© Philipp Paech 2017

In this post, I explore the third fundamental characteristic of blockchain financial (and other) networks, in addition to the basis of a distributed database and the replacement of trust by maths and cryptography: unstoppable execution.

Unstoppable execution is at the same time the idea at the basis of smart contracts. It means that computer code is designed automatically to execute contractual duties upon the occurrence of a trigger event.[1]

Traditionally, the simple example of a vending machine has been cited to explain the concept: upon insertion of a specific type of coin, the computer programme instructs the mechanism of the machine to release the good.[2] – However, I don’t think the example is very good, for reasons I will set out below. Smart contracts work on the basis of unstoppable execution – however, the feature of unstoppable execution does not make a smart contract. The latter is per se not a necessary part of the original blockchain idea. It might be described as an add-on extending the capabilities of the blockchain network beyond its function as a keeper of records.

Excision of human discretion in execution

A smart contract ‘excises human discretion from contract execution’.[3] Unlike the performance of contracts generally, performance on a smart contract cannot be stopped, neither voluntarily by the parties (ie it can neither be breached nor amended), nor by a central entity, nor by a court or supervisor.[4] Accordingly, the idea of smart contracts is different from that of the automated or high-speed execution of contracts, as the certainty of performance is the core issue here but not its speed or reduced cost of labour.

The absolute certainty of performance makes contracting much more efficient as the counterparty risk and settlement risk typically inherent in contracts are considerably reduced, if not eliminated. A simple example is the securities collateral kept in a blockchain network: if the debtor has not paid by a certain date, the smart contract autonomously transfers the securities to the creditor. Furthermore, the precision of the programming language is much greater than that of written human language; in particular, warranties and conditions can be formulated with much greater accuracy,[5] and contracts can be treated and processed in data formats.[6] Hence, it is argued, smart contracts make transacting considerably less expensive owing to the certainty of execution and the near-zero risk of litigation in court.[7]

Execution beyond automation

In the financial markets, smart contracts could be used for a variety of functions. For instance, a bond held in a blockchain network might have a smart contract attached to it that automatically executes interest payments on the payment date, and the amount to be paid is determined on the basis of data retrieved from a predefined, reliable Internet source. A second example relates to the derivatives market.[8] Parties might enter derivative contracts electronically; the relevant building blocks of that short programme would automatically be taken and assembled from an electronic contract library set up to this effect. The smart contract could be so designed as to automatically cater for due payments to be executed and to adjust collateral levels between the parties. Also, upon termination of the contract, the programme could autonomously calculate the due termination amount to be paid. Again, amounts would depend on reference data sourced from a predefined, reliable data provider.

The blockchain biosphere is made for smart contracts

Interestingly, the (older) concept of smart contracts will achieve its full potential only if combined with the (newer) invention of blockchain networks.[9] This is because the certainty of execution is not absolute as long as human discretion can interfere with the process: the vending machine is technically still under the control of its owner (this is why the classical example is actually unsuitable). In the context of financial markets, the issue is that IT systems, for example those running cash and securities accounts, are still controlled by a financial intermediary who can alter the process, either voluntarily or in compliance with a court or supervisory order. By contrast, the record of a blockchain network on which a smart contract is stored is supposed to be absolutely immutable and its execution automatic. As set out in the previous section, autonomy of execution is a direct consequence of the fact that blockchain networks operate without any central or trusted entity to balance the parties’ interests.[10] In other words, it is only in blockchain networks that there is truly no ex post review of contractual duties after contract formation.[11] The only way to influence the execution of smart contracts is by programming them in such a way that they seek external input on the further execution (from a non-smart, human-controlled IT process into which they are embedded, or from an authority or court) at the occurrence of certain, predefined events.[12] This is the point in time at which further execution can be aborted or otherwise influenced, yet exclusively on the basis of pre-programmed options.

DAOs

Smart contracts can theoretically be combined and thus interact with one another in a decentralised and distributed structure, operating autonomously, ie without human intervention, once deployed by their programmers on the basis of the rules and mechanisms programmed into them.[13] Such ‘decentralised autonomous organisations’ (DAOs) could even enter into new smart contracts with other market actors, creating a complex, evolving ecosystem of interacting agents linked by pre-determined, hard-wired and self-enforcing rules.[14] They are not owned or controlled by any single person or corporation; yet they can interact with the market.[15]

The most important DAO so far was created on the basis of smart contracts recorded and processed on the Ethereum network: ‘A humanless venture capital firm that would allow the investors to make all the decisions through smart contracts. There would be no leaders, no authorities. Only rules coded by humans, and executed by computer protocols.’[16] It raised a spectacular 150m USD of which 50m were subsequently diverted by a malicious node to a private Internet address, leading to the project being abandoned.[17] Still, similar projects may emerge in the future despite this failure. By contrast, it is not yet clear whether and to what extent the financial industry will develop an interest in such entirely autonomous, self-referential actors since, as for-profit organisations, they ultimately need to keep legal and economic ties with the device and exercise some control over it. In any case, the somewhat extreme concept of totally autonomous self-executing software shows that smart contracts stored on a blockchain network can operate in varying degrees of autonomy from humans and on a smaller or larger scale, providing input to one another in the form of reference data and triggering events, potentially across different blockchain networks. Obviously, the more intertwined smart contracts become and the lower the degree of control by humans, the more difficult it will be to govern this phenomenon.

Notes:

[1] H. Surden, ‘Computable Contracts’ (2012) U. C. Davis L. Rev. 46, 629, 656-657; Ortolani, n 36, 608; Raskin, n 44, 2; J. Stark, ‘Making Sense of Blockchain Smart Contracts’ (Coindesk 4 June 2016), at http://www.coindesk.com/making-sense-smart-contracts/, visited 30 Nov. 2016; Wright and De Filippi, n 23, 11.  N. Szabo, ‘Formalizing and Securing Relationships on Public Networks’ (1997) First Monday 2(9), http://firstmonday.org/ojs/index.php/fm/article/view/548/469-publisher=First, visited 15 Nov. 1997.

[2] Szabo, ibid.

[3] Raskin, n 44, 2.

[4] Wright and De Filippi, n 23, 25-26.

[5] Raskin, n 44, 21-22.

[6] Surden, n 52, 690-694.

[7] See Raskin, n 44, 33; Surden, ibid, 689.

[8] See Braine, n 17.

[9] Werbach, n 11, 30.

[10] Ortolani, n 36, 607.

[11] See Raskin, n 44, 7, 14.

[12] ibid, 24; see also text at n145-147.

[13] Wright and De Filippi, n 23, 15; Surden, n 52, 694-695.

[14] Stark, n 52; Wright and De Filippi, n 23, 17.

[15] Wright and De Filippi, n 23, 54.

[16] J.I. Wong and I. Karr, ‘Everything you need to know about the Ethereum “Hard Fork”’, Quartz (18 July 2016), http://qz.com/730004/everything-you-need-to-know-about-the-ethereum-hard-fork/, visited 30 Nov. 2016.

[17] See Wong and Karr, ibid.

Posted by Philipp Paech

Dr Philipp Paech joined the LSE in 2010 as an Assistant Professor of Financial Law and Financial Regulation. He is the Director of the LSE’s Law and Financial Markets Project and a research fellow at the Institute for Law and Finance in Frankfurt. Before joining the LSE, Philipp spent many years at the heart of international legal and regulatory reform of the financial sector, working from 2007-2010 for the European Commission’s Directorate for financial services in Brussels and from 2002-2006 for UNIDROIT in Rome. Philipp holds a doctorate from the University of Bonn and obtained the Diploma of EU Studies from the University of Toulouse. He is a qualified lawyer admitted to the Bar of Frankfurt.