Everything will be tokenized and connected by a blockchain one day.   -Fred Ehrsam

With the rapid digitization, we saw a new technology called Blockchain quickly emerge. This peer-to-peer distributed ledger has provided a platform to create transactions that are safe, secure, and immutable. Blockchain gave rise to a concept called “smart contracts”, a major contributor in the financial technology (fintech) sector. These contracts are a set of codes on the blockchain with some pre-determined rules, which are automatically executed when those rules are met. Smart contracts gained prominence after the widespread use of cryptocurrencies such as bitcoins.

To explain this concept, let’s review the process involved in purchasing a house. When you don’t have enough money to complete the transaction, you can finance the home through a la. This involves many visits to the bank as well as getting approved or cleared for the loan amount. In comes the role of smart contracts executed on blockchain: with your information stored on the blocks, the lending process would be much faster and easier. Once the conditions are seen to be met, the transaction (via cryptocurrency) between the lenders and seller would be initiated and a house’s title would be transferred automatically.

Smart contracts work using a chain of rules working on the principle of “If This, Then That”; that is, “if the conditions are met, then the transaction will be initiated”. This transaction will be recorded and stored on the blockchain, which will be verifiable any time, ensuring a greater level of transparency. This feature of verifiability is ensured by the hash function, an algorithmic mapping that generates a hash key that in turn produces the same pattern when entered in the system. It is nearly impossible to generate a similar result without access to that particular hash key.

Smart contracts have the potential to save a lot of time and money spent on the entire paperwork, procedure, and intermediaries. But, every rose plant has thorns. Thus, there are issues with smart contracts.

Generic Issues With the Pre-existing Rules

Pursuant to the discussion on the secured nature of the smart contracts, we must also consider that their extensive coding and obfuscated structure make these contracts something that may be above the layman’s understanding. Hence, this heavy dependence on the coders leaves room for bugs or other security loopholes. In addition to this, the pre-determined rules make the entire process rigid and leave no scope for improvisation or contingencies, which may not be foreseeable during contract formation. For example, one cannot reasonably expect to consider all types of situations which may lead to the frustration of a contract as mentioned under Section 56 of the Indian Contract Act. Moreover, the concept of concessions made due to some special conditions met (such as supplying a specific item or entire payment in cash) exists in the commercial, which acts in practical opposition to the peppercorn theory requirement of proportionate considerations.

Sustainability of Smart Contracts

Since the introduction of smart contracts and cryptocurrencies, one of the most debated topics has been the legal sustainability of these blockchain-enabled transactions. There have been several decisions on the topic, some providing clarity and some making this discussion even more vague. One of the basic provisions which form the foundation of a contract: Section 10 of the Indian Contract Act discusses the legality of object and consideration. Without a regulatory framework for these transactions and an absence of a central regulatory institute (due to the decentralized structure), there exists a potent-yet-elusive loophole for transactions involving illegal objects. The legality of object and consideration is judged by the governmental agencies and the absence of either in formulating the pre-determined rules makes the execution of illegal contracts possible.

There also may be a potential for execution of smart contracts without the proper meeting of minds in the presence of electronic agents. The regulatory laws are silent on this and treat the execution of a contract by e-agents similar to one that is executed by the owner himself. Hence, the self-executory nature of smart contracts may go on defying some of the basic rules of contract formation.

Considering that blockchain is still young, it is difficult to create an exhaustive set of rules because the technology is continuously growing. Laws formulated across the globe turn out to be obsolete once there is a new development in the field. When we talk about the legality of these contracts, it is imperative to consider that even though several states in the US and UK have allowed such transactions with some control by the state authorities, people and the government are still skeptical about blockchain and smart contracts.

Regulatory sandboxes are a kind of safe zone to carry out the developments of the fintech sector on a test-basis with the guidance of the state authorities and to some extent, minimal regulations. The Financial Conduct Authority (FCA) of the UK has been a pioneer in the area of fintech, setting up the first regulatory sandbox. Ina. regulatory sandbox, ideas with innovative approaches are provided an operational period to look for the response and loopholes of it in the market.

In India, the sustainability of smart contracts along with the use of cryptocurrency has seen a vague stance. The Reserve Bank of India (RBI) decided to stop the use of virtual currency in 2018. But in a recent judgment, the Supreme Court of India held transactions in cryptocurrency were valid and lifted the ban. Following the decision, NASSCOM and the Payment Council of India asked the RBI to include crypto-technology like smart contracts in the regulatory sandbox under the guidance of the RBI, the Insurance Regulatory and Development Authority of India (IRDAI) and the Securities and Exchange Board of India (SEBI) for comprehensive assistance and evaluation. This initiative would be beneficial for developers and help in devising a proper regulatory framework and methods to cover the issues apparent in smart contracts.

Unnat Akhouri is a second-year law student at NALSAR University of Law, in Hyderabad, India.

Suggested Citation: Unnat Akhouri, The Sustainability of Smart Contracts, JURIST – Student Commentary, June 18, 2020, https://www.jurist.org/commentary/2020/06/unnat-akhouri-smart-contracts/.

This article was prepared for publication by Gabrielle Wast. Please direct any questions or comments to her at commentary@jurist.org