The Basics of Blockchain and Smart Contracts

Blockchain – The Foundation for Bitcoin and More

Those who aren’t familiar with blockchain technology have almost certainly heard of some of the systems that are using it – Bitcoin, Ethereum, Litecoin, Ripple, and more. However, while these cryptocurrencies have been in the news a lot lately for their wild values and feverish speculation (Bitcoin peaked at a value of near $20,000 USD in mid-December and then tumbled to near half that in January), these are only one application of blockchain technology. Numerous companies are developing different applications that use the underlying features and design of blockchain to accomplish different outcomes, many of which promise to disrupt established industries.

As a brief recap, blockchain is a secure digitally distributed ledger of cryptographically sealed data. In simpler terms it is a spreadsheet of data, whatever data you want, shared across multiple users on the internet, who then check and update the spreadsheet of data against each other using the system’s algorithms, which can track, update, and encrypt data as necessary. It is a master list which is useful for sharing information without the need for a central computer or administrator, and because each user’s list checks against the other users for every change or modification the list cannot easily be tampered with or incorrectly changed by any single rogue user. As another interesting feature, the users themselves do not have to be identified by a real name or recognizable user name, instead they can simply be identified by randomly generated alphanumeric codes. Further, the data associated with these users can also be cryptographically sealed so that only parties with the encryption key (effectively a long and hard to remember alphanumeric password) can authorize certain changes associated with that user. These are some of the fundamental features of blockchain technology, though there are more complex design concepts related to incentivizing participation in the system (think of crypto mining), speeding up the rate of the system (hash rates), and so on.

The most recognizable application of blockchain is also one of the simplest applications so far. Bitcoin, the first blockchain-based cryptocurrency to gain mainstream awareness, operates as a straightforward ledger which tracks the anonymous movement of bitcoin from one digital address to another. This is a simple ledger application, but it has been revolutionary to the public because of the fact that it can provide anonymity to its users, and because it eliminates the intermediary that is normally required when moving currency values on a ledger – the banks. In short it is a simple application of the technology, with huge possibilities because of how that application is used.


Novel Blockchain Uses – Ethereum Smart Contracts

Though not quite as famous as Bitcoin, Ethereum has also risen to fame in this space by introducing an exciting blockchain-based platform with greater flexibility for applications. Where Bitcoin is only intended to track its digital currency from user to user, Ethereum is a platform that allows users and companies to run more complex applications on the blockchain. Again, the specifics of the coding and design are too complex to dig into here, but we can briefly summarize smart contracts.

On first glance the Ethereum network could be mistaken for the Bitcoin network. Participants in the network can mine and transfer the network’s commodity, called Ether, similarly to Bitcoin. However, the Ether that makes up the network is not purely a means of storing value. While Ether can be traded and used purely on its market value, it can also be used to pay for transaction fees and services through the network through something called “smart contracts.” These smart contracts are an additional item that is tracked through the Ethereum blockchain. They are effectively software applications that set out the terms of a digitally-trackable contract which is then automatically monitored and executed by the blockchain (more accurately the system of computers that make up the blockchain) as their conditions are met. The way the Ethereum blockchain is designed allows users and developers to create complex algorithms and codes for these smart contracts, which creates countless possibilities for tracking and executing smart contracts.

This concept makes the most sense with a simple example. Let us say that a buyer wants to order a physical product straight from the party that makes it, and they do not want to pay by credit card or e-transfer. The parties could arrange to have the transaction managed by a smart contract on the Ethereum network. A smart contract would be created that contained a simple set of conditions:

If Buyer receives item X, then transfer 1 Ether from Buyer to Vendor’s ledger.

This contract would be added to the ledger, the respective accounts/wallets of the two parties would be identified, and there would have to be a digital ‘hook’, a way to track the conditional statement of receiving the item. One solution could be that the Vendor will send a tracking number to the Buyer, and the status reported by that tracking number will act as proof of delivery. Thus, when the Vendor sends the item and it arrives at the Buyer’s delivery location the shipping tracker will change to status “Delivered” which would meet the if condition of the smart contract, triggering the transfer of payment to the Vendor. All of this would be automated in the blockchain, occurring as conditions are satisfied without any outside interference or delays resulting from waiting on human verification. Now, this is the simplest example.

The smart contract could be designed for a range of complex permutations. For example, maybe the Buyer wants the Vendor’s item to meet a specific performance criteria, so the payment condition should be based on that performance criteria being met. Or perhaps some of the money should be transferred initially to pay for the cost of parts and materials, and the rest of the balance should be released upon a certain time period elapsing or further conditions being met. So long as the network can track the conditions to the contract in some way it can automate the delivery of the contract, and the flexibility of the Ethereum network should in theory make it possible to track many different data points, and thereby create new and novel smart contracts.


What Is Blockchain Doing Right Now?

Right now blockchain technology and its application, whether in Ethereum-based smart contracts or otherwise, is in its infancy. There has been a rush in demand for blockchain programmers in the private market and universities are creating new blockchain-focused programs to try and meet this demand. It will take some time for a substantial amount of people to develop this speciality and enter this field, but even now there are some interesting applications and groups focused on the technology.

To start, Blockchain technology is already being adopted and explored in Canada. A recent application is a trial by the National Research Council, which has built an online database to publish and track grant information on the Ethereum blockchain platform. Users can view a live database of all major grants on the Council’s website, but the database also provides information for the Ethereum blockchain where users can also look up the specific blocks related to the grants in order to see the same data. This means that the numbers and information related to these grants will be permanently embedded in the network.

Keeping on the Canadian theme, the Blockchain Research Institute is a research network founded in Toronto in 2017. The BRI is currently conducting over 50 research projects related to blockchain technology, theory, development, and application. The organization is bringing together a range of technology engineers, industry experts, specialists, and government representatives in order to explore what blockchain can do differently. Our colleagues at Gowling WLG are included among the founding members of this organization, and have also announced the creation of a Blockchain group at the firm in order to respond to the developing trends and legal needs of the industry.

Finally, Canada also saw its first officially sanctioned Initial Coin Offering from Impak Finance, which has developed a platform for investing in socially responsible enterprises. ICOs have drawn scrutiny in the last year for acting as grey or outright illegal workarounds to securities regulations in various countries. Quebec’s securities regulator, the Autorite des marches financiers, approved this ICO and provided guidance for its continued operation, and this suggests that there are viable uses for this blockchain model. The added fact that Impak Finance has developed a blockchain application to improve society and support social enterprise also makes this story noteworthy, because it shows that blockchain technology does not just have to be about creating private financial wealth.

Of course, there are also some less than brilliant applications of blockchain. A recent example is a Dutch company called LegalThings One announced their intent to launch a blockchain based app called “LegalFling” where users will be able to enter “contracts” with other users to provide information and “consent” to sexual encounters, as well other “contractual terms and conditions”. The app has supposedly been designed in response to proposed legislation in Sweden, but there has already been a lot of criticism of the idea from activists, policy experts, and legal professionals. Some of these groups have written sharp analysis about this specific app and its host of issues, so we will save some space and link to their insightful words.


Blockchain and the Law

So what does blockchain and its related innovations mean for the legal industry?

Well, general blockchain technology itself poses some very interesting privacy questions. Most uses of the blockchain are anonymized in that users/accounts are identified by generated alphanumeric codes, and can usually access their data on the chain with complicated keys. This level of privacy is a key positive feature to some of the users of cryptocurrencies who do not want their identities or information to be available, either because they value their feeling of privacy or because they believe third parties will misuse that information. However, while bringing ease of mind for some law-abiding users, this privacy also has some problematic possibilities. Specifically the anonymity of blockchain makes it an ideal platform for illegal activities like black market transactions and money laundering. Proof of this can be seen in the early adoption of Bitcoin by the dark web marketplace, the Silk Road. This was an online illegal marketplace that dealt in drugs, weapons, humans, and other contraband that accepted Bitcoin as a means of payment years ago before it was accepted anywhere else. The users of the Silk Road bought and sold illegal products using the currency because it could not be traced to their real world identities. Now that blockchain currencies have growing mainstream acceptance and adoption these criminal entities will still be able to transact their business as before,  but it will also be easier for them to convert their illegal income for legal tender or services, all while remaining anonymous and difficult to track.

In an interesting contrast, the blockchain can also pose a privacy problem from the exact opposite angle. Once information is added to the chain it effectively cannot be removed under most current systems. So once that transaction for 1 bitcoin is recorded as being transferred to another user, it cannot be undone and remains in the digital ledger forever, regardless of where else that bitcoin might go. This will be a problem as more users adopt these systems and inevitably make mistakes when entering identifying info or accepting transactions. This will also pose a different problem when blockchain technology is applied to the collection or logging of personal data or sensitive information. While some of this information will be encrypted, different applications may bring different standards of security. If sensitive data like names, account numbers, or the specifics of contracts are put onto the blockchain they become a part of the digital record forever. Compromising information, or even incorrect information, may be on the record forever with no means to remove it.

Beyond these initial concerns, there are additional issues and shortcomings related to Ethereum and its otherwise highly promising smart contracts. One of the key concerns around these contracts is what will happen when a contract is incorrectly performed, or if there is a dispute about performance? The smart contract system is based on the ability of computer networks to track certain events related to agreements, but sometimes these systems have errors. For example, most consumers have had a problem with online shopping delivery where their order arrives late, or ends up lost in the mail, or arrives only for them to find the wrong items had been sent. Simple smart contracts may not be able to account for these realities. What happens when the wrong item shows up? What if its quality does not meet the representations that were initially made? There is no system to issue a refund or a charge-back at this time, or a way to undue a smart contract once the automated system has executed on it.

This begs the question of how we will be able to resolve disputes around these contracts. Can smart contracts be litigated like standard commercial contracts? In theory parties may be able to go to court to obtain a verdict, but courts will not have any ability to enforce their decisions on the blockchain. A court can order that one party pay another party for their damages, but a court does not have the ability in our current system to undo a blockchain transaction, or even force one party to transfer to another. Even when courts are ready to declare jurisdiction over a smart contract dispute, there will be numerous more questions about how to interpret the contracts. Do we interpret the terms of the smart contract based on the understanding of the parties and the general purpose of the agreement, or by the line-by-line programming code that makes up the contract itself? Will judges have to bring in programmers to interpret nesting conditions and unique algorithms? What if a smart contract contains reps and warranties, or even terms governing dispute settlement and arbitration? These questions are going to have to be answered in novel litigation and by courts exploring unknown territory, and the earliest previews of these issues only confirm that fact.

Finally, there is the looming concern about national and international regulation. While at home and abroad securities regulators and governments have turned their attention to the blockchain, there is no clear consensus on how to regulate the technology and its adoption. Some countries like China and South Korea have threatened to ban the existence of exchanges trading in blockchain-based currencies because of concerns of black market activity and market volatility. Countries like Canada and the USA have set out an initial policy on these systems with regards to taxation, but they have not yet dealt with the reality of enforcing these rules on transactions that take place between anonymized parties with no authorized intermediaries. Maybe this tax season we will get to see what happens when the policies meet reality. 

In short: the potential applications are exciting, the potential legal implications are sometimes confusing, and the potential for legal conflict is more of a guarantee. This is going to be an exciting space to watch.


How Momentum Can Help: Thinking of starting a company with a product or service based around a blockchain application? Interested in launching an initial coin offering and want to get it right? Schedule a free consultation with Momentum to discuss your ideas, and speak to tech-oriented and transparent lawyers who are excited to work in this innovate space.


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