Why are smart contracts the smart choice for financial services?

Introduction

In an age of rapid digitalisation, accelerated by the COVID-19 outbreak in 2020, “smart contracts” are seen by many as a building block in the development of a more efficient and more automated financial services sector. In this series, we will look at the use cases of smart contracts in financial services, and the Law Commission's report into the enforceability of such contracts.

In its broadest sense, a “smart contract” is a piece of computer code that can execute automatically (either in whole or in part). Smart contracts, or smart contract terms, usually follow the logical form, "if x, then y" and may be used for a variety of use cases. For instance, a smart contract can be set up to enable automatic initiation of a payment by one party upon occurrence of a certain event or action made by another party without the need for any human intervention.

Smart contracts may be executed automatically by computer programs. The recent and ongoing development and improvement of distributed ledger technology ("DLT") (see our summary of DLT below) has enabled smart contracts to be deployed on a distributed ledger. Computers on that ledger are then able to interact with the deployed smart contract, without necessarily having any contact with the person who deployed it.

DLT refers to a system of information management which utilises a shared ledger or database, as opposed to a centralised ledger, which is held by one node and has to be updated and distributed by that node. A distributed ledger is held simultaneously by a number of nodes, which all see identical copies of the ledger. This makes it a useful technology for the recording of transactions (as seen on the BitCoin blockchain). Later development of the technology has produced programmable ledgers, such as Ethereum, onto which smart contracts can be deployed.

Where contracting parties seek to regulate their mutual rights and obligations in a legally binding contract using computer code (whether fully or partially), there are a variety of legal issues that may arise. For a smart contract to be legally binding under English law, legal questions around contract formation, form, consideration and interpretation need to be assessed.

Against this background, the Law Commission published a call for evidence in December 2020, seeking views about the ways in which smart contracts are currently being used, and the extent to which the existing law of England and Wales can apply to their use. On 25 November 2021, the Law Commission published its long-awaited advice to the UK Government. The advice refers to "smart legal contracts" which are, broadly, smart contracts which are used to define and perform a legally binding contract, and concludes that the current legal framework in England and Wales is clearly capable of facilitating and supporting the use of such contracts. The Law Commission’s advice is in line with a previous statement of the UK Jurisdiction Taskforce (UKJT) made in November 2019, which concluded that, in principle, smart contracts are capable of giving rise to binding legal obligations.

In Part Two of this series we consider the findings of the Law Commission in more detail. First, we look at some of the specific use cases for smart legal contracts in the financial services sector.

Use of smart contracts in the financial services industry

Financial services is a particularly fertile breeding ground for adoption of this emerging technology. Existing financial services firms may deploy smart contracts to make their processes and transactions more cost and time efficient, and there is plenty of scope for new entrants to the market to access potential customers and scale in a way that would not be possible via traditional means. The use of DLT, and self-executing contracts, without necessarily involving a known counterparty might, to some, introduce a degree of risk that an investor, borrower etc. is unwilling to take. However, for others, it is the decentralised nature and (potentially) guaranteed execution which is an attraction. We've considered a number of use cases for counterparties in both camps below.

Derivatives market

The use of smart contracts in derivative transactions is seen as a solution that can enable more efficient monitoring and execution of complex and large derivative contracts that are usually based on comprehensive and heavily standardised master agreements. For instance, payment related provisions of a derivative contract, that require one party to pay a certain amount to another party upon the occurrence of certain events, can be coded into a smart contract that would enable their automatic execution. External information (like exchange rates necessary for calculation of payment amounts based on pre-defined calculation methodologies) can be incorporated into a smart contract via application programming interfaces (APIs) which are also deployed on the distributed ledger, meaning that external information may be incorporated into the computer code of the smart contract in completely automated way. This streamlines the process significantly, and can reduce the counterparty risk associated with such trades.

The International Swaps and Derivatives Association (ISDA), has recognised the importance of smart contracts for derivative markets, and has published a number of papers so far analysing various legal and regulatory aspects of the use of smart contracts for the purposes of automation of derivative contracts.

Decentralised Finance (DeFi)

DeFi is an umbrella term that refers to an emerging sector of the financial services industry whose rapid growth was a highlight of 2021. As a counterweight to the traditional, heavily centralized, traditional financial market infrastructure, DeFi uses smart contracts and DLT (most commonly Ethereum) to provide financial services on a bilateral basis, between the service providers and their clients. For instance, individuals seeking to earn interest on their savings can use DeFi protocols to lend money to individuals that seek financing on a peer-to-peer basis, without using any intermediary. Likewise, owners of cryptoassets can earn interest by providing liquidity to online market places (liquidity pools) where such cryptoassets can be traded. An essential component of the DeFi is the use of smart contracts that enable automatic execution of pre-defined obligations of various market actors in this decentralised space.

Syndicated loan market

The syndicated loan market is another area of the financial services industry that can be especially fruitful ground for the use of smart contracts. Due to the large number of different documents that accompany syndicated loan transactions (e.g. inter-creditor agreement, facility agreement, security agreements etc.), participants in the syndicated loan market see smart contracts as a suitable method that could, through automation of certain processes, make the management of syndicated loan transactions more efficient. Besides automating data and payment flows arising from contractual obligations of the parties, smart contracts can also check parties’ compliance with contractual undertakings (e.g. compliance with financial covenants, delivery of required documents and information) in an automated way that would be fully transparent for all parties involved.

However, despite having some great potential benefits, smart contracts cannot completely replace all text-based documents in syndicated loan transactions. For instance, security documents and inter-creditor agreements that are usually executed as deeds are unlikely to be able to be created solely in the form of a smart contract (since execution of the document in the physical presence of a witness can hardly be ensured in the digital environment – see Part Two for more details).

Service level agreement monitoring

Service level agreement monitoring is a use case which is identified in the Law Commission's November 2021 report (see Part Two, here), and has general application as well as application for financial services. Financial services firms are subject to strict requirements as to service levels to their customers (e.g. uptime) and as a result those firms expect high levels of service from their suppliers and service providers, for example, cloud computing service providers. Smart contracts could be used to monitor service levels under financial services firms' contracts, as well as managing fees or penalties under an agreement for services, a smart contract could alert a firm (or even a regulator) in the case that services fall below a prescribed level.

RegTech

As well as the use cases for financial services firms' services to their clients, there is a wealth of opportunities to use smart contracts to enable or streamline firms' many responsibilities to their supervisors. Certain rules or regulations could be codified into a "smart contract", which would enable firms to monitor compliance, and even complete (internally) regulatory reporting requirements in an automated way. Perhaps in the future, it might also be possible to submit regulatory reporting and notifications via smart contracts – although this is potentially a long way off.

Summary

As noted above, there are many use cases for smart contracts in the provision of financial services. Some use cases are more developed than others, and in a rapidly evolving decentralised space it is likely that many more will emerge over the coming months and years. Whilst smart contracts in their broadest sense simply automate actions which would be performed by a counterparty to an agreement, it is critical to understand whether a smart contract can, itself, be legally binding. We address this question in Part Two.