Why are smart contracts significant?
Lynn Johannson, Advisor, Sustainability and ESG
January 4th, 2024
Lynn Johannson, President of E2 Management Corporation and Catalyst for THE Collaboration
In a care[...]
Will the Law Keep Up with Smart Contracts in 2021?
Crowdfund Insider | | Jan 19, 2021
Why are smart contracts significant?
Traditionally, parties have relied on intermediaries, such as escrow agents, banks, or governments, to ensure the performance of a contract (or that a party didn’t simply run off with your cash). Smart contracts eliminate the role of intermediaries because they are both self-executing and self-enforcing. The entire transaction is dictated by computer code alone. By cutting out the “middleman,” transaction fees are dramatically reduced, while transaction speed is dramatically increased. Parties can now make a wide variety of agreements without fear that the agreement will be dishonored.
See: The UK Provides Legal Certainty For Smart Contracts And Cryptoassets In Its Landmark Legal Statement
Blockchain-based smart contracts are quickly becoming a common method of transacting. Since 2018, private parties have increasingly used smart contracts to tokenize assets and execute the terms of commercial loans and securities lending transactions, such as “repo” swaps of U.S. Treasury bonds.
In the near future, smart contracts may be used in an even greater variety of transactions involving international trade finance, derivatives markets, mortgages, and auto leasing. With their ability to instantaneously execute and settle transactions, smart contracts have the potential to increase the liquidity of traditional credit markets, as well as creating entirely new ones in intraday lending. The possibilities for creating new deal types and methods of transacting business are endless.
The self-enforcing feature of smart contracts may also have significant consequences for the Internet of Things. Take for instance a car lease stored on blockchain, where the financing company is entitled to automatically disable, or even seize, the vehicle if the lessee defaults on a payment. Once autonomous vehicles hit the road, one can imagine a delinquent lessee returning to the parking lot only to find his vehicle has literally driven itself back to the bank. Smart contracts may ultimately spell the end of the “repo man,” as well as a number of other professions.
See: FINTECH FRIDAY$ (EP.4-Aug 10): Importance of Smart Contract Safety Net with Amy Wan, CEO & Founder at Sagewise
How does current law treat smart contracts?
Traditional legal frameworks act as road maps for parties to create legal interests and rights when entering into an agreement. However, they are often subject to different – and sometimes conflicting – requirements. When a transaction shares the characteristics of different legal frameworks, disputes between parties can arise.
Smart contracts have the ability to capture and transfer assets from one party to another. As such, they can conflate contract law with other legal frameworks, such as property, secured transactions and entity law. For instance, contracts are typically private agreements in which the rights of third parties are unaffected. As such, the terms of a contract may be kept confidential. A smart contract, however, can put assets out of the reach of third parties that claim an interest in them. Property law has the ability to affect third parties’ rights. However, property rights require the giving of notice to be enforceable against third parties, such as by recording a deed or mortgage at the county clerk’s office.
See: LabCFTC Releases Primer on Digital Assets
A smart contract may also share the characteristics of a secured transaction governed by Article 9 of the Uniform Commercial Code (UCC).
Imagine a smart contract where a creditor extends a loan to a debtor and takes as collateral a “secured interest” in the debtor’s personal property, such as a vehicle, patent or valuable artwork. This same smart contract may also contain a self-enforcing protocol that uses blockchain to automatically capture and transfer the collateral to the creditor if the debtor fails to repay the loan on a certain date.
Smart contracts could also provide protections only available under entity law. Unlike a security interest, which prioritizes competing claims between creditors, entity law can completely shield assets from creditors’ claims. By incorporating and respecting corporate formalities, business assets of a corporation are placed beyond the reach of the creditors of the corporation’s owners. This ability is unique to entity law, and arguably its most important feature. However, a smart contract may have the same effect without requiring incorporation.
Why is regulation necessary?
As smart contracts become more commonplace, parties must have confidence that they are creating intended legal interests and rights. As such, new regulations must be enacted to account for how blockchain and tokenization intersect with traditional legal frameworks – or perhaps create new ones.
See: Blockchain: legal and regulatory guidance report
This process has already begun at the state level, where states like Arizona and Tennessee have enacted laws to define smart contracts and recognize electronic signatures secured by blockchain technology as valid and enforceable. Wyoming has gone even further, amending its state commercial code to specifically define and classify digital assets, and to establish requirements for the perfection of a security interest in a tokenized asset. However, these states remain the exception, not the rule.
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