Module 10

MODULE 10

SMART CONTRACTS AS LEGAL CONTRACTS AND SMART
SECURITIES AND DERIVATIVES

4.1. INTRODUCTION

In a customary centralized model of commercial relationships, there is always a third party who
is an outsider that stands between the two parties as they make a contract through certifying
terms and conditions of a contract. This third party may be a banking institution, a law
enforcement company, a government institution, or some other intermediary. When building
connections within a centralized model, these businesses are dependent on middle men, who puts
clients at risk. Also, central systems cannot guarantee payments and execution of contracts. The
growth of blockchain technology, which enables businesses to construct decentralized models,
opens new skylines for organization to make transactions and agreements. And one of the
technological advancements which suggests an alternative to the traditional model is the smart
contract.

Various international companies have already hopped onto the blockchain bandwagon and are
working on their own projects to stay ahead of the competition. Main technology providers like
IBM, Microsoft, TCS, Accenture are rendering blockchain solutions to their clients. Many tech
start-ups too are belligerently capitalizing on the affluent by building new products and services
that depend on the technology. For other class of business, the big question before the is that how
blockchain implementation can benefit them. There is no doubt that contemporary business
environments require companies to make their technology and innovation as fundamental to their
strategy.

4.2. WHAT IS SMART CONTRACT?

The term “smart contracts” was originally coined by cryptographer Nick Szabo in the early
1990s. Szabo saw a contract as a set of promises agreed to by a meeting of the minds. He aptly
noted that computers make it possible to run algorithms. First, the contract terms are translated
into code—a series of if-then functions. Once a condition is met, the smart contract will take the

next step necessary to execute the contract. Thus, the term “smart contracts” refers to computer
transaction protocols that execute the terms of a contract automatically based on a set of
conditions.1

A smart contract is cryptograph or a code generated by the computer consecutively on top of a
blockchain encompassing a set of rules under which the parties to the smart contract decide to
interact with each other. When the pre-defined rules are met the agreement between the parties
are automatically executed. The smart contract code enables, authenticates, and implements the
negotiation or performance of an agreement. It is the simplest form of decentralized
computerization.

It is an instrument involving digital properties and two or more parties, where some or all of the
party’s credit assets into the smart contract and the assets mechanically get redistributed among
those parties according to a formula based on certain data, which are not known at the time of
commencement of contract.

The term smart contract is usually mistaken since a smart contract is neither smart nor do they
have to be confused with a legal contract.

§ A smart contract can only be as smart as the people’s code taking into account all
available information at the time of coding.

§ While smart contracts have the potential to become legal contracts if certain pre-
conditions are met, they should not be confused with legal contracts accepted by courts
and or law enforcement. However, we will probably see a fusion of legal contracts and
smart contracts emerge over the next few years as the technology becomes more mature
and widespread and legal standards are adopted.

Smart contracts radically reduce transaction costs. Auto enforceable code – whether on the
protocol level or on the application level – standardizes transaction rules, thus reducing the
transaction costs of:

§ reaching an agreement,
§ formalization, and


1 Ng, T. (2018). Blockchain and Beyond: Smart Contracts. [online] Americanbar.org. Available at:
https://www.americanbar.org/groups/business_law/publications/blt/2017/09/09_ng/ [Accessed 2 Dec. 2018].

§ enforcement.2

A smart contract can validate the relationships between people, organizations and the assets they

own. The agreement of the smart contract defines the conditions, rights and obligations – to

which the parties of smart contract have to give their consent. It is often predefined, and

agreement is reached by simple opt-in actions. This transaction rule is set in digital form, in

machine-readable form. These rights, duties and obligation recognized in the smart contract can

now be automatically implemented by a computer or a network of computers as soon as the

parties have come to an agreement and met the conditions of the agreement.

The notion of a smart contract is not new. However, Blockchain seems to be the catalyst for
smart contract implementation. The most original form of a smart contract is a vending machine.
The rules of a transaction are programmed into a machine. You select a product by pressing a
number related to that product, insert the coins, the machine acts as a smart contract checking
whether you inserted enough money, if yes, the machine is programmed to eject the product, and
if you inserted too much money, it will also eject the change. If you didn’t insert enough money,
or if the machine ran out of the money, you will get your change back. Automatic vending
machines not only slashed transaction costs by making human vendors obsolete, but they also
expanded service, offering 24/7 availability instead of limited opening hours of a kiosk.

It is a mechanism involving digital assets and two or more parties, where some or all of the
party’s deposit assets into the smart contract and the assets automatically get redistributed among
those parties according to a formula based on certain data, which is not known at the time of
contract initiation.3

when all parties to the smart contract fulfill the pre-defined rules, the smart contract will auto
execute the transaction. The objective of smart contracts is to provide transaction security more
than the traditional contract law and reduce transaction costs of management and
implementation.


2 KUMAR, A. (2018). Smart Contracts On The Blockchain: A deep dive in to Smart Contracts. [online] Medium.
Available at: https://medium.com/@abhibvp003/smart-contracts-on-the-blockchain-a-deep-dive-in-to-smart-
contracts-9616ad26428c [Accessed 2 Dec. 2018].
3 Ibid.

Smart contracts have the capacity to become legal contracts if certain conditions are met, they
should not be confused with legal contracts accepted by law court and or law implementation.
However, we will probably see a fusion of legal contracts and smart contracts develop over the
next few years as the technology becomes more matured, widespread and legal values are
accepted.

Several people are critical of the term “smart contract”. One reason being that a smart contract is
not essentially smart. It is just a set of orders and instructions that anyone can write, and people
are very capable of creating some smart contracts on their own.

The term smart contract is misleading because it is not really a contract, not in the sense that it is
anything that needs to be complied. A normal contract has legal penalties in the ‘real world’. If a
party to the contract does not uphold their part of the agreement, the legal system can be used to
hold them liable. On the contrary, a smart contract does not have to be supported by anyone, it is
a set of instructions that self-executes. A smart contact does not have much preference in the
‘real world’. It is only able to send transactions to other accounts on the blockchain, any other
priority must be acquired by creating a legal wrapping around the blockchain agreement.

4.3. SMART CONTRACT CODE IS A LAW

A smart contract essentially consists of two elements which you need to understand/trust:
§ The code and how this are interpreted
§ The immutability of the blockchain

Just like with normal contracts, it´s important to understand the actual content of a smart contract
when interacting with it. But unlike a normal contract, which is written in legalese and
interpreted by the legal system, the content of the smart contract is written in computer code and
interpreted by computers. So, what does smart contract code actually look like.

The smart contract code is the terms and conditions that you are signing up for when interacting
with a smart contract. As long as you trust the blockchain that the smart contract resides on, you

know that the code will execute exactly as programmed — so no breach of agreement can exist. It
is important to note however, that working as programmed does not mean that it will work as
intended if there are errors in the code.4

Smart contracts can be used for simple financial transactions like transferring money from A to
B. They can also be used for recording any kind of proprietorship and property rights like land
registries and intellectual property, or managing smart access control for the distribution of
economy, just to name a few. Also, smart contracts can be used for more multifaceted
transactions like governing a group of people who share the same interests and goals.
Decentralized Autonomous Organizations (DAOs) are such an example for more complex smart
contracts.

4.4. HOW TO CREATE A SMART CONTRACT?

To create a smart contract, you need:
§ Subject of the contract: The program must have access to goods or services under
contract to lock and unlock them automatically.
§ Digital signatures: All the participants initiate an agreement by signing the contract with
their private keys.
§ Contract terms: Terms of a smart contract take the form of an exact sequence of
operations. All participants must sign these terms.
§ Decentralized platform: The smart contract is deployed to the Blockchain of this platform
and distributed among the nodes of the platform.5

4.5. BENEFITS OF A SMART CONTRACT

Smart contracts use all the benefits of Blockchain technology & provide:


4 Rubygarage.org. (2018). A Guide to Smart Contracts and Their Implementation. [online] Available at:
https://rubygarage.org/blog/guide-to-smart-contracts [Accessed 2 Dec. 2018].
5 KUMAR, A. (2018). Smart Contracts On The Blockchain: A deep dive in to Smart Contracts. [online] Medium.
Available at: https://medium.com/@abhibvp003/smart-contracts-on-the-blockchain-a-deep-dive-in-to-smart-
contracts-9616ad26428c [Accessed 2 Dec. 2018].

§ Security: The smart contract is encrypted and distributed among nodes. This guarantees
that it will not be lost or changed without your permission.

§ Standardization: There is a wide range of different types of smart contracts nowadays.
You can choose one and change it according to your needs.

§ Trustworthy: Bypass the traditional principal-agent dilemmas of organizations, thus
providing an operating system for what some refer to as “trustless trust”.

§ Direct dealings with customers: Smart contracts remove the need for intermediaries and
allow for transparent, direct relationships with customers.

§ Resistance to failure: Since businesses aren’t dependent on a third party, no single
person or entity is in control of data or money. Decentralization means that even if any
individual leaves the blockchain network, the network will continue to function with no
loss of data or integrity.

§ Fraud reduction: Since smart contracts are stored in a distributed blockchain network,
their outcome is validated by everyone in that network. Therefore, no one can force
control to release other people’s funds or data, as all other blockchain participants would
spot this and mark such an attempt as invalid.

§ Cost efficiency: Eliminating intermediaries removes additional fees, allowing businesses
and their customers not only to interact and transact directly but also to do so with low to
no fees for transactions.

§ Record keeping: All contract transactions are stored in chronological order in the
blockchain and can be accessed along with the complete audit trail.6

This implies that you do not have to trust people and organizations, you trust a code, which is
foundation and provides transparent procedures. With blockchains and smart contracts we can
now visualize a world in which agreements are implanted in digital code and stored in
transparent and shared databases, which are protected from erasure, tampering, and modification.


6 KUMAR, A. (2018). Smart Contracts On The Blockchain: A deep dive in to Smart Contracts. [online] Medium.
Available at: https://medium.com/@abhibvp003/smart-contracts-on-the-blockchain-a-deep-dive-in-to-smart-
contracts-9616ad26428c [Accessed 2 Dec. 2018].

In this world every contract, every procedure, job and payment would have a digital record and
signature that could be recognized, legalized, stored, and common Intermediaries like lawyers,
agents, and bankers, and public managers might no longer be necessary. Individuals,
establishments, machineries, and processes would freely transact and cooperate with one another
with little friction and a fraction of present transaction charges.
A smart contract can formalize the relations between people, organizations and the assets they
own. The agreement of the smart contract defines the conditions — rights, duties and obligations
to which the parties of smart contract shall give their consent.

4.6. EXAMPLE OF A SMART CONTRACT

If X and Y don’t know and don’t trust each other, they usually need a trusted third party to serve
as an intermediary to verify transactions and enforce them. With smart contracts & blockchains,
you don’t need those trusted intermediaries anymore for clearing or settlement of your
transactions. Take the example of buying and selling a car:
On the Blockchain, once all involved authorities and companies are on a blockchain, a smart
contract could be used to define all the rules of a valid care sale. If Alice wanted to buy the car
from Bob using a smart contract on the blockchain, the transaction would be verified by each
node in the Blockchain Network to see if Bob is the owner of the car and if Alice has enough
money to pay Bob. If the network agrees that both conditions are true, Alice automatically gets
the access code to the smart lock for the garage. The blockchain registers Alice as the new owner
of the car. Bob has € 20,000 more on his account, and Alice € 20,000 less. No middlemen
required. On the Blockchain, who owns what is transparent and at the same time anonymous or
pseudonymous. This means that every computer running the blockchain protocol could check
whether a certain person is the rightful owner of the car or not. Stealing cars won’t be as easy as
today, especially once we have smart keys granting access control verified on the blockchain, to
unlock our future vehicles. As the owner of the car, you could authorize other people to drive it
(stating the public key of the respective individual). In such cases opening the car would only be
possible with a smart key on the Blockchain.7


7 Ibid.

4.7. BLOCKCHAIN NETWORKS USING SMART CONTRACTS

While we have discussed the working of the smart contracts in context with blockchain
technology there are plenty of examples of smart contracts which are executed within various
blockchain systems and ventures, the few notable examples are Bitcoin and Ethereum.

4.7.1. Bitcoin
Though Bitcoin is frequently recognized for transactions of the Bitcoin cryptocurrency, its
procedure can also be used to generate smart contracts. Bitcoin offers a programming language
that permits for customizing smart contracts like payment channels, multi signature accounts,
time locks and escrows. In particular, there is a distinct smart contract platform called Root
Stock built on Bitcoin’s blockchain.

4.7.2. Ethereum
Ethereum is the utmost protuberant smart contract framework, formed and designed especially to
support smart contracts. This agenda, planned in the Solidity language, is a devolved platform
that runs smart contracts without any possibility of stoppage, censorship, scam, or third-party
intrusion. The Ethereum blockchain database stores transactions between people, transactions
involving smart contracts, and their source code.

4.8. SMART SECURITIES

Smart contracts are critical in supervising the evolution from Blockchain 1.0 to Blockchain 2.0.
The term “smart contract” is a vague concept. Attorney and computer programmer Nick Szabo
first defined the term in 1994. Much of the haziness surrounding smart contracts stems from the
interaction between the traditional legal understanding of contracts and the “smart” feature of the
code. Several online activities are administered by code and are legally related but they lack the
legal elements of contract formation. Smart contracts rely on the knowledge that the code can
enforce and implement the terms of the agreement. A smart contract is “self-enforcing” if the
software implements the terms without any supplementary input from the parties. This permits
an agreement to occur even in the absence of trust. For example, Szabo considered a simple

smart contract governing a car loan. The loan’s terms are expressed in code and programmed
into the car.8

The contract no longer hinges on the debtor’s willingness to abide by its terms; if the debtor has
the means to do so, the software ensures that he or she makes the payments. If the debtor cannot
make the payments, the smart contract invokes a lien by revoking the debtor’s permission to start
the ignition. This hypothetical loan also highlights the smart contract’s cost saving benefits. The
bank does not need to devote manpower to constantly monitor the status of each loan and handle
the paperwork required to invoke a traditional lien. It does not need to hire a debt collector, nor
does it need to contend with the possibility that an unscrupulous repo man may expose it to
additional liability. Szabo’s ideas were ahead of their time in the mid-1990s (though perhaps
somewhat prophetic of today’s era of driverless cars). Most smart contracts, to this point, have
not demonstrated quite the same ability to process inputs as Szabo envisioned. Their most
common use has been in multimedia digital rights management (“DRM”). Purchasing or renting
content on iTunes or a comparable service amounts to acquiring a limited use license. For
example, users can view rental content only over a limited period, they can access music only on
a certain number of compliant devices, and they can burn audio playlists to CDs only a few
times.9

DRM activities achieve results without presumptuous monitoring and implementation costs by
making it impossible for users to violate and intrude the smart contract. Each song comprises
software that assists as the agreement’s monitoring device. A movie rental, for example, is the
time printed when the user begins watching it. Twenty-four hours later, the software retracts the
user’s ability to access the video. Yet DRM smart contracts are restricted in their abilities. Unlike
Szabo’s utopian contracts, DRM does not process inputs and cannot apply the contract’s terms. It
thus has restricted functionality. Unlike simplistic DRM, smart contracts which is advancing can
use the blockchain’s computational authority and allocate the fundamental assets once the


8 Surujnath, R. (2018). OFF THE CHAIN! A GUIDE TO BLOCKCHAIN DERIVATIVES MARKETS AND THE
IMPLICATIONS ON SYSTEMIC RISK. [online] News.law.fordham.edu. Available at:
https://news.law.fordham.edu/jcfl/wp-content/uploads/sites/5/2017/06/Surujnath-Note_pdf_publishing.pdf
[Accessed 3 Dec. 2018].
9 Ibid.

agreement’s conditions are fulfilled. Smart contracts uploaded to blockchains that are automated
in code that embodies the “terms” of the agreement.

In a way, the coded language of a smart contract is less obtuse than that of its written
counterpart. To laypersons, traditional contracts evoke images of dense text walls, impenetrable
legalese, and linguistic butchery designed to mitigate liability. But smart contracts reduce each
term to its basic component in the form of “if/then” statements. For all their programming
complexity, it may be best to think of smart contracts as conditional payments. The process by
which a smart contract is uploaded to the blockchain varies across the different types of
blockchains. Because smart contracts are customizable and can be used for a variety of purposes,
it is advantageous to use a blockchain that supports a wide range of programming languages.
Bitcoin’s chief competitor, Ethereum, was specifically designed for smart contracts, and thus
permits users more freedom in drafting their programs. The process of uploading a smart
contract to the Ethereum blockchain is not dissimilar from the Bitcoin transacting process
discussed earlier. The user does so through a transaction containing the smart contract’s code.
This special transaction does not go to the counterparty’s address, as with a normal Bitcoin
transaction. Instead, nodes on the network recognize the smart contract and create a special
address for it. The parties can later trigger the contract by sending a transaction request to the
smart contract’s address that fulfills the conditions necessary for the contract’s execution.10

Triggering a smart contract can result in a chain reaction: it can automatically lead to another
transaction request, which may trigger another smart contract, and the process can theoretically
repeat itself an infinite number of times. This means that satisfying a single condition can trigger
a series of smart contracts that are contingent on that obligation. There must then be a way for
the blockchain to monitor these triggering conditions. The blockchain, however, cannot keep
track of every parameter that can influence the activation of a contract. Multi signatures and
oracles resolve this problem by keeping track of information off the blockchain and providing a
trusted signature once a condition to the contract is satisfied. As the name suggests, multi-


10 Surujnath, R. (2018). OFF THE CHAIN! A GUIDE TO BLOCKCHAIN DERIVATIVES MARKETS AND THE
IMPLICATIONS ON SYSTEMIC RISK. [online] News.law.fordham.edu. Available at:
https://news.law.fordham.edu/jcfl/wp-content/uploads/sites/5/2017/06/Surujnath-Note_pdf_publishing.pdf
[Accessed 3 Dec. 2018].

signature (or multi-sig) allows for more than two parties to enter into an agreement. With a “2-
of-3” contract, there are three parties to the agreement and the contract requires two parties to
sign with their private keys. This can create escrows by allowing buyers to commit money to
sellers and to third parties. If the parties consummate the transaction without issue, the buyer and
seller sign the agreement, and the payment goes through. In the event of a dispute, the third party
can arbitrate the dispute and release the funds. Oracles use multi-sig to incorporate outside
information into the blockchain. An oracle serves as an additional signatory that attests to
information that is not tracked by the blockchain. It can reference an agreed upon data source
and serve as an additional signature to a transaction that is contingent on a real-world event.
Once the required condition is met, the oracle signs the transaction with its private key to
effectuate the transaction. In a trading system that relies on numerous ledgers to keep track of
different assets, the oracle can facilitate a payment that is contingent on a factor tracked by
another blockchain. Smart contract technology is still very much in its early stages of
development, so some of the advantages and disadvantages may not be clear yet. But even as of
now, the technology is compelling enough to attract significant investment. 11

4.9. DERIVATIVES

Derivative contracts are financial instruments deriving from certain underlying assets, such as
stocks, bonds, goods or even interest rates. Derivative contracts are becoming increasingly
important to manage financial risk effectively and to create synthetic exposures to asset classes.
Wall Street and Main Street traders contend that the progress in platform technology will
profoundly change the frequently used securities known as derivative contracts. The distributed
books, unimaginable just a few years ago, are on the edge of a cliff of a new era of innovative
financial engineering and risk management accuracy.

Blockchain technology critics see the improvement in the settlement of funds and the risk
assessment of counterparties as a shortening of the liquidity cycle for different derivative
positions, making it much quicker for financial institutions to inject liquidity into the system for
other transactions. "In order to maintain liquidity levels firms, have to overcompensate where


11 Ibid.

the money has to be tied up for some time before the next transaction," said Derick Smith,
Cofounder and CEO of Chain reactor. "Transaction time will improve and risk assessment will
improve. Most other players will get to see who they are providing liquidity for."

Industry leaders expect distributed large- scale infrastructure to inspire new approaches to
financial engineering to customize derivatives consisting of individual cash flows to meet precise
timing and credit risk criteria. Industry leaders can also save costs by eliminating redundant IT
systems and overhead trading and risk management. The financial industry currently spends
approximately $ 150 billion per year on IT and operational expenditure, plus $ 100 billion on
post-trade and security service charges. It has been reported that many Wall Street companies
have doubled their capital budgets for technological development in blockchain.
Despite all the vigor around blockchain and intelligent contract technology, there are still many
challenges which exist. In a decade, some experts estimate that new systems will be fully
implemented. The well- documented connectivity challenge continues to impede progress.

The derivatives industry is highly intermediated and blockchain computing offers a chance to
reduce costs and increase efficiency. The basic characteristic of derivatives is long - term risk.
Regulators often say that they want to curtail risky practices, but this is a vague proposal when
dealing with parties that trade in risk in a very literal way. Therefore, a well- functioning
derivatives market is concerned with minimizing unwanted risks. Counterparty risk, i.e. the risk
that a counterparty cannot fulfill its contractual end, is the main source of concern for market
participants. It measures the degree of exposure a company has to the potential default of its
counterparty as a form of credit risk. As counterparty risk is an inevitable part of every derivative
transaction, it is more difficult to depreciate. Market participants fear a domino effect i.e. default
of one counterparty results in the default of the other counterparty. Because companies always
assume a certain degree of counterparty risk in each trade, they tend to avert the risk by
canceling transactions. An unexpected default by a counterparty to which a company is exposed
can re-expose itself to previously neutralized risks. In other words, the failure of one
counterparty can disrupt the balanced position of the company, resulting in a scenario in which
the affected positions need to be hedged again. If the entire market suffers from extreme
conditions, hedging may not be possible or at least more expensive.

The derivative value chain can be divided into three general levels: pre- trading, trading and
clearing and delivery. Orders are sent to and channeled to markets in pre- trading. During
trading, buyers and sellers are bridged. Compatible counterparties may then enter into trading by
entering into a derivative contract.138 At that time, the contracts are " open"; Open contracts
may be managed and traded again during the term of the clearing process throughout their
maturity. Finally, the contract is " closed" either by cash payment (which occurs in most cases)
or by physical delivery of the underlying asset when the agreement reaches maturity.

Blockchain is still in its formation and global regulators are still trying to keep pace with private
sector Fintech research. The role of regulators in the new, decentralized future is still far from
clear, so many foreign jurisdictions have taken a " wait and see " approach to the regulation of
blockchains.

Blockchains could radically revise the market structure for derivatives trades, depending on the
development of the technology. Existing regulations may not be enough to address the risks of a
market for blockchain derivatives. At this stage of the development of the blockchain, it is
difficult and possibly counterproductive to propose concrete proposals for new rules. Instead, it
is said that the systemic risk is the primary concern for regulating current derivatives and that a
new regulatory scheme must take into account the unique risks of blockchain. This part argues
that while CCPs are generally regarded as an effective way of reducing systemic risk, they
partially create risk by creating large central entities subject to failure. While blockchains can
reduce the risk of over- centralization, the blockchain technology can create different systemic
risks. Regulators should consider these risks in determining how blockchain markets should be
governed.

4.10. CONCLUSION

Unlike the customary unified business model, smart contracts foster a new kind of business
association built on trust.

By inheriting blockchain assets, smart contracts propose immutability and distributed storage,
which is what differentiates them most from traditional agreements and contracts. Immutability
and distributed storage allow smart contracts to become a reliable means for making business
contracts and executing transactions.
Blockchain technology are already impacting businesses. Indeed, it is hard – or even impossible
– to transform the way businesses operate with the snap of a finger. Important changes take time.
Nevertheless, positive and promising use cases for the blockchain and smart contract
technologies in particular are resting the foundation for the future of business.