Lawyer’s Perspective: Why Smart Contracts Are So Important for Our Society

I assume that you, the reader, already know what smart contracts are and what they do. The main feature is that this technology is able to ensure that once certain conditions are satisfied, exchange of promises will happen automatically. In this article, I am going to explain why this function of smart contracts is crucial for our society.

Exchange and Execution of Promises as a Base of Civilized Society

In the middle of the 18th century, David Hume, in one of the most weighty philosophical tractates in the human history titled A Treatise of Human Nature indicated that promises create obligations and following obligations is a base of civilized society. I am going to explain why David Hume is right.

A long time ago humans were living in tribes and fighting mammoths. At some point in time, they realized that instead of hunting and berry-gathering it is more efficient to become cattle breeders and farmers. Tribes began to specialize in different areas. This idea became so successful that tribes started to exchange surplus of their products with each other. They did it because exchange was beneficial for both parties. Then, money was invented, and trade became an engine of the world’s economic growth.

Generally speaking, contracts improve the well-being of both parties and provide value to the society. To be concise, in the world with no transaction costs rational and fully informed individuals with specified property rights are always able to reach efficient agreements. By entering into mutually advantageous agreements, parties create value, correct inefficient assignments of rights, and remedy externalities. In the absence of negative externalities, such agreements constitute Pareto improvements because they render contracting parties better off without violating the preferences of anyone else.

Trust Problems and Solutions

Nevertheless, if promises are not respected, no welfare improvement happens. But how do you know that your counterparty will follow the promise? A contractual relationship is just a game in which the first player has to decide whether he or she wants to enter a contract without knowing whether the second player ever makes their move.

It was noticed at the end of 17th century by Thomas Hobbes in his famous work The Leviathan that the mere trust between the parties is not enough for contracting, and there should be an institution that can make agreements binding and enforceable.

From a lawyer’s perspective, enforcement is the state-sanctioned protection of the parties’ economic interest in the performance of the contract. However, enforcement should not be only associated with state enforcement institutions. Enforcement is a reason why promises are executed. Without contracts, there would be no market, and without enforcement, there would be no incentive to conclude contracts, so the question of endogenous, or private, enforcement became discussed in law and economics literature. Scholars differentiate between private enforcement mechanisms such as reciprocal behavior, reputation, good relationships and formal enforcement that happens according to the law.

It seems obvious that neither formal enforcement, nor private enforcement can always ensure efficient and speedy execution of obligations. Hence, a notion of preemptive self-help, which is legally permissible conduct that individuals undertake to absent the compulsion of law and without the assistance of a government official in efforts to prevent or remedy a civil wrong, was introduced. More and more industries start using starter interrupt devices, a technology that helps one ensure that enforcement is potentially regarded as self-help under the article 9 of the Uniform Commercial Code (UCC).

Smart Contracts as a Step Forward

The concept of smart contracts is similar to the idea of starter interrupt devices, but it is much broader. Automatic execution of promises by a computer can solve the trust problem. Simply put, it is a step forward for the society, and here’s why.

Back in 1963, a research published in American Sociological Review has shown that firms rely on reputation and good relationship. However, later studies discovered that this was not the case, and lawyers and formal enforcement are still used as backup tools. While companies turn a blind eye to the small breaches of each other, they usually have a well-written contract and a team of litigation lawyers ready to help. In case of individuals, the reputation and good relationships can be applicable less often, especially on the internet. Quite regularly, people have to conduct business with unknown parties.

Formal enforcement is not always reliable and efficient. Undoubtedly, in some jurisdictions, it is more reliable than in some others, but globally speaking, the situation is very far from ideal. Firstly, formal enforcement implies a judicial process. It is not a secret that a trial may take decades for different reasons, and sometimes the high cost and slowness of trials deter people from going to courts at all. Secondly, even when a court finally decided something, the bill collection can take ages as well.

Smart contracts reduce transaction costs often by cutting off financial and trade intermediaries such as banks or eBay. Moreover, the adoption of the technology may lead to fewer  litigations and less performance monitoring.

Smart contracts may decrease the involvement of human beings in the decision-making process. Indeed, if people were always trustworthy, why would we need a contract law or laws at all?  Even the U.N. test the smart contract technology as it can ensure public confidence. Using blockchain as a platform can make every action transparent, and thus reduce human-related risks.

Smart Contracts Are Not That Perfect

We should not forget that smart contracts are just a technological solution that is supposed to make our life easier.  First, a smart contract is not a substitute for human relations inherent in any exchange of promises. Negotiations, discussion of breaches, making changes, or ignoring terms of a contract by both parties are all social processes that cannot be performed by a computer. Additionally, litigation, prediction of all possible consequences and the expected interpretation are way beyond the grasp of any artificial intelligence tech, at least at the moment.  Disputes will happen anyway, and solving them will be arbitrators of court.

Second, a smart contract code may contain errors, or the algorithm may just be wrong somehow.  How many times did you kick a vending machine to finally get your can of cola? Or how many times have you been really pissed off because of some software glitches? And don’t you forget about the security issues. Just think about the DAO hack.

Finally, while smart contracts may reduce some transaction costs, creating and maintaining a blockchain that supports smart contracts is still an expensive thing.  If you want to use Ethereum platform you also pay a transaction fee.  You spend time and money to create a smart contract code, and if you want your smart contract to be a legally binding one, you will have to pay even more.

Conclusion

Exchange and execution of promises drive the world economy.  However, this would not happen if people merely relied on trust between each other.  That is why there are informal and formal enforcement, and so many different technologies and legal concepts try to address the trust problem. Unfortunately, those mechanisms don’t always deliver the desired result at the minimum cost.

Smart contracts can solve the trust problem while reducing the cost associated with the agreement. Moreover, they can make the whole transaction process more transparent and reliable. There is, of course, a lot of problems related to the technology, but when they are finally solved, the humanity will take a big step forward.

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