Unravelling the Self-Executing Mechanism of Smart Contracts

Introduction

In the preceding article, we discussed the potential of smart contracts, their multifaceted benefits, and their implementation across diverse industries. Now, as we continue this exploration, we delve deeper into the functionality of smart contracts, focusing on what makes them “smart” or “self-executing” in nature. We will also draw a comparative analysis with traditional online contracts to better understand the transformative potential of smart contracts.

Understanding the "Smart" in Smart Contracts

A smart contract is an evolution beyond conventional paper contracts or digital agreements. Coined as "smart," it possesses capabilities that surpass traditional contractual mechanisms, akin to how a smartphone transcends the functionalities of a regular mobile phone. A smart contract is essentially computer code hosted on Distributed Ledger Technology (DLT) such as Blockchain or Corda. The "smartness" comes into play when the contract, upon receiving specific data inputs, executes predefined actions. This process mirrors an excel spreadsheet formula, where upon input, the formula adjusts itself and performs the programmed actions.

What is Distributed Ledger Technology ?

Distributed Ledger Technology (DLT) serves as the foundation for smart contracts and is crucial for their operation, especially in the legal sector. DLT is a decentralized database managed by multiple participants or nodes, recording all transactions with an unalterable cryptographic signature, ensuring both transparency and security.

In the context of smart contracts, DLT serves a dual role - a host and an executor. Smart contracts are self-executing contracts where terms of agreement are coded and reside on the DLT. When predefined conditions are met, DLT helps execute these contracts automatically, minimizing manual intervention and related errors or delays.

Blockchain, a type of DLT, is the most well-known and commonly used platform for creating and managing smart contracts. These smart contracts are self-executing contracts with the terms of the agreement directly written into lines of code. This code, or contract, resides on the blockchain, and its execution is managed by the network of computers that run the blockchain, thereby removing the need for a central authority or intermediary.

The inherent nature of DLT makes it an ideal platform for smart contracts. DLT's transparency ensures all parties involved can view transaction details, providing a single source of truth. Its immutability guarantees that once a contract is deployed, it cannot be altered or tampered with, ensuring the contract will be executed exactly as agreed unless otherwise mutually agreed between the parties. The decentralized nature of DLT enables peer-to-peer interactions, reducing dependencies on intermediaries, and potentially lowering costs and increasing efficiency.

Comparing Smart Contracts with Online Contracts

To further appreciate the ground breaking potential of smart contracts, let's juxtapose them with conventional online contracts. Online contracts, typically found on internet forms, lay out the terms of a transaction but lack access to the actual value being exchanged. In the event of a breach, such as a failed delivery from an online retailer, the burden of initiating recourse falls on the purchaser, who must navigate through complaint procedures or claims for refunds, as dictated by the General Conditions of the contract.

In contrast, smart contracts not only define the next steps but also execute them autonomously. For instance, in the event of a failed book delivery, a smart contract could autonomously re-order the textbook from an alternate supplier and levy a time penalty against the original seller by transferring value from the seller to the buyer. This level of automation is possible because the smart contract operates within a DLT that holds the value being transacted.

The Role of Oracles in Smart Contract Execution

In order for a smart contract to be self-executable, it needs to be triggered by data inputs that both parties trust and have agreed in the contractual terms. These data inputs could come from various sources, such as official registers capable of providing electronic messages, the Internet, including the Internet of Things (IoT), and other business networks.

These sources are connected to the DLT via connectors known as "Oracles". Oracles play a crucial role in the execution of smart contracts by providing a trusted bridge between the contract and the real-world data it needs to function. They also introduce a level of human oversight, ensuring that the data inputs are accurate and trustworthy.

Let us understand this with a simple illustration. For instance, a SaaS service provider and a customer could agree on a smart contract that automatically renews the customer's monthly subscription if the payment is made by the due date. The smart contracts could be programmed to say, "IF the customer pays the subscription fee before the end of the current subscription month, THEN extend the customer's monthly subscription for the next period." Similarly, if the SaaS service provider fails to provide the agreed service level, the smart contract could automatically issue service credit or refund to the Customer. The versatility of smart contracts makes them a powerful tool in automating legal agreements and obligations. In case of a dispute, the smart contract automatically freezes the current state of the agreement and initiates the dispute resolution process. This could involve notifying mutually agreed arbitrator or ODR service provider giving them access to the blockchain record of all transactions related to the agreement.

This automation and transparency offers a new way of enforcing and managing legal agreements that can increase efficiency, reduce the risk of disputes, and provide a secure record of all transactions.

Conclusion

By automating contractual obligations, smart contracts drastically reduce the need for the parties to intervene after execution of the contract. It simply executes whatever was mutually agreed between the parties in the contract. Smart contracts stand at the forefront of a new era of contractual relations, providing a level of efficiency, security, and autonomy that is unparalleled. However, to harness their full potential, we need to overcome the challenges they present and develop robust legal frameworks for their enforcement. As we continue to explore and innovate, smart contracts have the potential to significantly transform the way we conduct transactions and agreements, setting the stage for a more efficient and transparent future.

*Abhijeet is a corporate lawyer with a passion for artificial intelligence and law. He has graduated from the School of Law at UPES Dehradun with honours, earning a gold medal and recognition as the best law student at his university. Apart from his legal career, he focuses on developing strategies for integrating artificial intelligence in legal operations.