Blockchain, Smart Contracts and the Changing Landscape of Transactions

Posted 14 November 2016

In order to prevent fraudulent behaviour with respect to the execution of contracts, middlemen have fulfilled an important role in ensuring that transactions are carried out according to their specified terms. Banks, governments and other financial institutions have played an essential role in creating a climate of trust. Many mechanisms exist that promote authentication and identification; additionally entire bodies of law are dedicated to incentivising honest business practice.

The increasing reliance on centralised processes for completing transactions has significantly increased the risk of hacking and has subsequently increased the probability of widespread disruption in the financial industry. The SWIFT organisation, which is responsible for handling approximately 26 million transactions per day including major foreign currency payments between banks, is an example of a major centralised agency. If an organisation such as this could be compromised, the world financial system would be significantly disturbed. One striking example of such a breach was the widely reported 2014 JPMorgan Chase Data breach, where the data associated with 86 million accounts was compromised.

In addition to increased security threats, centralised systems are often laborious and expensive with firms taking significant cuts for facilitating transactions. This reliance on the middlemen has led to a significant appropriation of the transaction process by intermediaries. The emergence of Blockchain technologies seeks to significantly alter this landscape by providing a shared distributed ledger that can foster trust without excessive reliance on third-parties. Trust is established peer-to-peer through collaboration and advanced coding.

The logic behind the mechanism is relatively simple: assets such as currency are not stored centrally; rather, they are held across a sparse network of collected servers. Every ten minutes, a virtual block is produced that acts as a time register for all transactional activities that have occurred since the last block was created. If a party wishes to falsify a transaction they must not only hack the block that precedes the transaction, but the entire chain itself, which is immersed in a global chain of shared computing. This is exceptionally more secure than centralised systems. 

Of particular interest to the legal community is the emergence of smart contracts pioneered by Swiss non-profit, Ethereum. After crowdfunding $21 million in 2014, developers set about developing a simplistic system that executes on the basis of if ‘A and B, then C’ or an alternative set of conditions that can be encoded onto the platform. Smart contracts allow users to define the rules surrounding the transaction on the Blockchain. For example, users could specify particular timeframes and the requirement of multiple signatures in order for execution. The agreement is subsequently implemented by a computer in correspondence with defined inputs and will be enforced on its specific terms.

Outside of the finance industry, the legal sphere is likely to be affected by the emergence of smart contracts. It is important to note that the use of the term ‘contract’ is specific to an agreement that creates a mutual obligation. Smart contracts, may also serve this traditional purpose, in addition to acting as a peer-to-peer agent. Some examples of smart contracts encroaching on conventional contract law would be mortgages, rental agreements or even insurance contracts. These are relatively simple arrangements that rely on the principle of quid pro quo for their execution. By simplifying the system of contract formation, smart contracts are likely to shortcut the lengthy and complex processes that presently exist.  This is where smart contracts will play a ground-breaking role by automating and monitoring the satisfaction of this condition. In simple cases, the functionality of smart contracts will ensure that the exchange of consideration will occur as outlined in the terms of the programmed contract. A recent joint venture between Wells Fargo, Commonwealth Bank and Brighann Cotton has demonstrated the efficacy of such a system. It marked the first international trade transaction between independent banks relying solely on Blockchain technology for execution.

The transaction was facilitated with an open account transaction, similar to a letter of credit, that was implemented on a private distributed ledger as described above. This ledger was between the seller (Brighann Cotton US) and the buyer (Brighann Cotton Marketing Australia) and their banks Wells Fargo and Commonwealth Bank respectively. The transaction relied on a supply train trigger linked to the geographic location of the good in transit, which triggered at a certain time, the release of payment. The extra dimension provided by such a feature distinguishes the system from the traditional letter of credit system. By relying on a process that reflects the real-time progress of a transaction, transactions on the distributed ledger can clearly reduce errors and mitigate non-payment from occurring. The efficiency benefits of replacing the letter of credit in this scenario are quite clear. Given the use of such technology, it should be assumed that its commercial use will continue to rise and naturally the question turns to how such developments will redefine legal practice.

Although the technology appears to conflict with the role of lawyers as intermediaries, it is clear that the technology is in its infancy and is unable to deal with modifications, recissions and reformations. While firms must anticipate that programmers will work around these shortcomings, there is a clear role for lawyers in developing and supplementing these emerging technologies. The likely outcome will be an increasing crossover between law and engineering to ensure that a mutual language can be developed to navigate the emergence of smart contracts. In a recent interview with The Australian Financial Review, Herbert Smith Freehills partner Damien Bailey suggested that significant regulatory complexities would emerge in relation to smart contracts. Mr Bailey suggested that complex arrangements would have to be resolved before any such work, ‘could be done by LPOs [legal process outsourcing providers].’

The regulatory complexities indicate that law firms should not see smart contracts as a threat, rather a means of increasing efficiency where possible and incorporate technology into their legal practices. The emergence of Blockchain technologies will change the landscape of contract execution and in anticipation of this, law firms would be well advised to consider how they can incorporate such technology into their practices. Increasing collaboration between lawyers and engineers is one trend that is likely to increase throughout this period as smart contracts are refined and used more commonly in the marketplace. Ultimately, Blockchain technologies ought to be seen as an opportunity to add value and diversify current practice techniques; it should not be viewed as a short circuit for the entire legal industry.