Is the UK Financial Services Sector Ready for Smart Contracts?

The UK financial services sector is on the cusp of a technological change due to Blockchain and smart contracts, but is it ready? 

The future of the financial services sector is, whether it realises it or not, on the cusp of great change thanks in large part to strides in financial technology.  It is widely believed this revolution, in turn, will alter the nature and type of financial disputes – both introducing new solutions, and new problems.  In this article, we will delve into regulation and dispute resolution in the area of financial services technology, and how these will need to keep pace with the upcoming developments in the sector.

Smart contracts and Blockchain technology

In our recent blog , we briefly touched on the emergence of Smart contracts and Blockchain technology, and how this is impacting the area of eDiscovery.  We also discussed how ‘distributed ledger technology’ (DLT) is becoming widely recognised, and its use is predicted to grow significantly in the fields of insurance and fintech; indeed, it is seen as a ‘disruptor’ technology in this space.  While the underpinnings of Blockchain are complex, its benefits are more straightforward to understand.  Essentially Blockchain works by encrypting, recording, and validating electronic transactions which are recorded on multiple ‘nodes’ throughout the public blockchain network, and hence cannot be erased or modified.  This lends itself to the creation, and robust control of legal contracts as the historical integrity of the agreement cannot be compromised, as it, and all of its subsequent versions, are stored across a global network of Blockchain nodes.  However, there are limitations within smart contracts which must be recognised and understood.

Researchers in Austria and Iran have identified  that “today’s programmable blockchains, smart contracts are limited to being deterministic and non-probabilistic”.   In other words, they believe that to be truly secure, smart contracts should use purely random numbers, but the current system is vulnerable to manipulation by non-neutral parties.  They propose a new model for generating “provably unmanipulable pseudorandom numbers on the blockchain”, thus ensuring smart contracts cannot be compromised miners or ‘oracles’.

Such vulnerabilities show why Blockchain is not invulnerable.  In 2016, DAO , a decentralized autonomous organisation, was hit by a hacker who, using a programmatic loophole, stole 3.6 million ETH (Ethereum), the equivalent of $70 million at the time.  Such hacks showed how existing regulation was not keeping track with technology, allowing human error to render the system vulnerable to attack.

For Solicitors, this begs many questions; until DLT smart contracts are considered beyond technical and legal reproach, what does this mean for financial disputes, investigations, and disclosure?  How will investigators and Solicitors secure electronic information needed for a case where data is distributed and encrypted within a Blockchain network?  And can the information stored be treated as legally defensible?

The importance of regulation for DLT and smart contracts

While DLT has massive potential, there are (as shown above) challenges which pose a risk to its use, hence regulation and governance is much needed.  When considering the emergence of DLT and the need for regulation back in 2015, a report entitled, ‘Distributed Ledger Technology: beyond blockchain’ by the UK Government Chief Scientific Advisor, Mark Walport, identified the need for a legal code, as distinct from a technical code.  He stated the major challenge is that in contrast to private financial networks, such as Visa, ‘unpermissioned’ DLT’s such as Bitcoin are not regulated by a single central legal entity, but rather are developed in an ad-hoc manner by a core of programmers.  He nevertheless extolled the potential of DLT.  This early report led to the creation of a series of possible use cases for DLT  by Lord Holmes in 2017, especially in the sphere of public policy, including border control, national security, taxation, food standards, privacy, and cyber security.

In a recent publication  by the Houses of Parliament Office of Science and Technology, the Government have made it clear that progress is well underway with the development of systems and processes to make DLT fit for purpose for the fintech sector.  For example, the Financial Conduct Authority’s (FCA) regulatory ‘sandbox’ is allowing businesses to test new DLT solutions (amongst others) and services on a limited basis with live clients.

Despite all of this progress, as yet, there is no UK specific regulation on the use of DLT, and surprisingly, none are planned.  The FCA have stated , “we believe that our current regulatory requirements appropriately reflect our strategic objectives of consumer protection, competition and market integrity in the context of expected uses of DLT.

This does not mean regulation is not sorely needed; however, it is the global nature of this technology which poses challenges in doing so.

In conclusion

There has been and still remains a vacuum when it comes to the regulation of DLT based smart-contracts, and many countries are still grappling with the need to review the risks associated and deciding what to do next.  The Cambridge Centre for Alternative Finance ( part of the Judge Business School at Cambridge University) believe that the legal risks due to the lack of clear regulation surrounding DLT are precisely what is stopping companies and public institutions from adopting it.  Furthermore, regulation needs to find the answers to questions, which are often contradictory in nature; for example,  how can a system which is based on pseudonyms co-exist with anti-money laundering (AML) and ‘know your customer’ (KYC) regulatory requirements?

In 2018, the Law Commission initiated a project to review the current English legal framework as it applies to smart contracts.  The project is still in its infancy, but it is hoped it will answer many of the legal issues posed by DLT and smart contracts: many would say this cannot come soon enough.

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