“Blockchain and the Law” reloaded, or “The demise of smart contracts from three-pieces to blue-collar”

Five years ago, in 2018, Primavera De Filippi and Aaron Wright published "Blockchain and the Law", a book that rapidly became the yardstick for everyone talking about blockchain. It tracked the evolution of smart contracts from the telexed invoices of the 1948 Berlin airlift to Decentralised Autonomous Organizations. What has happened during these five years? As my custom, I will try to frame the problem from several points of view. In the following text, the two terms blockchain and DLT will be used interchangeably.

The News

Since 2017, Chainlink and SWIFT have been coordinating their efforts. However, it was in 2022 that they announced a comprehensive partnership, with the goal of establishing a cross-chain interoperability protocol (CCIP). In essence, this is a toolkit of actions and messages ensuring the ordered transfer of tokens across several blockchain environments.

On August 31st, SWIFT announced the successful end of their Blockchain interoperability experiment. More than a dozen major financial institutions and market infrastructures joined the project, including Australia and New Zealand Banking Group Limited, BNP Paribas, BNY Mellon, Citi, Clearstream, Euroclear, Lloyds Banking Group, SIX Digital Exchange, and The Depository Trust & Clearing Corporation (DTCC). Chainlink, a Web3 services platform, provided smart contracts-based connectivity across public and private blockchains: more on this later.

Last 18 September, DTCC, Clearstream, and Euroclear released a paper on the state of the digital asset industry, calling for more collaboration to advance the digital asset ecosystem. The three major Central Securities Depositories in the Western economy define scale and interoperability as priorities: state-of-the-art DLT projects involve too few players, resulting in an archipelago of proprietary DLTs, with little opportunity for growth. As a consequence, although it is possible to issue a digital bond, its secondary market is illiquid and few counterparties will accept it as collateral.

For Financial Market Infrastructures, securities tokenization is the holy grail of blockchain development, and the key for their own survival. On the contrary, many economists warn that tokenized assets are the ideal vehicles for transmitting volatility from crypto asset markets to the traditional financial sector. At the same time, everyone understands the need for reliable interoperability, that is, the capability of moving an asset in an ordered way across several DLTs.

The Law

An unexpected consequence of the scandals and of the following regulation efforts (horses bolted, door closed) is that now a new agreement is growing between the law and crypto- and stable-coins operators.

Of course, the U.S. Securities and Exchange Commission is still engaged in some very important cases, but everyone else is busy trying to avoid a shutdown and waiting for the outcome of the Presidential Election. In some other parts of the world, legislators and regulators cast a friendlier eye over digital assets, with unexpected consequences.

In Brazil, the Committee on the Constitution, Justice and Citizenship is considering Bill 4.420/2021, modifying section X of Art 833 of the Code of Civil Procedure, in order to protect personal savings from seizure by creditors (up to the amount of 40 minimum monthly wages). The rapporteur has recently integrated a new amendment, extending such protection to crypto-assets, stating: "Although Crypto-assets are a category within financial assets, their specificity makes it necessary to provide more clarity". Clearly, legislators understand that in some cases, crypto is the nearest thing to a bank deposit the unbanked can afford.

Hopefully, the international experiments described above will foster a new, wider concept of money and digital assets enabling reliable transactions even among jurisdictions belonging to different Law Systems.

The Market

After the big scandals, blockchain business in search of respectability flocked to law firms, who welcomed their new customers. Institutional investors needing to do business with crypto started looking for legal advice on developing de-risking strategies. Cave, Leighton, Paisner advised Apto Payments, a San Francisco-based ?ntech company, on UK regulation issues before launching its ?rst-of-its-kind cryptocurrency debit card.

Freshfields Bruckhaus Deringer advised about the definition of the London Stock Exchange Group/Microsoft strategic partnership, covering analytic platforms and digital market infrastructure. Workspace, LSEG’s own data and analytics workflow solution, will leverage Microsoft cloud-based analytics services. Also, partners have agreed to explore new infrastructures (blockchain) to support SME interactions with capital markets.

However, this is not the only market trend: after regulations for crypto have been approved, major institutions are trying to harness blockchain technologies, addressing areas left uncovered by public institutions.

In November 2019, South-Africa Reserve Bank Prudential Authority issued a guidance notice regulating deals with crypto-currencies. Last February, in his State of the Nation Address, President Ramaphosa admitted that the nation's backlog in processing title deeds amounted to over one million houses. Commercial banks were ready to eye the opportunity to expand into a new, less risky sector (I mean, less risky than the lending business). Last August, Jacques Celliers, CEO of First National Bank announced the bank's intention to explore blockchain application to title deeds, while denying at the same time any interest in crypto- or stable-coin business.

The Technology of Smart Contracts

Although powering the blockchains, smart contracts are just like any other software product, and so there are only three ways to deliver them:

• the old way: a mixture of craft and improvisation. Maybe good for fine wine, not the best for software or cars.
• the R&D way, layering software components one over the other, until the desired goal is reached.
• the innovation way, making information flow among ready-made components connected together in a novel (and hopefully smarter) way.

Most probably, software development in the real world is some horrible mix of those three. The fact is, smart contracts are just entering their third phase, thanks to two major technical improvements.

Factorization, introduced by Uniswap in 2018, allows people to build smart contracts by assembling modular components, in pretty much the same way the assistant of a public notary builds a contract through cut-and-paste. However, to solve some performance problems, smart contract pools needed to be introduced.

Pooling is a technique whereby, instead of running into the time and expense of creating a smart contract every time it is needed, the system fishes an idle one from a pool and starts using it. After that, the smart contract is returned to the pool and waits for another opportunity to work.

After factorization and pooling, are smart contracts humbled enough to enter the finance sector at the bottom of the ladder: Are they really? No, they are not (yet).

Enter the Auditors

Only those remembering the devastating disasters caused by OTC derivatives in the Nineties can appreciate the extent of similar problems in smart contract development. International organizations have brought greater transparency and integration to the OTC derivatives market. The definition and adoption of international standards made the OTC derivatives market a more stable environment, and allowed better control of operational risk.

The CCIP brings standards to the task of transferring digital assets across chains, and is based on audited token pool contracts that handle the complexity of burning/minting or locking/unlocking of tokens. As an asset enters its destination chain, its originating counterpart (call it the source token) must be deactivated. If the source token is permanently deactivated (burned) the destination token should be clearly created ex novo (minted).

In a high-performance setup, this burning/minting approach is too expensive. So, when as the asset is moved across chains, the source token enters a pool of locked tokens, and the destination token is made available by unlocking a previously locked one (as always, fished from a pool). The expectation is that sooner or later some other asset would ask to cross the boundary in the opposite direction.

This new generation of smart contracts allows token sponsors (the digital asset owners) to maintain full control over their token pools. For example, this means that they can stop operating the gateway when token costs become prohibitive or when some other danger is sensed.

The operation of the system is monitored by a Risk Management Network, powered by the Chainlink decentralized oracle network, a reporting infrastructure that is used to report external events to several blockchains.

Interoperability across Layer-1 and Layer-2

On July 17th, the Cross-Chain Interoperability Protocol (CCIP) was released on Chainlink Mainnet. The early access phase supports Avalanche, Ethereum, Optimism and Polygon (MATIC) networks, with CCIP also adopted by DeFi lending protocols Aave and Synthetix.?These are all Layer-1 networks, where any transaction in the systems is represented by a single transaction in the blockchain.

Sometimes, Layer-1 networks are deemed too costly and too exposed to crypto-coins volatility. Transaction costs can double up in the space of a week. Layer-2 networks, as the Lighting network layered over Bitcoin, roll up several transactions into a single Layer-1 transaction, in order to share transaction costs.

On Sept 21st, Chainlink released its CCIP protocol on the Arbitrum One, an optimistic rollup for Ethereum that powers high-throughput, low-cost decentralized applications. CCIP provides developers with the ability to easily reach Layer-2 in a number of cases where transactions costs must be kept low, such as cross-chain gaming, data storage and computation.