Beyond the Bitcoin Crash: Ontario Law Lays a Foundation for Enforceable Smart Contracts

The not-so-smart money has pushed the price of a Bitcoin well above US$6,000. The crash is inevitable. The first-mover “cryptocurrency” is based on an inefficient proof of work model designed for anonymous transactions on a public network. The next generation of blockhain developers, like those working on the Ethereum platform, are less interested in the ideology of anonymous transactions than the practicality of efficient business applications. Corporate adopters like the Enterprise Ethereum Alliance have already noted the pace of migration from anonymous public blockchain networks to a combination of public and permissioned private networks. Since “altcoin” currencies are not based on a commodity value, the profitability of an underlying business or the full faith and credit of a national treasury, the adoption of better designed shared ledger systems is sure to burst the Bitcoin bubble.

The Bitcoin crash should be welcomed by the smart money in law and business. Not only because the end of a bubble is always fun for everyone who wasn’t invested in it. The crash should be welcomed because it will focus the energy currently devoted to Bitcoin on more useful and sustainable blockchain applications such as smart contracts. Recent revisions to Ontario statutes lay a foundation for the enforceability of automated agreements.

The Blockchain and Smart Contracts in Concept

Bitcoin and blockchain are not synonymous. The blockchain shared ledger functions like an operating system—think Windows or MacOS—that forms the foundation for the development of specific applications. Bitcoin is one blockchain operating system, Ethereum is another. Developers can use blockchain scripting languages on either platform to create alternative currencies or applications like smart contracts.

Blockchain runs on the public internet using an open source software protocol. Along the network people operate “nodes;” computer programs that essentially validate transactions by keeping a ledger of all information related to the exchange of currency or other assets. Anyone can operate a node on a public network if they have the requisite minimum computing power.

For the limited purposes of this discussion, the basic features of a blockchain smart contract can be illustrated by a simple bet. I bet you one “infocoin” that my team will win. If we make our bet on a blockchain shared ledger system, we don’t have to trust each other or seek the help of third parties to enforce our bargain.

To form a blockchain contract, the parties to the transaction encode a block of data, essentially an encrypted message, that informs all the nodes on the network of the terms of the bet. The nodes validate the transaction by verifying the parties’ identities and available funds and then record the bet on the ledger shared by all the nodes. When the bet is resolved (i.e. the game we bet on is over), another encrypted block of data recording the score of the game can be attached to the first block that recorded the wager. All the nodes verify the score and again update the ledger. Since my team won, a third block of data will deduct the amount of the bet from your electronic wallet and add it to mine. Another encrypted message will be sent to the nodes incorporating the three blocks of data that record the bet, the score and the transfer of funds. Unless one of the network participants objects to the transaction, the ledger will be updated again.

Of course, this very-limited-purpose explanation hides the complexity of the technology that allows the shared ledger to function, particularly for anonymous transactions. For an excellent explanation of how blocks are created, combined, validated and recorded, including a discussion of the cryptography at the heart of Bitcoin “mining”, read Michael Nielson’s blog post.

Recent Changes to Ontario Lay the Foundation for Enforceability

In the near term, smart contracts will be best suited to narrow agreements like our bet, covering simple services that are objectively measurable and consistent. But at their most ambitious, smart contracts could fully or partially self-execute, self-enforce and self-verify the performance of an agreement and permit businesses to form contracts and avoid contractual disputes in a limitless array of transactions. Application developers currently working on IBM’s Linux-based Hyperledger blockchain project, for example, are developing open source “smart contract machines” that will enable parties to draft and assemble automated contracts in a range of industries.

For all its promise, blockchain is still a new technology with very few commercial applications and no standardized implementation. Lawmakers have not really begun to resolve questions about liability when transactions go wrong. However, recent changes in Ontario law lay the foundation for the enforceability of automated agreements, including smart arbitration clauses. In March 2017, the Ontario Burden Reduction Act, 2017 received Royal Assent. Among other provisions, the new statute adopts rules promulgated by the United Nations Commission on International Trade Law (UNCITRAL), a U.N. body that has long been concerned with promoting the enforceability of arbitration agreements and electronic contracts in its member countries.

The revised statute simultaneously enacted two UNCITRAL regimes, the Model Law on International Commercial Arbitration as amended in 2006 (adopted in Ontario as S.O. 2017 c 2, Schedule 5, Part V, Schedule 2 (the “Model Arbitration Law”)) and the 2005 Convention on the Use of Electronic Communications in International Contracts (adopted in Ontario as S.O. 2017 c 2, Schedule 6 (“Electronic Communications Convention”). In so doing, Ontario became the first jurisdiction in Canada to enact the UNCITRAL amended model rules and convention as a provincial statute.

The statute contains several provisions that will govern the formation of electronic contracts in general and arbitration clauses in particular. Model Arbitration Law Article 7(4) provides that an international arbitration agreement is “in writing” and enforceable if it is expressed in media including electronic data interchange. The Electronic Communications Convention has numerous provisions relevant to the enforceability of smart contracts. One of the more interesting is Article 12 which states that “a contract formed by the interaction of automated systems shall not be denied validity or enforceability on the sole ground that no natural person reviewed or intervened in each of the individual actions carried out by the automated message system or the resulting contract.”

Formation and Enforcement of an International Smart Arbitration Clause

The new Ontario statute provides a practical foundation for the automated formation and enforcement of smart arbitration clauses. The smart arbitration clause would not function as the entire contract. The clause would function as a partially self-executing feature of a contract. In theory, a smart arbitration clause application could be built with a shared ledger tool such as Hyperledger Composer. Composer promises that an application developer can define business rules, participants and identity and access controls.

Consider two parties to an international contract with an arbitration clause. They could agree that they want the strongest possible enforcement provision and that an automated tool provides the best solution. They would turn to a developer who would encode a data block to record the basic rule that if Canada Co. files a demand for arbitration then a digital system will automatically file a stipulated arbitration demand with the International Court of Arbitration that has been executed in advance by U.S. Co. The decentralized blockhain ledger would verify that the initial demand had occurred and the program would compel performance by filing the stipulation without human intervention. The goal of the application would be to create immediate performance without litigation over arbitrability.

This type of smart arbitration clause is not entirely self-enforcing because a party opposing arbitration can go to court to challenge the arbitrability of the dispute. However, penalties baked into the blockchain could deter a baseless or purely tactical challenge. For example, a block could be coded to incorporate a fee-shifting rule that if either party files any document contesting enforcement of an arbitration clause and loses, the losing party will automatically pay the prevailing party a pre-determined penalty held in escrow. Escrow-based smart contracts have been an early focus of Ethereum developers.

Hey, Not So Fast.

Despite the early legal advances in Ontario, there are plenty of barriers to widespread acceptance of smart contracts, not least of which are legitimate concerns about the bug-ridden code and hacking debacles that plagued Ethereum last year (and caused the handwringing of The Economist). So while blockchain and smart contracts promise to change the world by reducing another point of friction in economic activity, they won’t disrupt legacy systems like judges and banks anytime soon.