LegalTech for Asset Management 6. Oracle-Powered Smart Legal Contracts for Smart Investment Funds.

I took my question to the sanctuary that has not ceased from speaking,

The heart within, that tells the truth and tells it twice as plain;

And from the cave of Oracles I hear the priestess screaming

That she and I should surely not die and forever live again.

“The Oracles”, A. E. Housman, 1922, modernised.

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Inter-operating with Off-chain systems from a Blockchain Distributed Ledger Technology (DLT) involves using supplementary infrastructure called Oracles. Oracles increase resources of DLT networks. They supply access to outside DLT data and connect Oracle-operated Smart Legal Contracts with external systems. Thus, Smart Legal Contracts can carry out their operational obligations based upon inputs and outputs from existing data sources in the real world.

Any services that are impractical to do On-chain due to technical, operational, legal, or financial constraints can be performed with the help of Oracles. Input, Output and Inter-chains Oracles offer a variety of mechanisms for Smart Legal Contracts to obtain or deliver data outside the DLT. Oracles obtain, authenticate, calculate upon, and supply data to Smart Legal Contracts.

Moreover, Oracles can give to DLT ecosystems access to legacy systems still in use. Thus, DLT On-chain code and Off-chain infrastructure are combined to support Smart Legal Contracts that react to real-world events and operate with Off-chain conventional systems.

The UK Law Commission (the “Commission”) published a Smart Legal Contracts Advice to Government in November 2021 (the “Advice”).[1]?The Commission defines Oracles as external data sources which transmit information to a computer program. Another definition is given in a white paper by the Commission de Surveillance du Secteur Financier (CSSF) in Luxembourg.[2] CSSF explains that an Oracle can be defined as a Node of the DLT network that certifies to other Nodes the occurrence of specific events outside the DLT network.

Thus, Smart Legal Contracts for Smart Investment Funds need Oracles as external data sources (Input Oracles). They also need Output Oracles to certify the occurrence of events or to execute specific tasks outside the DLT network. An Oracle can be a Node that belongs and is operated by one of the Participants to the Smart Investment Fund described in Newsletter 2. It can also be a Node of a high quality service provider chosen by the Participants. CSSF explains that Oracles are essential for Decentralised Applications that run on a DLT network. Oracles are crucial to automate operational obligations of a Limited Partnership Agreement (LPA) using Smart Legal Contracts.

For example, as discussed in our Newsletter 4, the operational obligation to identify each person who is party to, and therefore bound by, the LPA can be automated. To on-board the Limited Partners (LPs), an Off-chain system could validate the KYC-AML information of each investor. This Oracle will transmit data to feed the Smart Legal Contract. If the KYC-AML checks are confirmed, the Smart Legal Contract will receive the input to execute the obligation and automatically accept the respective investors as LPs to the Limited Partnership (the “Partnership”). Input Oracles like this one get data from Off-chain sources and deliver it onto the DLT network.

Simultaneously, the operational obligation of funding the Partnership by each LP could also be automated with the help of Input Oracles. By this engagement, each LP makes a capital contribution of a nominal amount only. The rest of its investment may be by way of a loan to the Partnership. The contribution may be expressed as a Commitment Unit (the “Unit”).

Let’s take the example of an investor who is offered the opportunity to acquire a minimum number of Units. Each Unit is at ￡1,000 comprising 10p of capital contribution and ￡999.90 of loan contribution. To receive and process capital and loan contributions from LPs, the Administrator of the Partnership may have an Off-chain banking platform. This Input Oracle will supply the Smart Legal Contract so it executes the respective obligations using that input. Automatically, the capital and loan contributions received by the Off-chain platform will become Units for the respective LPs. We will discuss in the next Newsletter the possibility of “tokenising” the Units in Smart Investment Funds, as Decentralised Autonomous Organisations (DAOs) do.

The operational obligation of paying an annual management fee (the “Fee”) to the General Partner (GP) and the Investment Manager (the “Manager”) can be automated with the help of Output Oracles. The GP and the Manager usually receive the Fee from the Partnership. The Fee for the period during which investments are being made may be expressed as a percentage of total funds committed to the Partnership. It may be payable quarterly, six monthly or annually in advance. The Fee is intended to compensate the GP and the Manager for operating the Partnership and to cover the Partnership’s costs and expenses. Output Oracles will allow Smart Legal Contracts to send commands to Off-chain systems that trigger them to execute these Fee payments. This can also include ordering the Partnership Administrator’s data storage provider Node to store all the supplied data and to request the Partnership Administrator’s banking network Node to make payments. Establishment Costs, Transaction Costs and Fee Income reimbursements to the GP and the Investment Manager can also be made with the help of Output Oracle-powered Smart Legal Contracts. ??

Data delivered by Oracles to the DLT directly affect the outcomes of Smart Legal Contracts. The Commission recommends to ensure that external data sources provide accurate, reliable and timely data to the Smart Legal Contract so that it executes in a way intended by the parties. CSSF urges to put in place controls or remediation methods available in case of problems with an Oracle (wrong data entered by the Oracle, Oracle not entering any data unexpectedly…) A solution provider should be prepared for scenarios where Oracles are not working as expected. The Commission advises to consider a broader range of factors before contracting a Smart Legal Contract, including the use and regulation of Oracles. Parties would be well advised to allocate risk in relation to, and to provide for, a malfunctioning Oracle or inaccurate data inputs in their Smart Legal Contract. Similarly, CSSF encourages to carefully study how Oracles are chosen, to ensure that Oracles are trusted data sources.

Only one Oracle used as a centralised entity to supply data to a Smart Legal Contract is a single point of failure for the entire DLT. If the sole Oracle goes off, then the Smart Legal Contracts will not have access to the information necessary to their execution. Moreover, if the sole Oracle delivers incorrect data, DLT transactions are robotic and immutable, so Smart Legal Contracts effects based on defective data will not be reversed. ?Oracles sign and deliver their data onto an immutable DLT, so their historical performance remains. A solution is a Decentralised Oracle Network (DON). A DON pools several independent Oracle Nodes of various data sources to create decentralisation. DONs may incorporate several layers of decentralisation: first, at the data source level; second, at the individual Node operator level; and third, at Oracle network levels. This ensures Smart Legal Contracts can securely count on data inputs for their execution.

The Advice explains that regulation of Oracles and other intermediaries will be an important issue. ?Relying on accurate data from a service provider is not new or restricted to Oracles for a DLT. Almost all IT contracts between Asset Managers and their data services providers have several obligations of this kind. Thus, the Commission gives the solution and makes clear that the Oracle problem or any other issue with Oracles should be addressed through the contractual relationship between the parties to the Smart Legal Contract and the Oracle service provider.

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Louis Sanchez de Lozada

[1] Smart legal contracts Advice to Government, The Law Commission, CP 563, Law Com No 401, November 2021.??https://www.lawcom.gov.uk/project/smart-contracts/

[2] Commission de Surveillance du Secteur Financier, Distributed Ledger Technologies & Blockchain - Technological risks and recommendations for the financial sector. https://www.cssf.lu/wp-content/uploads/DLT_WP.pdf