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Blockchain, smart contracts and the law: overview on relevant legal issues

When a new technology comes into existence, it doesn’t just bring solutions to our everyday life or make a task easier to be accomplished, it can also bring some doubts and problems, especially from a legal point of view.

For instance, imagine what happened with the advent of the Internet and the World Wide Web.

The birth of a “place” where, at least at the beginning, was impossible to apply the traditional legal rules that were used since then, caused real chaos for legislators and scholars, who didn’t know what to do with this new environment.

We’re considering this particular example not just because, of course, is the most relevant one in the modern age, but also to demonstrate that the more innovative a technology is, the more it will be difficult for the existing law to be adapted to it and for the lawmakers to understand what has to be done and what are the issues that have to be solved.

This has to be underlined to understand the difficulties that lawmakers have at present: in a world that is continually changing and where increasingly complex technologies come to life every day, the legal system tends to remain always the same. Indeed, even if thirty years have already passed since the appearance of the first website, legal rules, anchored to a traditional approach, are still struggling in governing what we do on the web. Imagine the dimension of the problem looking at the newest technologies.


After the Internet and the www, we can affirm that one of the most disruptive innovations of the last decades is blockchain technology, which is an intense example of a completely new protocol. Of course, by saying this, we’re also referring to its applications, especially to cryptocurrencies and smart contracts.

The blockchain is a new type of ledger, which is characterized by an absolute decentralization (at least when it comes to the public permissionless blockchains), disintermediation, and immutability of the data entered in the system. This has created sort of a brand-new virtual world, hard to regulate and which has strongly shocked the original concept of register, and even currency, that we were and probably still are used to.

These unique characteristics generated legislators’ and law scholars’ attention. For this reason, different countries all over the world started attempting, more or less successfully, to create a blockchain regulation.

Taking into account Europe, we can notice that in the last years the Union has worked a lot to create a favorable environment for the technology’s development. Important examples are the foundation of the European Blockchain Partnership (EBP) and the European Blockchain Services Infrastructure (EBSI), initiatives that are designed to develop a common strategy and a blockchain infrastructure for public services inside the Member States. Furthermore, one of the last and most relevant proof of attention towards blockchain is the Markets in Crypto-assets regulation, known as MiCa, designed to give a framework for the use of cryptocurrencies inside the Union.

Looking more specifically at smart contracts, the European Union didn’t give a general definition nor any guidelines for their regulation; it just considered the importance to regulate them with attention in a Resolution of the European Parliament of 2018. This absence of general rules can lead to insurmountable problems, due to the very particular features that characterize this blockchain application.

Some Members States, such as Italy and Malta, tried to define smart contracts and find a way to delineate the rules applicable by connecting them with the existing laws on contracts, electronic documents, and signatures. Despite these attempts, there are still unsolved matters that generate legal issues, especially in the case of Italy which predisposed a very unclear framework, but more generally anywhere and every time a smart contract has to be used.

Before going deeper with our considerations and analyzing the concerns brought to light by the affirmation of smart contracts, let’s look better at the technology we are talking about.


What are smart contracts?

The first person who theorized smart contracts was Nick Szabo in 1994, long before Satoshi Nakamoto’s “Bitcoin: A Peer-to-Peer Electronic Cash System” and the birth of blockchain. Szabo defined smart contracts as “A computerized transaction protocol that executes the terms of a contract” automatically, following an if-this-then-that scheme. Its purpose was “to minimize exceptions both malicious and accidental and minimize the need for trusted intermediaries. Related economic goals include lowering fraud loss, arbitration and enforcement costs, and other transaction costs” (see Nick Szabo, Smart Contracts, 1994, available at https://www.fon.hum.uva.nl/rob/Courses/InformationInSpeech/CDROM/Literature/LOTwinterschool2006/szabo.best.vwh.net/smart.contracts.html). The author was also proposing the use of encryption and digital signatures to assure contract’s security and the possibility to determine the authorship of the transaction.

Leaving aside encryption and digital signatures, does this contractual scheme remind you of something you know and probably used? Well, it should as the most basic example of a smart contract is the vending machine: you insert a coin to get a coffee and from that moment on the contractual execution will be automatic. No other human activities: it’s the machine that completes, alone, all the rest, without the possibility of further human intervention.

So, as we can see, a smart contract is, in theory, something very easy: a conditional statement translated in an informatic code and technologically executable.

However, this original idea of having contracts that used encryption to assure the security of the agreement was unachievable with the technologies of the time, and we had to wait until the blockchain appearance to start talking about and using smart contracts.

Blockchain is the perfect environment for this technology, and now we’re going to show you why. In the “real world”, in a classic contractual relationship, each of the contracting parties, even if bound to the contractual obligation, can decide, more or less extensively, to don’t execute the obligations at stake, if prepared to handle the consequences of the breach of the agreement. In the case of a smart contract registered on a blockchain, this possibility seems to completely disappear.

The smart contract, once entered into the blockchain, becomes completely unchangeable and it will execute what is ruled by the code without any possibility to interrupt it or modify its content.

This carries clear advantages, especially assuming that there isn’t a relationship of trust between the parties of the agreement because the execution depends entirely on the code, that works automatically and irreversibly. Anyway, unfortunately, these positive features are accompanied by many complications.

First, imagine what happens if a smart contract is not well coded, and, even if someone realizes it, still there is no possibility to intervene to modify it or to stop its execution. Furthermore, for how the blockchain works, especially when we speak about public permissionless blockchain, the person who is part of a contract is usually not identified by name and surname and thanks to it easily reachable but is a stranger who is recognized by a pseudonym (an alphanumeric code) very difficult, if not impossible, to reconnect with its owner.

A very famous example of the problems caused by smart contracts is the “The DAO” case. The DAO was the very first Decentralized Autonomous Organization, based on complex smart contacts executed on the Ethereum blockchain, and designed to work as a distributed investment fund.

After a few weeks from its launch, some vulnerabilities were found on the code and, as no one could intervene on the code itself, no one had the power to solve the issue. The DAO then continued working with the original code, permitting a hacker to steal more than 50 million dollars in a few hours. After a long discussion between the community, the solution was just an extreme one: a hard fork on the Ethereum blockchain.

Without going on with this famous story, we can affirm that this is a clear testimony of the risks of entrusting the management of a large quantity of money to smart contracts. We also have to underline that bugs in smart contracts’ code are not easily preventable, as the language used is very flexible.

This is just a practical example of the dangers, and now we can go on with a more “legal” analysis.


From a strictly legal point of view, there are also other issues that this new protocol cause.

First of all, even if the name of this technology refers directly to an agreement ruled by the traditional civil rules, scholars are still discussing if smart contracts are contracts in the traditional sense. To respond to this doubt, experts have proposed a distinction.

On the one hand, we have the case of the smart contract code, which is a code that works how we described above, but that is written just after the parties have found an agreement using a traditional contract. So, the classic contract will define the obligations and use of the technology, while the smart contract, with its automatic and immutable features, will execute the terms of the agreement. In this case, of course, the smart contract (code) cannot be defined as an autonomous contract, and it exists just on the “on-chain” reality.

On the other hand, we have smart legal contracts, that are a more complicated hypothesis. In this second case, the informatic code represents the entire agreement and is the only way with which the parties establish their contractual relationship, creating a connection between the “off-chain” and the “on-chain” reality. The problem here is that to be defined as a real contract, ruled by the traditional laws, there are some necessary elements, established in the different national laws. As smart contracts are a completely new technology, with truly innovative aspects, is not easy to immediately transpose these classic concepts into this new reality.

For example, in the case at stake, the contract will not be expressed with a “natural” language, but exclusively with an informatic one that, as you can imagine, will make the situation more intricate.

Another complication, as we underlined above, is the usual difficulty in identifying the parties: as they often contract under a pseudonym, composed by an alphanumeric code, establishing the authorship of the agreement will not be something immediate. The impossibility to exactly know who is involved in the relationship will cause obstacles, especially in the case where the smart contract doesn’t work as imagined.


Going on, the use of informatic language to express the will of the parties will limit their possibilities and cause consequences in the interpretation.

As the code is very rigid, all the usual clauses that are inserted in the contract to maintain certain flexibility will be impossible to be placed inside the smart contract. This will lead to the non-convenience in the use of it in some kind of relationships, especially in long-term ones. Furthermore, the informatic language will make the contract difficult to be understood in legal environments, with the consequence that it will be necessary to ask for help from experts.

And again, if the parties that want to use the smart contract do not have the appropriate skills to prepare it, they will have to involve a programmer. The problem here is, from a theoretical point of view, that intermediation will be re-introduced in a technology that aims to be deprived of it, and, from a practical point of view, that the programmer could not well understand the legal aspects of the contract and don’t translate well the parties’ will. Anyway, with the gradual diffusion of this technology, this problem will be probably solved.


The real main issues of a smart contract are its automation and the environment in which it works. To make everything clear we repeat this once again: the data entered into a blockchain are unmodifiable, so there will be no possibility to modify the code of a smart contract.

On the one hand, these aspects are the most interesting and useful ones, as they practically assure the contract execution, and significantly reduce the possibility of a dispute between the parties.

But on the other hand, the blockchain structure impedes stopping the execution of the code or its modification, even where necessary. As a solution can be only found with ex-post tools, activable after the execution of the contract, there are particular problems in the case in which the agreement is flawed.

Imagine having a void or voidable contract. In both cases, even if the one of the parties realizes that there is this invalidity of the contract, they he/she could not react with the normal legal tools by asking for the contract termination. Or better, he/she could proceed like that, but this would not stop the code from its execution. This person would then ask a court intervention to solve the problem, and this demonstrates that the idea that smart contracts can manage the entire contractual relationship is not true. Moreover, a court’s assistance would be complicated by the characteristics of the technology, especially its informatic language and the likely impossibility to identify the counterpart of the contract.

Anyway, the blockchain community started realizing the necessity to give, at least in some cases, the possibility to intervene on the code, and started developing the kill function. This would give the opportunity to destroy the contract in case of need but still will not permit a modification of it.


Conclusions

This was just a short overview of the many legal questions that arose with the appearance of blockchain technologies.

Probably the readers that are now looking at this article, if are people used to utilize smart contract, could say that this is a classic example of “lawyers paranoid”, and that maybe we should just leave the technology taking its natural course. From a certain point of view this is true but thinking about giving smart contracts the chance to manage significant contractual relationships, it’s impossible to ignore these legal problems.

Considering that nowadays the technology it’s not at an early stage, but it’s not even completely developed, especially from a contract law point of view, smart contracts have to be used with particular carefulness. It would be better to limit their employment to basic and not economically significant relationships, minimizing by that the risks, as it’s still not clear how the situation will be handled in case of contract “pathologies”.

Furthermore, even considering basic relationships, it will always be better to use a smart contract (code) just as an accompaniment to a traditional contract. Thanks to this kind of choice, a contract drafted in natural language will be available and the identification of the parties will be certain, making it easier for courts to intervene.

To conclude, all the problems here presented are not insurmountable, but are the normal consequence of an unprecedented innovation, that moves away from our traditional way of contracting. In addition, this is a great occasion to give more autonomy to the parties, reduce costs and minimize the possibility of conflicts.

Anyway, to appreciate these possibilities, we have to wait for a wider diffusion of the technology, which we can say is very plausible looking at the current attention given to blockchain.


Author: Marta Belli

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