How Smart Contracts Will Change the Financial and Legal Systems – Part 1

CoinIdol conducts interviews with two experts investigating the issues and evolution of smart contracts concerning how they will change the financial and legal systems. This is Part 1 of a two-part interview.

Go to Evolving Issues of The Cryptocurrency Movement and Decentralization – Part 2.

CoinIdol investigates this topic with two experts - Mark Jackson, an Ethereum/Blockchain Application Architect from Fort Collins, CO, USA, and Rob Hitchens, an Ethereum, Blockchain, and smart contracts expert from Calgary, AB, Canada who also gives Project Guidance and Training to clients. Both experts describe the issues in the legal and financial industries and how innovation and technology are fueling the smart contract options. 

Legal Industry Issues 

There are differences between traditional contracts and smart contracts and who benefits is an important question. CoinIdol asked Mark Jackson, an Ethereum/Blockchain Application Architect who has worked with blockchain based contracts, what the difference and benefits are between the two contract formats. 

“I am obviously not a lawyer but I have worked quite a bit with blockchain-based smart contracts and I’d say the principle difference between the two is the concept of immutability. As an example, unforeseen future events can affect the outcome of what we know as a traditional contract through the operation of the legal system. Traditional contracts in the U.S. can be canceled or modified by the ruling of a judge. On the other hand, smart contracts operating in a distributed blockchain system are very hard to change or override. Not impossible, as we saw in the case of the Ethereum DAO hack and subsequent hard fork that created Ethereum Classic, but requiring lots of technical effort, debate and consensus buy-in.
I think who benefits the most from blockchain-based smart contract capabilities are financial technology innovators that can now press forward and bring their products to market with a much lower barrier to entry. As a result of these innovations, their targeted customer segments will also be better served by their innovative products, which becomes a second class of beneficiary.” 

When CoinIdol asked Jackson how challenges regarding conceptual misalignment, inflexibility, contractual secrecy and legal jurisdiction hinder the use of Smart contracts in the financial services industry, he thought it was an important question, considering a smart contract can’t be upgraded like operating systems or financial software systems are done on a consistent basis. 

“From my perspective, I think the question of legal jurisdiction will be huge moving forward because these systems are inherently global in nature. There are techniques current and evolving that will improve blockchain anonymity based on the present state of the art of technology, but no one knows how these cryptographic-based techniques will hold up against future computing capability and techniques. Because of these issues, I think it’s premature to consider blockchain-based Smart contracts as we know them today for anything other than uses that are short-term and experimental in nature. By short-term I mean anything in the 1-5 year time frame or less. 

As legal jurisdictions establish precedent and the industry innovates (maybe disrupts is a better term), smart contract use cases and capabilities will need to evolve and adjust. It’s that need for future change that becomes a technological barrier. Smart contracts as currently conceived are impossible to change once deployed. This is by design, but it also makes it very difficult to build a contract that is future proofed against unforeseen changes. In the real world, we can upgrade operating systems or financial software systems but on the blockchain, we can’t upgrade a smart contract.” 

Code of Law Versus Meeting of the Minds 

CoinIdol asked Jackson how a smart contract will conflict with the legal concept “Meeting of the Minds” where a contract is only valid when parties are able to fully understand its consequences, whether by themselves or through seeking legal advice, therefore making a smart contract legally restrictive. Jackson explained the very important difference and conflict with two concepts; Code is Law and Meeting of Minds. In fact, the conflict lies with the transparency of code versus the confidentiality necessary in the legal profession. 

“The blockchain community has much diversity of opinion but there is a considerable weight given to the idea that “Code Is Law” on the blockchain. Because a smart contract’s code is public and anyone can inspect it, reading the code as written is the only reliable way of determining intent for the operation of the smart contract. There is a problem with this of course because smart contract code can be complicated to inspect, poorly written or worst case intentionally obfuscated to have unintended (or possibly maliciously intended) consequences. If everyone using a smart contract needs to have a degree in computer science to enter into the smart contract, the scope of the technology will be far too limited to have a real benefit to society. 

"As an example of this conflict take the Ethereum DAO hack in June of last year. Whether the code that allowed the hack to occur was intentional or not or whether the hack was moral or justified is immaterial to this discussion. From a legal perspective, most investors in the DAO did not put their Ether into the DAO smart contract to have it end up in a private account they did not have any form of control over. So the idea that ‘Code Is Law’ is in fundamental conflict with the legal concept of ‘Meeting of the Minds’ because of the assumptions being made about the capability of smart contract users to fully understand smart contract code. 

Another example not directly smart contract related might be if in the future using large amounts of computing power or new cryptanalysis techniques someone figured out how to obtain a private key from any Bitcoin account. Does that mean that individual would meet the legal definition of an owner for all the Bitcoin in the targeted account? Of course not, it’s a ridiculous question and would be similar to someone today using a stolen credit card number. But on the blockchain, no one can recover stolen funds short of a hard fork with majority consensus, so the legal definition becomes irrelevant because it’s unenforceable.” 

Zero Knowledge Proof and Privacy 

Contractual secrecy is affected by a smart contract especially when the nature of a smart contract is transparent. For example, CoinIdol questioned Jackson on “zero knowledge proof,” and how it can be applied in the case of a financial contractual agreement which needs the utmost privacy. 

“Fundamentally, a zero knowledge proof is a way to prove that you have knowledge of a secret without giving away any details of that secret. On the blockchain with zCash for example, you can have shielded accounts that allow you to transfer value without disclosing publicly the accounts involved or the amount of value transferred. Obviously, this can be of great benefit for counter parties needing contractual secrecy on the blockchain and is a great step forward. With respect to the question of integrating cryptocurrency with current real world regulations and legal processes, it becomes an additional challenge to overcome,” explains Jackson. 

Then there is the issue of legal jurisdiction and smart contracts regarding how enforceability and jurisdiction will be applied due to its decentralized nature. Jackson continues, “That’s a good question for someone with a better legal background. The key points here in my mind from a technology standpoint are identity and enforceability. Anyone can create a crypto account and the only way to identify an account owner short of finding them in possession of the account’s private key is by regulating the on-ramps and off-ramps, i.e. the fiat exchanges that trade crypto for fiat currency. Once identity is known, the blockchain is public and transactions can start to be linked to real-world identities, that is if these transactions are not shielded as is now possible with zCash. It’s going to be fascinating to watch these issues evolve and play out.”
Regarding design and implementation, CoinIdol questions the accessibility and clarity issues for businesses that need to be understood before smart contracts can replace traditional legal contracts. Jackson gives a very detailed answer reflecting his technical expertise. 

“Rather than enumerating all the various issues, and there are many, I can describe the one that I think is the most important and that is how we import real-world data to the blockchain. The blockchain can’t reach out and query a URL to determine the current price of wheat or determine if a shipment was delivered late, incomplete or damaged. These types of real-world observations need to be gathered externally to the operation of the blockchain system and be delivered by a real-world actor or set of actors that vouch for the data’s authenticity. This constraint is due to the property that all blockchain transactions must be verifiable, both at the time the transaction is processed and at all times in the future. So a URL can’t be simply queried because the data returned can change over time. 

Even the best smart contract with the clearest, most correct code, can only provide meaningful output to the extent that it gets meaningful input. If the input can’t be trusted, the output of any smart contract will be essentially useless. So in order to fully replace traditional contracts, we need ways to decentralize the gathering of real-world data. This is easier said than done, especially in a trustless manner for contracts where the input data is only known to a limited set of real-world participants.” 

Financial Industry Issues 

Just as there are issues with a centralized economy, there are also issues with a decentralized economy because, with cryptocurrencies, there is no central authority to impose sanctions on if problems occur. Rob Hitchens shares with CoinIdol how these problems with decentralization can be resolved to maintain confidence in the financial sector. 

“There is a reason to believe Ethereum and Bitcoin were inspired by the financial crisis of 2008." 

"Ethereum is a public network designed for transparency, censorship resistance, and widespread participation. The system is socially engineered to resist any form of interference. 

Implicitly, users of public blockchains take upon themselves responsibilities traditionally delegated to their bank. In particular, in a public blockchain, there is no customer-facing help desk and no one with the authority to overturn a transaction. This is by design. 

Financial institutions have an opportunity to provide traditional banking services such as the safe storage of currency (and other assets), the formation of capital pools and lending. I suspect there is a significant opportunity for an interest accruing deposit account if the offeror can overcome an exceptionally high trust threshold. A major turning point will be behind us when a licensed bank takes the step of offering crypto deposit accounts somewhere in the world. 

The financial sector is investing heavily in initiatives such as the Ethereum Enterprise Alliance, Hyperledger, and R3. These platforms use many of the principles demonstrated by Ethereum or take inspiration from Ethereumn but they are not Ethereum itself. They are under construction because Ethereum was deemed unsuitable for some of the applications they have in mind. 

In particular, these private chain platforms are designed to scale and are designed with privacy built in at the outset and they are being developed in an environment of formal governance. This is vital because custodians must be able to pinpoint who and what is in control of their vital IT systems. 

Private chains are so called because membership would be controlled. For example, only the participating banks would be members of a private blockchain built for their interbank transactions,” explains Hitchens. 

How Banks Can Benefit From Smart Contracts 

CoinIdol asks Hitchens to explain how smart contracts will make it easier for the financial industry and how banks especially can benefit from the adoption of smart contracts on a day-to-day basis and overall. The fascinating answer describes blockchain as offering “certainty” where smart contracts offer the possibility of “immutable logic.” 

“The promise of this approach to software is the elimination of uncertainty. Considerable business processes exist to mitigate the risk of such things as counter-party failure and reconciliation of separate privately owned databases. 

A smart contract can bind the transfer of an asset with the transfer of funds to pay for it in a single atomic transaction. A blockchain can record what happened in a way that proves the transaction occurred and ensures the record won’t be lost or tampered with. Detection of forgery and tampering is immediate and trivial. When one sees a record in a smart contract on a blockchain, one knows it could only exist because the smart contract was executed, as written. No other explanation of history is economically feasible. 

Much depends on the correct design of the contract. Blockchain offers the possibility of certainty and smart contracts offer the possibility of immutable logic. Like any language, there is a qualitative aspect of the applications developers create. Developers are challenged to anticipate in advance the correct resolution of every eventuality that might unfold in the scope of the contract. In some cases, the resolution will include the reintroduction of a trusted authority with elevated privileges. Design considerations include determining who should have such authority and what special privileges that authority should have." 

"Smart contracts can provide a chain of custody, benefits of ownership, access control, fraud reduction, simultaneous execution (asset for funds) and transaction finality quickly and efficiently. Chain of custody can provide buyers a direct line of sight to asset origin and status. When fully realized, the idea of a title search or lien search may seem quaint. Anything at all that should be carefully recorded can be recorded. Anything at all that should be easily discoverable can exist in a single authoritative and shared source of truth.” 

Banking Use Case Examples 

Hitchens gives CoinIdol some examples of potential banking use cases that have been tested and worked well in a practical sense. 

“Bitcoin was the simplest demonstration of blockchain imaginable. It’s a very simple application. Ethereum builds on the demonstrated principle of distributed consensus and provides a Turing-complete application platform. It’s still very young and subject to rapid development. The private blockchain platforms are even newer. Hyperledger Fabric, for example, released their first production-ready code, version 1.0, just this past week. Developers are picking up the new skills needed to work with this technology. Many projects are just getting started.
Given the complexity of banking applications, the rapid development of the platforms and the conservative nature of financial institutions, we would only expect to see experimental proofs of concept at this stage.”
Hitchens cites these examples of banking use cases: 

- Axoni’s test of OTC smart contracts for equity swaps involving Barclays, Citi, Credit Suisse, JP Morgan, HIS Market, Thomson Reuters and Capco. 

- This letter of Credit demonstration by Bank of America Merrill Lynch, HSBC and the Infocomm Development Authority of Singapore (IDA), IBM Research and IBM Global Services. 

- Blockchain used for the energy industry. 

Blockchain Will Change the Structure of Financial Institutions 

CoinIdol raised the possibility that since banks are adopting more digital options, will banking jobs be obsolete if Ethereum use cases are proved to be so efficient? For instance, the question is posed of whether blockchain technology will definitely change the structure of banks and if new service applications would emerge. 

“Blockchain absolutely could change the face and structure of many organizations inside and outside of finance. Blockchain replaces “official” records and the departments entrusted with maintaining them. Smart contracts replace the processes that keep the official records current. We are finding that quite a lot of records and processes are candidates for restructuring.
Blockchain has already birthed new applications that were unimaginable only a few years ago. These are mostly in the proof of concept stage. The point is they are proving these concepts are viable." 

"In my opinion, this disruption is at least as significant as the Internet. It will take some time, but the implications are enormous and the principle discovery will not be forgotten. This is quite independent from the success of failure of any implementation. Much like the discovery of electricity or the internal combustion engine, ventures may succeed or fail but the principle is here to stay. 

We can’t be precise about the future with so many teams working on so many initiatives. We can probably say that blockchains of one type or another will almost certainly be in widespread use. There is a view that AI and machines may outnumber humans actually interacting with the blockchain.” 

How Smart Contracts Will Save Banks and Customers Money 

With customer focus considerations, CoinIdol inquired if the banks and customers would save money with the implementation of smart contracts. His answer is affirmative but includes other industries that would benefit as well. 

“Settlement, reconciliation processes, fraud prevention, KYC/AML are largely about being watchful for and resolving things aren’t supposed to happen. 

Smart contracts can eliminate many of these risks at the source. The idea that most kinds of material breach can be eliminated from the realm of possibilities – not because those things probably won’t happen, rather, because they *can’t* happen – greatly simplifies the complexity of agreements, the burden of administering those agreements, and the kinds of disputes that might require resolution. 

Estimates vary. For example, Accenture: the largest investment banks could save $8-12 billion dollars per year. 

This is, of course, just a portion of the financial industry. Use-cases also exist in insurance, international trade, and settlement and more; everywhere institutions deal with risk and uncertainty. 

Finance is only the tip of an even larger iceberg. It is a short cognitive step from Bitcoin to banking, but blockchain has applications in the supply chain, transportation, health care, real estate, energy, entertainment, everything related to the sharing economy and much more. 

Consider all the databases in the world and all the economic activity that uses computers in one way or another. In many cases, the potential benefits of shared truth and unstoppable logic are astounding. That’s how big blockchain’s potential is,” explains Hitchens. 

Disclaimer: The views, thoughts, and opinions expressed in this article belong solely to the authors and do not necessarily reflect the views or opinions of their employers, organizations, committees or other group or individual.