Smart Contract 2.0

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Smart contracts were the subject of many studies, reports, and articles, especially between 2016 and 2018, when ICOs began to become widespread. The term "contract" in the concept attracted especially lawyers to this new formation like a magnet. Studies examining smart contracts directly and conceptually have given way to application areas of smart contracts, such as tokenization, NFTs, decentralized finance, and decentralized autonomous organizations. These developments do not mean that smart contracts have lost their importance. On the contrary, it should be said that a new era has entered in smart contracts: the era of smart contract 2.0.

Smart Contracts Under a Microscope

The legal effects of smart contracts have begun to be examined in many different areas since 2015. In this context, institutions, and organizations such as the European Union, OECD, and European Law Institute have initiated research projects and prepared reports examining smart contracts from different perspectives. The European Union Blockchain Observatory and Forum published two different reports on smart contracts. The report, last updated in November 2022, stated that for smart contracts to become widespread, it is important that the smart contract reflects the legal concepts and purpose of the parties as exactly is and that the immutability of smart contracts is a source of concern. In this context, it was stated that the European Union will consider uniform conditions and standards to popularize the use of smart contracts. After three years of project work with stakeholders in the market, the European Law Institute published a report and created recommended principles on what smart contracts should contain to pass audits such as validity, general transaction conditions, and consumer protection.

The OECD included smart contracts in detail in its reports on tokenization. It was stated that until the legal nature of smart contracts and how contract law rules will be applied to smart contracts are clarified, problems such as enforceability and financial protection will continue.

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DeFi and Smart Contracts

Especially after 2021, with the increase in tokenization and decentralized finance (DeFi) projects, the need to establish legal certainty regarding smart contracts has come to the fore. Tokens have expanded their use cases thanks to their integration with smart contracts. Since unlimited digitizable content can be embedded in smart contracts, it is possible for tokens to be programmed and used for any conceivable activity or product. Complex rights owned by a shareholder, for example, can be integrated into smart contracts. Although the foundation of tokens, as we understand them today, was laid by the Bitcoin blockchain, it is stated that the real revolution in the use of tokens occurred with the integration into smart contracts.

Decentralized finance (DeFi) aims to create a border-crossing and transparent finance ecosystem by taking advantage of the features of blockchain technology. In this new ecosystem, financial intermediaries are replaced by smart contracts: Decentralized exchanges (DEX) allow users to exchange tokens directly with each other. Trust in computer software replaces trust in intermediaries or the other party of the transaction. Thanks to decentralized finance applications, expenses are reduced, innovation is supported, and users can truly take control of their own assets. In this context, it becomes possible to create new financial products and opportunities. In the DeFi ecosystem, financial instruments do not consist of traditional instruments but tokens or digital instruments such as stablecoins, governance tokens, and collateral tokens.

As in the era of smart contract 1.0, legal disputes may be encountered in the era of smart contract 2.0. In this context, smart contracts may have vulnerabilities or bugs. Smart contracts using artificial intelligence may pose new problems. The use of smart contracts in tokenization processes cannot guarantee that an off-chain asset or service will be transferred to the token holder.

IMF and Smart Contracts

In the IMF's study on tokens, published in July 2023, although not directly on smart contracts, it was pointed out that in order for tokens to reach their full potential, it is a needed for a set of basic legal rules that integrate them into the existing legal fabric and provide solid answers to the problems posed by tokens. Accordingly, laws should recognize and define distributed ledger technology and smart contracts to include them in existing legal mechanisms. It is also stated that it is significant to clarify their effects on the transfer of tokens and the determination of the parties' rights on the tokens. In this regard, in this study of the IMF, there is a connection between distributed ledger technology and offline assets and services with valid legal consequences.

ESMA's Smart Contract Report

In the report of ESMA (European Securities and Markets Authority), published in October 2023, it was pointed out that lawmakers and policymakers need to understand and monitor these complex structures in order to systematically evaluate DeFi-related risks to investors and financial stability. For this purpose, it is emphasized that it is critical to create and categorize the use cases of smart contracts. In the study based on 200 smart contracts, smart contracts are divided into five categories:

  1. Financial smart contracts that enable basic financial transactions such as collecting and redistributing funds,
  2. Operational smart contracts, which are related to the field of execution and efficient memory management, which play a significant role in optimizing resource allocation and usage,
  3. Token smart contracts that enable the creation, content determination, and elimination of new tokens,
  4. Wallet smart contracts that make it easier for users to interact with the blockchain,
  5. Infrastructure smart contracts, which form the basis of other smart contracts and support the interoperability and scalability of blockchain applications.

In this study, smart contracts are divided into two: the 2017-2018 period and the 2021-2023 period, and it is stated that smart contracts are becoming increasingly complex. It is mentioned that the variability in the usage intensity of smart contract categories can be explained by developments in DeFi deployed on the Ethereum blockchain. The dominance of financial smart contracts in the first Ethereum wave is attributed to the prevalence of ICOs.

It is stated that in the second wave of smart contract distribution, which lasted from late 2020 to January 2023 and largely reflects the increase in interest in DeFi applications, the increase in the token, operational, and infrastructure smart contracts categories is particularly striking. The rise in token smart contracts is thought to be linked to the proliferation of tokenization projects and the increasing importance of standards such as ERC20 and ERC721 in facilitating token creation and management. The increase in the operational and infrastructure smart contracts categories can be attributed to the growth, diversification, and evolution of the Ethereum system along with the development of dApps and protocols. It is stated that the wallet smart contract category, related to the management and storage of cryptocurrencies and tokens, exhibited a lower but relatively more stable distribution rate throughout both waves.