With more suppliers adopting digitization, traditional contractual agreements in the supply chain space are being superseded by new arrangements known as smart contracts, a type of self-executing program that automates the actions required to fulfill a contract, saving the involved parties time, energy and money.
A smart contract is an arrangement that’s digitized and takes effect after being created, without the need for any other type of physical or digital interaction once a set of pre-determined conditions are met. Even though smart contracts have offered another way to draft and create contracts for almost 20 years, they’re still relatively rare. The unique aspect of smart contracts is that they don’t require human interaction once they are drawn up, automating the process of fulfilling contractual obligations.
Traditional contract execution relies on the natural language used between humans. The process of drawing one up starts with an offer from one side to the other. From there, considerations are made by the involved parties requiring the participants to meet legally enforceable obligations laid out in the terms of the contract. After that, the contract is approved, allowing the participants to declare mutuality – the official announcement that the two sides have agreed to and understand the terms.
Drafting a smart contract follows a different process. They are written in computer code rather than in regular human language, digitizing the contract execution process and making it almost entirely automatic.
In their most current form, smart contracts are built on blockchains, a form of decentralized, distributed and pubic digital ledgers that are used to record transactions taking place across many computers around the globe, making it impossible to retroactively alter the records.
Smart contracts begin with a term sheet that utilizes human nuance to guide the programming code used to draw up the agreement. Then, a programmable language known as bytecode is integrated into the contract, allowing it to self-execute once certain conditions are met based on information gathered externally. Finally, the contract self-executes once the programming recognizes that the information from the external data fulfills the contractual obligations of all participating parties.
A major benefit of using smart contracts is that they can be drawn up in minutes, rather than hours or days as with traditional contracts. Also, the payments involved in smart contracts are automatically executed, unlike traditional contracts which require manual payments. Additionally, smart contracts save the participating parties money because they are almost completely digital, and do not often require the involvement of third parties. Most importantly, the automation of smart contracts creates fewer opportunities for human errors or, worse, contract manipulation.
A.J. Zottola, co-chair of the Intellectual Property Transactions Practice Group at the law firm Venable LLP, highlights some of the ways that smart contracts could be beneficial to supply chains. He says security is a major advantage of smart contracts, along with the ability to execute increasingly complex agreements almost instantaneously. “That could facilitate a lot of supply chain transactions in a positive way,” he says.
For all their advantages, smart contracts come with certain problems. It’s extremely difficult to amend a smart contract that has already been executed. Instead, the parties must come up with a completely new contract that supersedes the old one. “Before, you would have changed the terms and made the old contract disappear, but it doesn’t work like that anymore,” Zottola says.
A similar concern arises with contract termination and rescission. “From a traditional book-keeping perspective, that could become pretty cumbersome,” he says. “A lot of people who have to rescind, terminate or modify contracts don’t necessarily want the old one lying around, but it will be there.”
The process of creating smart contracts is also quite complicated. In addition to an attorney, signatories need a computer programmer. “You almost need a host of intermediaries to help you draft up that term sheet that is then turned into code,” Zottola says. “It puts a lot of importance into making sure everybody understands what the conditions are that lead to a self-executing event. I don’t think that has necessarily been sorted out.”
The automated aspect of smart contracts can cause additional problems. Issues that used to be easily remedied between trusted partners become more difficult to resolve if smart contract transactions are recorded on a blockchain, Zottola says. “It’s almost as if you’d need to have a closed network for supply chains to build up that level of trust, so that everybody participating in the contract is in agreement with its conditions.”
The timeline for mass adoption of blockchains and smart contracts is hard to predict, Zottola says. Wider acceptance requires reaching consensus on how they should be defined, regulated and executed.
“It may not necessarily happen in the U.S. first,” he says. “You’re going to be dealing with a landscape where some countries have set rules and are comfortable with adoption. Then again, you’re going to have to figure out how to work across borders or incorporate participants from other countries.”
“Nobody has got this settled yet,” he says.
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