Introduction
The increasing shift towards automation and digitisation, including modern technologies, has become the need of the hour. This is inclusive of smart technologies, which utilise blockchain technology. Consider the following situation:
Company A is a software development firm wishing to enter a business transaction with Company B, a marketing agency. Company A decides to develop a custom software application, while Company B decides to provide marketing services for the launch of the application. Both companies can then access a smart contract template designed for their collaboration to proceed with this arrangement.
This is your personalised guide on Smart Contract Agreements, which you can use while entering into modern business contracts, including but not limited to cryptocurrencies, healthcare, supply chain management, real estate, and others.
Through this guide and the assistance of LegaMart, you can gain access to smart contract templates, acquire coding assistance, legal compliance, secure storage and verification, and undertake auditing and compliance monitoring, among the various other benefits. You can commence this process by sharing your legal matter with us anonymously, free of charge, and without commitment, to understand whether you want to proceed with taking our services forward. Tell us about your issue, and we shall get back to you with suggested lawyers and a free consultation session. We support one-to-one meetings with the matched, trusted LegaMart lawyer and assure 100% customer satisfaction to our clients.
What are Smart Contracts?
Smart contracts are digital agreements that can be negotiated, checked, and enforced with the help of a computer program. They aim to expedite the contracting process by replacing paper-based contracts and automating their execution, enforcement, and payment. To provide a decentralised and trustworthy ecosystem, smart contracts are written in programming languages and executed on distributed platforms like Ethereum.
Unlike conventional contracts interpreted and enforced by legal processes, smart contracts automatically execute once the set circumstances are satisfied. Furthermore, the terms and consequences of the agreement are codified inside the smart contract’s code, disregarding the need for intermediaries and making it more challenging to misread or manipulate.
The smart contract is a self-executing agreement with the terms of the contract directly written into code.These are typically used in blockchain technology. Here’s a simple example of a smart contract:
Let’s consider a hypothetical example of how a smart contract could be used in conjunction with a design-build contract. Smart contract is integrated into the design-build contract to automate milestone-based payments, ensure transparency, and streamline the payment process. It also provides a mechanism for dispute resolution, reducing the need for legal intervention. The smart contract simplifies the financial aspects of the construction project and increases trust between the parties.
How do Smart Contracts work?
Smart contracts can be conceptualised as digital agreements based on conditional statements, similar to “if-then” statements, between two or more parties. Upon fulfilment of the requirements of a particular group, the accord can be duly acknowledged, thereby signifying the fulfilment of the contractual obligations.
For example, there is a vending machine: A person inserts cash (transaction), chooses a product (conditions), and the machine dispenses the product (execution). Smart contracts function similarly.
The usage of smart contracts can be seen in the transfer of ownership of digital assets after payment has been received. In addition, smart contracts are efficient and safe for many uses since they are kept on the blockchain, making them transparent, tamper-proof, and without requiring middlemen.
Examples of smart contracts usage
Among these game-changing developments, smart contracts have proven to be a potent tool that automates and simplifies several processes. Moreover, it has the potential to revolutionise various industries by providing effectiveness, openness, and security.
Some examples of the usage of smart contracts are given below –
Decentralised Finance (DeFi) – It refers to a financial ecosystem that operates on a blockchain and facilitates decentralised financial services. Smart contracts help these platforms to enable the automation of financial transactions, collateral management, and interest distribution.
Supply chain management system – An integrated supply chain management system is based on blockchain technology that helps the company operate. In this case, Smart contracts are utilised to monitor and verify the source and calibre of food items. Implementing the system facilitates the ability to promptly detect and withdraw tainted merchandise, thereby enhancing the safety of food products and diminishing expenses.
Blockchain-based gaming platforms – These platforms utilise smart contracts by facilitating the decentralised exchanges of digital assets, such as virtual properties and in-game commodities, among peers.
What are the various Steps for Building a smart contract?
Determine the involved parties and the terms of the agreement
The first step in developing a smart contract is to identify the parties concerned and get an agreement on the terms and conditions of the contract. It will set out the provisions of the agreement, the duties of each party, and the criteria for the agreement’s implementation.
Establish the requirements for contract execution
The second stage defines the circumstances under which the contract will be carried out. The contract’s validity depends on the fulfilment of certain conditions, which are often stated as a set of rules or criteria.
Create the code for the smart contract
Developing the smart contract’s software is the third stage. When the requirements are satisfied, the code will detail the precise actions that must be followed to fulfil the contract.
Install the agreement on a blockchain platform
The fourth step involves using the blockchain to deploy the smart contract. This requires the contract’s code to be uploaded to the blockchain network and checked for correctness.
Automatically initiate the contract’s execution
The fifth step is to carry out the smart contract. When the conditions that were set up front are met, the contract is automatically carried out, and the blockchain network makes it happen.
Enter the contract’s data into the blockchain ledger
When the contract is implemented, the relevant data is recorded into the blockchain. All of the contract’s stipulations, as well as the conditions for, and time of its execution, are included here. Once the contract details are recorded in the distributed ledger, they cannot be altered.
Benefits of Smart Contracts
Several benefits are offered through smart contracts. Some of them include:
Trust and Transparency
Considering that smart contracts are executed on the blockchain, they provide a transparent and decentralised environment to the parties. This is because the terms and conditions of the contract are stored within the blockchain, and all parties are provided equal access to the information. Therefore, if any party wants to change any information, they will have to complete the task before the completion of the contract since once the contract is prepared, there cannot be any argued miscommunication related to the terms. This reduces the need for intermediaries and builds trust among the contracting parties.
Security
High levels of security are built within blockchain technology. For example, once the contract is included as a blockchain, it becomes tamper-proof, wherein it is impossible to alter or delete any data without consensus from the other participants. This helps strengthen the integrity of the contract and reduce fraudulent activities.
Automation
The use of smart contract agreements allows the automatic enforcement of the terms of the agreement once the predefined conditions of the agreement have been met. Therefore, there is almost no need for any manual intervention, which results in a decrease in any potential manipulation or errors. Hence, the procedure is streamlined.
Accuracy, Efficiency, and Agility
It is possible for smart contracts to handle complex transactions (involving multiple conditions and participants) in an efficient, accurate and agile manner. Further, it becomes easier to process large numbers of transactions with higher efficiency in less time, resulting in greater results with no faults.
Enforceability of Smart contracts
The enforceability of any contract, including smart contracts, is essential. While smart contracts offer numerous advantages in terms of automation, efficiency, and transparency, their enforceability is contingent on several factors, such as legal frameworks, jurisdictional considerations, and practical difficulties. Simply put, smart contracts operate within legal frameworks; hence ensuring compliance is crucial for their enforceability. LegaMart offers legal expertise to help you navigate the legal aspects of smart contract agreements. We ensure that your smart contracts adhere to the necessary legal requirements, increasing their validity and enforceability. The following is an explanation of the enforceability of smart contracts:
Legal Recognition
The legal recognition of smart contracts varies across jurisdictions. Some governments have legalised smart contracts and blockchain technologies. The Uniform Electronic Transactions Act (UETA) and Electronic Signatures in Global and National Commerce Act (ESIGN) in the US recognise electronic signatures and contracts, including smart contracts. Smart contracts’ enforceability depends on the jurisdiction’s laws.
Meeting Legal Requirements
Smart contracts must fulfil legal standards like regular contracts to be enforceable. Mutual agreement, consideration, capability, and contract validity are usual prerequisites. Smart contract codes must correctly represent parties’ intents and comply with laws and regulations. To improve enforceability, smart contracts should include clear, unambiguous language that matches the parties’ purpose.
Interpretation Challenges
Smart contracts might be difficult to understand. Programming languages used to write smart contracts are difficult and need technical knowledge. Courts and lawyers may struggle to apply the rules to real-world scenarios. Legal experts with technical skills may need to work with programmers to evaluate and analyse the smart contract’s code and desired effects. Whether you need help writing secure and efficient code or require customisations to existing smart contract templates, we at Legamart support you.
Dispute Resolution
Smart contract dispute resolution is developing. Courts or arbitration may settle smart contract problems. However, smart contracts need technical skills and the capacity to verify and validate blockchain transactions. Hence these processes may need to be modified. Some projects are investigating blockchain-powered decentralised arbitration or dispute resolution systems for smart contract conflicts.
External factors
Smart contracts may also struggle to enforce external contractual commitments. If a smart contract includes the actual delivery of products, logistical or regulatory concerns may affect its execution and enforceability. Oracles or off-chain data sources may check external events or data inputs to overcome such difficulties.
Flexible amendments
Traditional contracts enable mutual revisions or adjustments. Blockchain-deployed smart contracts are immutable. This immutability protects contract execution but limits flexibility. Consider whether the smart contract should allow changes or a new agreement should be signed.
Amending and Terminating Smart Contracts
Currently, modifying smart contracts poses challenges for contracting parties. Unlike traditional text-based contracts, where amendments can be swiftly drafted or behaviours altered upon mutual agreement or changes in the law, smart contracts lack this flexibility. The immutability of the blockchain further complicates the process of modifying smart contracts compared to standard software code unrelated to the blockchain. Consequently, modifying smart contracts incurs higher transaction costs than text-based contracts, raising the risk of parties inaccurately reflecting their desired modifications.
If a party discovers an error in the agreement that grants the other party more rights than anticipated or realises that fulfilling their obligations will be significantly costlier than expected, they face a dilemma. In a text-based contract, they can resort to the concept of “effective breach of contract.” This means that if the performance cost outweighs the losses they would incur, they may intentionally breach the contract and compensate for the resulting damages. Furthermore, by halting their performance or threatening to do so, a party can prompt the other party to return to the negotiation table and seek a mutually agreeable resolution.
Smart contracts, on the other hand, have yet to offer a comparable self-service solution. However, efforts are underway to develop smart contracts that can be terminated anytime and are more easily adaptable. Although this somewhat contradicts the immutable and automated nature of smart contracts, it recognises the need for smart contracts to align with the commercial realities of the parties’ actions to gain widespread acceptance in the business realm.
Risk Allocation for Attacks and Failures
Smart contracts introduce a unique risk absent in traditional text-based contracts; the potential for contract hacking or unintended programming errors within the code or protocol. In the context of smart contracts, it becomes essential for the involved parties to carefully evaluate the allocation of risk and liability concerning unintentional coding errors and any subsequent exploitations. This evaluation may involve considering the distribution of responsibility between the parties and any third-party developers or insurers associated with the smart contract.
Vulnerability
A smart contract vulnerability refers to a flaw or weakness in the design, implementation, or execution of a smart contract that can be exploited by malicious actors. These vulnerabilities can result from logic errors, insecure coding practices, inadequate input validation, or incorrect assumptions about the behaviour of the contract. Exploiting such vulnerabilities can lead to unauthorised access, manipulation of contract data, theft of funds, or disruption of contract functionality. It is essential for developers and users to be aware of these vulnerabilities.
Logic bugs
Logic errors are a prevalent form of vulnerability found in blockchain smart contracts. They encompass typographical mistakes, misinterpretation of specifications, and more severe programming errors that compromise the security of the contracts.
The positive aspect is that these issues can be identified and rectified through smart contract audits. Therefore, it is highly advisable not to overlook this crucial step before deploying your smart contracts onto the blockchain. LegaMart offers auditing services to assess the security and functionality of your smart contracts, helping you identify and address logic errors. By conducting thorough audits, you can identify and eliminate logic errors, ensuring the integrity and reliability of your smart contracts.
Arithmetic error of integers
The arithmetic error of integers is a significant vulnerability in smart contracts due to the absence of floating-point support. It introduces risks such as rounding errors and loss of accuracy when reducing values for precision. Integer overflow is another critical vulnerability, where exceeding the maximum value results in unexpected behaviour. Incorrect integer arithmetic, particularly in percentage calculations, can lead to imprecise results. To mitigate these vulnerabilities, developers should use secure coding practices, employ appropriate math libraries, manage the order of operations carefully, and conduct regular testing and audits.
Vulnerabilities of the block gas limit
The block gas limit serves the purpose of preventing blocks from becoming excessively large. If a transaction requires excessive gas, it will exceed the block’s capacity and will not be executed.
However, this can also create a vulnerability related to the block gas limit. When data is stored in arrays and accessed through looping operations, there is a risk of running out of gas during execution, resulting in the transaction being refunded. Exploiting this vulnerability can lead to a Denial of Service (DoS) attack, as an attacker intentionally consumes excessive gas, preventing legitimate transactions from being processed.
Front-running
When submitted as pending transactions in the Ethereum network, they become publicly visible to smart contracts and users. This visibility allows block miners to prioritise transactions based on higher gas fees.
However, this visibility creates a vulnerability where malicious actors can observe the intended outcomes of smart contracts before they are confirmed on the blockchain. This enables them to copy and submit the contract with a higher gas fee, effectively front-running the original contract and seizing any arbitrage opportunities.
Preventing such attacks is challenging, but there are advanced practices to enhance contract security. Implementing gas limiting, which only accepts transactions with a gas price below a specific threshold, can be helpful. Additionally, employing the pre-commit scheme, where an initial commit involves submitting a hash instead of the actual data, provides some protection against front-running attacks. These techniques can help mitigate the risk of front-running and enhance contract security.
Security and privacy
Smart contracts carry higher risks and consequences than typical software bugs, making their errors more impactful. As smart contracts gain importance in Defi systems, even a single vulnerability can lead to significant user losses. Despite ongoing improvements, security remains a primary concern in the smart contract space. Unfortunately, many projects prioritise marketing and user acquisition, often overlooking the crucial aspect of ensuring system security.
On the other hand, while blockchain’s transparency is beneficial for ensuring integrity and preventing fraud, it raises concerns for users who value confidentiality in their contract details. Although the transparency of transaction information is crucial, users typically desire limited access to their contract information to maintain privacy. An analogy can be drawn to hidden source code data in an HTML file, which can be viewed using the View Source function, potentially compromising confidentiality.
Similarly, smart contracts face similar challenges, as malicious users can exploit the blockchain to expose contract states, violating user data privacy and confidentiality. This lack of privacy undermines trust in smart contracts, as sensitive information becomes susceptible to unauthorised access. As a result, preserving confidentiality becomes essential for maintaining user confidence in the security of smart contracts.
External Data Issues
Executing a smart contract requires prior information, such as specifying transaction conditions and delivery timelines for goods. However, blockchain’s limitations in external communication pose a challenge. To overcome this, developers use oracles, which fetch data from external sources for smart contracts. However, heavy reliance on oracles raises concerns about data accuracy and the potential for errors.
This reliance on external sources can lead to the “Garbage In, Garbage Out” problem. Multiple oracles can be used as a solution, but it increases transaction costs and may violate consensus rules. Ensuring all nodes adhere to the contract’s state is crucial for valid transactions, but receiving information from different oracles may hinder consensus among nodes, introducing further complexities.
Immutability
A significant issue faced by blockchains relates to the immutability of smart contracts, which refers to the inability to modify protocol rules once these contracts are deployed on the blockchain.
While this characteristic safeguards against malicious actors altering contract information, it also presents challenges in utilising smart contracts. As a result, modifying the contract or reflecting changes in the agreement becomes an impossibility due to the inherent nature of smart contracts.
The immutability of smart contracts further poses challenges when it comes to rectifying code bugs. Developers are constrained in their options for resolving bugs found in the code, leaving them with limited avenues for offering solutions.
Future of Smart Contracts
Smart contracts have been gaining popularity in recent years due to their ability to automate and streamline various business processes. According to Zion Market Research, the worldwide smart contracts market was valued at around USD 1750 million in 2022 and is expected to increase to approximately USD 9850 million by 2030, with a compound annual growth rate (CAGR) of approximately 24% between 2023 and 2030.
However, one of the main challenges smart contracts face is the legal and regulatory environment. This is because smart contracts operate decentralised and autonomously, making it challenging to determine legal liability and enforce regulations. As a result, many businesses and organisations are hesitant to fully embrace smart contracts until there is more clarity and guidance from regulatory bodies.
However, in the coming years, the proliferation of smart contracts will be especially beneficial in real estate and intellectual property. However, without more clarity on the legality of digital assets, smart contracts will not be useful as instruments for managing legal documents.
Conclusion
Smart contract agreements offer numerous benefits, including automation, transparency, and efficiency in executing contractual obligations. LegaMart has a collection of pre-designed smart contract templates which can serve as a starting point for your specific contract requirements, saving you time and effort in contract drafting. These contracts can potentially revolutionise traditional agreements by eliminating the need for intermediaries and providing greater security through cryptographic protocols. However, knowing the potential vulnerabilities and challenges associated with smart contracts, such as logic errors, security risks, and regulatory uncertainties, is crucial. To maximise the advantages and mitigate the risks, thorough planning, careful coding, extensive testing, and regular auditing of smart contracts are essential. Additionally, legal and regulatory frameworks need to evolve to address the unique aspects of smart contracts, ensuring the enforceability and protection of rights for all parties involved. Legamart provides ongoing compliance monitoring to ensure your smart contracts align with evolving regulations.
Nevertheless, with proper measures, smart contract agreements hold significant promise in transforming various industries and facilitating more efficient and trustless transactions.
