Law and Forensics | Insights
Smart Contracts & Cryptocurrency Made Simple
June 22, 2020
By Daniel B. Garrie, Hon. Gail Andler & Shraddha Patel
A senior lawyer asked his colleague “So when did Smart Contracts become “a thing”? The younger lawyers in our firm are talking past me with terms like “blockchain”, “smart contract”, and “Ethereum” and whether Elon Musk will send “Dogecoin” “to the moon.” “Can you help me catch up?”
These sentiments express concerns by lawyers everywhere, as the lexicon seemingly changes daily. This article serves to provide a general overview to help lawyers and others understand and make sense of smart contracts and cryptocurrency.
Since smart contracts are stored on blockchain, one must first understand what blockchain actually is. Blockchain is a public ledger, or database, of data available to, and shared by, a cluster of computers. Importantly, the information stored on the blockchain cannot be altered. That is, blockchain is a system of recording information that essentially makes it impossible to change, hack or cheat the system. Information that has been placed on blockchain by a user is available for everyone to see and is distributed in that form.
The term “smart contract” describes a type of computer code that is set up to run, or execute, all or parts of a contract when certain predefined conditions are met. In other words, it is an agreement between parties set forth in a computer protocol. The rights and obligations of the parties are described in the computer code stored on a public ledger (blockchain) which cannot be altered, and each transaction triggers subsequent events consistent with the rights and obligations of the parties. It has been described as an “if, then” technology that enables parties to enter into a contract knowing the outcome of the transactions, without the need for any intermediary.
So how does cryptocurrency factor into smart contracts? Consider this example: a parcel of land is sold for a specific price, in a simple transaction. If the owner of the parcel of land transfers the title into the program, the program validates that condition. The title is held until the price is paid, and if payment is not made on time, the title is released back to the original owner. If the buyer deposits the payment, in cryptocurrency, within the defined time period, the title to the land is transferred to the buyer.
So, what is cryptocurrency? How does it work? Cryptocurrency is digital, or virtual, money. This means that it is entirely online; there is no physical bill or coin like there is with other forms of currency. Cryptocurrency is generally decentralized, not issued by any central authority, and is secured by cryptography. This means that, unlike other currencies, it cannot be manipulated or controlled by the government.
Individuals can invest in and transact with cryptocurrency, just like they can with fiat money. In the scenario described above, for example, rather than the seller giving the buyer cash or a check to purchase the parcel of land, the buyer transfers funds to the seller directly from their cryptocurrency wallet. Unlike a normal transaction where a bank or credit card company is a common intermediary for transactions, cryptocurrencies allow parties to transfer funds independently. Additionally, cryptocurrency transactions offer the parties a certain degree of anonymity. That is, while the transaction amount would be public, the identity of the individuals would remain encrypted.
Smart contracts and cryptocurrencies are complex in many ways. The goal of this article is to offer a general overview to help lawyers obtain a broad understanding of what each is and how it functions. As such, it is important to acknowledge that while it is certainly appealing to have a decentralized digital currency and smart contracts, there are various inherent risks associated with the use of each. For example, because cryptocurrencies are not insured by the government, they do not have the same protections that money stored in a bank account would. In addition, the value of cryptocurrency is known to fluctuate constantly. This means that while an investment may be worth hundreds of dollars today, tomorrow it could be worth pennies, and there is no guarantee that the value will ever go back up. Similarly, while smart contracts make transactions simple, the codes for these contracts are still written by people, and people can certainly make mistakes. As such, if there is an error in the code for a particular contract, it could result in great losses for those involved. This risk is amplified by the fact that there is no clear regulation of smart contracts. In other words, due to the lack of clear regulation and no intermediary, if there was a dispute or error, it would be extremely difficult for parties to reach a resolution; ADR may prove to be a value in these situations.
The use of smart contracts and cryptocurrencies is on the rise. However, it is essential for anyone interested in these to fully evaluate the benefits and risks associated with such use. Interestingly, decentralized cryptocurrency and smart contracts can enable the use of completely decentralized financial services and institutions. Our next article will dive into the concept of decentralized finance and re-examine some of the risks associated with smart contracts to discuss potential resolutions for how to work around those risks.
Disclaimer: The content is intended for general informational purposes only and should not be construed as legal advice. If you require legal or professional advice, please contact an attorney.