Part 1 - Smart contracts, blockchain and distributed ledger technology: implications for business

Wednesday, March 29, 2017

Introduction

The legal sector needs to be aware of smart contracts, blockchain, distributed ledger technology (DLT) and the underpinning technology. It is part of a huge wave of transformational technology change that is already affecting the banking, financial services and payments industries, and which will have a much wider application across business.

These technologies are revolutionising business and the way people work:

  1. The banking, financial services and payments industries are at the forefront of these changes. Fintech (newly emerging digital technologies adopted in the finance industry) is about to disrupt traditional banking models, delivering increased convenience and efficiency for consumers of financial services, and the possibility of reducing risk and lowering the cost of operations for financial services providers.
  2. The legal sector is not immune. Futurists and technology vendors are already questioning how these technologies will change the way lawyers operate.

To put this in context:

Janet Yellen, Chair of the US Federal Reserve recently said:

[blockchain] could have very significant implications for the payments system and the conduct of business […]. I think innovation using these technologies could be extremely helpful and bring benefits to society”. (Think Consortium Blockchain, 2017 Outlook: Blockchain Impacts on Enterprise and Government)

Harvard Business Review in January/February 2017 had some thought-provoking insights:

“Contracts, transactions and the records of them are among the defining structures in our economic, legal and political systems. They protect assets and set organisational boundaries. They establish and verify identities and chronological events. They govern interactions among nations, organisations, communities and individuals. They guide managerial and social action. And yet these critical tools and the bureaucracies formed to manage them have not kept up with the economy’s digital transformation. They’re like a rush-hour gridlock trapping a Formula 1 race car. In a digital world, the way we regulate and maintain administrative control has to change.” (Professors Marco Iansiti/Karim Lakhani, Harvard Business Review January/February 2017)

In Part I of this article, we explain smart contracts, blockchain and DLT, and the potential benefits of each for business and lawyers. In Part II, we will outline some of the risks (technology, legal and regulatory) of smart contracts, blockchain and DLT, current examples in practice, and the implications for business (and lawyers).

What is a smart contract?

Nick Szabo, computer scientist, legal scholar and cryptography expert, is widely credited for inventing the concept of a smart contract. He defined a smart contract as a:

“a set of promises, specified in digital form, including protocols within which the parties perform on these promises”. (Nick Szabo, Smart Contracts: Building Blocks for Digital Markets, 1996)

Essentially a smart contract is "… a computer program code that is capable of facilitating, executing, and enforcing the negotiation/performance of an agreement (i.e. contract) using [distributed ledger] technology. The automated process can act as a complement, or substitute, for legal contracts, where the terms of the smart contract are recorded in a computer language as a set of instructions." Read more here.

For example, a contract that automatically calculates the payments that are due between the parties, and then automatically arranges for those payments to be made, where the automation (or self-executing part) relies on software code. The contract terms are expressed in logic statements such as “if A occurs, then B happens” or “on a certain date, one party pays money to the other party’s bank account”.

To be effective, it is critical the right coding language is used, and the code is well written and watertight, otherwise, the smart contract could be susceptible to attack – as occurred in 2016 where a hacker exploited a vulnerability in the DAO (a crowdfunding organisation on the Ethereum blockchain) by siphoning off 3.6 million ETH (a digital currency) (worth approximately USD$50 million at the time).

A smart contract can be broken down into two separate components:

  1. Smart contract code: Software code that is stored, verified and executed on a blockchain or other DLT (outlined below); and
  2. Smart legal contracts: Using smart contract code as a complement, or substitute, for legal contracts.

A contract does not need to be fully automated to be a smart contract – there is a continuum:

  1. A very simple contract can be fully automated (the contract is entirely in code).
  2. Other contracts may require both self-executing terms and terms that are outside the software code. This is because:
  • Not all decisions or steps in a contract can be reduced to logic statements, especially for complex contracts.
  • We live in an unpredictable and changing world. How we deal with that in a contract is not readily distilled into a logic statement. 
  • Human judgment may still be needed to assess options and take into account factors that may not be quantifiable or within the scope of the contract.
  • The parties may want to retain discretion around some decisions or steps (whether to retain control and/or flexibility).        

At this (relatively) early stage in its evolution, a smart contract seems to mean different things to different people:

  • To the technology industry (in fact to just about everyone, except lawyers), it means an automated (or self-executing) contract written in software code.
  • To a lawyer, however, contract has a precise meaning – it requires offer and acceptance, consideration and certainty of terms. To lawyers, the technologist’s view of a smart contract is alarming.

Before explaining the potential benefits (and risks) of smart contracts, we need to understand the underpinning blockchain and distributed ledger technologies.

What is blockchain or DLT?

DLT is a database spread across multiple sites, countries or institutions e.g. a ledger of digital records or transactions that are accessible to all computers (nodes) running the same computer protocol. Blockchain refers to one type of distributed ledger.

Blockchain is the technology behind the decentralised digital currency Bitcoin. While first developed as a core component of the Bitcoin, blockchain (and the wider concept of DLT) is now considered a transformational technology (rather than simply disruptive) and with much wider applications.

Put simply, a blockchain is a decentralised collaborative record of transactions (transaction records that are maintained on one digital ledger in multiple places):

  1. A series of individual “blocks” of information which are added to the “chain” every time a new piece of information is created and securely chained together. Any digital record of an asset (whether a copy of the title deeds for a property or a virtual commodity) can be stored in a block.
  2. New blocks are formed whenever participants create a piece of new information or change an existing piece of information about an asset, for example by entering transaction records, changes of status, new market prices, or new owners, and that information is verified by the participants.
  3. All blocks newly formed after the first block are securely chained to the previous one, thus ensuring their authenticity and creating a trustworthy audit trail. One of the earliest uses of DLT was in the area of virtual commodities (e.g. Bitcoin), where the change in ownership of a commodity is recorded in the blockchain.
  4. Unauthorised changes to the information and its history are difficult (if not impossible) to make. In other words, DLT systems are designed so that information stored and communicated through the networks has a high level of trustworthiness, and every participant can get simultaneous access to a common view of the information.

The World Economic Forum recently published an explanation of how blockchain (or DLT) works. Read more here.

Currently, there are two types of DLT platform - unpermissioned and permissioned:

  1. Unpermissioned (or open) systems: the ledger is maintained by collaborative action among nodes (computers) in a public network, and is accessible to anyone. Bitcoin (which started in 2008) is a well-known example of an unpermissioned (or public) network;
  2. Permissioned (or private) systems: the ledger is maintained by authorised nodes (computers) and accessible to registered members only. Permissioned platforms enable faster, more secure and more cost-effective transactions, offer enhanced privacy, and also take less energy to operate.

A DLT can transfer value along the chain, like Bitcoin (which works on a token of value (the Bitcoin) that is transferred on the Bitcoin blockchain). However, the transfer of value is not needed for the DLT/blockchain technology to be useful.

The potential of blockchain or DLT for the banking, financial services and payments sectors (and more widely) has been recognised by central banks, regulators and governments globally.

Some of the leading DLT platforms currently in the market are Bitcoin, Ethereum, Ripple, Corda and Hyperledger. Further details will be provided in Part II of this article.

What are the potential benefits of smart contracts, blockchain and DLT?

DLT (or blockchain) has the potential to deliver many benefits, including:

  • A trusted distributed ledger (rather than relying on one trusted centralised ledger);
  • Increased efficiency (the ability to broadcast information quickly and securely);
  • Traceability and transparency of records and transactions, for participants and regulators;
  • Lower operational costs; and
  • Increased efficiency and security. A decentralised shared record of transactions (effectively a shared infrastructure) facilitates joint outsourcing of back office functions, and increased compatibility between participating institutions. Itshould enhance (cyber) security of those records, by having a single record in multiple locations.

Technologists and others suggest it is the combination of smart contracts with blockchain (or other DLT) that will bring the greatest benefits:

  • The blockchain adds certainty, security and resilience - terms are verified by independent parties (computers); and the information stored on the blockchain is protected from security threats by being held on multiple systems;
  • A smart contract can be executed outside (or above) the blockchain (the software programme runs outside the blockchain and feeds information to the blockchain) or in (or on) the blockchain (where the software program is coded into blocks).
  • Smart contracts execute when specified events occur, for example, in a financial markets context, a smart contract could activate payments or deliveries or credit events. This already occurs on centralised financial market infrastructure, like clearing houses and trade warehouses. It could also work on a de-centralised financial market infrastructure using blockchain.

What are the potential risks of smart contracts, blockchain and DLT?

Alongside the benefits, the evolving smart contracts, blockchain and distributed ledger technologies does bring a number of potential risks, including governance, deployment, risk management, regulatory and legal. These risks, and how they are managed, fundamentally underpin market confidence in the technology.

We discuss these, together with current examples of smart contracts, blockchain and DLT in business, and the implications for lawyers, in Part II of this article.

For further information please contact Chris Linton or Helen Scott.

 

Disclaimer: the content of this update is not intended as a substitute for specific professional advice on any matter and should not be relied upon for that purpose.