Understanding the basics of Smart Contracts

Introduction

Blockchain has received widespread attention in the past couple years. Defined as a digital ledger that stores data in a decentralised network of computers and other devices, blockchain allows for preventing unauthorised mutations to data.¹ Apart from data storage, this ledger could be used for a number of purposes, like verification of transactions, generation of receipts, etc. One such use of blockchain technology is smart contracts.

Smart contracts

As evidently visible, the term smart contract is composed of two words – ‘smart’ and ‘contract’. The term ‘contract’ is easy to define as ‘an agreement enforceable by law.'² The literal meaning of the term ‘smart’ though is too vague as to make any sense to qualify the word ‘contract.’ Going purposively therefore, the term ‘smart’ used in this context refers to the automatic enforceability of the contract on meeting certain requirements. The contract is smart because it checks for conditions precedent required for its enforcement and if such conditions are met, it is enforced without the intervention of the parties.³

In simpler words, therefore, a smart contract can be defined as a code on the blockchain that can execute the terms of a contract or agreement when predetermined conditions are met. A question may be raised here as to why the blockchain is required for the enforcement of smart contracts. Can’t we create automatic contracts without using the blockchain? The answer to this question is twofold. – Firstly, automatic contracts may be created without blockchain, but they would require authentication by a central authority. This will be detrimental to the parties, as the central authority would have a lot of control over the contract in such a case. Secondly, as the blockchain contains the details of all the previous transactions of the parties, it becomes easy to determine whether the parties meet the consideration requirements of each other.

An example of smart contract may be given as: A promises to buy 20 units of X cryptocurrency from B for 10 units of cryptocurrency Y on 31 July 2024. On the mentioned date, if the consideration requirements are met on part of both the parties, there would be an automatic exchange on the above-mentioned quantity of crypto currency. 

Hybrid Smart Contracts

As most of the actual contracts don’t deal with crypto currency exchange and blockchain has not yet integrated with national economies, it is not possible to fully substitute a traditional contract by a smart contract. This is where hybrid smart contracts come into play. They have two components – the on-chain component which takes place on the blockchain and the off-chain component – which takes place outside of the blockchain. The on-chain component refers to the code running on the blockchain, mainly dealing with credit and debit of money from one account to another. The off-chain component deals with the performance of the contract outside of the blockchain. The information related to the performance of the contract outside of the blockchain is obtained through decentralised oracle network which consists of a system of oracle nodes providing off-chain information to on-chain contracts. The execution of the contract on the blockchain allows for the decentralisation of the process and prevents the need of any central authority to verify the contract.⁴

An appropriate example of a hybrid smart contract would be: A promises to buy 10 kg of apples from B for 10 units of cryptocurrency X on 31 July. This is a hybrid smart contract. The payment of the cryptocurrency is the on-chain component and would automatically be done when the off-chain part if performed which is the delivery of apples from B to A. Whether the apples have been delivered or not would be checked by the oracle network.

Conclusion

As technology evolves, law must also evolve with the same, otherwise people will find workarounds it. The blockchain technology though still in its early phases is proving to be a game changer in the realms of cybersecurity and privacy. Owing to such benefits, it is therefore being improved further and further. Smart contracts are also still in their earlier phases of development, and it seems unlikely that they would be used in the present form. But the law makers must be ready to deal with any prospective future change in their nature, which might make them viable for large scale contracts. 

In the next blog on this topic, we would see discuss the enforceability of the smart contracts in the present legal domain.