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Trust Law/Level IX · Trusts on chain/9.2 Tokens and real-world assets/Lesson 5

Escrow, smart contracts and the word ‘trustless’

How a legal escrow uses a neutral holder, what smart contracts can and cannot do, what The DAO hack and oracle risk show, and why ‘trustless’ means trust is moved rather than removed.

Education, not legal advice. Trust law changes from country to country and state to state, and the right structure depends on your situation. Anything you sign should be drafted or reviewed by a qualified lawyer where you live.

The lean path

The cheapest, lowest-tax, simplest and most private route the law allows, best first. Each step names the rule it rests on and the condition that keeps it lawful.

  1. For small peer-to-peer deals, a 2-of-3 multisig with buyer, seller and a named arbiter costs only network fees and releases funds when any two sign. Catch: set the arbiter’s role and fee in a short written agreement, since code alone gives no remedy.
  2. In England and Wales, smart legal contracts can be binding under ordinary contract principles (Law Commission advice, November 2021), so a simple written term can govern what the code does. Catch: other jurisdictions may differ, and a bug still moves funds irreversibly.
  3. For large or regulated deals such as land, a licensed escrow holder is usually cheaper overall, because it must follow instructions strictly and a court can enforce that. Catch: compare fees and confirm the holder’s licence where one is required.
  4. Before trusting any ‘trustless’ contract, check free on a block explorer for admin, pause or upgrade keys and see which oracle it relies on. Catch: The DAO hack (2016) showed code can run as written and still lose about 3.6 million Ether.

MaterialsAny standard escrow agreement or set of escrow instructions, read to see what the escrow holder must do and when it may release the propertyNIST Interagency Report 8202, ‘Blockchain Technology Overview’ (2018), free on the NIST website, for its definition of a smart contractThe Law Commission of England and Wales, advice on smart legal contracts (November 2021), free on the Law Commission website

Wonder

  1. What happens to funds held by a smart contract if the code has a bug?
  2. Does ‘trustless’ mean that nobody has to be trusted?
  3. How is a neutral escrow holder different from a piece of code?

Explore

  1. Escrow is a legal arrangement in which a neutral third party holds money, documents or other property until agreed conditions are met, then releases it to the party entitled to it. The idea is close to a trust: the holder keeps property for others and must not treat it as its own. The escrow holder’s duties come from the escrow agreement or instructions and from local law, and differ between countries and states. In the US, an escrow holder is often described as an agent of both parties whose main duty is to follow the escrow instructions strictly. This lesson explains these ideas and does not recommend any arrangement.
  2. A smart contract is code that runs automatically on a blockchain. NIST’s 2018 report ‘Blockchain Technology Overview’ (NISTIR 8202) describes it as a collection of code and data deployed using cryptographically signed transactions on the blockchain network. Code can hold tokens and release them when a programmed condition is met, which is why it is often compared to escrow. Unlike a human escrow holder, however, it cannot exercise judgement: it does what the code says, even if circumstances change in a way the parties did not foresee.
  3. A smart contract is not automatically a legal contract, and it is not automatically void either. In November 2021, the Law Commission of England and Wales advised that the current law of England and Wales is clearly able to facilitate and support ‘smart legal contracts’, where code is used to define or perform the obligations of a legally binding agreement. Whether a particular arrangement is binding still depends on ordinary contract principles, such as agreement and intention to create legal relations, and other countries may answer differently.
  4. Code can have bugs. In June 2016, an attacker exploited vulnerabilities in The DAO, a set of smart contracts on Ethereum, and moved about 3.6 million Ether, roughly a third of its funds and then worth around US$50 million, into an account subject to a 28-day holding period. On 20 July 2016, the Ethereum network was hard forked to move the funds to a recovery address, while those who rejected the fork kept using the original chain, now called Ethereum Classic. The code had run exactly as written; the remedy came from people agreeing to change the network.
  5. Smart contracts also depend on data from outside the blockchain, supplied by services called oracles, for example a price or the result of an event. If an oracle is wrong, delayed or manipulated, the contract still executes, but on false information. So a smart-contract escrow relies on the oracle’s operators, the developers who wrote and may be able to upgrade the code, and the validators who run the network. Each of these can fail in ways a reader of the code alone cannot see.
  6. ‘Trustless’ therefore does not mean that no one is trusted. It means trust has shifted from a known intermediary, such as a bank or escrow agent bound by law, to code, oracles, validators and developers, who may be anonymous and may owe no legal duties to users. A legal escrow gives a named holder with duties and a court to enforce them; a smart contract gives predictable execution but may offer no one to hold to account when things go wrong. The Blockchain Academy covers the technical side of smart contracts and consensus.

Key facts

  • Escrow is a legal arrangement in which a neutral holder keeps property until agreed conditions are met, with duties set by the escrow terms and local law.
  • NIST (NISTIR 8202, 2018) describes a smart contract as code and data deployed using cryptographically signed transactions on a blockchain network.
  • In November 2021, the Law Commission of England and Wales advised that the law of England and Wales can facilitate and support smart legal contracts.
  • In June 2016, an attacker moved about 3.6 million Ether, then worth around US$50 million, out of The DAO by exploiting vulnerabilities in its code.
  • Ethereum was hard forked on 20 July 2016 to recover The DAO’s funds; the unforked chain continued as Ethereum Classic.
  • ‘Trustless’ means trust shifts from a legal intermediary to code, oracles, validators and developers; it is not removed.

Exercise nine, six, three, one

9CollectList up to 9 parties or things that someone relies on when property is held for them, from this lesson or an escrow or smart-contract example you are reading (some sources give fewer), such as an escrow agent, written instructions, code, an oracle, validators or a court.
6ClusterSort them into 6 categories: human holders, written terms, code, outside data sources, network operators, and courts or regulators.
3DistillReduce the 6 categories to 3 groups: who holds the property, what decides when it is released, and who can be held to account if something goes wrong.
1CrystallizeWrite 1 sentence explaining, in your own words, why a ‘trustless’ smart contract still depends on trusting people.

Fact check

Dates, figures and claims checked against the published sources listed below.

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