The Smart Contracts Trilemma

Abstract

Contract law imposes formal requirements on certain agreements as a pre-condition for enforcement. The main economic logic behind such requirements is to minimize transaction costs, for instance, by ensuring a public transaction record.

The technology of “smart contracts”—algorithms that execute pre-defined actions if certain conditions are fulfilled—is a promising venue to achieve a similar goal through automation and transparency. However, smart contracts may also involve substantial costs, not only for the parties but also for society as a whole. In particular, as smart contracts are largely immutable, any (intentional or accidental) negative consequence may persist indefinitely.

Thus far, legislators in the United States have opted to permit the use of smart contracts (alongside written contracts), for instance, by giving legal effect to electronic signatures and creating a new framework for transactions in controllable electronic records (via amendments to the Uniform Commercial Code). In contrast, the European Union’s new Data Act takes a different approach, imposing stark regulatory requirements on smart contracts that involve data-sharing. However, a third possibility exists: whenever smart contracts provide significant advantages over written contracts, legislators can mandate their use as a formal requirement.

Our Article is the first to comprehensively analyze the legislators’ trilemma with respect to smart contracts, considering not only whether they should be enforced or regulated, but also whether they should be mandated in some cases. The analysis consists of three steps. First, we consider the conditions under which smart contracts are legally binding under current contract law. Second, we disentangle the complex relationship between smart contracts and written contracts, distinguishing between different features that smart contracts provide by (i) substituting promises with performance, (ii) verifying contingencies, (iii) fulfilling the necessary elements for the formation of a contract, (iv) satisfying existing formal requirements, and (v) revising the content of written contracts. In our third step, we build on insights from law and economics to explain when smart contracts should be enforced, mandated, or regulated. The analysis reveals that this trilemma's key determinants starkly depend on the magnitude and type of transaction costs and the mitigation of market failures.

Keywords: Smart contracts, contract law, transaction costs, blockchain, distributed ledger technology

JEL Classification: K12