Smart Contract Basics — A Legal Contract Perspective

Part I: Observability

Introduction
Smart contracts are the new buzz words in the blockchain legal industry this year, but
what are smart contracts? And what exactly makes them “smart”? And more importantly to those
in the legal profession, can smart contracts exist within the legal system as enforceable and valid
contracts between parties?
I have begun to dig through some of these questions in my research (available here) and
will continue to explore the legal implications and enforceability of smart contracts in future
research.
But for now, I want to present a deeper analysis of smart contracts and how they are
foundationally similar to traditional contracts between parties. Nick Szabo, in one of the earliest
analyses of the legality of smart contracts, broke down contractual design into four major
elements: observability, verifiability, privity and enforceability.[1] These elements taken together
form the foundation on which all contracts are formed and enforced, and how smart contracts can
be analyzed through a legal perspective.
In this four-part post, I will discuss each of the four contractual designs in greater detail
and discuss the nexus between smart contracts and traditional contract law. By breaking down
contracts into four fundamental elements, I hope to provide readers with a greater understanding
of how smart contracts are grounded in traditional understandings of contract law and hopefully
provide some useful background about smart contracts in general.
The first contractual design identified by Nick Zsabo is observability: the ability of the
parties to observe the performance of the other party to the satisfaction of the contractual
requirements.[2] We will first discuss how performance by the parties of their contractual
obligations is measured; understanding the basic mechanics of a legal contract is imperative to
understanding how observability operates. I will then discuss how parties “observe” the
performance of the other party to ensure compliance with the terms of the agreement. In
additional, we will consider the difficulties that smart contracts face when attempting to observe
external conditions outside the blockchain network. Lastly, this post will discuss how smart
contracts can be improved to provide better observability for the parties and accept more external
data inputs for more complex transactions.
Performance
A valid contract is generally defined by four basic elements: an offer, acceptance, intent
and consideration. What underlies all of these elements is the “performance” of the parties, the
completion of their promises memorialized in the contract. Black’s Law dictionary defines
performance as “the fulfillment or accomplishment of a promise, contract, or other obligation
according to its terms.”[3] Each party agrees to perform in a certain manner to satisfy their
promise to the other party. This covers an endless range of activities from mowing the lawn to
paying $100 for services.
 When the parties agree to a legally binding contract, they are in fact guaranteeing to the
other party that they will perform the actions they promised in the contract. If both parties
perform, then the contract is enforced and both parties are satisfied. Sometimes, one party will
first require performance by the other party before completing their own performance, such as
requiring performance of a service before releasing payment. If a party doesn’t perform according
to the terms of the contract, then the other may exercise its rights under the contract’s provisions,
such as terminating the contract or levying a penalty, or exercise its rights under contract law such
as specific performance.
Performance is at the heart of every contract, no matter how simple the contract is or how
sophisticated the parties are. Without performance by the parties, which can later be observed and
verified, a contract is inoperative. This is even more important in the context of smart contracts —
 a party only enters into the contract because it reasonably expects the other party to fulfill its
obligations through the performance of the provisions of the contract.
Observability
Observability refers to the “ability of principals to observe each other’s performance of the
contract, or to prove their performance to the other principals.”[4] Each party examines the
opposing party’s performance of their obligations to ensure the terms of the contract are being
followed. In traditional contracts, observation occurs through monitoring the performance of the
other party through delivery obligations, accounting exercises and performing various audits.
Smart contracts exist on a blockchain network where “assets and contract terms are coded
and put into the block of a blockchain…this contract is distributed and copied multiple times
between the nodes of the platform” and are then executed between the parties and recorded within
the blockchain as a new block of information.[5] Because smart contracts are hosted on a
blockchain, they enjoy several benefits of blockchain technology including a distributed network
of nodes that all confirm information simultaneously, enhanced anonymity, and automated
execution of the smart contract once the “trigger” has been detected by smart contract’s code.
Observability in smart contracts operates similarly to traditional contracts; both parties can
observe the other party’s performance to their satisfaction utilizing code in the smart contract to
confirm obligations have been fulfilled before executing the contract. Automation is an additional
benefit for smart contract, as the coding can confirm performance without third party intervention.
For example, a smart contract’s code could be written to confirm that a company made a delivery
at 2:00pm by collecting information from the company’s delivery notification system. The
contract, upon this information being confirmed by all the nodes on the blockchain, would then
execute the smart contract and remit payment to the delivery company for its services.
However, the decentralized nature of a blockchain presents two impediments for smart
contracts to observe and react to external conditions: the all-or-nothing nature of a consensus-
based system such as a blockchain and the validity of external sources.
All information entering the blockchain is vetted by all the nodes (or blocks) of the
blockchain before that information is recorded as new distinct blocks of information, relying on
the consensus of all the nodes to confirm the information is valid.[6] Going back to the delivery
company example, all the nodes would simultaneously confirm the delivery system marked the
package as delivered at exactly 2:00pm in order for the contract’s coding to be satisfied. If a

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single node returns an error message or a different time stamp from the delivery notification
system, the blockchain will reject the performance of the delivery company.[7]
While blockchain technology certainly has its benefits in terms of automation, there are
limitations as well.[8] Even if a smart contract’s code is able to retrieve the proper information
notwithstanding the possibility of errors discussed above, there still remains the issue of the
information obtained from third parties outside of the blockchain’s secure and decentralized
network. Is the information valid? Can the source of the information, in the case of our example
the delivery system operated and maintained by the delivery company, be trusted without any
further review?[9] This is an interesting dilemma, but nothing that doesn’t already exist in normal
contracts. Traditional contracts rely on trust and good faith between the parties. Even some of the
most secure forms of verifying information, such as a social security number used to verify one’s
identity, are not immune to modification or attack. Therefore, while sources must certainly be
vetted before they are trusted, there likely will never be a 100% trusted source, which should not
hinder the development of smart contracts.
Getting Smarter
Given the impediments to external observability of smart contracts, how do smart
contracts get smarter? Accounting for a wider variety of legal complications and developing a
better legal perspective regarding smart contracts are common themes I will return to in each part
of this broader post, beginning here with how smart contracts can better connect to the “outside
world.”
At its core, a smart contract’s interaction with the outside world can be distilled down to
the requirement for “some form of input data which the contract processes and, upon agreed
conditions met, it produces some resulting output.”[10] Retrieving that “input data” is a difficult
task because smart contracts lack consistent and trusted connections to the outside world for the
code to pull data.[11] In order to properly execute, “smart contracts need to be able to interface
with data in the wider world,” but how would a smart contract go about gleaning such information
in a quick and efficient way?[12]
The term “oracle” is used in the blockchain community to describe a third party that
provides external data for a blockchain as a trusted source.[13]Information required by a smart
contract can range from a stock’s price determined by the market and updated by the millisecond
to the credit rating of a company that is subjectively determined by a credit rating agency.[14] In
both cases, nodes of the blockchain where the smart contract is hosted would contact a designated
oracle to receive the data and then determine whether the retrieved data satisfies the thresholds set
by the smart contract terms.[15]
Service providers such as Oraclize act as a “data carrier for decentralized apps” utilizing
smart contracts that require external data inputs.[16] Oraclize provides trusted “avenues” of
information where a smart contract can retrieve external information inputs. This eliminates the
issues caused by consensus-based networks (as discussed above) because the nodes will all
contact the same trusted oracle to confirm information required to execute the smart contract and
thus will reach a consensus.

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 Oracles have helped resolved the other main issue surrounding observability of smart
contracts: trust. Parties looking to observe each other’s performance require a trusted source to act
as a “gate-keeper” to certify when a threshold or provision of the smart contract has been met for
execution to occur. While traditional contracts are often overseen by bankers, lawyers,
accountants and other trusted intermediaries, smart contracts exist outside of this traditional scope
of trusted sources of information. Therefore, oracles can begin to operate as trusted sources not
only of raw data but also acting as trusted verifiers of provisions of a smart contract before it is
irreversibly executed.
Observability of performance requires verification of that performance by either the
opposing party or a trusted intermediary as discussed above. Information flowing into a smart
contract needs to be validated in the same manner as information being applied to a regular
contract, such as a purchaser’s credit history before being provided a loan for a car. While this
may sound intuitive, trusting a source of information to feed decisions into the blockchain is still
fraught with potential issues that still need to be resolved.
Conclusion
Observability is one of the fundamental building blocks of traditional contract law and is
imperative to understand as smart contracts increasingly enter the legal realm as legitimate
agreements between parties. While smart contracts may seem “dumb” currently, coders are
increasingly designing more sophisticated triggers and provisions that require information from
more external sources. With this basic understanding of the first element of contract design we
will next move on to verifiability, how each party can prove breach or performance of the
contract. Please look for Part II: Verifiability next week!

About the Author

Jared Arcari is a third year law student at Fordham University School of Law. Jared currently
serves as the president of two student organizations, the Fordham Business & Law Association
and the Entrepreneur Law Society. He is also a Notes & Articles Editor at the Fordham Journal
of Corporate and Financial Law. When he isn’t writing about blockchain-related legal issues,
Jared enjoys serving as a research assistant to prof. Bernice Grant researching entrepreneurial
topics including non-compete alternatives and improving access to capital. To contact the author,
please email him at jarcari@law.fordham.edu.

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Disclaimer

Any information contained in this post is for informational purposes only. The information,
opinions and commentary contained herein does not constitute legal advice. It also does not
constitute tax advice. This post is not a complete overview or analysis of the topics presented and
may contain information that varies in different jurisdictions. The transmission of information to
the reader does not create a lawyer-client relationship. The reader should not rely upon this post
or treat it as a substitute for legal advice. The reader should consult a lawyer familiar with their
particular circumstances and licensed in the proper jurisdiction for legal advice.

[1] Nick Szabo, Smart Contracts: Building Blocks for Digital

Markets (1996), http://www.fon.hum.uva.nl/rob/Courses/InformationInSpeech/CDROM/Literature/LOTwinterschool
2006/szabo.best.vwh.net/smart_contracts_2.html.

[2] Id.

[3] Black’s Law Dictionary (9th ed. 2009).

[4] Szabo, supra note 1.

[5] Olga v. Mack, Smart Contracts: The Future of Contracts, Brought to you by Blockchain, (May 14,
2018) https://abovethelaw.com/2018/05/smart-contracts-the-future-of-contracts-brought-to-you-by-blockchain/?rf=1.

[6] See Jessica Messier, Why Consensus-Based Blockchain Technology is Better at Keeping Code Safe, (Feb. 13,
2018) https://mytechdecisions.com/it-infrastructure/consensus-based-blockchain-technology-better-keeping-code-
safe/.

[7] See Gideon Greenspan, Why Many Smart Contract Use Cases are Simply Impossible, (Apr. 17,
2016) https://www.coindesk.com/three-smart-contract-misconceptions/.

[8] See Tom Hingley, A Smart New World: Blockchain and Smart Contracts, (2018) https://www.freshfields.com/en-
us/our-thinking/campaigns/digital/fintech/blockchain-and-smart-contracts (noting that despite some commentators
worrying about smart contracts taking over jobs, “we’re not there yet…”).

[9] See BOScoin, Smart Contracts & Trust Contracts — Part 1 (Sep. 8, 2017) https://medium.com/@boscoin/smart-
contracts-trust-contracts-part-1-83f12dec7641.

[10] Id.

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[11] See id.

[12] See ISDA & Linklaters, Smart Contracts and Distributed Ledger — A Legal
Perspective (2017) http://content.linklaters.com/pdfs/mkt/london/Smart_Contracts_and_Distributed_Ledger_A_Legal
_Perspective.pdf.

[13] Greenspan, supra note 7.

[14] See id.

[15] Greenspan, supra note 7 (noting that “in other words, an oracle pushes the data onto the blockchain rather than a
smart contract pulling it in”).

[16] See Oraclize, Understanding Oracles (Feb. 18, 2016) https://blog.oraclize.it/understanding-oracles-

99055c9c9f7b.