain ecosystems, as seen in instances like Initial Coin Offerings (ICOs).
6. Conditional payment smart contracts automate payments based on predefined criteria, as evident in royalties triggered by views or downloads.
7. Complex governance smart contracts govern decentralised autonomous organisations (DAOs), enabling collective decision-making through token holder voting in DAOs. DAOs are blockchain-based entities that operate through smart contracts, enabling decentralised decision-making and governance by their members.

As technology continues to advance and embraces innovations for improvement, various other types of smart contracts may emerge.

How do Smart Contracts Operate?

Smart contract, processing begins with the creation of the contract, where users define the contractual terms and conditions. These terms are then translated into code using specialised programming languages such as Solidity. Once coded, the smart contract is deployed onto the blockchain, becoming a permanent part of the distributed ledger.

Activation of a smart contract is triggered by predefined conditions, which can include specific dates, events, or data inputs. When the triggering conditions are met, the smart contract is verified and executed. The decentralised nature of blockchain ensures that the contract’s execution is validated by multiple nodes in the network, enhancing security and transparency.

Smart contracts automatically execute the specified actions, whether it involves transferring funds, updating records, or triggering other events on the blockchain. The outcomes of the execution, along with any changes to the blockchain state, are recorded in a new block, which is then added to the existing blockchain through a consensus mechanism.

Smart contracts are immutable. Once deployed, the code is unalterable, providing a tamper-resistant and trustless environment. Additionally, smart contracts operate based on deterministic logic, meaning that given the same conditions, they will always produce the same results. This predictability ensures reliability in contractual agreements.

While the execution of smart contracts is automated, it is not free. Each action on the blockchain incurs a cost, known as a gas fee, which compensates the network nodes for the computational resources used during the execution. Gas fees serve as an incentive for miners to validate transactions and contribute to the overall security and integrity of the blockchain network. They operate through a series of predefined steps, from creation and coding to deployment, activation, execution, and recording of outcomes. The decentralised and immutable nature of blockchain ensures the reliability and integrity of smart contract-based transactions.

Advantages of Smart Contract

Smart contracts offer a range of clear advantages. They provide for enhanced efficiency as they are executed automatically when predefined conditions are met, significantly accelerating processes. Their reliance on the tamper-proof nature of blockchain ensures that once deployed, they cannot be altered without consensus, fostering trust between parties. By eliminating intermediaries, they also bring about substantial cost reductions in transactions. Moreover, they promote transparency and reduce disputes as all involved parties can access the contract’s terms and execution. Finally, smart contracts enhance security using cryptography and decentralisation, making them resistant to fraud and hacking attempts. To understand better let us examine the conventional contracts and the smart contracts on the basis of the aspects.

Therefore, it can be argued that rather than replacing traditional contracts, smart contracts are more likely to coexist with them. Each has its unique strengths and weaknesses, and their applicability depends on the specific context. Traditional contracts provide a well-established legal framework, offering a robust foundation for complex agreements. They are flexible and can handle a wide range of scenarios, often involving subjective interpretation and negotiation. In cases where human judgment and discretion are essential, traditional contracts will continue to play a pivotal role. Smart contracts, on the other hand, excel in situations where automation speed and trust are paramount. For repetitive, straightforward transactions with predefined conditions, they are a powerful tool. In scenarios where transparency and security are critical, such as supply chain management or royalty distribution in the creative industry, smart contracts can revolutionise processes.

Challenges

Despite their alluring potential, the challenge of integrating smart contracts into the real world is undeniable. Several hurdles stand in the way of their widespread adoption. At first, the question of legal recognition looms large, as smart contract’s legal status remains ambiguous in most jurisdictions, potentially leading to disputes due to a lack of clarity. Moreover, the irreversible nature of smart contracts poses a concern, as once deployed, their code cannot be altered, making rectifying coding errors or addressing unforeseen circ*mstances a formidable task. Additionally, smart contracts heavily rely on external data sources known as oracles to validate real-world events, and the accuracy and reliability of these oracles are pivotal to their trustworthiness. Arguably, adopting smart contracts necessitates robust technological infrastructure and a significant shift in mindset and legal frameworks, which can be a complex and time-consuming process in convincing businesses, governments, and individuals to embrace this transformative change.

Global legal frameworks pertaining to smart contracts

In the United States, contract law is governed at the state level, leading to variations in enforcement and interpretation. The Uniform Electronic Transactions Act (UETA) of 1999, adopted by 47 states, set rules for the validity of electronic contracts and signatures, recognizing them as legally binding. Despite certain contracts needing to be in written form – especially under the Uniform Commercial Code (UCC) and state statutes for fraud – code-only smart contracts may be enforceable under state contract laws. Szabo’s analogy of a vending machine illustrates that, beyond UCC and fraud statute constraints, the exclusive representation of an agreement in code poses no inherent obstacle to contract formation. The role of information technology in contract creation has long been a subject of legal examination, and while overarching principles exist, state-specific approaches and regulations remain influential. Additionally, states like Wyoming have passed laws recognising digital assets and blockchain.

The UK Jurisdiction Taskforce (UKJT) issued a legal statement in November 2019, asserting that, in essence, smart contracts have the potential to create legally binding obligations that can be enforced based on their stipulated terms.

In Singapore, smart contracts need to meet criteria such as offer, acceptance, intention to create legal relations, and consideration to be legally binding. While courts have not explicitly confirmed this, generally, such contracts are enforceable. However, factors such as illegality, duress, or explicit clauses disavowing legal relations can affect enforceability. For certain transactions, a writing and signature requirement exists, and it is unclear how code-based smart contracts fit this requirement in Singapore.

Countries globally are adopting diverse approaches to integrate smart contracts into their legal frameworks. Given the substantial benefits anticipated in the future, it becomes crucial to observe and understand how this evolution unfolds.

India’s Position on Smart Contract

India currently lacks specific legislation directly addressing smart contracts. However, existing legal frameworks, like the Indian Contract Act, 1872 and the Indian Evidence Act, 1872, can be applied to smart contracts. Nonetheless, these frameworks present limitations because they have not been updated to keep pace with technological advancements.

Section 10 of the Indian Contract Act outlines the fundamental nature of a contract, emphasising that agreements become contracts when they involve the voluntary consent of parties, lawful consideration, and a legitimate purpose. Applying this to smart contracts reveals that they typically encompass elements of offer and acceptance, suggesting that they could be considered valid and enforceable under Indian law. However, a critical requirement is that the consideration must be legally recognised, which raises questions about whether smart contracts are explicitly acknowledged by existing legal provisions.

The procedural statues like the Indian Evidence Act, 1872, Section 65B stipulates that electronic contracts can be admissible in a court of law. Still, there is a prerequisite that these contracts must possess a valid digital signature from a certified authority to establish their authenticity, as outlined in Section 85B of the Indian Evidence Act. This requirement conflicts with the typical characteristics of smart contracts.

The forthcoming Digital India Act is poised to oversee and govern emerging technologies. It remains to be seen whether smart contracts will find inclusion within its regulatory scope. While the Information Technology Act, 2000 lays the groundwork for enforcing digital contracts, its initial sections have seen limited practical application. Typically, digital contracts are acknowledged through the acceptance of terms and conditions. However, there is optimism that the prospective Digital India Act may introduce some essential provisions to enhance the enforceability of smart contracts.

State governments like Government of Telangana are building a blockchain framework for various use cases. Furthermore, “National Strategy on Blockchain” by MeitY in December 2021, outlined its vision to embrace blockchain technology across sectors such as healthcare, agriculture, finance, voting, and e-governance. It aims to establish a “National Blockchain Framework” to create a comprehensive infrastructure. The objective is to develop globally utilised “Made in India” blockchain technology by 2027, with a focus on convergence with the “BICA Stack,” comprising blockchain, Internet of Things, cloud, and Artificial Intelligence. It is seen with the latest developments that there is a clear shift towards the technology and the government is focusing to use the blockchain based technology in different use cases.

A way forward

Smart contracts are remarkable innovations with the potential to transform various industries. However, they are not a one-size-fits-all solution and should not be viewed as a wholesale replacement for traditional contracts. Instead, they complement traditional contracts by automating processes and enhancing trust and efficiency. We must address the legal, technical, and regulatory challenges surrounding smart contracts to harness their full potential. Only then can we truly unlock the power of these “smart” agreements in our digital world. Top of FormThere are various use cases in the industry like maintenance of land records, digitisation of judiciary, real estate, health sector, financial sector and e-commerce. NITI Aayog, has highlighted the shortcomings of the country’s land record system, deeming it inefficient and riddled with discrepancies. If blockchain technology and smart contracts are implemented in the land transfers there will be improved transparency and the accuracy of records.

While the adoption of smart contracts brings forth challenges like a shortage of skilled professionals and insufficient support systems, it is reasonable to anticipate that these obstacles can be overcome with the passage of time and increased industry expertise. Acquiring a deep understanding of smart contract functionalities and mastering the tools necessary for their development and utilization is paramount for governments and organisations seeking to harness the full potential of this technology in the era of the decentralised web. Proactive investment in education and skill development within the workforce will be instrumental in navigating and capitalising on the opportunities presented by smart contract integration.

*Sanhita is a Data Privacy and Technology Lawyer. She works in the Law and Technology vertical of Vidhi Centre for Legal Policy.