Smart contracts eloquently capture the dilemma facing traditional legal systems, whose inefficiency has reached dimensions threatening systemic incoherence and failure to achieve the purposes the law is intended to serve. The system needs urgent reform. But the alternative of replacing the law as we know it with automation and algorithms threatens the loss of the internal profundity of the law and its openness to nuances. This dilemma will be more and more apparent in the years to come. In this context, it is essential to achieve a clear understanding of the hopes and threats integral to smart contracts.
As argued by Douglass North and others, there is a link between legal efficiency and economic growth. Cheap and effective enforcement of contracts protects the economy against stagnation and underdevelopment. But current legal systems have ceased to be effective, not to mention cheap. The dynamism of technological changes has generated unprecedented proliferation of regulations. The system has become so internally complex that maneuvering effectively within the system presents a huge challenge for citizens and commercial actors. The state, appointed to provide instruments of legal security, is less and less successful at accomplishing this task.
The law creation process is labored and entirely ineffective, exacerbating legal uncertainty. Entire zones of reality are arising, lacking transparent rules and standards of behavior. Applying the law largely depends on lawyers who are no longer in a position to provide citizens and enterprises with simple solutions offering a sense of justice. The system of enforcing the law is also paralyzed and increasingly ineffective, especially in the context of the global dimension of many socioeconomic processes.
In effect, we are experiencing a deep crisis in the legal and justice system. It is only a question of time until this crisis leads to an explosion of social frustrations, a halt to economic growth, and a movement towards alternative systems of justice.
Acknowledging this threat is the key to understanding the hopes for the legal area, inspired by distributed ledger technology (DLT). The smart contracts made possible by DLT can become a tool for restoring to our societies and economy a longed-for sense of order and justice. Seen in this light, Blockchain is no longer just another technological novelty. It may offer deliverance from the collapse of the legal system. This raises the significance of the debate over DLT to a new level.
Where is the change?
A smart contract is a set of rules taking the form of electronic code, capable of self-execution. Predefined rules are launched automatically upon fulfilment of specified conditions and do not require the involvement of a trusted third party. As a result of execution of the smart contract code, certain transactions may occur, consisting for example of a transfer of values.
Today, the electronic form of the contract and the contracting process is nothing new. Digital contracts have opened up a paradigm shift in the law of contracts, particularly in recent years, in terms of the language and the degree of human involvement in the contract. First, we are getting better and better at converting natural language into machine language and recording contracts in a machine-readable form. Second, humans are no longer an essential element in the formation of a contract. Countless contracts on financial markets are already concluded and performed in a wholly automated fashion, without human involvement.
This shift in the paradigm of contracting does not require the use of Blockchain technology as such. So what does the technology of smart contracts contribute? First and foremost, it automates trust. Entering a smart contract on a Blockchain gives it complete transparency and removes it from the parties’ control. Performance of the contract no longer depends on the parties’ infrastructure.
Thus, smart contracts redistribute the load on the system. Today it is concentrated on ensuring the performance of the contract. The legal system creates institutions providing trust, i.e. monitoring the correctness of conclusion and performance of contracts and intervening in situations where the contract is not duly performed. This concern is superfluous in the world of smart contracts. Technology can achieve the same aims in an automated manner, without the need to involve trusted third parties. A smart contract executes itself. Ensuring performance of the contract, or more broadly, performance of certain socioeconomic processes, is no longer a systemic challenge.
Where are the benefits?
Smart contracts would thus enable automation of the process of performing certain legal acts and assume the function of monitoring compliance with the law, at least within certain areas. This is an incredibly appealing vision: the aims we try to achieve today using the administrative apparatus of the state can at least to some extent be achieved using technology.
Supervision over the correct conduct of certain socioeconomic processes is one of the key tasks of the administrative apparatus, which in this broad context also includes the courts. In the case of civil contracts, the apparatus of the judicial system ensures proper contract performance. In the case of complex commercial ventures (e.g. banking and insurance), the economic apparatus watches to ensure that these actions are performed in compliance with the rules we have agreed to, as reflected in the complicated regulations governing specific sectors of the economy. Theoretically, DLT renders this function of the state apparatus redundant, as civil contracts can be executed automatically. More complex economic structures could also take the form of a self-executing smart contract. Today, we know how to automate only simple economic structures, but our ambitions reach much further, including concepts for creating banking and insurance structures in the form of smart contracts.
The vision presented here assumes that any economic process, from the simplest loan agreement to highly complex structures, is a kind of algorithm, and any such algorithm can be recorded in the form of a self-executing smart contract. The time-consuming and expensive supervision over performance of such contracts becomes dispensable. Performance of contracts – or more broadly, automatic realization of defined rules upon fulfilment of predetermined conditions – will be ensured by transparent and reliable code, not susceptible to external interference.
Not having to concentrate the administrative apparatus on ensuring execution of the defined rules would free up great resources – a result very much to be desired. Instead of focusing resources on simple, repetitive processes, they could be redirected to underfunded but increasingly vital areas, such as cybersecurity.
The placement of a smart contract on a decentralized public blockchain makes its execution and the transfer of values resulting from execution equally transparent to all. This also opens up for the legal system unprecedented possibilities for tearing down barriers arising from the division of the global economy into separate jurisdictions. Much of the regulations and efforts of the administrative apparatus are today concentrated on establishing rules for mutual recognition of legal events occurring in different jurisdictions. Thanks to its global and universal nature and reach, Blockchain could radically cut the need to create regulations on mutual recognition between the legal systems of various jurisdictions.
Let’s consider an example. Imagine a simple insurance contract, enabling compensation to be paid out in the event of flight delays. Under today’s realities, launching such a product entails significant administrative effort. The administrative apparatus must first issue licenses and then oversee enterprises’ compliance with the rules set forth in provisions of law. This is a very costly system, consuming great resources on the side of both the enterprise and the administration. On top of that, despite such major expenditures, the system is not free from defects, and spectacular abuses by supervised entities sometimes occur. An alternative is to create a new product in the form of a smart contract and record it in a public Blockchain. The supervisory mission of the administration would then, in this case, be limited to auditing the smart contract and any subsequent amendments to it. Otherwise, supervision would be unnecessary, as the technology would ensure the absolute execution of the rules of the audited contract.
What are the risks?
Transferring familiar legal and economic structures onto Blockchain and giving them the form of a smart contract involves automating them and reducing them to algorithms. What, from a certain perspective, appears to be the fundamental advantage of the solutions discussed here can also present a major risk to the rights of individuals. The faith that the law can be boiled down to a set of algorithmic rules is both naïve and dangerous. The law must reflect nuances, emotions, and cultural and social contexts. For this reason the law will always remain an open-ended system, leaving room for various interpretations as well as changes. It is thanks to this systemic openness that the law can serve as a source of justice, rather than just a blind and soulless system of unmodifiable commands and prohibitions. Reducing the law to algorithms can dangerously simplify and calcify the law, stripping it of sensitivity to the nuances of reality.
Paralyzed by an excess of regulations, we may easily succumb to the temptation to simplify the law by exchanging vague legal standards for soulless computer code. This in turn may lead to the automation of certain processes at the cost of justice and the rights of individuals. Therefore it appears crucial to find a compromise and mark out boundaries to the algorithmization of the law. Such compromises are possible, as evidenced for example by solutions streamlining the conduct of judicial disputes. In practical terms, various types of summary and expedited court proceedings represent a simplification and a sort of algorithmization of the system for dispensing justice. As long as such solutions involve cases where such algorithmization does not threaten a loss of justice, they are systemically safe and acceptable.
Similarly, smart contracts could be applied to a certain category of socioeconomic relations not presenting a particular need for nuanced understanding, where the overriding value is security, certainty, and effectiveness. They should not be applied in socioeconomic relations where openness to complexity and context is the measure of justice and guarantee of the rights of individuals.
Smart contracts may be introduced into the legal system using various technological solutions. Some of them may create major challenges. These are particularly evident in the case of public Blockchains such as Ethereum. Blockchains of this type are characterized by far-reaching autonomy from existing legal systems. Their global reach makes them particularly attractive for creating smart contracts, as it allows automation of certain legal relationships on a global scale.
Smart contracts realizing certain economic processes independently of any traditional legal system can be created on Blockchains. This presents an opportunity for development of a new, autonomous legal order on Blockchain. By its nature, it can be global and free of the encumbrances associated with traditional legal systems. It can thus become a much better tool for creating the legal framework for a globalized world than currently functioning systems. But for effective implementation of this vision, an effective system for dispensation of justice is still missing. After all, situations will always arise where automatic execution of a smart contract is inconsistent with justice. In certain situations this might require, for example, unwinding of an automatically executed transaction. There may be less need for dispensation of justice, but that does not mean that it can disappear completely.
But even if an effective system of jurisdiction is developed on Blockchain enabling resolution of disputes arising with respect to the autonomous system of law on Blockchain, the autonomous system will still have significant limitations. In practice, it will only be capable of affecting selected digital assets. Why these limitations?
Blockchain participants are and will remain citizens of specific jurisdictions. Thus, they are each part of a defined, traditional legal order. This aspect is irrelevant for a certain set of transactions which the individual may successfully carry out on Blockchain. This applies to actions carried out under the principle of far-reaching freedom of contract, with respect to which existing legal systems impose only bare minimum requirements (e.g. very general requirements for transactions). These requirements can also be fulfilled on Blockchain, and thus no conflict arises between Blockchain and the existing legal order.
There are also certain acts where the existing legal order imposes specific requirements, which cannot be fulfilled on Blockchain. Consequently, such an act performed on Blockchain may be viewed by the traditional legal system as defective or even void. The individual participants in the transaction might ignore such consequences as irrelevant if the Blockchain ensures the effectiveness and secure performance of the acts in question, and their defectiveness from the perspective of the traditional legal system does not impose additional obligations on the individual participants (for example, the legal defect in the transaction does not result in a party owing greater tax).
On top of this, there is a very important set of transactions that are technically possible to execute on Blockchain (for example, there are no essential technical barriers to tokenization of real estate and enabling trade on Blockchain in tokens representing real estate), but cannot be effectively executed there unless they comply with the traditional legal order. This applies in particular to transactions involving material goods. Because the subject of the transaction is located in a defined physical space, trade in such items on Blockchain will require recognition by the traditional legal system. This is because if there are any difficulties in taking possession of an item (e.g. an automobile or real property), the owner can resort to the support of the state and its enforcement authorities only when the state recognizes the effectiveness of the underlying transaction.
The lack of recognition of events occurring on Blockchain by the traditional legal system will pose a fundamental barrier to further development of distributed ledger technology. It will also prevent existing systems from exploiting the benefits this technology can offer.
Looked at from this perspective, it becomes vital to build bridges between the Blockchain reality and the existing legal system. It is only the recognition of events on Blockchain by the traditional legal system that can truly unleash the potential of DLT for our systems.
Building bridges between Blockchain and existing legal systems is no easy task, primarily due to the two systems’ autonomy from each other. It seems that a condition for building effective bridges between these two systems will be to create something in the nature of a regulatory protocol – a solution enabling active involvement by the state in events playing out on Blockchain. There are various possible solutions for the architecture of such a protocol, but it is essential that they meet the vital need for the state in the context of blockchain.
This need boils down to guaranteeing that events carried out on blockchain are consistent with the legal order recognized by the given state, and enabling intervention in such events when the legal order is violated. In exchange, the traditional legal order will ascribe the traditional legal weight to events occurring on Blockchain.
One of the conceptions worth considering in this context provides for establishment of a regulatory protocol in layers superimposed on the basic layer of the Blockchain protocol. The Blockchain would retain the autonomy of its fundamental architecture and protocol. The state would not be involved in maintaining the Blockchain. State intervention would occur, however, at the level of the code of specific smart contracts. It would be manifest in auditing of smart contracts, and inclusion in smart contracts of “plug-ins” enabling the competent state authorities to take certain actions within a smart contract in strictly defined situations (for example, to reverse a transaction if it is shown that it was made under duress).
For many libertarian-minded proponents of Blockchain, this vision betrays the very ideals underlying it. But for the reasons indicated above, it appears that without constructing a regulatory protocol, we will not be in a position to extract the full potential of DLT for existing legal orders. Blockchain offers the chance to create an alternative legal system, perhaps free of many of the defects of the current systems. But it will be a system of limited application, because the participants in the Blockchain will continue to function within specific jurisdictions where traditional legal orders will take precedence. Thus, without developing solutions enabling intervention in Blockchain by traditional legal orders, we will not be in a position to achieve the full possibilities offered by the technology.
A new source of law
The direction for action outlined above calls for shifting the regulatory center of gravity toward smart contracts. Smart contracts can truly become an instrument for furthering specific public policies. Today this instrument is traditional law, which, as argued above, is becoming less and less effective.
Shifting the center of gravity to smart contracts will no doubt require an essential change in the conception of how regulations are created. In this case, very different solutions are all possible. In the near future we may witness some incredibly interesting experiments in this respect.
Implementing smart contracts into the legal system will require a rethink of the logic of law-making. First and foremost, there will be a linguistic challenge to overcome in connection with smart contracts. Today the legislature operates in the realm of natural language, but smart contracts function in the realm of computer code. So how should the legislative process work in the reality of smart contracts?
The first option assumes that the legislature, at the source, will create the smart contract in place of legal standards expressed in natural language. This vision, although intellectually interesting, is nonetheless quite abstract. Realization of this vision would require parliamentary debate and the democratic method of law-making to become the domain of programmers, practically inaccessible to the public. A more realistic scenario assumes that the existing model of law-making would be retained, i.e. drafting laws in natural language. This in turn assumes that implementation of the law in the form of smart contracts would require the conversion of law created in natural language into law in the form of computer code. But there does not seem to be any barrier to placing this process in the hands of the market. The role of the state would in that case be limited to auditing smart contracts and ensuring the existence of appropriate plug-ins enabling realization of the conception of a regulatory protocol. The latter scenario would require new actors to be enlisted in the law-making system.
The problem of language is not limited to potential difficulties at the law-making stage. It may assume even greater importance at the stage of applying the law. Here as well, collisions may occur between computer code and natural language. Contracts are negotiated and disputes resolved in natural language, and no doubt will long continue to be. In this context, there are intriguing experiments afoot, attempting to develop intermediate languages that would be commonly intelligible but also convey the logic of computer code. Development of such languages may prove indispensable for smart contracts to be effectively implemented in the legal system.
Distributed ledger technology has opened up a fascinating alternative for existing legal systems. This is happening at a time when we are hitting a wall in development of the old model. We are urgently seeking out new approaches. Without effective and just laws, we are at risk of decline in our civilization. Smart contracts are undoubtedly not the only available solution, and they are not free of risks. Nonetheless, they offer an opportunity to overcome many identified problems. For this reason, lawyers and regulators should take a much greater interest in this technology.
The article is an excerpt from Blockchain and the Legal Profession published by ARK Group