Introduction
A Smart Contract is a self-executing contract where the terms concluded among its parties are written directly into code. The code and the agreements contained therein exist across a distributed, decentralized blockchain network. The code controls the execution of the terms and the transactions are trackable and irreversible.
In general, a blockchain is a distributed database or ledger that is shared among the nodes[1] of a computer network. As a database, blockchain stores information electronically in digital format. Blockchains are best known for their crucial role in cryptocurrency systems, such as Bitcoin, for maintaining a secure and decentralized record of transactions.
Blockchain is exceptionally innovative; it guarantees the fidelity and security of data including through unique storage capacities. Additionally, blockchain generates trust among the Smart Contract’s parties, without the need of a facilitating third party.
Smart Contracts permit trusted transactions and agreements to be carried out among disparate, anonymous parties without the need for a central supervising authority or an external enforcement mechanism. Smart Contracts could be implemented in common transactions, in areas such as finance, insurance, sales, leasing, and licensing.
The Smart Contract can enforce and update itself automatically, including for instance, in connection with the transfer of funds between the parties, according to the parties’ determination.
For example, when selling real estate, payment will be automatically transferred from the buyer to the seller, as well as a request to update the ownership at the Land Authority, without the involvement of a third party such as a commercial bank or governmental authorities.
The Smart Contract is considered a reliable legal instrument since, due to its structure, the contract cannot be changed without the consent of all parties and cannot be hacked due to the decentralization of its details in the blockchain. Moreover, the contract is updated automatically as the transaction advances.
Related Challenges
The drafting of a Smart Contract requires the pre-definition of its terms so it will include any scenarios that may occur throughout the relevant period. The parties are required to predict in advance a wide-range of circumstances that may occur and to include them within the Smart Contract’s terms.
In addition, since Smart Contracts are based on code, they are created by qualified programmers and require powerful computer systems.
Once a Smart Contract’s code is sent to the blockchain, it is immutable and any modification is impossible. The only way to ‘modify’ a Smart Contract is to cancel the original version and draft an entirely new contract.
It may be difficult to convert ordinary and specific legal language to code (e.g. the terms “in good faith” and “with reasonable effort”) and the system may interpret the contract differently than a human being would have interpreted it.
Since there is no intervention of intermediaries such as banks or related authorities (governmental or others) in Smart Contracts, if and when required, the accompanying procedures may lack ‘supervision’ or review, and the execution may partially fail.
Hybrid Contracts
Due to the challenges related to Smart Contracts as described above, including the need to encode the contract on all its clauses upon its preparation, currently, the preferred solution is to combine a Smart Contract with a contract written in a more traditional, independent way, and in uncoded language. This solution is temporary until the outstanding gaps in Smart Contracts’ technology are addressed and eliminated.
The Hybrid Contracts combine the instructions as encoded and in natural language. At certain stages of the overall agreement, the code will be the underlying contract and the wording provided in the traditional way will be supplementary or present auxiliary rules for the interpretation of the Smart Contract.
Hybrid Contracts synchronize two distinctly different environments to create a superior application that neither a blockchain nor a traditional contract could achieve alone, particularly because each segment specializes in providing features that the other does not.
An additional avenue parties could undertake is the integration of an ‘Oracle’ – an external factor to the system that serves as a dynamic interface between the information in the blockchain and external databases.
The Oracle can be a human or technological factor that verifies occurrences in the ‘real world’ and submits the information to the blockchain system (for example, the Oracle can provide information from external sources – such as interest rates, currency rates, etc.).
In addition, the Oracle can examine whether each party has fulfilled its obligations as stipulated in the Smart Contract (for example, whether the seller has arranged for a Warning Note on a real estate property that was sold to the buyer).
Moreover, the Oracle could be the mediating function when disputes arise and the parties have agreed upon arbitration or mediation (or similar clauses) as part of such mechanism.
The Legal Status of Smart Contracts in Israel and Abroad
Certain countries and states have amended their respective laws and regulations to explicitly incorporate blockchains and Smart Contracts (e.g. US – Arizona, Nevada, Vermont and Delaware). Additional countries and states will follow their lead as there may be increasing pressure to adopt unified definitions to reflect blockchain and Smart Contract developments.
In the State of Delaware, where most of the US commercial corporations are incorporated, blockchain technology was introduced for use in connection with the incorporation procedure, shares transfers and other matters.
Israel has not introduced to date any significant law or regulation with regard to Smart Contracts. Academics and others generally conclude that the local legal environment (e.g. Contracts and other laws, related regulations and court precedents) allows for the implementation and legal use of Smart Contracts in Israel.
In the interim, until local laws and regulations specifically embracing Smart Contracts are enacted, additional validity and legitimacy may be obtained through court reviews and precedents.
Recently, the Accountant General of the Ministry of Finance and the Tel Aviv Stock Exchange have executed a feasibility test (Proof of Concept) of a blockchain-based issue and the clearing of government bonds.
Smart Contracts were used as part of the above-mentioned ‘dummy issue’. The related press release states the following: “At the heart of this process is a dedicated Smart Contract for bond management, which serves as an intermediary that enables the smooth and secure transfer of digital payment tokens against digital bonds”.
It is the Israeli perspective that the application of Smart Contracts and their accompanying technologies will improve efficiency concerning future transactions as in the above-mentioned bond issue, and at the same time reduce risks for the parties involved, including investors in the financial markets.
Conclusion
There are significant advantages in executing transactions through Smart Contracts. The ‘automated procedure’ provides certainty and definitive performance, while eventually requiring the investment of less resources and expenses.
Smart Contracts will probably become a significant legal and commercial vehicle in the near future globally as well as in Israel.
The legal system in Israel in its entirety can comprehend and positively relate to Smart Contracts, yet specific laws and regulations will be required as the Smart Contracts and the related technologies evolve.
[1] Blockchain nodes are network stakeholders and their devices are authorized to keep track of the distributed ledger and serve as communication hubs for various network tasks. A blockchain node’s primary job is to confirm the legality of each subsequent batch of network transactions, known as blocks.
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