Using Smart Contracts in Singapore: Benefits and Risks
When you think of the word “contracts”, you may think about the involvement of lawyers or an agreement made between parties that is legally enforceable. What about “smart contracts”? Such contracts exist on blockchains, which have become increasingly popular over the years, and are different from traditional written contracts commonly used for business transactions.
This article will explain more about smart contracts, namely:
What are Smart Contracts?
Smart contracts are self-executing transactions. What makes these contracts “smart” is that the contracts are written in code that automatically executes all or parts of an agreement between parties, if certain pre-determined requirements are satisfied.
For instance, a person may want to rent a room. Once he pays the designated rent amount of cryptocurrency on the blockchain, he would then automatically receive both the receipt and the digital key for entry to the room, as part of the virtual contract.
Another example is a smart contract outlining insurance policy terms. If the policy holder’s car is damaged and he/she upholds the terms of the insurance policy, such as providing sufficient documentation relating to damage and paying insurance premiums on time, the contract will automatically dispense the insurance payment for the damaged car.
The result is that the entire lifecycle of the smart contract potentially does not need the involvement of any other person or entity except for the contracting parties themselves (i.e. no courts, arbitrators, lawyers or even bankers, are required), who have the duty of fulfilling their obligations as per the contract.
How Do Smart Contracts Work?
Coding and implementation of smart contracts
Parties seeking to utilise smart contracts to conduct transactions would normally require a technical expert, such as a programmer, to code the essence of parties’ agreement, or confirm the accuracy of the code written.
The smart contract is then recorded on a blockchain-based platform, such as Ethereum. Blockchains are decentralised ledgers that use Distributed Ledger Technology (DLT). This means that there is no single user or central administrator that controls the entire blockchain system.
On the Ethereum blockchain, Solidity is a common programming language used to implement smart contracts.
Transactions in smart contracts
As mentioned, smart contracts will self-execute only once the pre-specified requirements have been met. To put it simply, parties may agree that to initiate a transaction, they will input parameter “x”, which will trigger the code to execute the step “y” to complete the transaction. If “x” is not entered into the system, then the transaction will not occur.
An analogy may be made to using a vending machine, where once the buyer has fulfilled the conditions of the “contract” (i.e. inserting a certain amount of money into the vending machine and choosing an item), the machine automatically delivers the item and satisfies its obligations under the transaction. Thus, you can see how transactions between two parties (“peer-to-peer transactions”) can occur without a third-party middleman.
Transactions are stored safely and precisely using cryptography, and can be accessed only through using cryptographic signatures or “keys”. Once the transaction has been signed or verified, they are permanently written to the blockchain and become immutable, which means that they cannot be altered or deleted.
Types of Smart Contracts
Parties may choose between three different types of smart contracts that run on a spectrum:
- On one end, the smart contract is essentially written in code on the blockchain and there is no other written agreement in natural language (e.g. English). This type of smart contract is ideal for parties who do not want to involve third-party intermediaries in their transactions, relying solely on the DLT.
- In the middle of the spectrum is a mixed contract where parties agree that the contractual terms are written in natural language. However, a few or all of the operative terms are written in programming language, which may then be used to execute the transaction. The contract may also be in the form of a “Ricardian contract”, which is a digital agreement between two parties that is signed and encoded on the blockchain. Sometimes, natural language clauses like dispute resolution and governing law clauses may be added on such smart contracts.
- The last type of contract is a traditional natural language contract that may include a portion of code that executes a single clause. The contract may also allow for the blockchain to execute the contract.
What Can Smart Contracts be Used For?
Smart contracts are commonly used for transferring the title to assets (e.g. once a certain amount of funds has been credited to a specific account), and ensuring the payment of funds to an account, or removing access to an asset if payment has not been made. Smart contracts can also be used for checking and transferring payments for insurance claims, as well as for bookkeeping in financial services.
CSE SG is a company established in Singapore that has created “Smart Contract 2.0”, which has been applied to industries such as healthcare, education, agriculture, e-commerce and banking. Smart Contract 2.0 has been used to authorise payment transactions for e-commerce, improve the security and efficiency of healthcare and enable food supply sustainability.
It has been said that in the future, all contracts have the potential to be smart contracts and obligations under the contracts can be enforced by code.
How Do Smart Contracts Compare with Traditional Written Contracts?
The similarities between smart contracts and traditional written contracts are that both contain terms and conditions that are supposed to give rise to mutually intended outcomes between parties.
However, smart contracts differ from traditional contracts in a number of ways. First, unlike written contracts that can be taken offline (e.g. writing the contract on paper), smart contracts occur online (especially for contracts written only in code) as they involve programming.
Traditional contracts also commonly involve the engaging of lawyers to draft their terms, where these can be drafted in a more vague manner to leave room for discretion. Smart contracts, on the other hand, may be done without the involvement of any other entity. The outcomes are also binary (i.e. to transfer the asset or not to transfer), and there is little room for discretion as the terms entered are usually clear and precise.
Lastly, since smart contracts are immutable once encoded on the blockchain, they cannot be altered, unlike traditional contracts where terms can be changed or “rectified” by parties.
Are Smart Contracts Legally Enforceable in Singapore?
Yes and no, depending on the type of smart contract and its clauses.
In Singapore, requirements for a binding contract include an offer and acceptance of the offer, made with the intention to create legal relations and, the provision of consideration (something promised or given in exchange).
Generally, as long as smart contracts fulfil these legal requirements for binding contracts, they are legally enforceable in Singapore, although the local courts have not explicitly confirmed this as of writing.
Each smart contract would have to be individually examined to determine enforceability. While smart contracts purely written in code do not seem to require legal enforcement due to their self-executing nature, they are not exempt from it entirely.
For example, where the contract is for something illegal or is made as a result of duress, the law may still step in to intervene. As for smart contracts that are primarily written in natural language, or that provide for parties to resolve disputes through the courts, there is no issue of legal enforceability.
However, where parties include a clause stating that they do not intend to create legal relations, this could potentially prevent a smart contract from having legal enforceability. In the event of a dispute, the courts may look at all surrounding circumstances to see whether parties objectively intended for the agreement to be legally binding and capable of being enforced. While this was as decided in a case in the United Kingdom, the Singapore courts may similarly look at the surrounding circumstances despite the insertion of the clause (even though local courts have not ruled on this yet).
For certain transactions such as contracts for the transfer of ships, hire-purchase agreements, and sale of property, there is an additional formality requirement that the contract itself, or evidence of it, must be in writing and signed. The Singapore courts have not yet ruled on whether smart contracts that are entirely in code can fulfil this formality requirement such that they are legally enforceable. Where the contract is primarily in natural language, the requirement of writing and signature becomes less of a hurdle to legal enforcement.
What are Some Benefits of Using Smart Contracts in Transactions?
Smart contracts provide many benefits that make it a more ideal choice of contracting than traditional contracts for some parties. The self-executing nature of smart contracts means that transactions can be enforced without involving intermediaries. This makes the process more efficient and reduces time and transaction costs. Parties also benefit from not having to manually process documents.
Due to the lack of a central entity for smart contract transactions, all information on the blockchain is transparent and permanent, and is updated in real time. This means all the nodes (or computers on the blockchain) can track when the blockchain ledger has been modified and draw attention to any mistakes. The data is more accurate and less prone to manipulation, and it is difficult for parties to lose records of transactions.
Unlike traditional contracts, smart contracts also invoke the concept of “trustless” transactions, which means that parties do not need to trust each other as they rely on the blockchain protocol to ensure the guaranteed performance of the transactions.
Additionally, the complex data encryption offers robust level of protection and security to all transactions occurring on the blockchain, while in other online transactions there is a higher risk of being hacked.
Lastly, smart contracts are most useful when the intended terms and conditions of the arrangement are clear-cut, objective and quantifiable. This reduces the chances of misinterpretation, which may happen in traditional contracts.
What are Some Risks of Using Smart Contracts in Transactions?
While smart contracts can reduce the workload of lawyers, it can still be hard to incorporate technical code with written legal terminology. In reality, many nuanced, subjective or qualitative terms are used in contracts, such as the words “reasonableness” and “materiality”, which may not be easily captured by the code representing the smart contract.
It is also difficult for more complex contracts to be reduced to code, and it may not be possible to code for every single “if-then” situation to adapt to commercial realities of business transactions. Should legal issues arise from smart contracts, lawyers would be needed to help resolve those disputes. Therefore, smart contracts are used to supplement rather than replace the work of lawyers and traditional written contracts.
There are also other risks. Blockchain platforms that house smart contracts are not completely safe from hacks due to security weaknesses and bad coding causing the contracts themselves to contain bugs. Bugs would mean that the smart contract cannot execute the intended functions, such as releasing Ether coins to the other contracting party once they have completed their obligations under the smart contract.
Furthermore, if a smart contract had been infected with a virus, its immutability may mean that it would be difficult to fix the smart contract without coming up with an entirely new one. Viruses may also enable coins to be stolen on the blockchain, and the loss of these coins means payment cannot be made for smart contract transactions.
Smart contracts may also suffer from defective terms, that have been coded into them or from mistakes in coding, leading to undesirable outcomes for one or more parties. The programmer may not accurately represent parties’ intentions when writing the code, for whatever reason, and it may be difficult for parties with no programming background to verify what the code represents.
In addition, even if the smart contract were to perform as coded, parties may have intended another result. And if the smart contract is a type of contract that is not capable of being legally enforced, it would be tough for the wronged party to obtain legal remedies.
Smart contracts may also not provide for governing law or dispute resolution mechanisms. Given that transactions occur in many different countries, this could result in much uncertainty as to which country the wronged party should initiate legal claims against the wrongdoing party in.
What Recourse is Available If a Smart Contract is “Breached”?
A breach of a smart contract can technically occur only when the smart contract is first proven to be legally enforceable, and either of the parties fails to perform a contractual obligation without lawful excuse. If the smart contract is created mainly in natural language, it is easier to see how breaches can occur, since the natural language clauses provide room for parties to fail to perform their obligations as intended.
If a smart contract is not accompanied by natural language provisions, its self-executing nature means that the transaction would be automatically carried out once the required conditions are met, and there is virtually no room for non-performance of the contract. However, while the contract itself might not have been breached by contracting parties themselves, risks like programming errors may cause the contract to produce an outcome that goes against the parties’ intentions, which may then have to be resolved by the law.
Smart contracts that use external data through oracles, a third-party service that sends data from outside the blockchain (such as the data on the weather or stock prices) to the blockchain, would be able to receive information that can halt their performance for dispute resolution. Different remedies can then be awarded for “breach” of the smart contract depending on its intended outcome.
For example, where payment has been made for an asset according to the smart contract, but the asset in question has been stolen, or the contract does not fulfil the intended outcome, one remedy could be a refund on the blockchain.
Legal remedies such as compensatory damages or restitution (i.e. the breaching party gives the non-breaching party what he gained) may also be available for straightforward one-off transactions. Alternatively, where the smart contract calls for the obligations to be repeatedly performed, a new smart contract could be created to “rectify” and accurately represent parties’ intentions.
Using smart contracts can be a good way of streamlining business transactions and making them more efficient. You may also benefit from the increased transparency and security of information relating to your transactions. However, you should also be mindful of the risks that are involved such as hacking, coding errors, and the potential lack of legal enforceability of your smart contract.
As smart contracts are still not commonplace for businesses in Singapore, you may want to consult a fintech lawyer if you need tailored legal advice on using smart contracts for your business transactions. A fintech lawyer would also be able to advise you on the legal risks arising from the use of blockchains and smart contracts, and the steps you may take in the event of a dispute.
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