Blockchain Contracts: Too Smart To Be Regulated? - HKS Student Policy Review (2024)

Smart contract or dumb contract? Everyone should consider this question before using a blockchain to carry out a transaction.

Any transaction on a blockchain requires the use of a contract that is itself encoded on a blockchain: a “smart contract.” Blockchain users unfortunately often discover that this so-called smart contract is not as smart as it seems. Aware of the risks generated by the use of smart contracts, the European Union attempted to address this issue in the Data Act in December 2023.¹ The Data Act, however, suffers from several shortcomings: in addition to containing only a single article on smart contracts it appears to be largely disconnected from technological realities. The anticipated failure ofthis European regulation raises a fundamental question: is it possible to regulate smart contracts?² In other words, can a technology created to evade law enforcement be regulated?³

What is Blockchain? And How Does It Relate to Smart Contracts?

Blockchain is a transparent, secure information storage and transmission technology that operates without a central control body. It is a secure, distributed database containing the history of all exchanges between its users since its creation.⁴ In other words, Blockchain is a big notebook that anyone can write in at the same time, and where no one can erase anything.

Although there is one blockchain technology, there are many implementations of this technology. There is not just one blockchain, but many blockchains operating according to different rules and enabling the exchange of different cryptocurrencies. For example, the most famous blockchains to date are Bitcoin and Ethereum.

In addition to storing information, blockchains enable transactions to be carried out via smart contracts. Smart contracts — theorized in 1996 by Nick Szabo before the emergence of blockchain, and then brought to life by Ethereum blockchain founder Vitalik Buterin in 2014 — are computer protocols organizing the automatic exchange of digital assets, i.e. anything that is stored digitally.^{5, 6} For instance, cryptocurrencies or NFTs are registered on a blockchain. A smart contract — written on the “IF x, THEN y” pattern — executes itself. Smart contracts are immutable. Consequently, their execution cannot be interrupted either by the contract parties or a third party. This certainty of execution has quickly seduced many players, with the result that the number of daily uses of smart contracts has already reached several million.⁷ In theory, all “traditional” contracts can be executed by using a smart contract.

A famous example is the Fizzy smart contract, launched in 2017 by insurer AXA, which enabled automatic compensation for passengers on a flight delayed by more than two hours.⁸ No human intervention was required to compensate passengers for delays. As soon as the smart contract — linked to global air traffic — detected a flight delay of more than two hours, passengers were automatically compensated by the smart contract. While nearly 11,000 people signed up for the Fizzy program, AXA abandoned the project in November 2010, claiming that the market was not yet mature enough for this type of product.⁹ The reason for the project’s abandonment would therefore be a lack of consumer interest in this type of product. However, AXA has always remained very obscure on this matter and has refused to respond to my requests for clarification.

Benefits of Smart Contracts

The immutability of the smart contract eliminates the risk of non-execution, late execution or poor execution of the obligation. As the execution of the smart contract is not subject to any additional action by the parties, but only to the occurrence of external pre-defined conditions, smart contract prevents any opportunistic behavior by the parties or any effective violation of the contract. In practice, smart contracts eliminate the risks of late payment or non-payment, frequently encountered in traditional contracts.

In business, speed is imperative. Smart contracts embody the maxim “time is money:” they provide a definitive solution to the problem of the speed of financial transactions. Indeed, smart contracts do not simply speed up transactions; they make them immediate.

Risks of Smart Contract

Despite these advantages, smart contracts raise numerous legal concerns. Paradoxically, the principal weakness of smart contracts lies in one of their greatest strengths: certainty of execution. Even if both parties wish to prevent the execution of their smart contract, they are condemned to suffer its execution. What is worse, a judge faced with an illegal smart contract — an unbalanced smart contract imposed on a consumer by an extremely powerful company exploiting its dominant position or a smart contract concluded with a minor or a disabled person in violation of contract law — can do nothing.¹⁰ Indeed, since smart contracts are self-executing, a judge cannot prevent the execution of an unlawful smart contract.

In other words, smart contracts are not so smart. This is not to say it is dumb. Rather, in the wrong hands, smart contracts can become an instrument of oppression. Indeed, smart contracts can be used by the dominant party in a contractual relationship to impose its domination over the weaker party, by escaping the law. The smart contract can therefore serve as an instrument for breaking the law in the business sphere.

European Regulation of Smart Contracts

The European Parliament rightly pointed out that smart contracts “are being used in a number of areas without a proper legal framework.”¹¹ Consequently, the European Union legislator dedicated an article in the Data Act to smart contracts.^{12, 13}

This regulation begins by requiring that smart contracts offer “a very high degree of robustness” to avoid functional errors and to withstand manipulation by third parties.¹⁴ The European legislator, however, fails to define robustness or indicate how it is to be assessed technologically.

Article 36 states that smart contracts shall include internal functions which can reset or instruct the contract to stop, or interrupt the operation to avoid future accidental execution. One wonders whether the European Union legislator has confused the Data Act with its wish list! The is a utopian requirement disconnected from technological realities and the immutable nature of blockchain.¹⁵

How Can Smart Contracts Be Regulated Effectively?

The European Union legislator has adopted the wrong approach by refusing to speak “technological language.” It needs to explain in concrete terms what a robust smart contract is and provide examples of the lines of code that make up a robust smart contract.

The current regulation suggests a lack of technological knowledge. This illustrates a bad habit of the European Union: it tends to regulate as quickly as possible, often before really understanding the technology it regulates. This leads to regulations that are either inapplicable practically, like the Data Act, or highly open to criticism, like the AI Act.

This obviously concerns the legislator, but also all the other smart contract stakeholders: judges, consumers, developers and so on.

In this context, in a French-language white paper I co-authored with Fabrice Lorvo for the Paris City of Law organization, I put forward 7 concrete recommendations for the desirable development of smart contracts:¹⁶

1. Educate consumers to identify the risks involved in using smart contracts.
2. Educate vendors to use smart contracts effectively in response to growing consumer demand for simplification of the contractual process.
3. Train developers to create smart contracts that meet the needs of consumers.
4. Involve the courts and create a specialized jurisdiction.
5. Involve law enforcement authorities to combat the possible emergence of fraudulent smart contracts and enable immediate deletion in response to consumer reports.
6. Encourage standardization of smart contracts.
7. Develop alternative dispute resolution methods for the disputes arising from the use of smart contracts.

Conclusion

Regulation of smart contracts is possible but requires knowledge of blockchain technology. Consequently, when it comes to smart contracts, Lawrence Lessig’s fear that “code is law” is not the end of the road.¹⁷We are not doomed to live in a world where the rules are not set by laws passed by the political representatives we have chosen, but by coders. We can adopt laws that will apply to smart contracts in a way that brings them into line with our values.

Today, code is law. Tomorrow, law will be code.

1. Regulation (EU) 2023/2854 of the European Parliament and of the Council of 13 December 2023 on harmonised rules on fair access to and use of data and amending Regulation (EU) 2017/2394 and Directive (EU) 2020/1828 (Data Act), https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=OJ:L_202302854. ↩︎
2. Federico Casolari, Mariarosaria Taddeo, Aina Turillazzi, and Luciano Floridi, “How to Improve Smart Contracts in the European Union Data Act,” Digital Society 2, no. 9 (2023). https://doi.org/10.1007/s44206-023-00038-2. ↩︎
3. Nick Szabo, “Smart Contracts: Building Blocks for Digital Free Markets,” Extropy Journal of Transhuman Thought 16 (1996). ↩︎
4. Aaron Wright and Primavera de Filippi, “Decentralized Blockchain Technology and the Rise of Lex Cryptographia,” March 20, 2015, https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2580664. ↩︎
5. Szabo, “Smart Contracts: Building Blocks for Digital Free Markets.” ↩︎
6. Vitalik Buterin, “Ethereum: A Next-Generation Smart Contract and Decentralized Application Platform,” 2014, https://ethereum.org/content/whitepaper/whitepaper-pdf/Ethereum_Whitepaper_-_Buterin_2014.pdf. ↩︎
7. Thibault Schrepel, “Smart Contracts and the Digital Single Market Through the Lens of a ‘Law + Technology’ Approach,” European Commission, October 21, 2021, https://ssrn.com/abstract=3947174. ↩︎
8. “Bringing Innovation to the Next Level,” Axa, January 23, 2019, https://www.axa.com/en/news/bringing-innovation-to-the-next-level. ↩︎
9. Laurent Thevenin, “Axa Sort Totalement de l’assurance-vie et de la Gestion d’actifs aux Etats-Unis,” Les Echos, November 9, 2019, https://www.lesechos.fr/finance-marches/banque-assurances/axa-sort-definitivement-de-lassurance-vie-et-de-la-gestion-dactifs-aux-etats-unis-1146716. ↩︎
10. Alexander Savelyev, “Contract Law 2.0: ‘Smart’ Contracts as the Beginning of the End of Classic Contract Law,” Information & Communications Technology Law 26 (2017): 116-134. ↩︎
11. European Parliament Resolution of 20 October 2020 with Recommendations to the Commission on a Digital Services Act: Adapting Commercial and Civil Law Rules for Commercial Entities Operating Online, https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:52020IP0273. ↩︎
12. Communication from the Commission to the European Parliament, the Council, the European Economic and Social Committee and the Committee of the Regions, “Shaping Europe’s Digital Future,” February 19, 2020, https://eur-lex.europa.eu/legal-content/EN/TXT/HTML/?uri=CELEX:52020DC0067. ↩︎
13. Regulation (EU) 2023/2854 of the European Parliament and of the Council of 13 December 2023 on Harmonised Rules on Fair Access to and Use of Data and Amending Regulation (EU) 2017/2394 and Directive (EU) 2020/1828 (Data Act), https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=OJ:L_202302854. ↩︎
14. Data Act, art. 36. ↩︎
15. Primavera De Filippi, Chris Wray, and Giovanni Sileno, “Smart Contracts,” Internet Policy Review 10, no. 2 (2021). ↩︎
16. Fabrice Lorvo and Timothee Charmeil, “Quel Avenir Pour le Smart Contract en France? Oser la Vitesse Sans Précipitation,” 2023, https://www.parisplacededroit.org/wp-content/uploads/2023/10/Livre-blanc-smart-contract-Paris-Place-de-Droit.pdf. ↩︎
17. Lawrence Lessig, Code and Other Laws of Cyberspace (New York: Basic Books, 1999). ↩︎