9 min read · Jul 24, 2023
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Smart Legal Contract vs. Smart Contract Code
Oracles: Connecting Smart Contracts to the Real World
Requirements Imposed by the European Commission
Smart Legal Contracts (SLC) represent an innovative form of digital contracts based on blockchain technology. These contracts combine traditional legal language with programmability and automatic execution of transactions. This document analyzes the information provided regarding SLC, focusing on key points: blockchain technology and its role in SLC, legal validity and security of SLC, transparency in financial operations, and the need to protect consumer rights.
- Focus 1 — Smart Contract and Blockchain
Blockchain technology is a decentralized and immutable digital ledger that enables secure recording and verification of transactions. An example of using blockchain for SLC could involve a peer-to-peer loan contract. In this context, the contract could be automatically executed on the blockchain once both parties have agreed to the loan terms and conditions. The blockchain acts as a public and transparent record of transactions, providing a complete and easily auditable trail.
- Focus 2 — Legal Validity of Smart Contracts
For SLC to be legally valid, they must meet fundamental requirements, such as written form, identification of the involved parties, and acceptance of contractual conditions. An example of the legal validity of SLC could be an insurance contract entered into between an insured individual and an insurance company. Through an SLC, the contract could be automatically created on the blockchain, and the insured’s information and policy details could be immutably recorded on the blockchain, ensuring traceability and data integrity.
- Focus 3 — Security and Data Protection
Security of SLC is crucial. While blockchain technology provides a high level of data protection through encryption and decentralization, SLC may still be vulnerable to cyber-attacks and human errors. For example, in creating an automated payment contract, robust security measures are essential to safeguard sensitive customer financial information and prevent fraud or unauthorized access.
→Furthermore, careful programming of SLC is necessary to avoid errors that could compromise the proper execution of contractual clauses. An example of security and data protection could be an automated investment contract, where SLC enables automated investment transactions, reducing the risk of human errors and ensuring compliance with financial regulations.
- Focus 4 — Transparency
SLC used for financial and banking operations must comply with regulations concerning transparency of contractual terms and customer relationships. For instance, an SLC-based bank account contract should ensure that all information regarding fees, interest rates, and charges is clear and easily accessible to the customer. Blockchain technology can facilitate the creation of clear and transparent relationships, making all information available securely and immutably on the blockchain.
The main difference between Smart Legal Contract (SLC) and Smart Contract Code (SCC) lies in their legal context and nature.
- Smart Contract Code (SCC) are autonomous computer programs executed on a blockchain that automatically execute the contractual clauses defined in the code. These contracts are self-executing and self-verifying, and their validity and security depend on the correctness of the programming. SCCs are essentially a form of programmable computer code, but their legal validity may be questioned in some jurisdictions as they might not adhere to traditional legal standards concerning written form and identification of involved parties.
- On the other hand, Smart Legal Contracts are based on Smart Contract Code but are specifically designed to comply with legal regulations and the needs of the legal system. SLCs rely on blockchain technology and incorporate traditional legal language, thereby ensuring the legal validity of contracts. Additionally, SLCs are structured to meet specific requirements, such as party identification, written form, and acceptance of contractual conditions. SLCs act as a bridge between legal and computer languages, combining the security and automation of Smart Contract Code with legal validity and transparency of contractual regulations.
Smart contracts, being self-executing programs on a blockchain, lack the ability to access external data or directly interact with the outside world. To enable the automatic execution of real-world event-based functions, smart contracts rely on “oracles.” Oracles act as intermediaries, providing external data to the smart contract or allowing smart contracts to communicate with the external world.
Inbound vs. Outbound Oracles
There are two types of oracles: inbound oracles and outbound oracles. Inbound oracles provide external data to the smart contract residing on the blockchain. They allow the smart contract to react to real-world events, such as weather conditions, market prices, or IoT sensor data. On the other hand, outbound oracles enable smart contracts to communicate with the external world. For example, an IoT-enabled lock can act as an outbound oracle when the smart contract triggers the lock’s unlocking based on a specific transaction on the blockchain.
Types of Oracles
Oracles come in various forms, each serving different purposes:
- Software Oracles: these oracles connect smart contracts to online data sources. They gather information from the internet and provide it to the smart contract. For example, a software oracle can provide data on temperature, commodity prices, or transportation delays for contract execution.
- Hardware Oracles: hardware oracles involve physical devices that capture real-world data and transmit it to the smart contract on the blockchain. For example, RFID sensors can detect environmental changes and trigger a smart contract when specific conditions occur.
- Human Oracles: in some cases, individuals can act as oracles by providing real-world information to the smart contract. Cryptography can be used to ensure that information is provided by the correct person. Another approach involves a consensus protocol, where multiple people vote on the input to be provided to the oracle. However, using human oracles introduces the risk of human error. Nevertheless, human oracles may be preferred when a decision requires subjectivity or when continuous event monitoring is complex.
The Importance of Oracles
Oracles play a crucial role in enabling smart contracts to interact with the real world, making them more versatile and applicable to a wide range of use cases. They bridge the gap between blockchain-based automation and the external environment, facilitating the execution of complex business logic that requires real-world data. However, ensuring the accuracy and security of data provided by oracles is essential, as it directly affects the reliability and dependability of smart contract operations. With the increasing adoption of smart contracts, the development of reliable and secure oracle solutions will be essential for their successful integration across different industries and applications.
The European Commission has shown interest and attention to Smart Contracts and recognized their potential for innovation in the financial and commercial sectors. However, the European Commission also emphasizes the need to protect consumers and ensure the security, legal validity, and transparency of Smart Contracts.
Among the requirements imposed by the European Commission for Smart Contracts are:
- Transparency and Consumer Protection: SLCs must ensure transparency of contractual terms and customer relationships, especially in the financial sector. Consumers must be empowered to make informed contractual decisions.
- Data Security: SLCs must adopt robust security measures to protect sensitive customer data and prevent fraud and unauthorized access.
- Regulatory Compliance: SLCs must comply with existing regulations and laws in the financial and commercial sectors. Their programming must ensure adherence to legal standards and compliance with existing regulations.
- Comprehensible Language: they should be formulated in a clear and understandable manner, allowing consumers to easily grasp the contractual terms and conditions.
- Monitoring and Experimentation: the European Commission encourages experimentation and monitoring of SLCs in the legal and financial context to evaluate their effectiveness, security, and compliance with regulations.
- Compliance with European Directives: in the European Union, SLCs must comply with relevant directives issued at the community level, such as the Payment Services Directive (PSD2) or the Markets in Financial Instruments Directive (MiFID II).
- Updating Regulatory Standards: SLCs should be designed flexibly to adapt to any regulatory changes over time, ensuring their ongoing compliance with evolving laws and regulations.
In conclusion, the European Commission recognizes the potential of Smart Legal Contracts as an innovative tool to streamline financial and commercial operations but emphasizes the need to ensure security, legal validity, and consumer protection in their implementation. Adherence to regulatory standards and transparency will be key to the success and widespread adoption of SLCs in the European context.
→When is a Smart Contract a “Contract” from a Legal Perspective?
A smart contract may constitute a legal contract if it contains the elements of a valid offer, adequate acceptance, and valid consideration. General principles of contract law define an offer as a manifestation of willingness to enter into a bargain, and acceptance as an agreement to that offer. Consideration, on the other hand, denotes something of value exchanged by the contracting parties.
Furthermore, for the smart contract to constitute a legally binding contract for the sale of goods, the contract must also satisfy the various requirements of Article 2 of the Uniform Commercial Code (UCC), including its statute of frauds requirements and its requirement that the contract set forth a quantity in order to be enforceable. Professionals will need to assess on a case-by-case basis whether a smart contract meets these elements and thus constitutes a legally binding contract for the sale of goods.
The Uniform Law Commission and the American Law Institute established a Uniform Commercial Code and Emerging Technologies Committee to study and examine the UCC in the context of, among other issues, “distributed ledger technology, virtual currency, electronic notes and drafts, other digital assets, payments, and bundled transactions.” The Uniform Law Commission released an issues memorandum discussing these topics in July 2021 following two years of committee meetings.
Although smart contracts have been part of the discussion, the Uniform Law Commission or the American Law Institute has not yet performed a formal evaluation for smart contracts, leaving open the possibility of clearer guidelines in the future to determine whether a smart contract amounts to a legal contract.
Vulnerabilities
While properly coded smart contracts could dramatically increase efficiencies in supply chains, companies face a risk that their smart contracts contain bugs or other technical issues such as data block corruption. There are three common types of vulnerabilities that arise from improperly coded smart contracts: greedy contracts, prodigal contracts, and suicidal contracts.
Smart Legal Contracts have the potential to revolutionize the banking and financial sector, streamlining operations and enhancing transaction security. However, there are challenges to overcome, such as ensuring the legal validity of SLCs, data security, and protecting consumer rights. Collaboration between regulators, industry, and sector specialists will be crucial to develop an appropriate regulatory environment and foster public trust in SLC technology. Continuous experimentation and monitoring will be essential to assess the effectiveness and suitability of SLCs in the legal and financial context.
Furthermore, attention to clarity and comprehensibility of the language used in SLCs will be crucial to ensure consumer protection and the rights of parties involved in financial transactions. Only through a careful and rigorous approach can we maximize the benefits of Smart Legal Contracts and promote transparency and innovation in the financial sector. The illustrated examples demonstrate how SLCs can be applied in various financial contexts, providing a clearer view of the opportunities and challenges related to this emerging technology.
In conclusion, the analysis of Smart Legal Contracts (SLC) and Smart Contract Code (SCC) reveals the fundamental differences between these two forms of digital contracts. SLCs integrate legal validity, transparency, and compliance with regulations, making them suitable for use in various industries and commercial scenarios. On the other hand, SCCs are purely programmable code executed on blockchains, raising questions about their legal enforceability in some jurisdictions. The need for accurate and secure oracles to connect smart contracts with real-world data underscores the importance of dependable external information sources.
Adherence to European Commission requirements ensures consumer protection, data security, and regulatory compliance in the implementation of Smart Contracts. Despite the vulnerabilities associated with improperly coded smart contracts, their potential to revolutionize supply chains and streamline financial operations is promising, provided that rigorous programming and security measures are in place.
- Mik, E. “Smart Contracts: Terminology, Technical Limitations and Real World Complexity” SSRN: Link (2017)
- “Caratteristiche degli Smart Contract”, BANCA D’ITALIA, UNIVERSITÀ CATTOLICA DEL SACRO CUORE, UNIVERSITÀ ROMA: Link (2023)
- EU Blockchain Observatory and Forum, “Smart Contracts” (2022)
- “United States: Smart Supply Chains Using Smart Contracts” by Richard H. Casper , Eugenia Wang , Kathleen Wegrzyn and Jose A. Lazaro: Link (2021)
