"New World Order"-Promulgation of 'Blockchain' Technology and Smart contracts. Legal Observations and Proposals.
1. Introduction
In 1989, the demolition of the Berlin Wall has been fairly characterized as the most notable sociopolitical event of the 20th century. However, the wall’s fall signaled the subsequent “fall” of trade obstacles signifying the so called “gold era” of global trade and Finance during which trade growth accelerated almost two times the rate of the world GDP till 2008.
And if one wall fell, others were erected. 2008 has been fairly characterized as the “double-face” year during which two diametrically opposed occurrences have taken place. On the one hand, the Global Financial Crisis led to the largest drop in global trade volumes since World War II and put Regulators, Banks and Governments to unexplored waters. From the other hand the promulgation of Blockchain technology literally “rocked” the boat, described by many as the greatest invention after the Internet, giving rise to discussions for further applications.
2. Distributed Ledger Technology (DLT)
Distributed ledger technology (DLT) is a general term used to refer to a digital record system built upon decentralized overlay databases that allow participants to disseminate, store and access information (Data) across a shared network. It is called distributed because the record is consisted of users (nodes) operating outside the scope of central administration.
DLT forms a certain type among other types of digital ledgers displaying same functionality features but different systematic actions and philosophy. In contrast to centralized related platforms where an appointed administrator validates any information insertion and access of potential users, DLT structure enables the verification of a transaction through the “consensus” mechanism to safeguard assent of every node maintaining the record. Once validation is made a “single-truth” copy is duplicated and transmitted across the nodes simultaneously. It should be noted that hybrid or hierarchical forms of DLTs utilizing a semi-decentralized approach exist.
Despite the disintermediation and the benefits associated with, the “golden stone” of distributed structure refers to the data interoperability ensured through a unified record, eliminating multiple records that need to be reconciliated.
3. Blockchain Technology and Basic Features
The most prominent type of DLT technology refers to the Blockchain overlay networks underpinning the technology of the first promulgated cryptocurrency, named Bitcoin invented in 2008. It is fairly considered the most notable technological invention of the 21st century. Blockchain can be defined as a distinct form of self-maintained ledger capable to maintain a record (chain) of all the executed transactions forming “blocks” once approved, mitigating potential opportunistic behavioral issues whilst single point of failures (SPOF) are eliminated.
Authentication of the underlying transactions is verified right after complex systematic equations are solved (Proof of Work) through the mining process on a peer to peer basis (P2P). However different types of distributed ledgers utilizing different types of authentication techniques. Unlike PoW, in the Proof-of-Stake (PoS) consensus type, verification is not performed by miners solving cryptographic puzzles, but by forgers or provers placing sum or “stakes” that correspond perfectly which their chances to validate the block and make profits.
Other related and Hybrid forms of consensus such as Delegated Proof-of-Stake (DPoS), Proof -of -Authority (PoS), Proof-of-Capacity (PoC), Proof-of-Burn (PoB) have emerged, albeit inherent vulnerabilities related to certain types justify their little attraction. Despite some differences between them, their purpose is to validate a proposed transaction, encrypt the data related to this and store into the block.
Once data is entered into the overlay network it is almost unfeasible technically to be amended. Security is even more enhanced through the unique “hash” key of every block which acts as a digital data fingerprint that cannot be reversed since it is automatically built in “numeric sequence”. Since every block contains the previous hash, any external intervention to the data stored , automatically changes the hash and cryptographic connection with the next block is interrupted.
Blockchain technology is fairly characterized as “trust machine” capable to eliminating potential double-spending problems and well- established “Byzantine Faults” with its unique features. Verification security and traceability are even more enhanced through the utilization of private-public encryption keys to initiate algorithms for execution and signing.
There are two distinct processes under which verification can be made. Each model has been formulated to satisfy a unique purpose, however both types based on the same philosophy. According to the first model, called “Permissionless”, any party can participate in the transaction validation (mining) without obtaining any related authorization to participate in the network. Specific legal concerns arise regarding the anonymity associated with this specific type since miners and participants remain anonymous to a certain extent (e.g., Zcash).
In contrast, a “permissioned” blockchain can be defined as “in-Cognito” ecosystem within which validation is permitted only by a limited number of predetermined parties, under the auspices of a central administrator/adjudicator. The utilization of the current structure enables transparency of the transactions performed among the consortium (KYC/AML), data interoperability is even more enhanced while business interests are better reflected, justifying their rapid adoption in the business world.
Furthermore, a distinct line should be drawn between private, public and consortium networks. According to the first network type only a limited number of predetermined participants can transact within it provided that certain membership requirements are met. As opposed to private networks, in native ledgers anybody can be involved in the process. The third type constitutes a hybrid model resembles to a semi-private network within which only certain appointed participants can validate transactions.
4. Defining Smart Contracts and Background
Distributed ledger technology-based systems can literally change the way parties memorialize their contractual arrangements. Smart contracts refer to a specific type of agreements which are written in code and self-execute pre-programmed functions after certain conditions have been fulfilled. More specifically, smart contracts operate under a “conditional framework” adding a greater level of certainty and predictability as a result of the “Boolean Logic”. Its functionalities and limits are still unknown since its potential range of application is still being tested, however its more than obvious that its promulgation will inevitably revolutionize the existing contract principles.
Digital contracts were first promulgated in 1948, after the Soviet Union restricted supplies to Western Germany and parts of Berlin. United States in collaboration with other countries began the “Berlin Airlift” by throwing tons of food to the divided city. US Sergeant Edward Guilbert invented a system to track the cargo sent, based on “radio- teletype telex” or telephone. In 1966, Guilbert in collaboration with DuPont, developed a group of electronic messages for transmitting cargo data between the company and their clients. These telex-type messages were converted into paper tape and then inputted into computers constituting paper agreements transformed into digital representations (EDI).
5. Smart Contracts as Legal Contracts
Nowadays, EDI (Electronic Data Interchange) systems have acquired massive adoption especially in trade finance by permitting to swap invoices, bills of lading and inventory data, reducing commercial and transaction costs and paperwork they do little to change the way parties interact with each other contractually , since they only reflect existing terms and conditions in an electronic type.
In 1995, Nick Szabo, identified these restraints and published a paper showing that through cryptophafic protocols, rights and obligations could be encoded in a restrictive way that resembles to contractual clauses and subsequently confine the opportunities upon which parties can terminate their contractual performance obligations. Only few months after the publication of Szabos’ work, Bill Frantz and Mark Miller structured digital contracts using an “object-oriented” programming language.
Microsoft and Julia Seward from the University of Glasgow, in 2004, modeled the former types of computerized financial contracts. In 2012, a Law Professor from the University of Colorado, Harry Surden in cooperation with a small group of scholars investigated the way contractual obligations translated in the form of data can guide the way for the first time to “computable” terms.
Unlike traditional contracts, smart contracts have the capacity to enforce obligations by utilizing autonomous code. In comparison with the traditional and EDI contracts, are based in structured and systematic language and executed in a distributed manner performed by nodes supporting the blockchain-based platform, without necessarily the need for a central authority, legal system or even external enforcement mechanism. However, it is crucial to ensure that the result of a smart contract act is legally operative and enforceable by the parties in the case of a dispute.
6. Oracles
It’s worth noting that traditional paper- based contracts despite their inherent flexibility, are less dynamic than smart contracts, since the latter can be structured from scratch to adjust performance obligations throughout the term of an agreement by using Oracles , third-party sources or digital agents that store and emit information in real time from the outside world by enabling the opportunity to interact with real-life individuals and be affected by external effects. Their adaptable character enables them to respond rapidly in ongoing alterations on terms and conditions of a contract right after they occur.
By utilizing oracles, a new sense of objectivity and fairness could be introduced, since parties’ obligations and rights are trusted and measured not by the subjective and arbitrary judgments of individuals, but by guaranteed and objective promises that are readily translatable into code . Additionally, they can process microtransactions at low or even zero charges on a peer-to-peer basis formulating decentralized commercial marketplaces to coordinate the sale of goods globally, using human-based oracles to settle errors or bugs that normally arise in the ordinary business of trade.
7. Enforceability Problems
Assuming that natural language promises can be conveniently incorporated into a s smart contract a lot of legal uncertainties arise with regard to their deployment, which actually confers that despite their definition, they are not always strictly legal contracts. Analyzing prewritten computer codes under the auspices of traditional contract law principles is challenging. Despite the versatility of the laws adopted regarding the formalities for a contract to be validly concluded certain minimum requirements should be met. At least the majority of jurisdictions globally recognize that the agreed terms in order to be legally binding have to reach consensus or “meeting of the minds”.
The well-established divergences between Common Law and Civil Law jurisdictions complicate the picture even more since many jurisdictions require for parties to have the legal competence or capacity to enter into a valid contract e.g., to be a human or a natural person, while others do not.
An intercorrelated issue that will most probably arise under the regulatory auspices of numerous developing countries, refers to the legal framework surrounding the public/private key cryptographic technology (PKI), which is used to implement strong authentication, digital signatures and advanced data encryption.
Similar difficulties and the subsequent need for judicial determination arise as to whether digital currencies exchanged between parties in the proposed smart model are capable to obtain legal identity under the auspices of property Law. Regulatory discrepancies across the jurisdictions involved in a chain as to what constitutes property generally, enacted IT, IP rights, tokenised assets and data protection related provisions can generate legitimacy concerns when applied internationally. Another prominent concern refers to the proper legal classification of data utilized in blockchain structures. A lot of different opinions have been expressed, however in the absence of a harmonized regulatory framework, they remain indecisive, pending statutory clarification.
7. Technical and Operability Risks- Proposals
In addition, emphasis should be put on the fact that any type of software and automated process is likely to contain multiple kinds of errors such as bugs and malfunctions. These can occur in multiple stages of any smart interaction and may disastrous consequences. Furthermore “external integration” errors might arise from the problematic provision or process of information, such as conditions that must be verified for a smart contract to be triggered, by an external mechanism such as Blockchain-enabled devices or an oracle. In such a case if the interconnected source ceases to exist, auto-performance, the commencement of which depends on the satisfaction of a condition will not occur.
In addition to bugs or unexpected errors, blockchain-based consensus mechanisms are not immutable and can be manipulated by malicious parties. There is a theoretical risk that a 51% attack on the network running smart contracts (total hashing power) is feasible. Other possible viruses such, as “Sybil” or “Denial of service” attacks can cause the same operational and performance failures. Potential scalability issues should be carefully considered.
Resolution Technology (ResTech) could possibly be the answer, by formulating advanced Resolution and Recovery Programs (RRPs) alongside with external formal Special Resolution Regimes (SRRs) in case RRPs fail to manage effectively potential exposures. As Professor Walker stresses, proactive mechanisms could be utilized to protect systemically important FinTech Companies (SIFTCs) running the platforms to prevent systemic risk exposure or other disastrous consequences. An alternative “back-up” ledger within which all data and accounts are saved in real-time would be able to restore potential errors or attacks.
8. Contractual Limitations
An indirect form of error may arise, especially in the case of sophisticated encoded contacts since they may reflect different intentions or results of what parties initially agreed for. What is the legal position and how the courts can allocate liability since neither party is at fault?. Is it possible for the party bearing the loss to establish liability and subsequently commence proceedings against the other party or a third party? A lot of regulatory alterations exist as to how a court characterizes auto-performance malfunctions as well as the degree or form of the evidence required to be successfully invoked.
Having in mind the irreversibility of smart contract transactions once they are triggered, a prominent solution would be for the court to force litigants to stipulate a second transaction to bring in line potential inconsistencies or damages occurred during the execution of the main transaction. Courts and regulators must as soon as possible decide between ex ante, ex post or compound solutions to deal with the problem in question.
9. Peering Into the Future-The Middle Path
There is a wide misconception that there is only type of smart contracts and their experimentation will be decisive in determining their suitability as well as the functionalities associated with. Smart contracts are deployed on blockchain technology simply because its characteristics considered to be, at least in the current experimental stage, more suited and easily adopted than other alternative platforms. However, it is quite possible as the distributed technology will become more advanced over time, other more sophisticated models to prevail.
A smart contract can be structured in different ways leading to a wide spectrum of different types generating different legal implications and concerns as well as benefits and capabilities. The most extreme view refers to “code is contract” group of proponents, which suggests the codification of the entirety of terms of a contract into a fully-digitalized separate automated contract, the performance of which relies solely on smart “logic”. In the opposite side, a smart contract could be nothing more than an advanced digitalization of a paper-based contract, embedded with an encoded payment mechanism capable to transfer, buy or sell digital tokens or currencies.
However, between these extreme approaches intermediate positions exist, including encoded contract forms which are replicated with a concrete traditional contract written in standard legal prose, corresponding perfectly to each other. Nevertheless, the most prominent form, taking into consideration the evolving business practices, the underlying commercial and legal risks, while guaranteeing immediate adoption alongside the maximum of benefits for Trade and Supply chain, involves the concept of a “split” contract.
Parties can memorialize only a certain part of non-human performance related terms into code , while other human based and remedial premises are written into context-sensitive language version, sticking together a coherent contract. Their functionality resembles to what are known as “Ricardian” contracts, by deploying a hash or an identifier, to connect a paper-based contract with automated activities embedded in a distributed ledger architecture in the form of data.
However, other types and hybrid forms may be possible. A lot of discussion surrounding the introduction of advanced master supply ‘smart’ agreement into the realm of trade finance, consisted of different smart contracts harmonized into a single agreement, under which supply is triggered when certain memorialized by reference terms in each of these are accomplished.
Taking into consideration the complexities inherent in recent commercial transactions and assuming that there are legal phrases or operations that cannot be appropriately encoded such as “material adverse change” clauses, “best efforts” premises and other provisions that are not as clear-cut and could be easily interpreted subjectively by the court. Hybrid split contracts constitute the cornerstone of a new digital contractual era, embedding the best of both worlds.
It is noteworthy to mention that is of considerable value to keep certain type of contracts open-ended or ambiguous, because it provides flexibility for parties to amend existing premises according to their preferences over time and at the same time vagueness can be used as a powerful weapon to decrease monitoring and negotiation costs. Smart contracts, at least for a short future timeframe , they will not be able to adapt open-ended rights and obligations, since it is impossible to predict and formulate into the strict logic of code all the relevant circumstances that may occur.
To conclude, Hogan and Lovells initiated an experiment by creating a smart ‘earthquake’ contract based on Ethereum’s solidity platform. After only a few days running of the code, significant differences were identified between the smart contract and the comparable traditional context-based agreement, as well as other regulatory and technical gaps. Based on the aforementioned assumptions, it is suggested that the application of smart contracts will walk in line with the EDI agreements, with parties choose not to rely the total amount of their arrangements on code, but only a limited set of them (pre- agreed rules) as part of a broader contractual relationship.
?Author: Gkikas Panagiotis- Lawyer
Date: 02.10.2018
E-mail: [email protected]