Mon. Dec 9th, 2019

Planet Compliance

Innovation & Regulation in Finance

FinTech, Blockchain, Smart Contracts and Regulation – An interview with Sean Murphy and Imogen Garner (Part 2)

6 min read

In the first part of our interview with Sean Murphy and Imogen Garner of Norton Rose Fulbright we talked about what Brexit means for the future of FinTech in London, legal essentials for start-ups and financial regulation. Find out in the second part about the consequences of RegTech and LegalTech for the legal profession and questions that surround Smart Contracts!

SeanMurphyImogenGarner PlanetCompliance interview

PlanetCompliance: What are the implications of RegTech or LegalTech for the legal profession? Are you as lawyers afraid that machines will soon replace you?

Sean Murphy: If you look at smart contracts and think about what effect they might have on the legal profession, the first point to make is that there is a spectrum of possibilities in terms of what people think smart contracts are. On one end of the spectrum, there is the “code-is-contract” model. According to this model, even complex commercial agreements could be entirely codified and there would be no need for natural language contracts. On the other end of the spectrum, you’ve got models that are simpler, but still very powerful. For example, smart contracts that automate the performance of certain aspects of contracts. At this end of the spectrum, a natural language contract might set out the relationship between the parties and the smart contract might automate aspects of that natural language contract.

I think that the “automation of performance” approach is more viable than the “code-is-contract” model, at least in the short to medium term. There are a number of reasons why I say that.

First, contracts, as lawyers understand them, have many terms and clauses in them that simply cannot be expressed in code, at least with current technology. For example, what do “best efforts” or “reasonable endeavours” mean? Human intervention will be required in order to understand what these terms mean.

Secondly, there is a completeness of terms issue. As a matter of law it may not be possible to entirely codify all of the terms of a contract. For example, terms might be implied into a contract by law or by judgment of a court, so that even though those terms are not written down, they form part of that contract. This would apply to entirely codified contracts as well. Therefore, it may not be possible to have 100% of a contract expressed in code because the law or courts imply terms into it.

The template for a smart contracts developed by Dr. Lee Braine of Barclays in conjunction with R3 is an example of the “automation of performance” approach. It focuses on derivatives contracts, which is a brilliant case study to use, because ISDA, which is a trade organisation of participants in the market for over-the-counter derivatives, has produced standardised contracts that are recognised and accepted by the industry. Transactions for which there are already standardised contracts will be the first use cases for smart contracts. More complex contracts will still require bespoke negotiation by lawyers. Even with the derivatives example, the smart contract template works very well with vanilla derivatives. The template might not work so well so well for complex derivatives transactions.

PlanetCompliance: How soon do you expect smart contracts to be used for the more simple solutions described then?

Sean Murphy: Dr. Lee Braine talks about an 18 months to 3 year time period for the first “live” deployments of smart contracts. The adoption of smart contracts will then increase over the next 5 to 10 years, so this is more of a medium to long-term adoption curve.

PlanetCompliance: Do you envisage that smart contracts could be used for regulatory compliance as well?

Imogen Garner: I’ve certainly been hearing that they could be, as many out there see the possibilities to use smart contracts as almost unlimited. So, yes, I can imagine we might see smart contracts being developed potentially for purposes of firms’ own compliance either with regulatory obligations or their own policies and procedures.

Sean Murphy: Going back to the example of the smart contracts template for derivatives transactions, it would be quite conceivable that the smart contract could include limits on what traders are allowed to enter into, for example, in terms of the size of exposure.

PlanetCompliance: Going back to your comments on the complex nature of most contracts: Is it right to assume though that one of the biggest hurdles to overcome then to determine what a smart contract is supposed to do when it encounters, for instance, circumstances that weren’t envisaged at the time of the coding? Especially given that a smart contract should be able to execute itself without external interference?

Sean Murphy: That is a great point. A lot of people in the industry believe that immutability is an important feature of smart contracts. Once the smart contract goes live, it can never change. But you’re quite right: What happens if there is an error in the code? What happens if the smart contract doesn’t anticipate a particular scenario? What happens if there is a change in law that means that that contract becomes unlawful in some respect? Lawyers recognise that we don’t have crystal balls and we can’t anticipate everything. And we recognise that it may be necessary to amend contracts in the future. It may be, therefore, that many parties will want to have the ability to amend smart contracts..

PlanetCompliance: Is the recent incident at the DAO (a case where $60 million worth of cryptocurrency where stolen – for more information, read our post here) such an example?

Sean Murphy: To some extent. However, the DAO attack raises a much wider set of issues.

PlanetCompliance: Do you think that the DAO attack will have consequences for Blockchain and smart contracts in general similar as scandals like Mt. Gox had on Bitcoin’s credibility and public perception?

Sean Murphy: I don’t think it’s completely comparable, but I assume the DAO attack will encourage people to think more carefully about how smart contracts operate. In the short to medium term, it may also encourage financial institutions and other large enterprises to focus their attention on private Blockchains rather than public Blockchains, a trend that existed before the attack. Financial institutions and large enterprises will naturally feel more comfortable operating within environments that are closed, walled off and more controllable.

PlanetCompliance: With regard to the development of solutions based on Blockchain technology, what are the key regulatory issues?

Imogen Garner: I suppose there are two ways of looking at it: One is to say, what is it that firms are using the Blockchain technology to do? If you are using it to perform some form of financial service or develop a financial product like a smart security, for instance, then the question is whether what you’re doing is regulated or not, i.e. are there already regulations that cover this activity. There is another angle though for institutions that are already regulated, which might be using the technology not to do financial services per se but just in the course of their business. A really key question that the regulators then will be interested in is, does it work, is it a robust solution, does it create risks, and, if so, how are you managing, identifying, mitigating these risks within your institution. There are different angles to look at this.

PlanetCompliance: Since one of the key factors of distributed ledger technology is decentralisation though, one of the resulting issues could d differences in legal and regulatory frameworks across jurisdictions. What are your thoughts on that?

Imogen Garner:

It’s a really key question, and a very difficult one – I think many out there are grappling with it and we don’t yet have all the answers.

 

 

If you missed the first part of our interview with Imogen and Sean, have a look here!

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