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Blockchains and smart contracts in a nutshell

Scritto da Teresa Prudente

New Year has begun and we shall take stock of the latest developments and transformations occurred among the digital world. It seems that the next generation of internet has arrived. We all have heard about blockchains, bitcoins and smart contracts. And they say 2017 will be the year of the revolution. But, what blockchain and smart contracts are? How do they work? What are the legal implications?

It is plain for all that business faced the digital revolution step by step, gradually reducing frictions in business processes. Let’s think of the 1990s elimination of content friction operated by the Web or of the IT resource friction implemented by Cloud systems in the 2000s. It is now blockchains’ turn to remove or reduce authentication and verification frictions for transactions.

Indeed, blockchain is more than just bitcoin or cryptocurrency. Admittedly, the success of bitcoin’s blockchain has been crucial since it made enterprises confident and conscious of the emergent phenomenon. It was the 2009 when the first public blockchain, backing bitcoin, started to work up to became, over the last decade, the blockchain par excellence.

However, blockchains may serve various and broader scopes as the experience and the process of experimentation have been demonstrating. Indeed, a blockchain (whose name comes after its graphical representation) may be defined as a shared, distributed and decentralized digital ledger which keeps records of all economic transactions occurred across the peer-to-peer network, either public or private. Its peculiarity resides in the absence of a central trusted third party (an authority or institution) in charge with the management of transactions and verification tasks. Blockchains bear a unique and global perception of transactions’ truth: they rely on a robust cryptography that “chains” together and authenticates block of transactions making any distortion almost impossible.

The experience has shown power and benefits of blockchain technology which can perform even more complex operations, paving the way for decentralized and smart transactions. As a result, the so called smart contracts are the natural consequence as well as a pivotal component of next-generation blockchains. For example, each smart transaction in the bitcoin blockchain constitutes a smart contract on small scale. In fact, smart contracts are made up of sequences of smart transactions rooted in a delimited legal context.

The origin of smart contracts (aka blockchain contracts, self-executing contracts or digital contracts) dates back to 1993 when Nick Szabo coined the term to identify self-automated computer program codes capable of executing and enforcing contractual terms without the intervention of a third party. In other words, smart contracts are digitally signed, computable agreements between two or more parties. More specifically, smart contract is fully digital and written by programming code languages (e.g. C++, Java, Python, Go) which define its terms, as well as a traditional legal document would do; then, the execution of the contract is transferred from the single parties to the hands of the distributed ledger structure. Consequently, once the smart contracts enter a validated and verified blockchain, no central control is required. Given that such contracts are deterministic, every conceivable outcome of the agreement must be encoded in advance.

Admittedly, the concept underlying smart contracts is not that original. For instance, an embryonic version of smart contracts can be found in the mechanism under patents allowing software use widespread in the 1970s. Further, online shopping sites or online transaction process management systems are precursors to smart contracts. If smart contracts, even under false colors, are so common, why are they so discussed nowadays? The answer is the widespread of blockchain technology (along with the success of its strong verification system) and its constant integration in the IoT.

Blockchain phenomenon, indeed, triggered a worldwide race to find appropriate paths to create an Internet of digital assets or business assets flows. Stakeholders are increasingly addressing their resources to test and adjust blockchain-based technology. Businesses have been started to appreciate the potential benefit of such a revolution. Indeed, the advantages that smart contracts bring in terms of cost efficiency and time optimization in business models are numerous. Above all, blockchain-based smart contracts will overcome the traditional role of the myriad of intermediaries (e.g., lawyers, platforms, middlemen, notaries, banks, social media companies, credit card companies) necessary within conventional transactions. Nowadays, is the financial sector the major applicant for blockchain systems and the most successful companies belong to that industry: according to the report on “fintech 2.0”, published last year by InnoVenture, smart contracts could lessen banks’ infrastructure costs by between € 13.8 to 18.4 billion per year by 2022. Moreover, the reliable fashion provided by a blockchain may weaken corruption, fraud, loss of information, transaction costs and risks while enhancing, for example, the management of official records, security, transparency, the integrity of stored information, the traceability of luxury goods or works of art. As a result, blockchain technology is breaking into new sectors such as health, intellectual property management, accounting, insurance, cancer research, clinical trials, supply chain and the IoT, mortgages. However, the sector in which blockchain may bring the greatest advantages is the music industry where a public blockchain could keep track of ownership rights and royalties’ payments may be transferred in real time. Furthermore, blockchain based smart contracts are likely to give back to users control over their digital identity and data (and digital assets) related to them; with this regard, Brian Cooper, chief creative officer of Oliver Group UK, defines blockchains as a good chance to defeat the exploitation of our personal data by the big players of the social network industry.

Following the experimented success of blockchain-based technology, enterprises have started working on it. Above all, we can recall the achievement of Ethereum, a blockchain-based platform launched in 2011, or The DAO, a distributed independent organization for venture capital funding launched in 2016. Therefore, we can definitely say computable contract technology is itself feasible today. Then, it comes the reality. It will take long time before not only business but the entire society could operate in an automated fashion. If technology is ready for the revolution, is what someone has defined a “human-centric legal process” the real villain to be defeated? Isn’t it?

Accordingly, many are the obstacles to a rapid revolution. Firstly, several roles within business organizations will require reorganization: for example, for what is of our interest, lawyers and judges shall learn how to write and interpret a computable code. Secondly, the absence of standards and the uncertainty surrounding best practices hinder the adoption of blockchain-based smart contracts. Not to mention lobbying pressures from established organizations. Furthermore, privacy and security issues related to blockchain technology would render public ledgers less attractive for private organizations. As usual, the worst enemy is the legal and regulatory environment, always tagging along behind technological progress. An established and unambiguous regulatory framework is essential to provide reliance both from the supply and demand sides.

In this regard, the important thing for us is to emphasize the correlation between “dumb” and smart contracts and their compliance with the legal order. Of course smart contracts share similarities with a traditional legal contract in the sense that they both regulate the interaction between different parties. As mentioned above, the biggest revolution provided by blockchain technology is the elimination of the necessary intervention of the Third Trusted Parties for the execution of transactions. Today, before a transaction becomes effective, a third trust party is required in many cases: let’s think of the Italian legal order and the effectiveness of certain categories of acts (e.g. notary deed) or the perfection formalities for certain categories of goods. Many concerns arise with regards to the inner nature of smart contracts which are deterministic and predefined and settled in all their stages. Conversely, a “dumb” contract may embrace and perceive all the nuances of the human reasoning. A traditional contract, in fact, is capable of framing mutual promises and obligations in all the stages of the negotiation process taught in a language which is, in theory, easily comprehensible by the parties. Moreover, a “dumb” contract is affected by the surrounding legal environment which provides the relationship between parties with legal effects and sets part of the execution of the contract. Furthermore, the legal framework can also require modifications and amendments or penalize the conduct of the parties as well as decide the destiny of the contract (e.g. validity, nullity).

From an overall perspective, smart contracts are not able to cover all the feasible obligations exhaustively, especially when complex operations occur. Indeed, a computer code cannot be as accurate as the human judgment which is able to perceive the negotiations shades, terms and conditions, any possible agreement to agree, the understanding of legal concepts, any amendments or the precise intention of the parties. In addition, the choice of the relevant jurisdiction to be applied requires the intervention of a legal expert. Moreover, difficulties may arise after smart contracts’ inability to reflect and interpret parties’ will and identity (e.g. common mistake of fact or law, misrepresentation) or to assess the legal capacity to enter a contract (e.g. under age or incompetent). At the same time, however, even if a smart contract acts independently from the surrounding legal framework, the latter, willing or not, cannot be prevented from applying to and affecting the broader contractual bond.

More specifically, as far as our legal order is concerned, obstacles come from the compliance with the Italian Civil Code. First of all, the compliance with formalities requirements (e.g. written authentication ad substantiam under Art. 1350 cc) or perfection formalities (e.g. the enrolment of real estates in public registers). Furthermore, an important issue relates to signing methods and their effectiveness: under Article 21, par. 2 of the d.lgs. no. 82/2005 digital signatures gain probation value within the meaning of Article 2702 cc. Moreover, assuming that the subject matter of a smart contract can be identified, difficulties arise from the transposition of legal concepts such as licit, determined and possible (art. 1346cc), into the code language of the blockchain. For instance, the validity of a contract will be assessed in the light of what is possible under the computer code rather than the legal order.

To sum up, today’s technologies allow in some ways the advent of an Internet of Transactions especially in scenarios in which legal order is less complex or the legal infrastructure low. As already highlighted, still many are the obstacles to face. Experts believe the 2020s will be an era of experimentation and thinking, similar to the dot-com era of 1990s. Few legal law firms have expressed the intention to adopt smart contracts within their business; for example, the London Selachii Law Firm announced its intention to cooperate with the start-up Stash to implement smart contracts for wills, donations, shareholders’ agreements or titles of ownership. However, skeptics abound. Therefore, some propose to test a transition period of hybrid paper-plus-code-contracts, or a dual integration, in order to make society more familiar with this new phenomenon (e.g. Ricardian Contracts). Moreover, the industry of blockchain-based companies is still not mature, predominantly consisting of unfunded start-ups, and in phase of experimentation. From a policy perspective, the development of blockchain technologies requires the commitment of policy makers and a homogenous and consistent legislation among Member States. Collaboration and cooperation among/with stakeholders is essential in order to establish a common regulatory context. Standards are developing and policy makers are making efforts towards. For instance, the Commission de Surveillance du Secteur Fiancier decided to shape the regulatory framework after the applications of this new technology and few Member States (e.g. UK and Luxemburg) started giving their contributions. Not to mention the recent Resolution adopted by the European Parliament in May 2016 on virtual currencies. Even Universities’ laboratories are contributing to the process of experimentation.

Though the increased attention and efforts to develop blockchain-based technologies, it will still take some time to see an automated society. Once smart contracts leave the cyberspace to enter the reality, they start coping with the legal order rather than the computable code. This is the real challenge for smart contracts. Who will be the winner between the resistant society and the rapid technology? We can only wait for the process of experimentation for now. The same has happened with the Web, after all.