Part one – Clever contracts, blockchain and distributed ledger technology: implications for business, Duncan Cotterill, Lawyers Fresh Zealand

Part one – Wise contracts, blockchain and distributed ledger technology: implications for business

The legal sector needs to be aware of clever contracts, blockchain, distributed ledger technology (DLT) and the underpinning technology. It is part of a meaty wave of transformational technology switch that is already affecting the banking, financial services and payments industries, and which will have a much broader application across business.

These technologies are revolutionising business and the way people work:

  1. The banking, financial services and payments industries are at the forefront of these switches. Fintech (freshly emerging digital technologies adopted in the finance industry) is about to disrupt traditional banking models, delivering enhanced convenience and efficiency for consumers of financial services, and the possibility of reducing risk and lowering the cost of operations for financial services providers.
  2. The legal sector is not immune. Futurists and technology vendors are already questioning how these technologies will switch the way lawyers operate.

To put this in context:

Janet Yellen, Chair of the US Federal Reserve recently said:

[blockchain] could have very significant implications for the payments system and the conduct of business […]. I think innovation using these technologies could be utterly helpful and bring benefits to society”. (Think Consortium Blockchain, two thousand seventeen Outlook: Blockchain Impacts on Enterprise and Government)

Harvard Business Review in January/February two thousand seventeen had some thought-provoking insights:

“Contracts, transactions and the records of them are among the defining structures in our economic, legal and political systems. They protect assets and set organisational boundaries. They establish and verify identities and chronological events. They govern interactions among nations, organisations, communities and individuals. They guide managerial and social act. And yet these critical implements and the bureaucracies formed to manage them have not kept up with the economy’s digital transformation. They’re like a rush-hour gridlock trapping a Formula one race car. In a digital world, the way we regulate and maintain administrative control has to switch.” (Professors Marco Iansiti/Karim Lakhani, Harvard Business Review January/February 2017)

In Part I of this article, we explain clever contracts, blockchain and DLT, and the potential benefits of each for business and lawyers. In Part II, we will outline some of the risks (technology, legal and regulatory) of wise contracts, blockchain and DLT, current examples in practice, and the implications for business (and lawyers).

Nick Szabo, computer scientist, legal scholar and cryptography accomplished, is widely credited for inventing the concept of a clever contract. He defined a clever contract as a:

“a set of promises, specified in digital form, including protocols within which the parties perform on these promises”. (Nick Szabo, Clever Contracts: Building Blocks for Digital Markets, 1996)

Essentially a brainy contract is "… a computer program code that is capable of facilitating, executing, and enforcing the negotiation/spectacle of an agreement (i.e. contract) using [distributed ledger] technology. The automated process can act as a complement, or substitute, for legal contracts, where the terms of the clever contract are recorded in a computer language as a set of instructions." Read more here.

For example, a contract that automatically calculates the payments that are due inbetween the parties, and then automatically arranges for those payments to be made, where the automation (or self-executing part) relies on software code. The contract terms are voiced in logic statements such as “if A occurs, then B happens” or “on a certain date, one party pays money to the other party’s bank account”.

A brainy contract can be violated down into two separate components:

  1. Wise contract code: Software code that is stored, verified and executed on a blockchain or other DLT (outlined below); and
  2. Brainy legal contracts: Using brainy contract code as a complement, or substitute, for legal contracts.

A contract does not need to be fully automated to be a wise contract – there is a continuum:

  1. A very ordinary contract can be fully automated (the contract is entirely in code).
  2. Other contracts may require both self-executing terms and terms that are outside the software code. This is because:
  • Not all decisions or steps in a contract can be diminished to logic statements, especially for elaborate contracts.
  • We live in an unpredictable and switching world. How we deal with that in a contract is not readily distilled into a logic statement.
  • Human judgment may still be needed to assess options and take into account factors that may not be quantifiable or within the scope of the contract.
  • The parties may want to retain discretion around some decisions or steps (whether to retain control and/or plasticity).

At this (relatively) early stage in its evolution, a wise contract seems to mean different things to different people:

  • To the technology industry (in fact to just about everyone, except lawyers), it means an automated (or self-executing) contract written in software code.
  • To a lawyer, however, contract has a precise meaning – it requires suggest and acceptance, consideration and certainty of terms. To lawyers, the technologist’s view of a brainy contract is alarming.

Before explaining the potential benefits (and risks) of wise contracts, we need to understand the underpinning blockchain and distributed ledger technologies.

What is blockchain or DLT?

DLT is a database spread across numerous sites, countries or institutions e.g. a ledger of digital records or transactions that are accessible to all computers (knots) running the same computer protocol. Blockchain refers to one type of distributed ledger.

Blockchain is the technology behind the decentralised digital currency Bitcoin. While very first developed as a core component of the Bitcoin, blockchain (and the broader concept of DLT) is now considered a transformational technology (rather than simply disruptive) and with much broader applications.

Put simply, a blockchain is a decentralised collaborative record of transactions (transaction records that are maintained on one digital ledger in numerous places):

  1. A series of individual “blocks” of information which are added to the “chain” every time a fresh lump of information is created and securely chained together. Any digital record of an asset (whether a copy of the title deeds for a property or a virtual commodity) can be stored in a block.
  2. Fresh blocks are formed whenever participants create a lump of fresh information or switch an existing chunk of information about an asset, for example by coming in transaction records, switches of status, fresh market prices, or fresh owners, and that information is verified by the participants.
  3. All blocks freshly formed after the very first block are securely chained to the previous one, thus ensuring their authenticity and creating a trustworthy audit trail. One of the earliest uses of DLT was in the area of virtual commodities (e.g. Bitcoin), where the switch in ownership of a commodity is recorded in the blockchain.
  4. Unauthorised switches to the information and its history are difficult (if not unlikely) to make. In other words, DLT systems are designed so that information stored and communicated through the networks has a high level of trustworthiness, and every participant can get simultaneous access to a common view of the information.

The World Economic Forum recently published an explanation of how blockchain (or DLT) works. Read more here.

Presently, there are two types of DLT platform – unpermissioned and permissioned:

  1. Unpermissioned (or open) systems: the ledger is maintained by collaborative act among knots (computers) in a public network, and is accessible to anyone. Bitcoin (which commenced in 2008) is a well-known example of an unpermissioned (or public) network;
  2. Permissioned (or private) systems: the ledger is maintained by authorised knots (computers) and accessible to registered members only. Permissioned platforms enable swifter, more secure and more cost-effective transactions, suggest enhanced privacy, and also take less energy to operate.

A DLT can transfer value along the chain, like Bitcoin (which works on a token of value (the Bitcoin) that is transferred on the Bitcoin blockchain). However, the transfer of value is not needed for the DLT/blockchain technology to be useful.

The potential of blockchain or DLT for the banking, financial services and payments sectors (and more widely) has been recognised by central banks, regulators and governments globally.

Some of the leading DLT platforms presently in the market are Bitcoin, Ethereum, Ripple, Corda and Hyperledger. Further details will be provided in Part II of this article.

What are the potential benefits of brainy contracts, blockchain and DLT?

DLT (or blockchain) has the potential to supply many benefits, including:

  • A trusted distributed ledger (rather than relying on one trusted centralised ledger);
  • Enhanced efficiency (the capability to broadcast information quickly and securely);
  • Traceability and transparency of records and transactions, for participants and regulators;
  • Lower operational costs; and
  • Enhanced efficiency and security. A decentralised collective record of transactions (effectively a collective infrastructure) facilitates joint outsourcing of back office functions, and enhanced compatibility inbetween participating institutions. Itshould enhance (cyber) security of those records, by having a single record in numerous locations.

Technologists and others suggest it is the combination of brainy contracts with blockchain (or other DLT) that will bring the greatest benefits:

  • The blockchain adds certainty, security and resilience – terms are verified by independent parties (computers); and the information stored on the blockchain is protected from security threats by being held on numerous systems;
  • A brainy contract can be executed outside (or above) the blockchain (the software programme runs outside the blockchain and feeds information to the blockchain) or in (or on) the blockchain (where the software program is coded into blocks).
  • Brainy contracts execute when specified events occur, for example, in a financial markets context, a wise contract could activate payments or deliveries or credit events. This already occurs on centralised financial market infrastructure, like clearing houses and trade warehouses. It could also work on a de-centralised financial market infrastructure using blockchain.

What are the potential risks of wise contracts, blockchain and DLT?

Alongside the benefits, the evolving wise contracts, blockchain and distributed ledger technologies does bring a number of potential risks, including governance, deployment, risk management, regulatory and legal. These risks, and how they are managed, fundamentally underpin market confidence in the technology.

We discuss these, together with current examples of clever contracts, blockchain and DLT in business, and the implications for lawyers, in Part II of this article.

For further information please contact Chris Linton or Helen Scott.

Disclaimer: the content of this update is not intended as a substitute for specific professional advice on any matter and should not be relied upon for that purpose.

Part one – Wise contracts, blockchain and distributed ledger technology: implications for business, Duncan Cotterill, Lawyers Fresh Zealand

Part one – Clever contracts, blockchain and distributed ledger technology: implications for business

The legal sector needs to be aware of brainy contracts, blockchain, distributed ledger technology (DLT) and the underpinning technology. It is part of a phat wave of transformational technology switch that is already affecting the banking, financial services and payments industries, and which will have a much broader application across business.

These technologies are revolutionising business and the way people work:

  1. The banking, financial services and payments industries are at the forefront of these switches. Fintech (freshly emerging digital technologies adopted in the finance industry) is about to disrupt traditional banking models, delivering enlargened convenience and efficiency for consumers of financial services, and the possibility of reducing risk and lowering the cost of operations for financial services providers.
  2. The legal sector is not immune. Futurists and technology vendors are already questioning how these technologies will switch the way lawyers operate.

To put this in context:

Janet Yellen, Chair of the US Federal Reserve recently said:

[blockchain] could have very significant implications for the payments system and the conduct of business […]. I think innovation using these technologies could be enormously helpful and bring benefits to society”. (Think Consortium Blockchain, two thousand seventeen Outlook: Blockchain Impacts on Enterprise and Government)

Harvard Business Review in January/February two thousand seventeen had some thought-provoking insights:

“Contracts, transactions and the records of them are among the defining structures in our economic, legal and political systems. They protect assets and set organisational boundaries. They establish and verify identities and chronological events. They govern interactions among nations, organisations, communities and individuals. They guide managerial and social activity. And yet these critical instruments and the bureaucracies formed to manage them have not kept up with the economy’s digital transformation. They’re like a rush-hour gridlock trapping a Formula one race car. In a digital world, the way we regulate and maintain administrative control has to switch.” (Professors Marco Iansiti/Karim Lakhani, Harvard Business Review January/February 2017)

In Part I of this article, we explain wise contracts, blockchain and DLT, and the potential benefits of each for business and lawyers. In Part II, we will outline some of the risks (technology, legal and regulatory) of brainy contracts, blockchain and DLT, current examples in practice, and the implications for business (and lawyers).

Nick Szabo, computer scientist, legal scholar and cryptography pro, is widely credited for inventing the concept of a wise contract. He defined a brainy contract as a:

“a set of promises, specified in digital form, including protocols within which the parties perform on these promises”. (Nick Szabo, Clever Contracts: Building Blocks for Digital Markets, 1996)

Essentially a brainy contract is "… a computer program code that is capable of facilitating, executing, and enforcing the negotiation/spectacle of an agreement (i.e. contract) using [distributed ledger] technology. The automated process can act as a complement, or substitute, for legal contracts, where the terms of the brainy contract are recorded in a computer language as a set of instructions." Read more here.

For example, a contract that automatically calculates the payments that are due inbetween the parties, and then automatically arranges for those payments to be made, where the automation (or self-executing part) relies on software code. The contract terms are voiced in logic statements such as “if A occurs, then B happens” or “on a certain date, one party pays money to the other party’s bank account”.

A brainy contract can be cracked down into two separate components:

  1. Brainy contract code: Software code that is stored, verified and executed on a blockchain or other DLT (outlined below); and
  2. Brainy legal contracts: Using brainy contract code as a complement, or substitute, for legal contracts.

A contract does not need to be fully automated to be a brainy contract – there is a continuum:

  1. A very elementary contract can be fully automated (the contract is entirely in code).
  2. Other contracts may require both self-executing terms and terms that are outside the software code. This is because:
  • Not all decisions or steps in a contract can be diminished to logic statements, especially for elaborate contracts.
  • We live in an unpredictable and switching world. How we deal with that in a contract is not readily distilled into a logic statement.
  • Human judgment may still be needed to assess options and take into account factors that may not be quantifiable or within the scope of the contract.
  • The parties may want to retain discretion around some decisions or steps (whether to retain control and/or plasticity).

At this (relatively) early stage in its evolution, a brainy contract seems to mean different things to different people:

  • To the technology industry (in fact to just about everyone, except lawyers), it means an automated (or self-executing) contract written in software code.
  • To a lawyer, however, contract has a precise meaning – it requires suggest and acceptance, consideration and certainty of terms. To lawyers, the technologist’s view of a wise contract is alarming.

Before explaining the potential benefits (and risks) of wise contracts, we need to understand the underpinning blockchain and distributed ledger technologies.

What is blockchain or DLT?

DLT is a database spread across numerous sites, countries or institutions e.g. a ledger of digital records or transactions that are accessible to all computers (knots) running the same computer protocol. Blockchain refers to one type of distributed ledger.

Blockchain is the technology behind the decentralised digital currency Bitcoin. While very first developed as a core component of the Bitcoin, blockchain (and the broader concept of DLT) is now considered a transformational technology (rather than simply disruptive) and with much broader applications.

Put simply, a blockchain is a decentralised collaborative record of transactions (transaction records that are maintained on one digital ledger in numerous places):

  1. A series of individual “blocks” of information which are added to the “chain” every time a fresh lump of information is created and securely chained together. Any digital record of an asset (whether a copy of the title deeds for a property or a virtual commodity) can be stored in a block.
  2. Fresh blocks are formed whenever participants create a lump of fresh information or switch an existing chunk of information about an asset, for example by injecting transaction records, switches of status, fresh market prices, or fresh owners, and that information is verified by the participants.
  3. All blocks freshly formed after the very first block are securely chained to the previous one, thus ensuring their authenticity and creating a trustworthy audit trail. One of the earliest uses of DLT was in the area of virtual commodities (e.g. Bitcoin), where the switch in ownership of a commodity is recorded in the blockchain.
  4. Unauthorised switches to the information and its history are difficult (if not unlikely) to make. In other words, DLT systems are designed so that information stored and communicated through the networks has a high level of trustworthiness, and every participant can get simultaneous access to a common view of the information.

The World Economic Forum recently published an explanation of how blockchain (or DLT) works. Read more here.

Presently, there are two types of DLT platform – unpermissioned and permissioned:

  1. Unpermissioned (or open) systems: the ledger is maintained by collaborative act among knots (computers) in a public network, and is accessible to anyone. Bitcoin (which commenced in 2008) is a well-known example of an unpermissioned (or public) network;
  2. Permissioned (or private) systems: the ledger is maintained by authorised knots (computers) and accessible to registered members only. Permissioned platforms enable quicker, more secure and more cost-effective transactions, suggest enhanced privacy, and also take less energy to operate.

A DLT can transfer value along the chain, like Bitcoin (which works on a token of value (the Bitcoin) that is transferred on the Bitcoin blockchain). However, the transfer of value is not needed for the DLT/blockchain technology to be useful.

The potential of blockchain or DLT for the banking, financial services and payments sectors (and more widely) has been recognised by central banks, regulators and governments globally.

Some of the leading DLT platforms presently in the market are Bitcoin, Ethereum, Ripple, Corda and Hyperledger. Further details will be provided in Part II of this article.

What are the potential benefits of brainy contracts, blockchain and DLT?

DLT (or blockchain) has the potential to produce many benefits, including:

  • A trusted distributed ledger (rather than relying on one trusted centralised ledger);
  • Enlargened efficiency (the capability to broadcast information quickly and securely);
  • Traceability and transparency of records and transactions, for participants and regulators;
  • Lower operational costs; and
  • Enlargened efficiency and security. A decentralised collective record of transactions (effectively a collective infrastructure) facilitates joint outsourcing of back office functions, and enhanced compatibility inbetween participating institutions. Itshould enhance (cyber) security of those records, by having a single record in numerous locations.

Technologists and others suggest it is the combination of brainy contracts with blockchain (or other DLT) that will bring the greatest benefits:

  • The blockchain adds certainty, security and resilience – terms are verified by independent parties (computers); and the information stored on the blockchain is protected from security threats by being held on numerous systems;
  • A clever contract can be executed outside (or above) the blockchain (the software programme runs outside the blockchain and feeds information to the blockchain) or in (or on) the blockchain (where the software program is coded into blocks).
  • Clever contracts execute when specified events occur, for example, in a financial markets context, a wise contract could activate payments or deliveries or credit events. This already occurs on centralised financial market infrastructure, like clearing houses and trade warehouses. It could also work on a de-centralised financial market infrastructure using blockchain.

What are the potential risks of wise contracts, blockchain and DLT?

Alongside the benefits, the evolving brainy contracts, blockchain and distributed ledger technologies does bring a number of potential risks, including governance, deployment, risk management, regulatory and legal. These risks, and how they are managed, fundamentally underpin market confidence in the technology.

We discuss these, together with current examples of clever contracts, blockchain and DLT in business, and the implications for lawyers, in Part II of this article.

For further information please contact Chris Linton or Helen Scott.

Disclaimer: the content of this update is not intended as a substitute for specific professional advice on any matter and should not be relied upon for that purpose.

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