Blockchain Based Smart Contracts: Key Tech & Regulatory Aspects

Stella Joseph, Partner and Yash K Desai, Senior Associate at Economic Laws Practice (ELP) have come up with a new episode in our Podcast series, titled ‘Blockchain Based Smart Contracts: Key Tech & Regulatory Aspects.’ 

While in the previous podcast, we had looked at the basic concepts of Non-Fungible Tokens (NFTs) and how they work, in this episode we will be discussing the concept and technology of Blockchain Based Smart Contracts, and after having understood the concept and technology behind such smart contracts, we will discuss some key legal and regulatory issues that one can associate with the concept of smart contracts.   

Transcript

Blockchain based Smart Contracts: Key Tech and Regulatory Aspects

 Stella Joseph: Hello everyone, I welcome you all to the second part of ELP’s podcast on NFTs and Smart Contracts. 

While in the first part of the podcast, we had looked at the basic concepts of Non-Fungible Tokens (NFTs) and how they work, in this part we will be discussing the concept and technology of Blockchain Based Smart Contracts, and after having understood the concept and technology behind such smart contracts, we will discuss some key legal and regulatory issues that one can associate with the concept of smart contracts.   

So, let us start in this part of the podcast with Smart Contracts. I once again invite Yash Desai from Economic Laws Practice, to throw light on the various technological related aspects in relation to Smart Contracts.   

SMART CONTRACTS:

Stella Joseph - Question: Hi Yash, let’s start with you telling us what exactly is a smart contract and how does it work?

Yash Desai: Hi Stella, and welcome to all the listeners.  

The concept of Smart Contracts was introduced in early 90’s by computer scientist Nick Szabo, according to him a smart contract is a “computerized transaction protocol that executes the terms of a contract.”

Now, smart contracts are just like contracts in the real word – the only difference being that they are completely digital! 

So, a smart contract is a digital contract which is a piece of code on the blockchain and is preprogrammed with certain logics. It fundamentally functions upon happening of certain events which are mutually agreed between parties and on happening of such events, they can be self-executed and self-verified without having any “intermediary” or a “central authority” to govern whether the conditions of such contract are fulfilled.  

Stella: Thanks Yash, for that explanation! Can you help us with the key features and functions of a smart contract with an example?

Sure, Stella. 

So let me explain the features by way of an example. These days there are certain online gaming applications wherein you can form a group with individual players to select your own cricket or football team. In such apps each player in the team created by you is awarded certain points based on their performance in the real match. If the team that you have selected gains certain no of points beyond a threshold set in the app, you are awarded a prize money! Now, there are three (3) important features in this application which resonates to how a Smart Contract functions: 

1.       FIRST: There is no third party or a central authority – which keeps a track of the winnings and the score – the points allocated to the players in a cricket team created on the gaming app is based on their performance in the live match, which is embedded through a pre-determined logic. For eg, if a bowler takes a wicket – he is awarded 25 points, which is updated on the app on real time basis and 25 points are added against that player in the team. 

2.       SECOND: The points which are updated on the gaming app are based on happening of a certain event – which is performance of players in the live match. This logic is normally called as a “IF” and “WHEN” logic. That is, IF a player takes a wicket – he will get 25 points, so and so forth. 

3.       THIRD: On completion of the cricket match, based on the performance of players in the real match, the player with highest points – WINS! On winning the contest, a certain sum of money is automatically credited to the wallet inside the app. So, all of this takes place based on a logic that is built in the app. 

Though such gaming apps may not be a smart contract on blockchain – but for an understanding purpose – it is a simplified example which explains how smart contracts function. In fact, there are quite a few blockchain based games that have been introduced, such as FireLotto, Truflip. These are online lottery games functioning on the blockchain technology. So, having understood the examples of online gaming apps, we can say that, smart contracts, fundamentally have 3 key features: 

1.       There is no central authority or a third party to oversee it or control it; 

2.       Such contracts are based on predetermined/ preprogrammed logics – which are coded in a token on the blockchain. 

3.       The contract functions on happening of certain events in the real world; 

 Stella: Thanks Yash, for that explanation! But can you explain how are smart contracts secure on the Blockchain? 

Sure, Stella. Because smart contracts are stored on a Blockchain, they inherit some interesting properties such as, they are Immutable and Distributed.  

Being Immutable means that once the smart contract is created – they can never be changed – so no one can go behind your back and tamper with the code your smart contract. 

And, being Distributed means that the output of the smart contract is validated by miners/stakers on the blockchain network – so a single person cannot manipulate the contract – because other people on the network will spot this attempt and mark it as invalid. 

And, because of these reasons – tampering with smart contracts becomes nearly impossible and therefore blockchain based smart contracts are quite secure.

Stella Joseph - Question: Thank you Yash, for this explanation on how smart contracts operate and its key features. Having understood its functionality and key features, what are the applications of smart contracts?

 Thanks Stella. Before, we discuss the applications, I’d like to also state that because of the unique features of smart contracts, which we already discussed, it allows substituting traditional contracts and develops business growth in several industries, such as, supply chain management, logistics and shipping, insurance and several others. 

 At present, the most common smart contracts are written on Ethereum’s blockchain network, using a programming language called “solidity”.

 Insurance Industry: So, now coming to the applications of Smart Contracts , one place where smart contracts can be used is in the Insurance industry. Currently, insurance policies can take weeks or even months to be paid. The process of getting reimbursed is still very procedural and manual. With the help of smart contracts on blockchain, it is possible that insurance companies could automate the process of clearing insurance claims using smart contracts. For eg, there are certain factors which trigger insurance claims, such as in case of natural events or calamities like the magnitude of an earthquake could be recorded in a blockchain and such claims could be triggered if certain thresholds are crossed. This would reduce administrative costs and make the process more transparent. It would also allow insurance companies to do more accurate pricing.  

Now, in the above example of application of smart contracts, one may question on how factors like magnitude of an earthquake could be recorded onto a blockchain and claims could be triggered if certain thresholds were crossed? For these sorts of events, you need something in the real and physical world to get that information onto the blockchain. These are commonly called “oracles”. It is a software that allows the real-world data to be transferred to the smart contract code in the blockchain. As a result the conditions embedded in a code in the blockchain which are dependent on happening of a real-world event – get notified through such a software. 

Another application of smart contracts is Supply Chain Management: 

Smart contracts could also be used in the copyright industry: In an industry like music where copyright privileges allow the copyright holder to receive a royalty anytime their work is used, there’s a big administrative cost in the current system keeping track of who owns the rights and who is using them. A system of blockchain smart contracts could easily track who owns the copyright and who is using the copyrighted material so that royalty payments could be paid accurately and in real time.   

The last example that I want to give is of, trade of NFTs can also be done on blockchain based Smart Contracts: Any image or a piece of art when converted into a NFT is stored as code on the blockchain. So, when the owner of such NFT further sells the NFT in the market, smart contracts can be used to track such a sale and such further sales of NFT. Now, when the buyer further re-sales such NFT, the smart contract would intimate the original owner and a consideration, which is typically understood as “re-sale” royalty may be paid to the original owner of the NFT. 

 Thank you, Yash, for providing a detailed insights on the functionalities of Smart Contracts. 

 Stella Joseph: 

When one considers some of the characteristics of smart contracts, such as, the decentralization, auto-enforcing ability, and verifiability, and there is per se no involvement of any centralized control or trusted authority or Government authority to enforce the smart contract, they are certainly expected to revolutionize many traditional industries in the future. 

 However, on the other hand, one could also imagine some legal and regulatory in relation to smart contracts. 

 The first issue would be the aspect of whether smart contracts could ever replace the traditional legal contracts which exist today and make the requirement of lawyers/consultants redundant. From the technological understanding of how smart contracts function, it can be said that blockchain based smart contracts cover aspects which are in relation to information validation, as Yash explained in the Insurance sector – whether a natural calamity occurs is a matter of validation, but when it comes to subjective issues, as of today, smart contracts may not be helpful. For eg, a services agreement between an Indian subsidiary and its Parent located outside India, wherein the Indian entity is obliged to perform certain functions for a fixed amount of consideration. Now, to what extent such functions are successfully carried out may be a subjective issue, which cannot be easily pre-programmed under smart contracts. Also, it may be difficult to incorporate within a smart contract certain legal clauses typically found in a normal contract, for eg, force majeure or change in law, which are bound to be situation specific and dynamic.

 The second issue that arises is as regards the cross border presence of such smart contracts 

If one compares smart contract with a normal contract, a normal contract will be bound by the laws of the land, whereas a smart contract which exists on the blockchain is not bound by any geography. Since each country would be having its own laws and regulations it may be complicated to ensure compliance will all regulations, provisions and conditions of legislations. 

 Immutability feature:

Again, if one considers the immutability feature of a smart contract, a big downside to this would be that in case any errors are made in the code while programming it, the immutability feature of a smart contract prevents it from being rectified. Similarly, if circumstances in a contract change for e.g., the parties have mutually agreed to change the parameters of their business deal, or if there is a change in law, etc, an amendment to a smart contract is not possible. Therefore, it is important that thorough reviews of the smart contract are performed by experts before they are deployed on the blockchain. 

 One will have to wait and watch the Government’s Stance:  

Smart Contract is just another application of the blockchain technology. So, the underlying technology here is blockchain and it will be really critical to understand how blockchain will be regulated by the Governments. The Government may adopt three approaches to regulate smart contract:

-          Government can work outside the technology itself. So it will effectively superimpose existing regulations on the technology 

-          It could regulate while becoming an inherent part of the technology itself, so for instance the government can mandate that in every smart contract, it be made a party to the same such that it incorporates logic within the smart contract itself that upon the event of the payment occurring, certain tax automatically gets paid to the government 

-          The third approach is that it could develop its own blockchain and then mandate that all smart contracts are implemented on that blockchain so that such blockchain can have logics of relevant regulations incorporated within the same. 

 One will have to wait and watch what the final stand of the government would be as regards regulating smart contracts. 

 So, with this we can rap up with this part of the podcast. Hope the explanation about the technology was interesting and insightful. Thank you all for joining.