Courtesy of Joseph Lee
Fintech developers and financial institutions have presented the benefits of using smart contracts to facilitate securities/interests transfers (trading) on distributed ledger technology (DLT) platforms. The benefits are DLT’s technological ability to bring about decentralization and disintermediation which are the main characteristics of peer-to-peer (P2P) trading platforms and reduction of transaction costs for users and financial systems as a whole.
Although the use of smart contracts and DLT platforms to transfer securities interests, such as shares of stock, have yet to be successfully deployed at scale, some exchanges have already used smart contracts to automate securities transactions – notably, by using their centralized match-engine to deal with multiple securities transactions. Using a smart contract on a DLT platform to facilitate P2P securities transactions is technically feasible; however, the concern is how to ensure that the system is safe to operate and legally certain enough so that the general public (both individual retail investors and consumers) can use it without the need of relying on professional intermediaries.
Using smart contracts on a DLT network to facilitate P2P securities transfers raises a number of legal issues. First, how is the legal nature of the ‘interest’ encoded on the smart contract defined? Second, how is the smart contract compatible with the principles of contract law? Third, how is the interest in the securities deemed delivered and perfected, and the transaction settled? Fourth, how can issues relating to conflict of laws be resolved in the areas of regulatory oversight, dispute resolution, and consumer/investor protection?
The legal status of the underlying asset
Smart contracts are computer code that represent financial instruments such as shares, bonds, money, and derivatives. The smart contract represents the tokenized interests, i.e. a tokenized share or tokenized currency (e.g., stablecoins). In other words, the smart contract is a dematerialized certificate that proves the interest attached to the underlying asset, such as a share or a debt instrument. Some smart contracts appear to be an ‘asset;’ however, they may not be legally recognized. For instance, the underlying ‘asset’ for unstable cryptocurrencies is difficult to define; hence, the smart contract is unlikely to be recognized as a certificate or a negotiable instrument that is capable of being disposed of. Therefore, a smart contract can be used as a certificate to support the underlying interest that is capable of being legally defined, such as share interest (securities) or debt interest.
Securities interests are encoded into a smart contract. This is similar to the process of share dematerialization, in which the certificate of a securities interest is digitized. The process for encoding the interest into smart contracts to be issued on the DLT network is called tokenization. The process does not affect the legal nature of the underlying asset – share, debt (bond), and derivatives. Even if the securities interests are encoded into a smart contract, the interests represented by the smart contract are not necessarily of a contractual nature. A smart contract, containing a set of computer codes, may contain securities interests but may also contain other contractual terms relating to the number of shares to be transferred, the price, and the date of such a transfer (i.e. a purchase/transfer agreement). In other words, a smart contract may need to be treated as a combination of multiple legal instruments such as a share along with its share purchase agreement.
The risk of contractual invalidity and its management
There are legal factors that can cause a default in the chain of transactions. On a DLT platform, an underage person, who does not have the legal capacity to execute transactions, may have access to the trading platform and begin dealing in tokenized securities or interests. If material information was not properly presented to the user, as a result of such a misrepresentation, the user is entitled to rescind the contract. There is also the risk that people using a smart contract do not have a good understanding of what it entails. For instance, they may not appreciate that pressing the ‘click’ button will trigger a transfer of shares to a third party at a particular price with reference to a benchmark, and this may give rise to a mistake in contract where there is no meeting of minds. When the validity of the contract is successfully challenged, the smart contract may cause the securities transferred (not fungible) to third parties to be re-vested to innocent parties.
The computer programs will not be able to ‘correct’ the mistakes in coding, and the effect can be both systematic (causing a computer glitch in the transaction) as well as systemic (causing a serious problem in the chain of transactions). The risk of mistake is amplified when vague terms such as ‘reasonable’, ‘good faith’ or ‘frustrating event’ are coded into a smart contract. Even when using advanced natural language processing (NLP) to define these terms based on legal precedents, there is a substantial risk that parties may not agree with an outcome delivered by algorithms. The codes in smart contracts would need to be able to suspend the automation function until the parties decide how such disputes will be resolved. It is not possible in a contract for parties to waive their right to have the disputes resolved through a dispute mechanism. It is also questionable whether the outcome of an NPL ‘decision’ would be legally recognized as a dispute resolution.
In a DLT securities trading platform facilitated by smart contracts, there is a need to have a central counterparty (CCP) that stands in the middle of all the transactions. The CCP would perform the function of a contractual guarantee to mitigate risks but not that of a netting agent to increase the efficiency of the trades. The CCP would need to certify that the smart contracts are securely coded and that they are compliant with relevant laws and regulations. When the CCP acts as a guarantor to the transactions, they can ensure that transfer of the securities and the corresponding funds would continue uninterrupted. The CCP can act as a mediator or adjudicator in case any dispute arises among the parties. The parties can make any compensation claim for damages outside the trading system. For instance, the users could claim mistaken transactions because of ‘fat fingers.’ The parties may not allow the transactions of the securities to be rewound, but the funds could be returned. The CCP needs to design a system where consumers can be protected from these mistakes. This may require margin to be collected from the users as a form of insurance. This would also allow the CCP to vet users and assess their risks based on their attributes and previous behavior on the blockchain. The CCP could provide risk scores on the users which will affect the collateral and margins required of them.
Delivery and perfecting tokenized interest
How can a securities transaction be settled on a DLT platform? In other words, how can a tokenized security be delivered, or tokenized interest perfected, in a decentralized DLT platform? The major difference between a centralized blockchain-based platform and current payment securities settlement systems is that the users of the blockchain-based platform can deliver and perfect the tokenized securities and the tokenized interest without the intervention of a centralized settlement body. That is to say, the delivery can be done on a P2P basis. The public and private keys— the encryption technology— are the main tools to prevent hacking into this P2P system that can tamper with the messages and distort transactions. The legal question is, at what time is settlement final? Is settlement achieved: 1) when the transferor sends a transaction message to the transferee using the keys? or 2) when the transferee receives the message using the keys to access the account? Parties on the chain may agree to use the English ‘postal rule,’ whereby the delivery is made when the transferor sends the transaction message.
Since transactions on the blockchain network are ‘transparent’ and cannot be tampered with, it would not be difficult to prove sending and receiving the messages by the transferor and the transferee. On the DLT network, the contracting parties should deem a transaction settled, i.e., the tokenized security being delivered or the tokenized interest perfected— when the transferor sends the message and not when the transferee receives it. It could be the case that the settlement is made when the parties agree to the transfer by clicking a button.
This system does pose a significant risk. This is because there is a time lag – approximately 15 minutes in the current bitcoin blockchain – in updating all the accounts (nodes) on the blockchain network. Therefore, it is likely that within this time lag no further transactions can be made with regard to the particular tokenized securities. If there is a blackout or system failure before all the nodes have updated the information, the risk is with the transferee. This may present an unjustified risk to the transferee, even though they have been made aware of such a risk. Hence, the CCP should also act as the settlement guarantor so that in the event of a blackout or system failure, the transferee’s funds are not affected, despite not having the appropriate account credited with securities. This means that the CCP will have access to the users’ accounts on their requests in order to guarantee that the transferee does not take on this counterparty risk. The transferees may not be able to receive economic benefits or other entitlements such as voting rights during this period. As a smart contract can automate the distribution of economic benefits, such as dividends, and other entitlements, there must be a system to ensure that the accrued interests and rights are allocated to the transferee during the window period. In addition, certain corporate communications could be made during this period, such as corporate notices to call a general meeting for casting votes. However, communications could be lost during this period as the issuers (companies) do not have an updated list of the holders of tokenized securities.
Jurisdiction and the choice of law
The governing law for the settlement of tokenized securities or interests affects the rules on the delivery of securities and on the perfection of interests. It also affects enforcement against the property interests of the participants. However, since the accounts are collectively maintained by the nodes in the blockchain network, the lex situs rule may not be applicable. This is because the accounts are distributed rather than centrally maintained by a central securities depository (CSD). A contractual approach may not work either. If a participant is treated as a consumer, the consumer law of the country will override the chosen governing law. Furthermore, control of the tokenized assets is based on access to the public and private keys (the wallet). The participants might be mobile and use the keys to make each transaction in different jurisdictions. Unlike bank deposit accounts, or securities accounts, enforcement against property will depend on the location of the accounts rather than the person.
In a decentralized system, the rule may have to be based on the location of the person at a particular time, rather than the location of the account, because the person who possesses the keys (password) to the accounts (wallet) is able to dispose of the property. It might be that a trusted third party also has access to the keys, and in that case, proceedings would be against the third party. Unless there is a requirement to be registered in a particular jurisdiction, the third party could be a mobile virtual entity without a centralized office, thus rendering the lex situs rule inapplicable.
The law governing economic benefits and other entitlements of tokenized securities or interests will be governed by the law in which the issuers are based (lex societatis). It is likely that the issuers will not be a registered legal entity, but a decentralized project such as the DAO (Distributed Autonomous Organization). This will present a major risk as there will be no gatekeepers to control the quality of the ‘listing’ of the tokens on the platform. This may prompt regulators around the world to assert jurisdiction over these tokenized securities and interests.
Impact of smart contract on other businesses
The current securities lending system is intermediated through a number of entities – custodian banks, securities firms, and brokers. On the blockchain network, it would be difficult to lend securities. There are two reasons for this. First, securities borrowing is normally done by hedge funds to short-sell securities. Hedge funds borrow securities with a perceived high market price and sell them immediately back to the market for cash. They then buy the securities back at a lower price (betting on their price going down) and return them to the lender.
On the blockchain platform, it would be difficult for hedge funds to use this trading strategy, since borrowing tokenized securities from distributed participants would be more costly and slower, even if it is technically possible. Furthermore, hedge funds may not wish to disclose their short-selling activities to the market, nor to reveal the owner of, the number of, and the price paid for the borrowed securities. They may lose this advantage when smart contracts are used to facilitate trading, since the price, time, and amount that will trigger the automation will need to be pre-set in the code. This will allow the market to have knowledge about the event before it is triggered.
The second question is, whether securities borrowing is technologically possible. The contractual terms will need to be encoded into smart contracts that will automate both the terms of the tokenized securities lending agreement and the transfers and re-transfers of tokenized securities. As a result, automated distribution of income from the tokenized securities will need to be re-directed (re-programmed) to the beneficial owners under the securities lending agreement. Furthermore, transferring the loaned tokenized securities back to the lender will be technically difficult, because tokenized securities are not ‘fungible’ (inter-changeable) so it is not possible to automate the return of the securities, if the third party (who is not bound by the tokenized securities lending) does not wish to transfer them. An off-chain platform will be required to continue such a mechanism for lending securities and this is important for collateral management as well.
Proxy voting enables a person who is not the legal owner of securities to cast votes, thereby exercising governance rights. Under the current system, a legal owner can appoint a proxy to cast votes, using the corporate proxy form. Smart contacts can facilitate this by encoding a proxy form into the tokenized securities so that the votes can be ‘transferred’ to the nodes (accounts) of the proxies, according to the instructions given by the proxy forms in the smart contract. However, such proxy votes can only be transferred by the legal owner of the securities. In other words, once tokenized securities have been transferred to another legal owner, the associated proxy forms will be invalid unless the transferees of the tokenized securities are aware that a proxy has been appointed to cast votes on his or her behalf. Otherwise, the proxy votes may be deemed invalid because they were cast without the consent of the legal owners. Therefore, when tokenized securities are transferred, such a proxy arrangement must be made known to the transferees before the transfer. Furthermore, the legal owners are entitled to revoke a proxy (termination of proxy’s authority); so, the smart contract enables the legal owners to do so and notifies the issuing company.
On a P2P platform, intermediaries on the proxy votes chain will be less relevant since the participants will be able to cast their votes directly. If a smart contract facilitates the voting system directly, rather than through intermediaries, changes of votes and last-minute vote submissions would be more efficiently managed than under the current system. Yet, proxy advisory services may continue to exist since the participants may not have the time or resources to understand all the voting issues. Advisory services will need to focus more on individual participants rather than institutional investors. While individual investors can take more control of voting issues, advisory services can provide instructions (or advice) to the investors, and the votes can be automated by smart contracts. For instance, the investors can indicate how their votes should be cast on directors pay by linking their votes to an advisory service. The instructions of the advisory services will automate the votes of investors with smart contracts. Individual investors could even change the way they wish to vote by switching to another advisory service.
What does a smart contract entail?
Smart contracts are computer codes that can perform whatever actions the participants agree to do with tokenized securities or interests over the blockchain network. In this decentralized and disintermediated platform, trading of tokenized securities or interests can be a simple way to achieve the P2P goal. However, the computer codes may contain several legal elements such as property rights, and a number of contractual obligations which the participants may not be aware of, or are easily confused about, and this poses a major risk to market safety. Hence, even though this method of P2P trading is simpler and more efficient than the current system, participants will need to be aware of the legal risks of using this platform. They need to understand the legal nature of the tokenized securities or interests, the legal risks involved in contract and consumer protection law, and appreciate the implications of the encryption keys for transaction settlement. They will also need to comply with the market conduct rules on the platform, such as market manipulation and insider trading. They will also need to be aware of other securities market practices such as securities lending and proxy voting in order to safeguard their interests.
How would the automated element be compatible with contract law?
With smart contracts, transfers of tokenized securities or interests are automated according to pre-set parameters or more advanced algorithms utilizing artificial intelligence. However, several elements in contract law can potentially make such contracts invalid, void, rescinded, or unenforceable. This risk is amplified when participants are treated as consumers who are entitled to a higher level of legal protection. Virtual dealing over the blockchain platform also requires a stronger level of proof of identify in order to ensure that people trading on the platform have the legal capacity to do so. This may involve using digital identification, such as personal biometric data, for the purpose of authentication. This calls for stronger personal data protection laws and a robust data management system on the blockchain platform. Furthermore, errors in the coding of contracts bring a major risk of rendering transactions invalid. Since automation is the essence of the system, the question arises as to whether trades facilitated by smart contracts can be technically halted without causing the system to fail, and whether mistaken transactions caused by errors in coding can be legally remedied. Smart contracts should be vetted by trusted parties to make sure that they are not confusing, compliant with contract principles, correctly coded for use on the platform, and that legal remedies are available outside the system. Even if transactions cannot be reversed, damages should be made to innocent parties.
How would automation between different contracts coordinate?
In traditional securities trading models, there are several layers with a chain of intermediaries to facilitate transactions. These intermediaries have their own arrangements to manage the risk caused by any default in the chain. Furthermore, the membership-based model for each layer of the trading cycle (trading, clearing, and settlement) removes the risk of misunderstanding and default. The internal rules for the members at each layer of the trading cycle ensure standardization. Smart contract facilitated trades over the blockchain platform do not use intermediaries. Therefore, the system needs to be able to coordinate different smart contracts in order to provide efficiency through automation. For instance, how can a new resolution pass to allow pre-emption rights in the securities vis-à-vis smart contracts? Would trades be automatically halted if a party challenges the validity of the contract? How could settled trades be rewound if the transaction was fraudulent? How can securities lending and proxy voting be implemented? Risk management entities would need to take up some of the default risks as they do in the current securities trading system. They may also collect margin and collateral based on individual risk scores. They should also be responsible for certifying the safety of the smart contracts, and ensuring that the contracts are legally compliant and correctly coded.
How can a workable solution be constructed to deal with conflict of laws issues?
Conflicts of laws have already caused major problems to the integration of securities markets. The legal status of the securities, their issuance, trading, clearing, and settlement can be subject to different laws. In some areas, parties can decide the governing law and jurisdiction but there may be competition between different jurisdictions. On a P2P platform, since participants are likely to be consumers, this will allow consumer protection claims to override other contractual agreements. National regulators will also want to have regulatory oversight of the activities. There should be an internationally agreed upon approach to conflict of law issues that takes into account the P2P nature of the platform and the automation function of smart contracts. This situation is unprecedented, so national regulators need to agree on regulatory cooperation to provide assistance in prevention, investigation, and enforcement. Even if the platform is decentralized, regulatory oversight will continue to be centralized unless regulators can develop a framework to share it, especially if actions will be required against persons and assets outside the country.
Major changes to securities businesses (resistance, recalibration, or transformation)
Disintermediation will affect some trade practices in which intermediaries are the major provider, such as securities lending and proxy voting. Since securities will be distributed across the nodes, custodian banks and some CSDs will no longer be able to loan securities. Losing this business may prompt resistance from the securities custodian industry against migrating current trades to the blockchain platform. The securities lending business could be re-calibrated so that, for instance, securities lending business providers may allow owners of securities to ‘bank’ their securities with them using a digital ‘wallet’. This will require the business providers to provide financial benefits to the securities owners, and allow owners to share benefits made through securities lending. It might also be the case that a smart contract enables ‘securities lending’ on a P2P basis with all the subsequent actions automated. Since this will be done on a P2P basis on the blockchain, the algorithms can detect who wants the borrowed securities, why they want them, how they are using them, and what amount they want and for what price.
While DLT-based smart contracts have the potential to fundamentally disrupt modern securities trading, there are a number of legal and regulatory challenges that need to be addressed before this technology sees widespread adoption. The legal basis of some cryptoassets, such as cryptocurrency, remains obscure while others, such as tokenized vouchers, require further investigation to determine the legal structure of the investment. Further, issues regarding conflict of laws affect market safety on the platform and regulatory oversight. There are difficulties for both market surveillance and the enforcement proceedings involved in a potentially cross-border securities trading platform, so it is likely that a legal seat will be required for the platform operators, despite the fact that the platform is technologically accessible to parties outside the jurisdiction. Despite the ability for DLT-based smart contracts to create borderless and decentralized financial markets, the law, as well as the needs of market participants, necessitate trusted third parties that are legally accountable.
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