Smart financial contracts as a mixed blessing

Technology increasingly plays a governance role. Hence, smart contracts (a term coined by Nick Szabo) are progressively shifting decision-making from the real to the digital world. On the upside, they facilitate contract drafting and contribute to decision-making; on the downside, smart contracts may drift over time. In any event, major financial centers are increasingly recognizing their importance, especially due to compliance and security issues being dealt with via distributed ledger and ‘hashgraph’ technology.

differences in smart contract practice will have more to do with platform compatibility than with dissimilarities across legal regimes.

Smart contract use is likely to facilitate agreements, especially among non-trusting operators: the parties’ input is mostly limited to agreeing to the code governing their interactions. To be sure, contractual terms may not be fully grasped by everyone; however, this is also the case for standard financial contracts. More importantly, the gap between what has been subjectively agreed upon and what is effectively delivered is likely to decrease over time. It follows that differences in smart contract practice will have more to do with platform compatibility than with dissimilarities across legal regimes. In other words, enforcement consistency is a function of technical rather than regulatory harmonization.

Current transaction systems enable every participant to contribute to decision-making. However, a 100% horizontal system has yet to emerge. Consensus occurs via an underlying network of computer nodes. Changes cannot be altered, a property that is ideally suitable for situations where data is shared between multiple participants―i.e. in the financial sector. Every transaction is subject to node-specific conditions and verifications; it must bear the users’ digital signature and will get a unique ID. Completed transactions are stored in blocks, with indication of amount and time; each block has its unique hash, which represents the conversion of an input of arbitrary length into an encrypted output of fixed length. The parties can see their transaction once it is added to the ledger; depending on the network's characteristics, others may also be able to see it. Recorded information cannot be altered or recovered. Practice consistency is currently facilitated by mimicking the ‘international private law’ regime applicable to traditional contracts.  Ideally, an international agreement would provide for the mutual recognition of smart contracts. Enforcement could occur under either uniform rules or  ̶̶  which could prove more practicable - the rules applicable in the defending party’s country of ‘residence’.

automation will not prevent biases: some design choices are superior to others, and algorithms are not impartial.

Whether smart contracts will prove welfare enhancing remains to be established. To begin with, automation will not prevent biases: some design choices are superior to others, and algorithms are not impartial. More importantly, smart contracts may drift over time, especially when there are deficiencies in the provision of new training data. A drastic way to address the issue is to rely on self-destruct functions; a more nuanced approach is to limit the ‘gas’ provided to process contractual instructions.

The importance of smart contracts is increasingly recognized by major financial centers. The trend is especially noticeable in leading European jurisdictions. England, which has a robust smart contract tradition, is currently modernizing its ‘emerging technology’ conflict of law provisions.  Germany and Switzerland foster smart contract use by letting one party write the contract and the other agreeing to the code displayed in a front-end application. By contrast, the French approach is more restrictive, subjecting smart contracts to automation and security requirements. In the US, the current view is that smart contracts are generally enforceable provided they fulfill basic contractual requirements. It follows that traditional contractual frameworks apply.

Compliance with regulatory requirements is facilitated by reliance on distributed ledger technology (DLT). In public DLT, everyone can participate in decision-making and transactions are visible to all; under this approach (which is adopted by Ethereum), data cannot be modified post validation and acceptance. By contrast, only those given permission can access private DLT; under this approach (which is adopted by Hyperledger), data is highly secured and kept confidential. Recent technology allows for relying on agent-centric rather than data-centric DLT approaches. For example, nodes run their own chain at Holochain, thus operating independently while remaining part of a larger network.

Transaction security can be reinforced by relying on hashgraph- instead of DLT-technology. Here, parallel transaction storage results in multiple transactions getting the same ‘time stamp’ and being provable within minutes. Alternatively, the parties may use the directed acyclic graph (DAG) approach. Here data enters a processing element through the incoming edges and leaves it through the outgoing edges. This enables the validation of randomly chosen transactions, thus providing a new way to improve scalability. These developments (and the still complex nature of distributed databases) provide some protection against hacking. Nevertheless, malicious actors regularly carry out hacks. This is often attributed to the persistence of vulnerabilities, especially when it comes to regular user interactions with the system. On the other hand, it may also be due to rewards being higher for hackers than for security agents.

Summing-up, smart contracts have pros and contras: they facilitate contract drafting but may drift over time. Going forward, they are likely to play a significant practical role, especially when it comes to compliance and security issues.

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Gerard Hertig, Principal Investigator, Future Resilient Systems Program, Singapore-ETH Centre and ECGI Fellow and Research Member

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