Meet the next generation of contracts

The development in the last few years of distributed ledger technology (“DLT”), cryptoassets, smart contracts and associated technologies has far-reaching implications for financial and legal markets, both domestically and internationally.

Unsurprisingly perhaps,  there is a lack of certainty regarding the legal status of cryptoassets, DLT and smart contracts, and in many instances a lack of understanding of these concepts within the legal profession, and hence a reluctance to embrace them.  

The UK Jurisdiction Taskforce (the “UKJT”) of the LawTech Delivery Panel believes that perceived legal uncertainty is the reason for some lack of confidence, and has launched a consultation which ends on 21 June 2019.  This can be accessed at  https://www.lawsociety.org.uk/news/stories/cryptoassets-dlt-and-smart-contracts-ukjt-consultation.

The main reason for this is the necessity for the English Law to adapt to these novelties and to properly provide for them. The end goal will be to have a final decision on whether and under what circumstances cryptoassets are property under English Law, and following from that how can they be owned, where they are located, what happens if they are stolen, can they be charged and so on. Also, are they physical things, or are they rights of action? All good questions, to be answered in due course.

For now, the issue remains that these concepts need to be understood. As lawyers, our technical foundations are not necessarily strong, and quite clearly coding and computer science proficiency was not one of the requirements for qualification. We have IT teams, right? The legal status of cryptoassets however, is something that is down to us as lawyers to qualify, classify, understand and apply.

We all hear notions like Distributed Ledger Technology (“DLT”), Bitcoin, Cryptoassets, Smart Contracts, that are fairly new in the legal market. In fact, they are fairly new all over. I had no idea what they meant, and because I didn’t want to be left behind by the progress train, I set myself to learning them. When I say “learning”, I simply mean having a fairly good understand of what they are and what they do, and not the technical knitty gritty of the code that brings them into existence. Existence is a relative term here – they only exist in virtual terms, in a computer memory, and one can never ever hold them in one’s hand. There is a human difficulty here, as our senses are geared to help us accept and understand what we can experience directly.

There will be a transition period here for the lawyer mind, during which new patterns and pathways will be established. In a way, and this is a very basic example, it can be compared with the transition from a paper based Solicitor’s office to a paperless one. I have been through it twice. It takes time to educate your mind and to not rely on the papers and instead, to access files stored in the case management system. The papers haven’t just disappeared by shredding them – they transformed into computer files.

A parallel can thus be drawn with the smart contracts generally. They are not on paper. They are in code. They have no physical form. This however doesn’t negate the effects of the parties’ agreement, and logic dictates that they have to produce binding legal consequences. Laster in this article a brief explanation of the “smart legal contracts” is given.

So what is the meaning of all these terms?

Let’s start with Distributed Ledger Technology (“DLT”), also called a “shared ledger”, which is a consensus of replicated, shared, and synchronized digital data geographically spread across multiple sites, countries, or institutions. There is no central administrator or centralized data storage. The distributed ledger database is spread across several nodes (devices) on a peer-to-peer network, where each replicates and saves an identical copy of the ledger and updates itself independently.

There is no central authority. When a ledger update happens, each device constructs the new transaction, and then the nodes (devices) vote by consensus algorithm on which copy is correct. Once a consensus has been reached, all the other nodes update themselves with the new, correct copy of the ledger. Security is accomplished through cryptographic keys and signatures.

So basically it is a network of computers that talk to each other thanks to a certain software they all have installed, update simultaneously and undertake a vote on which the correct version is. Then they all just keep the correct version. It sounds simple enough. I don’t know what a consensus algorithm looks like, I don’t need to. I just need to know what it does – it achieves the unanimous agreement between the relevant computers that are in that particular DLT setting.

One form of distributed ledger design is the blockchain (the block is simply a packet of data) system, which can be either public or private, permissioned or permissionless. We will not go into more detail now.  So now we know what the DLT is.

What are the cryptoassets? There is no generally agreed definition.

The term “cryptoasset” is often used to describe something which is, or of which at least a component is, represented by certain data which, by virtue of the design of a broader system, can only be updated upon the satisfaction of specific conditions.

They are cryptographically secured digital representations of value or contractual rights that can be transferred, stored and traded electronically. The system keeps an overview of cryptocurrency units and their ownership.

The system defines whether new cryptocurrency units can be created. If new cryptocurrency units can be created, the system defines the circumstances of their origin and how to determine the ownership of these new units.

Ownership of cryptocurrency units can be proved exclusively cryptographically. They do not have any physical form and they only exist in a computer memory. What do they look like? They look like computer code.

The system allows transactions to be performed in which ownership of the cryptographic units is changed.

Usually, individuals hold cryptoassets as a personal investment.

Three types of cryptoassets have been identified: exchange tokens, utility tokens and security tokens

The most common type of cryptoasset is an exchange token, for example Bitcoin or Ether, which facilitate an electronic means of exchange between different participants on the same network and do not provide any rights to anything outside of the “network”. Virtual money. There are many different cryptocurrencies currently available on the market (some 1600 at the moment). Certainly, Bitcoin is the most popular amongst these currencies as it is the pioneer, the first ever cryptocurrency to be created, in 2009.

It is worth mentioning that currently the HMRC does not consider cryptoassets (or cryptocurrency) to be money. It will not be a surprise for anyone, however, that owning cryptoassets has tax implications, which do not form part of this article.

How does one get to own Crypto assets? The main ways are two : mining and airdrops. Without any intention of being too technical about it, the basic meaning of the two is as follows.

Mining is a validation of transactions or using computers to solve difficult maths problems. For this effort, successful miners obtain new cryptocurrency as a reward. To earn bitcoins one must obtain specially developed software that most miners use. Then, a certain mathematical problem will be assigned that needs a solution. Once a math question has been solved a fixed amount of Bitcoins are awarded to the user who has solved the question. It’s a slow, tedious process. There are even bitcoin mining farms. One such farm, in China, has 3000 purposely built computers and makes $2 million a month in bitcoin.

Airdrops are limited time events created by coin projects to promote their crypto-currencies. How? By distributing tokens or coins to early adopters, for free. It’s a form of marketing. Sometimes all you need to do is create a post or like a page, or share some personal information.

Moving on to the last notion I’m dealing with in this article – Smart Contracts.

If we are totally accurate, in reality a smart contract is not even a contract, it is a computer protocol intended to digitally facilitate, verify, or enforce the negotiation or performance of a classic contract.

Smart contracts permit trusted transactions and agreements to be carried out among disparate, anonymous parties without the need for a central authority, legal system, or external enforcement mechanism. They render transactions traceable, transparent, and irreversible. If the conditions are satisfied, they will complete, no matter what, and the process cannot be stopped. It is a basic “if-then” system. Ultimately, smart contracts are logical processes dependant on the blockchain with which they interact. Currently the only blockchain that supports various smart contract is Ethereum, because, as opposed to the other platforms, it allows developers to program their own smart contracts. The others have templates that cannot be changed. Bitcoin, for instance, is limited to cryptocurrency transactions.

A smart contract may or may not have legal ramifications as it is merely computer code, whereas a “smart legal contract” refers to a smart contract that either is, or is part of, a binding legal contract. There will have to be offer, acceptance, and consideration. The three most common models of smart legal contracts are: Solely Code Model (only code), Internal Model (code and natural language) l and External Model (natural language, but with some elements of code for limited purpose) (ISDA Whitepaper: “Smart Contracts and Distributed Ledger – A Legal Perspective”).

While their potential is significant, their uptake to date is rather low and limited to the type of contracts where agreement on negotiated terms is not the norm. What is our role as Solicitors in relation to the smart legal contracts? It would appear that none, unless there are the Internal or External Models.  We won’t be involved in a Solely Code smart legal contract at all. Unless problems happen after execution, due to external factors.

This concludes my very brief analysis and hopefully helps others in understanding what is ahead of us as Solicitors. As always, it will be the needs of the clients that will dictate what kind of contracts we need to prepare. And if a client wants our assistance with a Legal Smart Contract Internal Model with consideration payable in bitcoin or Ethereum on a specific DLT, we should be able to provide exactly that.

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