Priyanka Malik
What Are Smart Contracts? +Benefits, Limitations, Use Cases
- Published: March 17, 2021
- Updated: March 8, 2024
All industries are adopting new technologies to streamline their business processes and increase efficiency in a process called digital transformation. However the legal industry is falling behind, as a recent Deloitte report suggests, 71% of professionals feel their legal departments are not ready for rapid tech adoption.
The legal industry is resistant to change due to high risks and exposure. But, traditional paper-based contracts are time-consuming and expensive to create. These contracts are susceptible to tampering and forgery. In addition to the storage and printing costs, the contract signing process lacks transparency as no time logs are available in traditional contracts.
With digital transformation disrupting businesses globally, the legal industry needs to consider digital technologies to keep pace with the changing tech trends. One such technology is blockchain-based smart contracts.
Interestingly, blockchain technology was invented for bitcoin and has been an enabler of cryptocurrency. The blockchain protocol allows multiple unknown parties to maintain consensus on the current state of agreement and changes made to a shared database. Because of increased transparency, permanent ledger, reduced costs & human intervention, blockchain technology has gained acceptance across different industries.
What Is a Smart Contract?
Smart contracts are self-executing digital contracts with terms of an agreement between parties directly written into a code. The code leverages blockchain technology to create a decentralized ledger that controls execution and makes contractual transactions trackable and irreversible.
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Characteristics and Traits of Smart Contracts
Following are the distinguishing characteristics of smart contracts which can disrupt the conventional legal industry-
1. Self-Enforcable
Smart contracts reduce human intervention considerably as they are self-executing. Code of a smart-contract is logic-driven, and it unlocks value or access when a pre-agreed condition is met.
2. Self-Verifying
These contracts can police themselves if both parties are compliant with the terms of the contract or not. In response to a breach, these contracts can penalize the offending party as well. For instance- Smart contracts can issue a refund automatically if a vendor doesn’t deliver on the pre-agreed timeline.
3. Tamper-Proof
There is no way to change the agreed-upon terms and conditions of an agreement, which reduces the risk of manipulation and unfair advantage to any party. The only way to edit these contracts or make changes is to add another block to the existing chain with the mutual consent of all parties.
Traditional Contracts vs Smart Contracts
Contracts have been around for a long time to formalize agreements, build trust and protect associated parties. If you are considering automating the entire contract lifecycle management process you should opt for CLM software solutions. But, if you are looking to go a notch ahead with self-executing code-based contracts, consider smart contracts.
However, before investing in blockchain-based smart contracts, the obvious question that needs to be answered is, “what is the need for smart contracts and how are they superior to traditional contracts?”
Smart contracts are associated with two major KPIs used across the organization’s time and cost. These contracts are highly time and cost-effective and can be approved without any physical presence as digital signatures suffice. Now that digital transformation is on the rise and remote work is a norm, these contracts offer unparalleled convenience.
Benefits of Smart Contracts
Smart contracts are much more than digital versions of paper-based contracts. Organizations can use smart contracts to automate the contract lifecycle, improve collaboration, and digitize their assets or transactions. Here are a few of the biggest benefits of smart contracts in 2021:
1. Security
Smart contracts use data encryption and are tamper-proof, making them a highly secure alternative to paper-based contracts. Due to high-level security, smart contracts have the potential to be used in financial institutions and government offices.
2. Speed
Automation of contract lifecycle process and the self-enforcement capability of smart contracts speed the process considerably. Automation of the CLM process makes it less prone to human error.
3. Fewer Intermediaries
There’s a reduced dependence on intermediaries for trust services like escrow between the counterparties.
4. Transparency
Smart contracts ensure higher transparency and hence a lower execution risk. Any amendment to the contract can require the mutual consent of the involved parties. There is no scope of manipulation or non-performance due to any individual.
5. Cost-Effective
Unlike paper-based contracts, smart contracts are highly cost-effective because of reduced dependence on intermediaries and ease of storage.
Limitations of Smart Contracts
While there are plenty of reasons to adopt smart contracts, there are a few reasons to not. Here are a few of the challenges and limitations associations with smart contracts to consider before making the change.
1. Flexibility
Logic-based execution is often challenging for law firms. Contract creation has a subjective element in it and has intentional usage of terms like ‘good faith’ or ‘reasonable’ or ‘best endeavors to have room for flexibility. This type of contract is required when the parties want to create a relational contract instead of a transactional one. In such scenarios, smart contracts fail to offer utility.
2. Legal Ramifications
Since smart contracts reduce dependence on intermediaries and lawyers, it’s imperative for involved parties to be aware of the legal ramifications of public, private, criminal, and mercantile law.
3. Delayed Transactions
There are cases where technology proves to be a bane rather than a boon. One such instance is that congestion in a blockchain network can result in a delayed transaction and eventually push transactional cost above the cost incurred in traditional contracts.
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Uses Case for Smart Contracts
Smart contracts are finding applications across industries. However, the low-hanging fruits for these contracts are applications in which contracts are narrow, objective, and mechanical. Agreed-upon clauses are straightforward and have clearly defined outcomes.
A few of the prominent legal use cases are as follows:
1. Intellectual Property Rights
With increased digitalization, intellectual property thefts have increased, which is impacting the livelihoods of authors, artists, and inventors. Blockchain-based smart contracts leverage non-fungible-tokens (NFTs), which are cryptographic tokens used to represent the unique property. This technology allows users to upload and register their work with time stamps on a public ledger to create irrefutable proof of ownership.
2. Property Rights
Smart contracts are part of the digital transformation in real estate as the sector is relatively less organized and highly dependent on intermediaries. The property owner can utilize blockchain architecture to bypass these intermediaries and register their properties on a public ledger. Additionally, they can sell their properties in a transparent and immutable way to save on transactional costs.
3. Chain of Custody
It is the evidence handling process from obtaining a piece of evidence to presenting it in court. During this time-frame, the evidence is handled by multiple people and can easily be tampered with. Leveraging blockchain technology allows users to monitor the evidence in real-time by generating and tracking a unique evidence token for every item of data collected and stored. This creates a level of transparency and data integrity.
4. Electronic Signatures and Notarization
Electronic signatures speed up the approval process. Currently, most organizations are leveraging platforms like DocuSign or AdobeSign. Blockchain-based smart contracts reduce the cost associated with e-signatures to a fraction of the original cost. It makes the notarization process more trustworthy through document authentication and signature verification with time stamps and hashes.
In addition to these legal use cases, there are other use cases spread across the industries which are stated in the below table:
Smart Contract FAQs
Now that we have seen the benefits, limitations, and use cases of smart contracts, there are still a few important questions that remain unanswered.
1. Will smart contracts replace lawyers in the future?
No, although smart contracts are self-executing in nature, they can’t replace lawyers but will drastically change the way the legal industry operates and play a part in the digital transformation of law firms.
Lawyers spend most of their productive hours ensuring the correctness of technical details, signatures of involved parties, and risk assessment.
By embracing smart contracts, lawyers don’t have to sweat the small technical stuff. These contracts liberate lawyers from administrative tasks and allow them to focus more on operational strategies, evaluate the feasibility of multiple solutions, and negotiate a profitable deal and convert it into a legally binding principle.
Because of this reduced intervention, the fee structure of various law firms might change. The legal industry would be able to charge only for their strategic solutions and not for contract management activities.
2. How can smart contracts be implemented?
For such a logical framework to gain acceptance, it will be imperative to incorporate inputs from legal experts within the code for the contracts to be legally binding. Otherwise, such contracts would be mere codes.
Practically, instead of putting pressure on your legal team to learn blockchain, a simple way is to partner with organizations to work on the blockchain code along with your legal expertise.
For instance: Companies like Openlaw have sprung up to enable smart legal contracts by assisting lawyers in the negotiation and execution of legal agreements. Additionally, it handles the integration of these contracts to automate various aspects of the written contract.
In Canada, six major law firms have collaborated with GenesisB to create smart contracts on the Ethereum blockchain. These contracts automate the merger and acquisition escrow agreement. Similarly, Latham & Watkins (United States) has collaborated with ConsenSys to develop a smart legal contract that automates convertible note agreements.
In addition to Ethereum, other renowned platforms to facilitate smart contracts are- Aeternity, Azure Blockchain Workbench, IBM Blockchain Platform, Corda, and Hyperledger.
Adoption of Smart Contracts
With the advancement in technology, adoption challenges are inevitable. Since legal is slow to embrace change, these challenges become more critical.
PWC suggests that the adoption curve and learning curve are the two prime barriers to the scalability of smart contracts.
However, investment in a digital adoption solution like Whatfix can put your legal department on a successful digital transformation journey. Whatfix provides a seamless user experience by enabling personalized learning with contextual in-app guidance to boost their confidence in using the application. Instead of overwhelming users with a load of information, microlearning is encouraged. Whatfix provides multiple formats of the same content for self-paced learning and convenience. It leverages learning in the flow of work and provides the right information at the right time, which shortens the learning curve and ensures better retention amongst users.
If you are looking to embrace smart contracts and want assistance with your adoption challenges, book a demo with one of our experts today!
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