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Unravelled: Blockchain and why smart contracts still need smart lawyers

6 July 2016

Written by Managing Associate Simun Soljo and Senior Associate David Rountree

There has been so much talk about blockchain and distributed ledger technology recently, especially in financial services, that you might be forgiven for thinking it might be more hype than substance. But we think it could be very important technology. We think it's so important that we have written a long paper on the potential uses in banking, securities settlement, foreign exchange and other areas, and the legal and governance issues it raises. This short article hits the high notes, but we highly recommend reading the full report.

What is it?

The most common question we've been asked around the office since publishing the report is, 'so, what's blockchain'? To be honest, we didn't attempt to answer this question in any detail in the report. For one thing, we are not computer programmers, and they are perhaps the only people who truly understand the technology. For another, there is a lot of stuff out there which tries to explain it and probably does it better than we can.

But if we had to give a response, we would give the classic lawyer's reply – 'it depends!' It depends on what aspect of the technology you are looking at, and how it is being used. While the origins of the technology lie in the 'blockchain' concept used in Bitcoin (that slightly mysterious digital currency), it has moved on and is now used in a number of ways. Many now prefer to refer to the general concept of 'distributed ledger technology' or 'DLT' rather than 'blockchain'.

If we were forced to give an answer to the question 'what is blockchain?' or 'what is 'DLT?', we might point out some of its main features which have attracted so much attention:

  • At its core it is an electronic database or ledger – a record of who owns a particular asset. So far, not very innovative. Electronic ledgers have been around for decades. And like traditional ledgers, blockchain and distributed ledgers can be used to record ownership of pretty much anything – digital and conventional currency, shares and other securities, intellectual property, contractual rights (smart contracts), and physical assets (including real estate, diamonds, and agricultural products among many others!).
  • The database or ledger is distributed. This is where things start to get a little bit more innovative. Traditional electronic records are centralised – held in big central computer systems, usually maintained by a bank, government or other big institution. Transactions between two parties have to go through the central ledger keeper. If you want to transfer $10 to a friend, this may involve your bank, your friend's bank, other banks, and the RBA, each of whom maintain their own ledgers. The concept of a distributed ledger involves every participant in the system having an electronic copy of the same ledger and being able to add transactions to it. So if the ownership of individual shares is recorded in a distributed ledger, a copy of the ledger could be available to every participant in the share market and they could, in theory, update it with new transactions. This new transaction will be confirmed against all distributed copies of the ledger, and, if valid, will be included on the ledger itself. The blockchain provides a secure record of the history of transactions on the ledger, and one that is almost impossible to tamper with.
  • Why is that? Wouldn't there be a proliferation of fraudulent transactions? In fact, it is the opposite – the system is designed to prevent double spend. This is done by two features: encryption and distribution. Encryption (or as we see it, very complicated maths) provides protection so that the various copies of the ledger are secured, and can only be changed if you hold the correct cryptographic key.
  • Distribution refers to the way blockchain has been designed as a system or network which relies on many copies of a record. There is no central record and so no 'single point of failure'. Changing a single copy of the ledger would not be effective to create fraudulent transactions. A hacker would have to change all of them (or at least a majority) which would be very difficult.

It is also important to understand that there are two broad types of blockchains – public or 'unpermissioned' and private or 'permissioned'. Public/permissioned ledgers are available to be accessed and added to by anyone. There is no single controller. The lack of control makes them more difficult to use in many circumstances, where entities may want to control who has access and on what terms. For example, a securities exchange that is considering using distributed ledger technology may only give access to the distributed ledger to approved participants – brokers, clearing and settlement providers, custodians, the central bank etc. This would be a permissioned/private blockchain. We think many applications of the technology in financial services are likely to be 'permissioned' systems.

Legal issues

From a legal perspective, three key issues come to mind: 1. how this technology will be regulated, 2. what governance structures are needed, and 3. how the 'smart contracts' it enables may affect legal obligations as we know them.

Regulation

Just as the use of the technology is still in its infancy, it is probably fair to say that current regulatory responses to distributed ledger technology are largely in the regulators' versions of an innovation lab – still nascent, as regulators try to grapple with how the technology sits within the existing legal frameworks for banking, securities, financial services and consumer protection.

However, there appears to be a consensus that distributed ledger technology should not be regulated as a technology in isolation, but that regulators should look at how it is being used. We support this view. We think regulators should focus on the uses of the technology which emerge. Like the internet, it is fundamentally a technology which is neutral.

Innovation is currently outpacing the ability of regulation and the law to change. We think regulators should allow the uses to develop before jumping in to regulate. They may also need to be more active in providing relief to allow innovation. To be fair, so far, Australian regulators have taken a measured and open minded approach and we hope this continues.

Distributed ledgers may also present an opportunity for more efficient (or intrusive) regulation – regulators could get access to the ledger, automating regulatory compliance and broadening regulatory reach.

Distributed ledgers may also interact with many other existing legal requirements, such as regulation of privacy, transaction reporting and anti-money laundering requirements. If there is no central intermediary or owner of the system, working out who is responsible for complying with existing legal obligations will be a challenge. This is another reason we think permissioned ledgers will be favoured initially.

Governance

Governance goes to how the ledger systems will organise themselves, how participants will be allowed to interact with each other, the terms on which new participants will join, what interactions with 'outsiders' will be allowed (in a permissioned system), and how the rules for all of this will be determined and changed.

Formal governance arrangements are particularly important for 'permissioned' systems which may have a small group of participants who will want some control over the system. Owners of a private ledger may be legally liable for errors or malfunctions of the system. They may want to consider how that liability can be shared between them. And they may also consider who to appoint as the administrator or controller with the ability to exercise powers in relation to the code.

Smart contracts

Whenever blockchain comes up, the discussion almost always involves some mention of 'smart contracts'. As lawyers, we hope 'smart' contracts have been around for a long time – we at least try not to write dumb ones. In this case, however, the name is not particularly apt – as in isolation a smart contract is neither 'smart' nor necessarily a binding contract.

Smart contracts are really just computer code which automatically execute contractual obligations. An example might be to execute an obligation in a derivative contract to make a payment when the value of the reference asset reaches a certain level.

Smart contracts have been possible for a long time – as long as computers have been around. The innovation with smart contracts on blockchain is that they are supposedly securer and less capable of interference, and therefore provide parties certainty regarding performance in accordance with the coded terms. This creates both an opportunity (automation and trust), as well as risk (loss of control).

It's important to remember that a smart contract will only be a 'legal' contract if the necessary conditions for a legal contract are met – remember offer, acceptance, consideration, and intention to create legal relations? They still apply. But by introducing automation, they could make entering into and performing certain types of contracts much more efficient. This does not, however, spell the end of lawyers. While many contracts may be automated, in any slightly complex interaction there will be a need for judgement which is still best done by humans. Smart contracts are good at dealing with clear and defined outcomes, but in many ways they are dumb – they can only do exactly what they are programmed to, and they cannot deal with ambiguity (they certainly aren’t Skynet). Really smart contracts still require smart lawyers. Smart contracts also raise interesting new questions about the kinds of disputes that will arise when smart contracts do what one or more parties was not expecting – lawyers aren’t out of a job yet!

We hope this little article has helped to remove some of the ambiguity around blockchain and distributed ledgers. Maybe the next article can be written by a computer!

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