Digitization of Contracts and web3【From the History of Contracts to Smart Contracts: Part 2】
Smart contracts may change the history of contracts.
Good morning.
I am mitsui, a web3 researcher.
Every Saturday and Sunday at noon we update the web3 basics report. This week we will discuss "Contracts". Please take a look until the end!
The Era of Electronic Signatures and Digital Contracts
What is a smart contract?
Strengths and Challenges
Summary: Evolution of trust and new paradigms
The Era of Electronic Signatures and Digital Contracts
The Impact of the Internet Revolution on Contracting
With the dawn of the 21st century, the explosive spread of Internet technology has brought fundamental changes to the contract system. The world of contracts, which until then had been dominated by paper and seals, was given a new dimension: digital. This change was not merely a replacement of media, but a revolutionary event that expanded the concept of the contract itself.
As companies went fully digital in the late 1990s and 2000s, inefficiencies in contracting operations emerged as a serious problem. Global companies had to spend weeks just to mail contracts between locations around the world, and had to rely on airmail and faxes for urgent transactions. This physical limitation was a major bottleneck that prevented them from keeping pace with the speed of business in the digital age.
Public key cryptography, the theoretical basis of digital signature technology, was invented by Diffie and Hermann in 1976, but it took more than 20 years to put it into practical use. In the late 1990s, the implementation of RSA cryptography and digital signature algorithms (DSA) finally stabilized, and a digital signature system that could withstand commercial use emerged.
The U.S. Electronic Signature Act of 2000 (ESIGN Act) was a milestone. It provided clear legal protection: "A contract executed with an electronic signature cannot be denied validity or enforceability on the basis of its electronic nature. This was followed by the EU Electronic Signature Directive of 2001 and the Electronic Signature Act of Japan, which established the legal status of electronic signatures around the world.
The Emergence of DocuSign and the Democratization of Digital Contracts
Founded in 2003, DocuSign has played an important role as a pioneer in the field of electronic contracts. The company's founders adopted an innovative approach to providing a cloud service that anyone can use easily, replacing the traditional complex and expensive electronic signature system.
DocuSign's success was due not only to technical excellence, but also to a thoroughly improved user experience. Conventional digital signature systems require the installation of specialized software, the acquisition of digital certificates, and complex configuration tasks. DocuSign, however, provides an intuitive interface that is completed on a web browser, allowing non-technical users to sign contracts in minutes.
In the 2010s, the use of electronic contracts expanded rapidly with the spread of cloud computing and the penetration of smartphones. Electronic contracts are now accepted in areas such as real estate transactions, automobile purchases, insurance policies, and employment contracts, where in-person signatures were previously considered the norm.
The new coronavirus pandemic decisively accelerated this trend: after March 2020, curfews were implemented worldwide, making in-person contract signing physically impossible. 300% increase year over year. The pandemic pushed electronic contracting from "an option" to "essential infrastructure.
Crowdsign Innovations in the Japanese Market
In the Japanese market, Lawyer.com launched a successful crowdsigning program in 2015. Japanese contracting practices have some peculiarities that differ from those in the West. These include a culture that emphasizes seals (especially jitsuin) over handwritten signatures, a rigorous identity verification process, and a complex approval system.
CloudSign differentiated itself with a design concept that addresses these unique Japanese requirements. Features optimized for the needs of Japanese companies included an "electronic seal" function that replaces seals, a contract format compliant with Japanese commercial law, and a multi-person sequential approval workflow.
Of particular note is the uniquely Japanese approach to legal validity. While Western digital signatures are based on strict identity verification (PKI: Public Key Infrastructure), Cloudsign utilized a special exception to Japan's Digital Signature Law called "Party Type Signature. This means that a legally valid electronic contract can be created without the need for a digital certificate, but only by verifying the identity of the user with an e-mail address.
This strategy has been a great success, and as of 2023, the number of companies that have adopted Cloudsign has exceeded 200,000. It has penetrated a wide range of small and medium enterprises (SMEs) as well as large corporations, and has led the digitalization of contracting operations in Japan.
The Transformational Implications of Electronic Contracting
The proliferation of electronic contracts has brought about structural changes that go beyond mere efficiency gains. Most important is the revolution in the speed of contract execution. The contracting process, which used to take days or weeks, has been reduced to hours or days. This has dramatically accelerated business decision-making cycles and improved responsiveness to market changes.
The cost savings were also remarkable. In addition to direct costs such as printing, mailing, and storage, labor costs associated with creating, sending, collecting, and filing contracts were also significantly reduced. One major trading company reported an annual cost reduction of 500 million yen as a result of the introduction of electronic contracts.
Reducing environmental impact was another important side effect. For a large company that handles hundreds of thousands of contracts annually, going paperless has contributed significantly to the conservation of forest resources, which is an important factor in increasing corporate value in this era of ESG (Environmental, Social, and Governance) management.
The sophistication of contract management cannot be overlooked. While paper contracts were difficult to search and analyze, electronic contracts make it possible to create a database of contract details, automate deadline management, and perform statistical analysis of contract terms. This enables more strategic contract management.
Structural Limitations of Electronic Contracts
However, current electronic contracting systems have fundamental limitations. Most importantly, they still rely on a "centralized administrator"; platforms such as DocuSign, CloudSign, and Adobe Sign store contract data, verify signatures, and operate the system all from a centralized location in-house.
This is a direct transplant of the traditional paper-based intermediary dependency system into the digital realm. Users are completely dependent on the continuity, security, and terms of use of the platform operator and cannot escape this dependency.
Data portability is also a serious issue. When migrating from one electronic contracting platform to another, it is technically difficult to completely migrate historical contract data. This creates a situation where users are "locked in" to a particular platform.
Legal binding force is certainly recognized, but the automation of contract performance is limited. Electronic contracting platforms can streamline contract execution and storage, but still rely on human judgment and intervention to monitor contract performance, manage deadlines, and automatically respond in the event of breach.
Complexity in International Transactions
Global electronic contracts present additional complex challenges. Electronic signature legislation in different countries is not fully harmonized, and an electronic signature valid in one country may not be recognized in another. There are different standards in different regions.
Data transborder transfer regulations have also become stricter over the years, with countries tightening their regulations for reasons of privacy protection of their own citizens and national security, such as GDPR, China's cybersecurity law, and Russia's data localization law, making it difficult to operate global e-contract platforms. The following is a list of some of the most common reasons for this trend.
Differences in currency and tax systems are also an issue. International contracts require settlement in multiple currencies, compliance with each country's tax system, and foreign exchange risk management, but current electronic contract platforms have limited financial capabilities in these areas.
What is a Smart Contract?
Ethereum Opens a New Era of Contracts
The July 30, 2015, go-live of the Ethereum blockchain marked a historic turning point in the concept of contracts. Launched by Vitalik Buterin at the age of 19, the platform was designed as a "world computer" that was more than just a cryptocurrency.
Ethereum's greatest innovation was the ability to run "smart contracts" on the blockchain. This was a practical realization of a concept proposed by cryptographer Nick Szabo in the 1990s. Szabo defined a "smart contract as a computer protocol that executes the terms of a contract," but the technology at the time remained limited to theory.
Smart contracts, made possible by Ethereum, have fundamentally overturned the traditional concept of contracts. Whereas a contract was previously "a document to be read, understood, and executed by a human being," a smart contract is "a program to be understood and automatically executed by a computer." With this shift, contracts have evolved from static promises to dynamic execution mechanisms.
Conditional auto-execution with if/then logic
At the heart of smart contracts lies the "if/then" logic, a basic conditional branch in programming. The simple structure of "if condition A is satisfied, then action B is automatically executed" opens up revolutionary possibilities by implementing this in an immutable and verifiable form on the blockchain.
Let me explain with a concrete example. In a conventional real estate sales contract, the procedure required "the buyer pays the price, the seller confirms it, and then the ownership transfer is registered. This process required a lot of human work and time, including confirmation of payment, registration procedures, and issuance of a certificate of ownership.
However, with smart contracts, the transaction can be completed instantly with the logic of "IF (when it is confirmed that ETH worth 1,000,000 yen has been transferred to the specified wallet address) THEN (ownership of the real estate NFT is automatically transferred to the buyer's wallet)".
This automatic execution does not require any human judgment or intervention. The moment a condition is met, the entire Ethereum network verifies that fact and executes the result as programmed. This means that complex transactions that previously took days or weeks can now be completed in a matter of minutes.
Three innovative properties guaranteed by blockchain
Smart contracts are fundamentally different from traditional contracting systems because of three revolutionary properties of blockchain technology.
The first is the realization of "Trustless" (no need for an intermediary). This concept of "trustless" does not mean "trust is unnecessary" but rather "trust in a third party is unnecessary. In conventional contracts, a trusted third party such as a bank, lawyer, notary, or court acts as an intermediary when the parties cannot establish a relationship of trust with each other.
Smart contracts, however, ensure the fulfillment of contracts without relying on a specific intermediary by allowing globally distributed Ethereum nodes to work in concert. This decentralized agreement mechanism ensures that contracts are no longer affected by the corruption, failures, or arbitrary decisions of a single institution or individual.
Second is "Immutable" (unalterable). Once recorded on the Ethereum blockchain, a smart contract cannot be changed without the agreement of an overwhelming majority (51% or more) of network participants. This is a near-impossible condition in practice and virtually guarantees tamper-resistance.
This characteristic prevents ex post facto falsification of contracts and unilateral changes in terms and conditions. In conventional contracts, changes in power relations or circumstances frequently force the stronger party to change the terms to the disadvantage of the weaker party. With smart contracts, however, the initially agreed-upon terms are mathematically protected and cannot be unilaterally changed by either party.
Third is "Transparency" (Transparency). The source code and execution history of smart contracts are fully publicly available on the Ethereum blockchain and can be verified by anyone in the world. This is an innovative characteristic not found in traditional contracts.
Conventional contracts are kept secret from all but the parties involved, making it difficult for third parties to confirm the details of the contract and the status of its performance. With smart contracts, however, the terms of the contract, the status of execution, and the movement of funds are disclosed in real time, maintaining an extremely high level of transparency.
The Programmable Money Revolution
One of the most innovative concepts made possible by smart contracts is "programmable money. While traditional currencies are simple means of storing and exchanging value, the combination of cryptocurrencies and smart contracts makes it possible to incorporate complex logic into the money itself.
For example, you can create programmable money that "automatically pays rent on the first of every month". As long as there is a sufficient balance in the tenant's wallet, the money is automatically transferred to the landlord each month, and if the balance is insufficient, it is paid from a pre-defined cosigner's wallet. There is no need to worry about late payments and no need for reminders.
Innovative applications are also possible in corporate accounting operations. Programmable money, which incorporates the logic of "automatically remitting 30% of sales to the tax authorities, pooling 20% as capital investment funds, accumulating 15% as employee bonus funds, and retaining 35% as business operating funds," can fully automate complex cash management.
In the field of investment funds, even more sophisticated applications have been realized. Programmable money is used to ensure that investment strategies such as "automatically take profits when the stock price of the company in which we invest rises by 20% or more and cut losses when the stock price falls by 10% or more" are executed without being influenced by emotions.
Code is Law: the meaning of contract as code
The concept of "Code is Law" (Code is Law) is an important concept proposed by Professor Lawrence Lessig of Harvard University that expresses the essence of smart contracts. This represents a fundamental shift from the traditional system of "human-made laws interpreted and enforced by humans" to one in which "mathematical code functions as an absolute norm.
In conventional contracts, contract clauses written in natural language (e.g., Japanese, English, etc.) are interpreted by humans, and in the event of a dispute, a judge makes the final decision. However, natural language is ambiguous and the same sentence can be interpreted differently. Expressions such as "within a reasonable period of time," "in good faith," and "in accordance with normal commercial practice" do not clearly set forth specific guidelines for conduct.
In a smart contract, the terms written in a programming language such as Solidity are absolute norms. There is no ambiguity in the program code. The condition "if (balance >= 1000000)" leaves no room for interpretation other than to say that it will only be executed if the balance is greater than 1,000,000.
This mathematical certainty makes the outcome of the contract predictable. Parties can know in advance exactly what the outcome will be and under what conditions. This eliminates uncertainty and allows for more efficient decision making.
The Revolutionary Meaning of Automatic Execution
The automatic enforcement capabilities of smart contracts have fundamentally changed the concept of promises in human society. Whereas in the past, the system "expected" a promise to be kept, smart contracts enable a system in which "promises are automatically fulfilled.
There is always a risk of broken human promises. Changes in economic conditions, emotions, or values can make it difficult to keep an initial promise. With smart contracts, however, the programmed conditions are executed mechanically, independent of human intention or changing circumstances.
This is an innovation also known as the "automation of trust. There is no need to trust the other party and no need for the other party to trust you. Mathematical and cryptographic mechanisms take the place of trust, allowing transactions to take place with confidence, even with strangers.
However, this innovation has important implications. It is the loss of the ability to deal with the complexity and uncertainty of human society. Conventional contract law was flexible enough to deal with unforeseen circumstances through the "principle of good faith" and the "principle of change of circumstances". With smart contracts, however, only programmed conditions are enforced, and humanitarian considerations and changing circumstances are not automatically taken into account.
Strengths and Challenges
The overwhelming advantage of smart contracts
The advantages that smart contracts have over traditional contracting systems have already been demonstrated in a number of areas, and their effects have far exceeded previous expectations. The most important advantage is the dramatic reduction in transaction costs.
Taking a conventional real estate transaction as an example, brokerage fees, judicial scrivener fees, registration fees, stamp tax, financing fees, and other costs amounted to 5-10% of the property price. 2.5 to 5 million yen for a 50 million yen property is the transaction cost. However, real estate transactions using smart contracts eliminate the need to pay these middlemen, reducing transaction costs to only the cost of Ethereum gas (typically several thousand yen to several tens of thousands of yen). Cost reductions can reach over 90%.
The time-saving effect is also revolutionary. Taking international remittances as an example, conventional bank remittances require 3-5 business days due to complicated routes through correspondent banks, and the handling fee ranges from several thousand yen to several tens of thousands of yen. However, with cryptocurrency international money transfers, money can be sent anywhere in the world in a few minutes to a few hours, and the fee is only a few hundred yen.
Another important advantage is the reduction of psychological burden due to the automation of trust. In conventional transactions, there is always the uncertainty as to whether the counterparty will keep its word, and various collateral and guarantee mechanisms were necessary to eliminate this uncertainty. These include contract guarantee insurance, performance guarantees, and joint guarantors. However, with smart contracts, once the conditions are met, the contract is mathematically executed with certainty, thus freeing human beings from concerns about trustworthiness.
Revolution in cross-border trade
The power of smart contracts in global transactions is particularly striking. In traditional international contracts, differences in national legal systems, currencies, time zones, and languages are multi-layered barriers.
For example, consider a transaction in which a Japanese investor invests in real estate in the United States, the property is managed by a British management company, and the proceeds are remitted to a Swiss bank account. Under the conventional system, the investor would have to prepare contracts compliant with the legal systems of the four countries, file filings with the regulatory authorities in each country, sign remittance agreements with multiple banks, and enter into currency risk hedging agreements, which would have required several months of preparation and cost several million yen.
With smart contracts, however, all of these elements can be incorporated into a single program. Automatic distribution of rental income, automatic calculation and payment of taxes, automatic acquisition and application of exchange rates, and automatic remittance of dividends to investors can be performed without human intervention. It operates on the globally unified Ethereum network, so the concept of borders does not exist.
Financial systems that operate 24/7
The traditional financial system has the limitation of business hours. Banks were open from 9:00 am to 3:00 pm on weekdays, and stock exchanges were open only during limited hours on weekdays. Trading was halted on weekends and holidays, making it difficult to raise funds or settle accounts in an emergency.
The smart contract-based DeFi system completely eliminates this limitation: protocols such as Uniswap, Compound, and Aave keep you up and running 24/7. Late at night or on weekends, from anywhere in the world, loans can be made, investments can be made, and transactions can be executed instantly.
This always-on system is especially powerful for transactions between parties in different time zones. Complex international transactions, such as a Japanese investor investing in European assets and trading in the U.S. market, can be executed without regard to time zones.
Serious technical risks and challenges
On the other hand, there are a number of important issues that need to be resolved for smart contracts. The most serious is the risk of catastrophic loss due to bugs. While a typographical error in a traditional contract can be interpreted by common sense to capture the intent, a bug in a smart contract can have irreversible consequences.
The DAO incident on June 17, 2016, demonstrated this danger in action: approximately 3.6 million ETH (approximately $6 billion in value at the time, or about $1 trillion in today's value) was stolen by attackers after exploiting a recursive call vulnerability in DAO's smart contract.
The severity of this incident went beyond mere financial loss and split the entire Ethereum community. A heated debate ensued over whether to implement a "hard fork" to rewrite the history of the blockchain in order to regain the funds, ultimately leading to a permanent split into Ethereum and Ethereum Classic.
Even after 2020, large-scale losses due to bugs have been frequent: bZx Protocol attacks ($25 million), Poly Network attacks ($600 million), Ronin Bridge attacks ($600 million), and other attacks that exploit smart contract vulnerabilities have resulted in losses totaling billions of dollars. The attacks have resulted in losses totaling billions of dollars.
The Oracle Problem: Difficulties in Connecting with the Real World
The "oracle problem" is one of the fundamental challenges of smart contracts. Blockchains are fundamentally closed systems and cannot directly obtain outside information. However, many contracts depend on real-world events (weather conditions, stock prices, exchange rates, delivery status of goods, etc.).
For example, consider a smart contract for a weather insurance policy that says, "If the maximum temperature in Tokyo tomorrow exceeds 30 degrees Celsius, we will pay the insurance claim. In order to execute this contract, external weather data must be imported into the blockchain. The service that provides this external data is "Oracle.
However, the presence of an oracle raises important issues that undermine the decentralized nature of smart contracts. If the oracle sends the wrong data or maliciously sends false data, the smart contract will execute the wrong result.
Oracle services such as Chainlink, Band Protocol, and API3 attempt to solve this problem by combining multiple data sources and requiring staking (collateral) from the data provider. However, a complete solution has not yet been established and remains a critical bottleneck in the practical application of smart contracts.
Unclear legal status
In many countries, the legal status of smart contracts remains ambiguous. Traditional contract law presupposes the expression of human intent, and how to legally position code that is executed automatically is a new challenge.
In Japan, the promotion of the use of smart contracts was clearly stated in the "Priority Plan for the Realization of a Digital Society" in May 2022, but a specific legal framework has not yet been developed. Issues include how to apply the requirements for the formation of a contract under civil law (matching offer and acceptance) to smart contracts, remedies in the case of inadequate contracts, and regulations from the perspective of consumer protection.
In the U.S., states are divided in their responses. While states such as Delaware, Nevada, and Arizona have enacted laws explicitly recognizing the legal validity of smart contracts, there are no uniform regulations at the federal level.
The EU has developed a legal framework for digital technology through the MiCA (Markets in Crypto-Assets) and eIDAS regulations, but the response to the challenges specific to smart contracts is limited.
Privacy and Compliance Challenges
While the transparency of the blockchain is an advantage, it also poses serious privacy concerns. Since all transaction history is publicly available, it is possible to infer the behavior of individuals and companies by analyzing transaction patterns.
For important business-to-business contracts, the terms and conditions of the transaction and information about the counterparty are a major concern for competitors; for sensitive transactions such as M&A negotiations, new product development, and strategic alliances, the current transparent blockchain is difficult to apply.
Another challenge is the consistency with privacy regulations such as GDPR (EU General Data Protection Regulation), which provides for the right to delete personal data (the right to be forgotten), which is inconsistent with the immutability of blockchain. It is technically impossible to delete data once it has been recorded, making regulatory compliance difficult.
Summary: The Evolution of Trust and the New Paradigm
Paradigm shift from "the law protects people" to "the code is enforceable"
The advent of smart contracts represents the most fundamental turning point in the concepts of trust and enforcement in human history. From ancient times to the present, social order has been built on the principle that the law protects people. Legal rules and the judicial system guarantee the fulfillment of contracts, and in the event of a breach, state power intervenes to enforce them.
In this conventional system, human beings (judges, arbitrators, administrators, etc.) had the final authority to make decisions. Legal provisions were written in general and abstract terms, and their application to specific cases was left to human interpretation and judgment. Human values such as exceptional circumstances, socially accepted norms, and fairness were reflected in contract interpretation, avoiding unreasonable results from rigid application of the articles.
In the web3 world, however, a completely new paradigm has emerged in which "code is enforceable". In smart contracts, once the programmed conditions are met, the contract is executed with mathematical and cryptographic certainty, without any human judgment or intervention. This is a completely new form of enforcement that does not depend on human good will, morality, or the authority of the state.
The implications of this change are extremely significant.
This new form of governance, also called "algorithmic governance," allows for purely rational enforcement of rules, free from human arbitrariness, corruption, and emotion. On the other hand, it loses the ability to respond flexibly to the complexities and uncertainties of human society. Only programmed conditions will be the absolute standard, and there will be no human warmth or exceptional considerations.
Revolution of trust mechanisms from web2 to web3
The difference between electronic contracts in the web2 era and smart contracts in the web3 era represents not just a technical improvement, but a fundamental ideological shift in trust-building mechanisms.
Web2's electronic contracting systems (DocuSign, CloudSign, etc.) are based on "centralized assurance". The platform operator acts as the centralized administrator and guarantees all contract validity, authenticity of signatures, and data integrity. Users rely entirely on the platform operator's technical competence, continuity of management, and trust in its ethical behavior. This is a digitized version of the traditional intermediary-dependent system, with no essential change in the trust structure.
In contrast, web3 smart contracts introduce the innovative concept of "decentralized assurance". Instead of relying on a specific central administrator, thousands of nodes distributed around the world work in concert to guarantee the fulfillment of a contract; in the case of the Ethereum network, approximately 400,000 nodes operate independently and the validity of a transaction is determined by the agreement of a majority of them.
The most important feature of this decentralized assurance system is that the trustworthiness of the system as a whole outweighs the trustworthiness of individual participants. As long as the majority of network participants are acting in good faith, the entire system will remain secure even if some malicious participants are present.
Looking back again at the history of contracts, a bird's-eye view of the evolution of trust in human history reveals a shift from "personal trust" based on blood and land ties, through "institutional trust" based on institutions and authority, to "mathematical trust" based on algorithms and codes.
Smart contracts with blockchain may become the new way of contracting in the human race.
Disclaimer：I carefully examine and write the information that I research, but since it is personally operated and there are many parts with English sources, there may be some paraphrasing or incorrect information. Please understand. Also, there may be introductions of Dapps, NFTs, and tokens in the articles, but there is absolutely no solicitation purpose. Please purchase and use them at your own risk.
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mitsui
A web3 researcher. Operating the newsletter "web3 Research" delivered in five languages around the world.
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