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Blockchain Projects Need Smarter Contracts That Build Resiliency

Nov. 28, 2022, 9:00 AM

Smart contracts are a key foundational element of blockchain projects, ranging from decentralized finance to digital collectibles to carbon offset exchanges. Now that developers have a moment to breathe, it’s worth considering how this blockchain building block informs future projects.

Smart contracts are a bit of a misnomer. In essence, they are digital code that automatically executes an action if conditions are met. If you pay someone two ether, the non-fungible token (aka NFT) evidencing their ownership of a digital collectible is transferred to you.

Contract Limitations

The last 18 months have shown that smart contracts currently have significant limitations, especially when it comes to legal rights. A smart contract is only as good as the developer(s) who create it and the pattern of conditions that are put in place to execute it.

Consider the last time you purchased a house. Did you read the contractual provision describing the rights of the parties in the event of a condemnation event? The issue almost never comes up when you purchase a home, but it is usually part of the form contract to allocate that risk.

This question frames up the issue of what level of smart contract coding is necessary to allocate varying risks between two parties? Does the smart contract have sufficient conditions for all risks that might occur? How do you determine if a party to a contract acted reasonably?

That is very unclear. One answer is we begin to use technology to augment the utility of existing smart contracts. One example might be using decentralized storage with a link to a license agreement. That link could be stored in the meta data that is part of the non-fungible token being sold.

That might give the parties permanent immutable access to a license agreement that sets rights with respect to the digital asset for the parties. That technology solution could provide greater clarify around the legal rights surrounding the digital asset associated with a non-fungible token like digital art.

The point is, now is time to identify the limitation of smart contracts and assess ways they can evolve to provide greater clarity among the purchaser and seller as to the sale terms.

Impact of Sanctions

The development of smart contracts has been impacted by the Department of Treasury acting through its Office of Foreign Asset Controls to sanction the Tornado Cash software protocol. Tornado Cash software is designed to protect the privacy of those transacting crypto currency.

In the case of North Korea, they used this software feature to hide the illicit laundering of stolen crypto funds. As a result, OFAC, in an unprecedented and unusual move, sanctioned the Tornado Cash smart protocol itself. A Dutch government agency, furthermore, arrested an individual suspected of being a Tornado Cash developer.

The point of this story is to raise the issue of how these sanctions will impact developers who want to create software protocols that respects privacy in an uncertain regulatory environment. Conversely, since cybercrime is rampant in the industry, should emphasis be placed on developing software protocols that have features to facilitate law enforcement investigations and thereby deter crime? Many in the industry might say that runs counter to the decentralized and egalitarian ethos of the blockchain community.

Blockchain and Cyber Risk

Cybersecurity continues to pose significant challenges as blockchain use cases seek mainstream adoption. Not a week goes by without a significant hack on a blockchain. Since smart contracts are essential to so many use cases from non-fungible tokens to engine running DAOs, they are a prime target for threat actors. In the recent bull market where the need for speed to market was paramount, many developers used existing code and did not take the time to audit the vulnerabilities in that code.

Since many projects used open-source code, moreover, that same code was available to threat hackers to assess for the same vulnerabilities. Open-source vulnerabilities plus valuable assets equal inevitable hacking and cybercrime. Building secure products by design is a competitive advantage as it builds trust especially with enterprise customers.

As you think about managing cyber risk with smart contracts as you get into your car next time, you probably do not even think about the fact you buckled your seat belt. That behavioral norm was not the case for your parents. What changed? Education about the safety seat belts provide coupled with changes in laws that made their use mandatory. As we ponder new blockchain projects, we should make smart contract cybersecurity by design the digital seat belt protecting the value stored in that smart contract.

While the present forecast in the blockchain industry is chilly, it also provides an opportunity to learn from the past. Recent history shows that the bust gave way to the essential internet we have today. Blockchain technology has similar potential. The question is how well will the smart contract technology evolve, along with setting up the necessary regulatory guardrails.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

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Author Information

Josh Berger is deputy general counsel for CleanSpark, a sustainable bitcoin mining company.

Justin Daniels is an attorney at Baker, Donelson, Bearman, Caldwell & Berkowitz where he co-chairs the Blockchain and Digital Assets Technology practice.