Blockchain and smart contracts

21 June, 2017

Blockchain technology is becoming increasingly important and has the potential to change and replace traditional business practices and entire industries. To date, the blockchain has mainly been associated with cryptocurrencies like Bitcoin, but numerous other potential applications have long since emerged.

At the core of blockchain is the virtual generation of certificates, state registries and public authentications, and thus it is clear that potential applications go far beyond mere monetary transactions. Blockchain can be employed in any situation in which goods of monetary value are exchanged and the parties involved desire a guarantee of both payment and delivery of the agreed services.

The idea behind blockchain and one source of its appeal lies in guaranteeing the veracity of the information contained within it by creating numerous public copies within the online community. At the same time, numerous cost factors can be circumvented, because it removes the need for clearing stations and central trusted institutions such as notaries, public authorities and banks.

What is the blockchain?

The principle underlying blockchain is that all transactions made by all participants in the entire network are validated by mass collaboration and recorded in a continually reconciled database that is maintained across numerous computers.1 The transactions are put into groups called “blocks”, are linked together in the blockchain and cannot be subsequently altered. Transactions are added to a block until it is a full and a new block has to be created. A “hash”, a kind of digital fingerprint, is used to validate the blocks.2 In this way, each member in the network can at any time, anonymously and with absolute certainty, ascertain the current owner of a value.3 This eliminates the need for a centralised middleman to vouch for the trustworthiness of a party and thus reduces transaction costs.

How is the blockchain used?

Smart contracts: An important field of application for blockchain the “smart contract”. Smart contracts are not the same as classic contracts in writing, although they might replace them in the future, provided that the appropriate conditions are fulfilled.4 Smart contracts use software to conclude a transaction automatically once all parties have fulfilled the previously established conditions.

Preferably, the software itself can confirm whether all parties have rendered their services.
A smart contract is not a contract in the sense of civil law but rather a piece of software that can control and/or document or even bring about a given legally relevant activity as long as the predefined conditions are fulfilled.5

This technology is therefore often compared with a vending machine, where the conclusion of the contract is also the result of external circumstances and its execution occurs solely by means of a mechanical device.6 This type of communication is conceivable for all application configurations for commercial and legal transactions. For example, in smart homes, “intelligent” refrigerators can automatically order food items that are low in stock (B2C). Similar transactions would also be conceivable between companies (B2B) in an Industry 4.0 context. Within the civil law sector (C2C), it could be arranged that a smart door will only open once the correct amount of rent has been transferred to the landlord’s account.7

Decentralised autonomous organisations (DAOs): This is a new form of organisation whose charter, rules of procedure, articles of association or bylaws are encoded and automatically executed by a smart contract. This would then take the place of a centralised management of daily operations. However, this development is still in its infancy. Since this kind of organisation exists exclusively on the internet, there arise, for example, difficulties in determining such a company’s status.

Industries and areas of application

Smart contracts can fundamentally transform industries that have to date fulfilled the function of a trusted authority, archiving, verifying, authenticating, licencing, and providing information.9 However, they will also affect traditional production and sales chains, corporate organisation and much more. Furthermore, blockchain also has the potential to evolve into the basic technology for classic Industry 4.0 solutions by providing efficient solutions with automated contract processing.10

Accounting and auditing: Uniform standards prevail across accounting and auditing, and they can be linked with transactions in the blockchain. Every financial transaction in the blockchain can thus be used as proof of payment for accounting and cost accounting.

Supply chain: Blockchain-based applications make sales chains shorter and more transparent. Brokers, wholesalers and platforms which only perform clearing tasks without adding value can be replaced by the blockchain.

Banks, insurance, fintech: Bitcoin can be used to transfer securities and values in the billions from continent to continent within the space of milliseconds.

Energy industry: Transaction efficiency is a particularly important issue in the energy industry. RWE has already become a pioneer in the area with its attempts to combine blockchain with the internet of things and physical delivery. Other potential applications are P2P energy trading and the opening of new markets.

Health care: Health care stakeholders are still observing how blockchain is being used in other industries, but the technology has great potential for process optimisation. The use of blockchain is made difficult by the numerous regulations with which the health sector must comply. However, the picture is different in what is known in Germany as the “second health care market” and in billing practices between doctor, patient and health insurance providers.11

Legal regulation

Depending on the industry in which blockchains are used, different regulatory questions may arise. There is simply not space here to list them all. And at the same time, discussion of the topic is only just beginning.

In terms of civil law, there is the question of the relationship between the veracity guaranteed by blockchain and circumstances that would annul a contract, such as the possibility of avoidance in the sense of section 142 of the German Civil Code (BGB) or the violation of social norms. Taking account of these circumstances within the blockchain is difficult because they cannot be checked automatically but instead require legal analysis, especially when it comes to normative questions. Other critical points are how to take into account the protection of minors and withdrawal.12

In addition, the purely virtual handling of contracts also entails various data protection challenges. As a rule, no personal data are archived,13 and names are replaced with pseudonyms. In certain cases, however, it is necessary to pinpoint the identity of a specific individual, for example, in the case of improper performance in real-world transactions, for regulatory reasons (securities trading, Money Laundering Act), or in applications where it is crucial to establish the identity of an individual (eg, land or other registers, industrial property rights, motor vehicle registers).14 Moreover, the inability to remove data also violates the basic principle of data protection which states that personal data must be deleted once it has fulfilled its purpose and is no longer required.

Challenges and outlook

It seems clear that blockchain technology will become an integral part of commercial trade and will play a greater role in more and more areas in the future. The legal assessment will develop in parallel and it is essential that it be considered as part of the risk assessment of companies.

 

Sources

1For details on the operating principle, cf. Shermin Voshmgir, Technologiestiftung Berlin, Blockchains, Smart Contracts und das Dezentrale Web, 2016, p. 8, 35
2Cf. Viktor Becher, So funktioniert die Blockchain, available on www.pcwelt.de/a/so-funktioniert-die-blockchain,3389680
3Cf. Jörg Platzer, Bitcoin kurz & gut, 2014, S. 65
4Shermin Voshmgir, Technologiestiftung Berlin, Blockchains, Smart Contracts und das Dezentrale Web, 2016, p. 14, 35
5Cf. Joachim Schrey, Thomas Thalhofer, Rechtliche Aspekte der Blockchain, NJW 2017, 1431 (1431)
6,8,10Cf. ibid.
7Cf. Christoph Simmchen, Blockchain (R)Evolution, MMR 2017, 162 (165)
9Cf. Shermin Voshmgir, Technologiestiftung Berlin, Blockchains, Smart Contracts und das Dezentrale Web, 2016, p. 17 ff.
11For all examples cf. Shermin Voshmgir, Technologiestiftung Berlin, Blockchains, Smart Contracts und das Dezentrale Web, 2016, p. 17ff.
12Cf. Joachim Schrey, Thomas Thalhofer, Rechtliche Aspekte der Blockchain, NJW 2017, 1431 (1436)
13Cf. Hofert, ZD 2017, 161 (163); Franziska Boehm, Paulina Pesch, MMR 2014, 75 (76)
14Cf. Joachim Schrey, Thomas Thalhofer, Rechtliche Aspekte der Blockchain, NJW 2017, 1431


 

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