Beware of Risks in Blockchain–Based Smart Contracts (as published in South China Morning Post on November 16, 2019)
Beware of Risks in Blockchain–Based Smart Contracts
By Emir Hrnjic and Nikodem Tomczak
Among the many technological advances enabled by blockchain technology, such as the emergence of cryptocurrencies, smart contracts have attracted significant attention due to their potential transformative power in business and finance.
Digital contracts, much like traditional contracts, outline the terms of an agreement between two or more parties but the terms are in the form of computer code residing and executed on a blockchain. The “smart” aspect of these contracts comes supposedly from their ability to automatically enforce and execute the contract provisions on the blockchain when preset conditions are met.
The self-verifying, self-executing and self-enforcing nature of smart contracts removes the need for any central authority or intermediaries for the contract execution, drastically reducing the cost of doing business.
Transacting parties can easily audit the smart contract code, while the blockchain technology theoretically provides a tamper–proof record of the contract code and of every transaction executed by that code, minimizing risk and greatly improving transparency and accountability.
However, these contracts are arguably neither “smart” nor “contracts.”
The code describing the contract provisions is not necessarily legally binding.
For its obligations to be legally enforceable the transacting parties may also need real-world legal agreements to facilitate the resolution of potential disputes that would arise from human-made errors in the smart contract code.
Appropriate legislation needs to be passed to recognize the legal effect of smart contracts when conducting electronic business transactions. To this end, many jurisdictions have recently passed relevant bills recognizing the legal effects of smart contracts, helping to pave the way for their wider acceptance.
Smart contracts have widely proliferated on different blockchain platforms and currently underpin the emerging decentralized finance sector that facilitates funding and servicing of loans, digital securities trading, as well as initial coin offerings.
Furthermore, they are poised to transform businesses by drastically cutting overhead costs, increasing efficiency by automating many business tasks, and accelerating financial transactions by reducing the likelihood of disputes.
However, smart contracts are relatively new, and to achieve wider adoption, some key hurdles need to be overcome.
Since a smart contract is as good as the underlying computer code, vulnerabilities and hacking that would result in loss of funds are major concerns that may force potential adopters to stay on the sidelines.
In one infamous example of smart contract vulnerability, a weakness in the smart contracts code underpinning a blockchain-enabled venture capital fund, caused a loss of 3.6 million Ether (the equivalent of roughly US$50 million at the time) in 2016.
The recovery of the funds came at a major reputational cost to the blockchain security and governance.
Despite regulatory efforts around the world, unscrupulous developers remain a danger to the industry, while the legal uncertainties of conducting business on blockchain platforms across different jurisdiction significantly increase the risk.
Before smart contracts achieve wider adoption, the code vulnerabilities and the legal frameworks need to be properly addressed. In the meantime, entrepreneurs should figure out what role smart contracts can play in defining the future of their business and factor in the risks involved.