Turkish Law Blog
Smart Contracts: End of Conventional Contracts?
Contracts are among the legal instruments most frequently used by individuals and institutions to meet their needs and to perform all kinds of businesses, transactions, and actions. Contracts, which are arranged in detail by legal norms, are established by the mutual will of the parties. Although their establishment and operation depend on mutual agreement, contracts always need an intermediary to be a fully effective instrument. Because there is always the risk that the actions agreed in the contract will not be fulfilled properly. If the acts borrowed in the contract are not executed, there is a need to force the parties to do so. This power is the judicial organization of the state with a monopoly of the legitimate use of force. In other words, even if the contracts are established between the parties, a third person is needed to resolve the disputes that may arise and to force the parties to fulfill their undertakings.
The smart contract brought to the literature with blockchain technology differs from the classical sense of contract especially in terms of the above-mentioned issues. No third-party intermediation is required to implement the smart contracts. Because, thanks to the software on which they are installed, a situation such as not executing the contract is excluded. In a way, the establishment and execution stages of the contract have been combined and it is left to blockchain technology to ensure this functioning. Although blockchain technology is generally known for cryptocurrencies, it also allows for digitalization in countless areas such as smart contracts. Already, interpersonal crypto money transfer is a smart contract process in itself. In this article, we will first briefly examine the blockchain technology and then the reflections of the smart contract concept to the law.
1. Blockchain Technology
Blockchain can be called a database on which participants can perform various operations. The blockchain, which is described as distributed ledger technology, consists of data carrier blocks connected to each other in a chain. Each of these blocks carries every single data available in the chain. That is, data is not stored in a central location. Each user on the system can access each single data. Certainly, these data are cryptographically encrypted. In other words, all data on blockchain are anonymous because they are encrypted, although they are open to anyone with access to the database. At the same time, the blocks are connected to each other by cryptographic bonds.1
A block is actually a data bundle. Each block can be thought of as a fixed-size box containing different items, including but not limited to, the 'hash' of the previous block, the time stamp and a number of operations. Hash is actually called the encrypted version of each data in the chain. Hashs created for blocks can also be thought of as the encrypted version of the total data they contain or a photo of it. Since each block contains the hash of the previous block, it also carries the data contained in the previous block in encrypted form. Simply put, each block contains information about the actions performed within its own structure, along with the hash of the previous block. In this way, change in one block requires all blocks to change. This is how distributed information technology of blockchain works.2
Distributed data storage also ensures blockchain security against attacks from outside. Because there is no central data warehouse to be targeted for a single attack. In order for each block to be added to the system, it must be approved by more than 50% of existing participants. Therefore, for an external attack to be successful, it must affect the majority of the participants in the system, which is highly improbable.3
2. Smart Contract
A smart contract (or crypto contract) is a computerized transaction protocol that automatically proceeds under conditions stipulated by the parties. To put it more clearly, the smart contract consists of transferring the rights and obligations determined by the parties in the physical world to the computer environment, self-execution, advancement and conclusion of these conditions.
It was in 1994 when Nick Szabo, a computer scientist, cryptographer and professor of law, first mentioned smart contracts.4 Szabo explained the smart contract with a very simple example: Vending Machine. When we want to buy a can of cola from this machine, we put the specified amount of money in the hopper and dial the required number. According to the defined coding, the machine firstly controls the value of the cola, the number of which is dialed, and then the money placed. If the codes of these two are compatible with each other, the machine leaves the can in the compartment so that the receiver can take it. Thus, a contractual relationship is established between the buyer and the vending machine, and this is actually a smart contract relationship. Therefore, the operation of smart contracts created with blockchain technology is not much different from the vending machine.
3. Establishment and Implementation of the Smart Contract
In order to establish a smart contract, the contracting parties first determine their rights and obligations, turn these rights and debts into blockchain-based codes, sign them cryptographically and upload them to the blockchain. The contract uploaded to the blockchain will be able to interact with other components on this network. Thus, the blockchain-based smart contract now automatically begins to progress and self-execute without human intervention. If we want to illustrate, company A wants to buy 500 kg of yarn from company B. Company B requests a total of $ 2,500- on the date of delivery of this product. The parties encode all commercial and legal conditions such as product features, payment amount, payment date, delivery date and transfer them to the computer environment. Then they sign with their digital signatures. When company B delivers the products to company A, the smart contract detects delivery from company A's stock data, and then automatically remits an amount of $ 2,500 to company B's account. In this way, the smart contract automatically progresses and results without any third-party intervention.
Today, US-based Wallmart Inc.5 is one of the first companies to fully integrate blockchain technology into its organizational structure within the scope of the project it carried out with IBM. Transferring food supply chain processes to blockchain, Wallmart Inc. makes purchases from its suppliers through smart contracts. Similarly, AIG6, an international insurance company, has transferred its international insurance activities to blockchain as part of its project with IBM and executes many insurance contracts worldwide with smart contracts. The Australian Stock Exchange develops blockchain-based post-processing solutions to replace the existing system.7
There is no limit to the area where blockchain-based smart contracts will be applied. In the near future, it is stated that banking and insurance, supply chains, real estate and vehicle sales, and all types of rental contracts will be the priority application areas for smart contracts. For example, we will be able to obtain an artist's album, which we listen to in a virtual environment, within a smart contract. While listening to the song, we will be able to make the payment that corresponds to the artist's intellectual property right without any further action.
4. Advantages of Smart Contract
The reason why scope of application of the smart contract has been exponentially growing every passing day is the vast number of benefits that provides us, undoubtedly. Touching briefly on these:
- Verifiability: One of the greatest features of blockchain technology which is the basis of the smart contract is that it cannot be altered or be revised at all. Therefore the parties will not have any doubts on its content.
- Transparency: It is quite straightforward to find out for the parties through the blockchain technology whether other party fulfills its liabilities in accordance with the smart contract or violates it. The smart contracts have the massive opportunity to provide such transparency to the extent that traditional contracts cannot offer in any way.
- Quickness: The smart contract totally eliminates paperwork and bureaucracy, removes all agents and mediators and ensures that the whole contractual process is proceeding as rapidly as possible due to its self-functioning nature.
- Autonomy: The third parties cannot intervene or manipulate the smart contract due to blockchain technology. The whole contractual process is proceeding over the network.
- Saving: Removing all agents and mediators, eliminating paperwork and bureaucracy and putting away of interventions of any third party provide substantial savings for the parties and lead to a significant reduction in costs.
- Security: Owing to encrypted basis of the blockchain technology breaching can be described as impossible. Besides, network and computer security greatly contribute to self-functioning nature of the smart contract8.
- Trust: Since it is quite simple to take countless back-up of a smart contract thanks to the blockchain technology, there will be no such case like losing it.
5. Disadvantages of Smart Contract
By nature, the smart contract has somewhat risks and problems alongside of the benefits mentioned hereinabove. Principal risks and problems are followings:
- Validity: Since the smart contract does not comply with the traditional contract law rules according to some jurists, the courts might not consider it as a legally valid contract. For instance, it is hard to determine even when or by whom offer/acceptance is initiated under a smart contract.
- Probative Force: Even if a smart contract is considered as a legally valid contract according the present law rules, we will confront diverse controversial subjects related both material law and procedural law: Which code is to be applied to this contract or which court’s jurisdiction prevails if a competent court article is lacking within the contract or how expert review is effectuated for a smart contract etc.
- Capacity: As is seen, the scope of application of the smart contract is vast. We can conclude a smart contract in almost all cases ranging from a simple membership agreement to a complex supply agreement. In this context a minor, sitting in front of his/her computer, may conclude a smart contract in spite of not having legally capacity for it.
- Unrevisability: Owing to the blockchain technology on which a smart contract is based, it cannot be revised at all. It is undoubted for establishing trust between the parties and verifiability for the contract. Nevertheless on the flipside we must admit that a new and essential variance or an unexpected event which might occurs after having concluded a smart contract cannot be added into it.
- Content: We have need for an explanation due considering of its importance of the Content subject despite of being another reflection of Unrevisability mentioned hereinabove. It is required to be added and to be transformed as computer codes all probabilities might be encountered in the future. We may not encounter any problem under a simple smart contractual relationship, however if any new and essential variance or unexpected event arise during that the contractual relationship continues especially in a complex smart contract we will not be able to revise that contract, thereby the parties may be in somewhat uncomfortable positions.
Blockchain is a technology that has the potential to revolutionize almost every aspect of our life. Individuals and institutions exchanging different currencies without any need for central banking authority and making all daily transactions just relying on each other’s trust will clearly create major reversals on their lives. Here, the smart contracts are merely one of the innovations of this technology has already begun to make real. Although it is seen from an external perspective as quite simple, a transaction like sale and purchase that we put into practice countless times in our daily lives involves various parameters and many complex procedures for being legally valid. Despite the fact that we can conclude a smart contract in almost all cases, we cannot completely transfer it into the blockchain technology for the present day. Given that the smart contracts having simple content become widespread rapidly in the very near future. However, the flexibility required by the law is unfortunately eliminated due to its feature of unrevisability. This drawback has the potential to cause problems in terms of errors, frauds, and similar willing processes.
As is evident for the smart contracts in the long-term that we will spectate the massive conflict between the technology constantly evolving and the law gradually changing.
Since the technological developments are an irreversible fact of today, our hope is that the lawmaker all around the world legislates the necessary legal rules which can keep up with that rapid change without any delay.
- Osman Gazi Güçlütürk, Blockchaın: A Trustless Network Or A Technologically Disguised Shift Of Trust?, https://ssrn.com/abstract=3440044
- Mesut Serdar Çekin, Borçlar Hukuku ile Veri Koruma Hukuku Açısından Blockchain Teknolojisi ve Akıllı Sözleşmeler: Hukuk Düzenimizde Bir Paradigma Değişimine Gerek Var Mı?, İstanbul Hukuk Mecmuası, 77 (1): 315–341
- Kevin Werbach,Trust, But Verify: Why The Blockcha,n Needs The Law, https://ssrn.com/abstract=2844409
- Smart Contracts 1994 by Nick Szabo,
- Robert Hackett, Walmart and 9 Food Giants Team Up on IBM Blockchain Plans, Fortune (Aug. 22, 2017),
- Annap Derebail, Helping AIG Innovate on Its Multinational Insurance Programs with Blockchain, IBM Insurance Industry Blog (July 13, 2017)
- Smart Contracts: Building Blocks for Digital Markets 1996 by Nick Szabo