Scalable blockchains, tokenization, and smart contracts are all in the headlines these days. With financial giants like Larry Fink loudly promoting the virtues of tokenization and organizations like the Bank for International Settlements (BIS) experimenting with digital ledger technology, it seems the world’s movers and shakers have woken up to blockchain’s utility.
While this can only be a good thing, it’s essential to recognize the possibilities and limitations of these interlinked technologies. For all their promise, smart contracts have one inescapable limitation: they do not, and cannot, exist outside the bounds of real-world law. Let’s dig into why.
The vision – a world powered by smart contracts
Smart contracts can best be defined as self-executing contracts with the terms written directly into lines of code. While that idea sounds simple, it has revolutionary implications. Smart contract proponents imagine a trustless world of automated, unstoppable agreements with everything from dividends to bonuses and winning bets being paid out without human administrators.
However inspiring this idealistic vision may be, it eventually runs up against reality. Like it or not, smart contracts intersect with legal, social, and economic rules and norms, and where they violate them, the real-world laws written in ink must always take precedence. In a nutshell, when the code conflicts with the law, the law will and should supersede it.
Code may execute flawlessly, but that’s not enough
The ‘code is law‘ mantra is parroted by many cypherpunks and Ethereum advocates. To this type of person, Western legal systems are an outdated construct from a bygone era, and the power of decentralized, immutable networks will render them ineffective in due course.
However, we already have multiple real instances where this ideal falters when faced with reality. In 2016, the Ethereum DAO hack happened because there was a conflict between the intention of the code and the reality of how it was executed. Ultimately, the Ethereum bigwigs had to intervene and roll back the blockchain to “save the project” for the existing whales of the network but this move hurt anyone that made transactions on the chain that got rolled back.
Here, we have a perfect example of how code may be executed flawlessly but not in alignment with what was intended. This is just one somewhat abstract example of how a world governed by pure code would be far from ideal and could be extremely harmful. However, philosophical flaws aren’t the only concern. When smart contracts collide with legal reality, the consequences can be far more than theoretical.
What happens when real-world law clashes with smart contracts?
It has been said by more than one critic of the ‘code is law’ mantra that its loudest supporters are technologists with limited business or personal experience. In reality, legal agreements evolve and change as time goes on, and even when they don’t, disputes arise about definitions, meanings, and more.
Smart contracts are, by design, inflexible. While they can be updated and amended if both parties agree, that’s hardly likely amid a dispute. For example, a smart contract could execute a payment in breach of consumer protection laws in a given country; it is not a desirable outcome if the payment is irreversible and the smart contract supersedes the law of the land.
There are also jurisdictional issues to consider; the law in the United Kingdom may differ from that of the United States. If two parties engage in a contract, they may have different understandings of what legal terms and definitions mean. Thus, different expectations and disputes may arise as a result. Legal systems exist to solve these issues and come to a settlement, but no such mechanisms exist in the world of pure code.
Analogy: A world of pure code is more like a dictatorship than Western Democracies. Might makes right may be good for the more powerful party, but it’s not good for anyone else. For example, Russia has approximately three times the mineral wealth of the United States but a GDP a fraction of the size. There’s a reason for that – few want to do business in a country where they have no legal recourse and where the dictator and his friends (might) can take what they wish without any recourse for the injured party.
Ambiguity, interpretation, and conflicts
Anyone familiar with legal agreements and contracts knows that the terms can be vague and ambiguous. Terms like ‘reasonable effort’ and ‘good faith’ leave a lot of room for interpretation and subjectivity. Smart contracts, by contrast, are rigid and binary. If, then, and either/or rule the roost in the world of pure code, but reality is messier than that.
Employment contracts, divorce settlements, IP licensing, and countless other legal agreements require interpretation, and that means human beings and their judgments must be involved. Not all legal concepts can be reduced to if/then logic, but the cypherpunks either don’t know or refuse to acknowledge that.
Aside from ambiguity, there are some very obvious examples of legal conflicts where code falls short. What happens if a judge issues a ruling to stop a transfer? What if a smart contract is flawed and either freezes or transfers assets after an agreed deadline? What if a token issuance contract is illegal in one or more participating jurisdictions? These all clearly show that smart contracts alone cannot rule and decide everything.
Reconciliation is possible in legal-linked smart contracts
So, does this mean smart contracts are a failed idea that will never work in the real world? Not at all, but they need to be legally linked to the real world. Fortunately, efforts are underway to legally anchor smart contracts without sacrificing utility.
As regulated industries like finance and logistics adopt blockchain technology, we’re already seeing efforts to reconcile the conflicts between code and laws written in ink. For example, Chainlink is exploring live data feeds for its oracles; this would allow smart contracts to react to legal outcomes. Many tokenization platforms build smart contracts that embed legal safeguards like Know Your Customer and anti-money laundering (KYC/AML) checks and role-based permissions for issuers and custodians.
Better yet, scalable utility blockchains like BSV have been designed to make Digital Asset Recovery possible. Due to the structure of this network, nodes can freeze and reassign coins and tokens when instructed to do so via court orders.
While the cypherpunks and purists may lament and resist all of this, this is just another example of their ideals colliding with reality. BlackRock (NASDAQ: BLK), Fidelity, banks, lenders, and law firms are all regulated in their jurisdictions, and they will never adopt technology that doesn’t allow them to comply with industry rules and standards.
So, blockchain technology faces a crossroads: either scale in a way that complies with the law or be relegated to a plaything for anarchists, cypherpunks, and criminals. Thankfully, at least some blockchain architects and developers have taken a realistic and sensible approach.
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Gavin Lucas