Smart contracts are typically used to facilitate the transfer of cryptocurrencies but can actually be used to conclude all sorts of transactions. Technically speaking, a smart contract is just an automated algorithm. It triggers a pre-defined action once certain preconditions are met but with an added layer of cybersecurity. Yet scholars have been struggling to make sense of the legal status of smart contracts, with some scholars arguing that smart contracts can create legally binding obligations, others asserting that smart contracts are simply an automated enforcement mechanism, and still others concluding that there is no categorical answer to the question of whether smart contracts are legally binding.

Policymakers across the globe are equally divided in their approach toward smart contracts. The United States has largely opted to embrace smart contracts through federal laws, granting legal effect to electronic transactions. These include, among others, the Federal E-sign Act, The Uniform Electronic Transactions Act, and a recent amendment to the Uniform Commercial Code that enables trade in “controllable electronic records.” Conversely, the European Union has recently taken steps in the opposite direction, imposing strict regulations on smart contracts used for data-transfer agreements as part of its new Data Act.

In a recent paper,  we propose to view the legislators’ policy choice as a trilemma. Specifically, for each type of transaction, regulators can either: (i) take a laissez-faire approach and enable the use of smart contracts alongside written contracts, (ii) regulate or prohibit the use of smart contracts, or (iii) mandate the use of smart contracts. Analyzing these different options, we show that the optimal choice depends on a potential tradeoff between transaction costs and the mitigation of market failures.

In general, smart contracts may either reduce transaction costs (e.g. by automating certain processes) or increase them (e.g., because one must hire programmers), but if those costs are borne by the parties, they will opt for the cheaper solution anyway. The need for intervention arises only if the transaction costs invoked by smart contracts are borne by third parties, such as future buyers of the traded asset. Such transaction costs become what economists call an “externality,” which is one common source of market failures. At the same time, smart contracts may also be a solution to other market failures, for instance, by providing a tool to resolve trust issues that otherwise hinder cooperation. This duality already explains why it might be efficient to enforce some smart contracts but regulate others but does not (yet) explain why it might be preferable to mandate smart contracts while prohibiting written contracts.

To elucidate the latter point, our paper disentangles the complex relationship between smart contracts and written contracts. We identify five main features. First, smart contracts can sometimes establish binding promises, reflecting offer and acceptance through code. Second, smart contracts can sometimes substitute promises with direct performance – the transaction is fulfilled automatically and simultaneously, eliminating the need for a promise altogether. Third, smart contracts can be used to verify contingencies (e.g., whether the market price of some benchmark is above a given threshold). Fourth, smart contract may fulfill formal requirements (e.g. that documents  in real-estate transactions be in writing). Finally, smart contracts can be used in conjunction with written contracts to revise the content of the agreement. These functions highlight that smart contracts are partially a substitute and partially a complement to written contracts.

Upon these identifications, we recommend mandating smart contracts for certain transactions, namely whenever the smart contract: (i) complements a written contract in a manner that substantially diminishes transaction costs for third parties, (ii) substitutes for a written contract that would have entailed substantial externalities in the absence of automation, and (iii) forces parties who, for whatever reason, starkly underestimate the relative benefits of the smart contract for their transaction. The rationale behind these three cases stems from the seminal work of Guido Calabresi and Douglas Melamed,[1] who explain why one would opt for “inalienability rules” – rules that prohibit both voluntary and involuntary transactions. Our paper explains that a rule mandating smart contracts is equivalent to imposing an inalienability rule for written contracts and is therefore desirable only when there are substantial externalities or when there is a need to (paternalistically) protect parties from making mistakes.

Thus, building on insights from law and economics, our paper draws a new path for policymakers and highlights the relevant considerations of choosing between the different options.

ENDNOTE

[1] Calabresi, Guido, and A. Douglas Melamed. “Property rules, liability rules, and inalienability: one view of the cathedral.” Modern Understandings of Liberty and Property. Routledge, 2013. 139-178.

This post comes to us from Professor Roee Sarel and Bahadir Köksal at the Institute of Law and Economics, University of Hamburg. It is based on their recent paper, “The Smart Contracts Trilemma,” available here.