Smart Contracts & Automated Contracts: 5 FAQs
Published:
January 25, 2022
Author(s):
More and more people are using smart contracts: the global smart contracts market was valued at USD $145M in 2020; it’s projected to be valued at USD $771M by 2028. Yet people often confuse “smart contracts” and “automated contracts”. To help you understand and distinguish between them, here are the answers to five questions businesses frequently ask us about these kinds of contracts.
1. What’s a Smart Contract?
A smart contract is a type of automated contract. It’s fully automatic and fully digital. Unlike traditional contracts, smart contracts are non-negotiable. Its original terms are absolute: they cannot be changed. And they have no room for interpretation; all terms are predetermined and automatically enforced by the contract itself, according to a set of digital criteria.
2. How does a smart contract work?
Smart contracts are often executed by computers on the blockchain via cryptocurrency transactions. There’s no third-party involvement for fulfilling its terms. The rules of the contract are set when it’s created. Once the designated event occurs, the contract parameters automatically execute. Smart contracts are increasingly popular for simple transactions, like consumer orders for products or services. Because of their simplicity, the goal is to avoid intermediaries (like lawyers), to reduce transaction costs while maximizing transactional security and reliability. For example, when a customer initiates a smart contract, the contract can automatically perform a customer deposit into escrow for a certain amount of crypto: if the product or service is delivered on time, then the crypto flows to the provider of the product or service; if the transaction fails, the deposited crypto returns to the customer.
3. What are the risks of smart contracts?
For all their benefits around transactional efficiency, there are of course some risks associated with using smart contracts, including:
Customer (Dis)satisfaction. Even if they smooth the contract execution process, smart contracts aren’t necessarily smart enough to guarantee the customer’s satisfaction with the product or service they’re receiving.
Fraud. Since smart contracts can be executed without negotiation or any kind of other meeting, there’s potential for fraud or misrepresentation regarding the contractual bargain. So be careful trading off diligence for the sake of efficiency.
Liability. Smart contracts create a unique challenge: the contract terms are executed via computer code and usually don’t come with the traditional set of standard protective terms. What if there are coding errors in the smart contract, or if it malfunctions? What jurisdiction does the transaction reside in for dispute purposes? Despite the advances in smart contracting functionality, there remain a number of significant risks and unknowns when it comes to the liability picture.
However, for many businesses, the commercial benefits of automated contracts generally, and smart contracts specifically – if they’re properly implemented and utilized – can outweigh the risks.
4. What’s an Automated Contract?
In contrast to smart contracts, automated contracts are characterized by a wide spectrum of digitization: it can mean a number of different things relating to the process of contract design.
Technically. At a high level, it’s the use of software that enables both legal and non-legal teams to self-serve on routine legal documents, at scale. This can happen in many layers, depending on the nature of the contract and the degree to which someone wants to automate it.
Practically. In practice, it often means that contract templates are developed (either by the servicing law firm or a third party automation provider, or both in combination) with a set of “smart variable” terms (or fields) built into the contract. The lawyer in charge, or the client in many cases, can then fill out an online questionnaire or otherwise input all of the variables, and voilà: the automation feature resolves all the variable fields and generates an initial draft contract. This avoids the traditional process of someone manually updating all tedious contract terms from a precedent word processing document to generate a draft.
Vs. Smart Contracts. While smart contracts are (fully) automated, an automated contract isn’t necessarily smart, because it might only provide a starting point instead of automatically executing the entire contractual process like a smart contract does. Basic automation certainly enables stipulated language to be robotically inserted into a contract draft, and might end up as the “one and only” version of more rote contracts like Non-Disclosure Agreements (NDAs). But generally, the draft contract generated by automation – especially more complex and important commercial contracts – will be further (heavily) negotiated by the parties. In those cases, the automation functionality has simply eliminated the administrative aspects of drafting and compiling the initial contract to get it ready for negotiation.
5. What are the benefits of automated contracts?
Nowadays, most businesses that regularly contract with others – whether B2B or B2C – would likely see some benefits from contract automation (especially for standard commercial templates), even if they’re not to the point of using smart contracts. Beyond the process of how contracts are automated, there can be a number of commercial benefits when automation is implemented properly, such as:
- Streamlining low-value work by removing duplication and wasted time due to manual processes.
- Decreasing version control risk (and related confusion by enterprise sales and in-house legal teams) by using a series of master templates.
- Standardizing sets of legal documents for better data integrity and compliance.
- Speeding turns of documents between lawyers, clients, and their counterparties in deals.
Please contact your McInnes Cooper lawyer or any member of our Technology Law Team @ McInnes Cooper for help understanding, reviewing, or implementing automated contracts or other technological initiatives involving commercial contracts in your business.
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