Smart Contracts on Blockchain, Challenges and Government Applications-Legal Insights for Lawmakers.

Smart contracts are pieces of code which codify terms and conditions chosen by the parties involved in the smart contract. Smart contracts are not contracts by law but can be recognized as contracts by law if they bring along with them all essential elements of a contract by law. Essential elements of a contract as the contract law provides are those almost all of you know, i.e. offer, acceptance, intention to create legal relations, consideration, capacity, mutual assent. If a smart contract which is a piece of code codifying terms and conditions, brings with it the above essential elements then, provided that its purpose is legal, it will probably be recognized as contract by law and it wouldn’t be wrong to even refer to it as a “smart legal contract”. So in this case, the smart contract will not only be a code but will be a coded contract by law, thus a smart legal contract. And if recognized as such, i.e. as a smart legal contract then it will enjoy all benefits that contracts by law enjoy, such as, enforcement by the courts and the various remedies available for breach of contracts, such as damages, compensation.

In this respect smart contracts may present certain legal challenges, few of which I will share with you briefly. Such relate for example to jurisdiction and the fact that participants in blockchain transactions and smart contracts are located in every part of the world where different legal frameworks apply. Also they relate to the issue of dispute resolution in case any disputes arise and the fact that judges will most probably find it hard to resolve them because of the sophisticated and unique technology-related issues involved and the fact that courts cannot draw from dispute resolution methods that are used in cases of previous technologies such as for example the internet, cloud computing and IoT. Another challenge is who is to be liable in case of defects in smart contracts or the underlying blockchain system deployed. Where would liability rest and which remedies would be available to address this liability? Would the “managers” of the blockchain system be liable or the coders?

Another important legal issue that is identified within the context of blockchain is compliance with the existing regulatory framework. We have traced numerous such instances where the decentralized nature of blockchain and smart contracts especially, as well as their immutability, render the technology non-compliant with the current legal regime. Let me share with you a significant example. Individuals may, according to article 17 of the GDPR, compel the processors of their personal data to erase these data. This right of erasure is referred to as the right to be forgotten. It is hard to see how this provision can be enforced in the context of blockchain where data are permanently stored in blocks and can’t be deleted.

The actual process of codification of certain set of terms may also present legal challenges. Let’s say that two parties have agreed to exchange value on a particular set of terms and conditions and intend to put these terms and conditions of their agreement into lines of code and have a smart legal contract between them. In other words, they want their contract on the blockchain. Irrespective if they have agreed orally or if they have also drafted a relevant agreement, the terms and conditions upon which they have agreed need to be codified. And who is going to do this work? An expert coder of course. In this case we need to ensure that the codification of the agreed terms and conditions is made in an accurate way, that the exact intention of the parties is properly recorded in the code and that all essential elements necessary for the formation of a smart legal contract are properly reflected in the code. This is hugely important for both parties because due to the self- and automatic execution of the smart contract code, a mistake or defect in the way terms and conditions of a contract are codified, will bring about results not intended by the parties. In fact, it is quite challenging to code written contract terms with accuracy and precision. Not all terms that we ordinarily find in traditional contracts are capable of being recorded or may be easily recorded in smart contracts. For example, it is hard, if not impossible, to code subjective terms like “within reasonable time”, “best efforts”, and “good faith” that we often find in agreements. Also, force majeure clauses which provide for the termination of a contract in case of natural disaster, or other disasters may also be difficult to code.

Further legal challenges may be illustrated by the following example which relates to the Land Registry’s blockchain applications. I will be very brief here, since this analysis would mostly interest lawmakers and can be presented separately at a relevant event which will deal with addressing the various legal challenges around smart contracts.

As you may know in many countries, the possibility of registering title deeds and sale property agreements as well as mortgages in blockchain smart contracts has been widely and thoroughly discussed. Indeed, the potential efficiency gains are very important in this regard. However, prior to implementing it, certain legal considerations must be made.

1)  At first lawmakers should ascertain whether the law is broad enough to encompass programming languages as a type of language in which a contract can be written. If the law as it stands, does not explicitly recognise that programming languages may well qualify as written language, then, there is no doubt that relevant amendments to the existing framework need to be done.

This consideration is important, because as the contract law stands today it requires property sale agreements to be made in writing. It should be clarified whether codified smart contracts could qualify as contracts in writing. If codified smart contracts do not qualify as contracts in writing then, smart contracts for the sale of property as the form of contract, will not be considered as valid.

2)  Another point that is relevant to all contracts, including property sale contracts, is the sort of evidence that courts would accept in relation to smart contracts. In case of a dispute, whether a smart contract has properly and validly been concluded by the parties, would be determined by reference to certain evidence that the existing framework based on certain legal principles may constitute permissible evidence.

Cryptographic keys, which grant access to the particular smart contract run on blockchain, could work as identification by electronic means. The crucial question here is, whether the cryptographic keys would be considered as permissible evidence? If not, existing law needs to be amended accordingly to expressly permit such evidence to be admitted by courts. Another crucial question may be posed here in relation to the required weight that should be given to such evidence and the way in which such evidence may validly be presented in practice.

As national delegates to ISO, we are looking at setting the standards in regard to blockchain’s Reference Architecture, Taxonomy and Ontology, Terminology and Concepts, Security Risks and Vulnerabilities, identity, privacy and personally identifiable information protection, Legally binding smart contracts and interaction between smart contracts in blockchains and DLTs. Our focus is to set quality requirements, build trust in blockchain solutions, guide new business models and develop standards that are aligned with Cyprus’s interests.

The few legal challenges that I shared with you may indeed reveal the inadequacy of the existing legal framework but were neither meant to disappoint you nor make you think that they are impossible to overcome. In fact, these challenges are already being discussed and many suggestions have already been made at an international level to address them. I am very confident that by taking in consideration the blockchain type that a smart contract runs on, be it public or private, permissioned or permission-less, hybrid or governed and with the help of the international standards, blockchain and smart contracts, legislators, lawmakers, decisionmakers and policy makers together and with the collaboration of the academia, of blockchain coders, computer experts, mathematicians, lawyers and other experts we will identify these challenges and find ways to address them successfully and resolve many of the key issues by introducing the necessary pieces of legislation and by amending our existing regulatory legal framework. It is only through these collaborations that we will determine the optimum balance between governance and regulation, thereby enabling blockchains’ interoperability and enhancing trust and security of distributed ledger systems.

Public and private sector can prioritise the blockchain smart contract use depending on their needs and priorities, by asking questions such as, what is the problem? What is the most serious problem we have been facing? What we want to solve? What can we solve? How can we solve it? What can we do better? What would the impact be? What applications of the technology should we apply? For what purposes? And applied in what way and with what safeguards? Only by fully understanding the technology can we choose the applications that best fit our needs as a society.

There are certain public-sector use cases that have been put in priority by governments and have already been implemented by few, such as operating the land registry on blockchain through smart contracts, as I have already mentioned, or registering citizens’ KYC-related information on a blockchain platform (what we call the “Self-Sovereign Digital Identity”). Other widely discussed use cases include those regarding voting and the prevention of electoral fraud through the use of smart contracts, or those in the supply chain management, whereby tracking and updating on the product’s location and details is facilitated and securely recorded in real-time. Further, widely discussed use cases are found in the insurance industry, where a triggering event, such as a flight delay, automates the execution of a smart contract and the release of funds to the insured person. Also, smart contracts function as replacement to escrow services. IP rights protection can be enhanced through smart contracts, whereby the sale of creative work could be facilitated, and proof of ownership could be securely identified, especially in relation to copyright, since recording rights and assets on blockchain as we have highlighted, is time-stamped.

The potential, future and promise of blockchain and smart contracts in the financial industry cannot be stressed enough. Finance raising and investment services have already changed by the operation of blockchain and smart contracts and are expected to undergo further, even more drastic change. Smaller businesses, especially of innovative character, seek to raise capital through blockchain. Smart contracts enable what is called “fractionalisation by tokenisation” and thus the issuing of tokens and their subsequent offering to potential investors or users. You most probably have heard of ICOs, STOs, IEOs and Listed Co Coin Offerings (LCOs), these are directly related to tokenisation and the creation of a tokenised economy. Tokens may take various forms as they may represent a utility, which grants access to a business’s services, or a security, which could function as traditional securities, or be a hybrid utility-security token.

The efficiency of blockchain lowers the cost of such finance raising, opening the doors to innovative companies with lower initial capital to finance their operations. Blockchain and smart contracts, offering the potential for efficient transactions, enable crowdfunding, whereby finance is raised by the public, including small investors.

I am currently participating in a team of experts from around the world researching in the area of blockchain and smart contract applications.  Australia is heading this team of experts and the research. The specific area which I was appointed to research in is blockchain Governmental applications and the standards that need to be used by the government when implementing the relevant application systems. The team is supposed to prepare a global report which is planned to finish in June this year and will be published later in the Summer in the International Journal of Information Technology.

So, I will give you, in more detail, some examples of smart contract governmental applications. I will treat these applications separately but in fact any smart contract application can combine one or more applications. I will touch upon certain use cases that have not been widely discussed or used, to demonstrate the width, breadth and potential scope of smart contracts.

In the context of governmental applications, potential uses mostly refer to dApps that accommodate smart contracts on permissioned blockchains or hybrid public-private blockchains.

In relation to Public health, blockchain and smart contracts can be utilized by the Ministry of Health for the establishment of better public health surveillance. In this way the Ministry of Health through the public hospitals will be able to establish an improved approach to the continuous and systematic collection, analysis, interpretation and review of health-related data needed for planning, implementation and evaluation of public health measures. As a result, blockchain based smart contracts could be used to more efficiently manage data during a public health crisis or other related incidents.

In relation to third-country workers, another use of blockchain and smart contracts system by the government can relate to third-country workers who come with a temporary Visa in Cyprus. The Government could use blockchain and smart contracts to streamline the process, making it more efficient for employers-applicants, less costly for the Cyprus responsible department and much more safer for workers. What I mean by saying that it would be safer for workers is that, by using the blockchain-based system, workers would be able to verify the job that they are about to accept and make sure that it exists. Furthermore, workers would be able to confirm the terms and conditions of their employment contract. The system would also be able to verify the worker’s identity and manage the worker’s immigration status in this way eliminating the threat of document confiscation. For employers, the blockchain system would be able to ensure that workers posses the skills they claim that they have for the job. it also would reduce paperwork and provide transparency in the recruitment process, increasing efficiency and considerably reducing costs and expenses. For the relevant responsible department, such a blockchain-based system would provide streamlined workflows, reduce redundancy and enable instant status verification and tracking, with accountability at each step. In this way, the blockchain-based system would increase interoperability between the various departments involved, allowing them to communicate securely and more transparently.

Another application relates to Government’s e-borrowing, i.e. electronic borrowing.

Government borrowing can also be transformed by the blockchain and smart contracts.

The Cyprus Government can issue ‘micro-bonds’ in denominations of Euro 10 to Euro 100 for example to raise money for local projects including its own blockchain projects. The typical bond size is currently Euro 1000:- at the minimum. Typically, finance fees for issuing mini bonds is such that it wouldn’t be feasible to issue for small amounts. The issuance, however, of the micro-bonds on the blockchain does not require centralized intermediaries, the government will deal directly with the buyer, the value transfer will happen directly and will potentially allow for much more efficient transactions for much smaller value transactions with direct maintenance and tracking of the information with considerably reduced transactional costs. In this regard smart contracts applications can be used to manage, track and implement the interest rate process, the repayment process and securitization process of these micro-bonds.

Our rapidly evolving technological landscape poses challenges for all of us. We will continue to see practical applications of the technology exponentially expand and I believe that the transformation will be dramatic. It is not surprising that blockchain and smart contracts are becoming an increasingly important part of the strategy of various governments around the world and an equally promising tool for the business world. In this regard, we are looking forward to receiving our Government’s strategy for blockchain, which is expected to circulate over the next few months.

Governments attempt, through pilots, trials, and testing programs, to navigate through and implement these promising technologies.

At the same time, the private sector seeks to use these technologies with a view to meet the increasingly demanding consumer needs and achieve time and cost efficiency.

We anticipate that these technologies will be used by the public and private sector and between the two. For this reason, immediate action is required from a policy-making perspective. New legislation and regulatory framework will dissolve some of the current uncertainties and will facilitate the operation of these technologies.

I think it is incumbent upon regulators to continually educate ourselves on new technological developments and to study all possible legitimate use cases for blockchain so that we can fully understand the technology, accurately evaluate the benefits and risks and develop appropriate policy responses, design strategies, set actions and introduce laws and regulations that will embrace and facilitate these technologies, while at the same time enabling a new tomorrow, a better future.

Christiana Aristidou