Smart contract
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The JC pontificates about technology
An occasional series.
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Smart contracts cleave to Lawrence Lessig’s coinage Code is Law — you code legal rights into the electronic operating parameters between the parties: they physically constrain what you do to each other, rather than being abstract metaphysical considerations agreed amongst lawyers, committed to paper, filed and forgotten, floating free, high above your messy actual interactions with your counterparty. Wouldn't it be great to code legal terms directly into your API, so to speak, so everything was deterministic, automatic and utterly certain?
Notwithstanding breathless distributed ledger technology chat to the contrary, we’ve had smart contracts for a while: wherever counterparties interact electronically, as they do when posting collateral under a CSA, for example: it is the algorithms, thresholds and validation sub-routines embedded in the technological infrastructure, rather than the abstract ones set out in paper, that, in practical terms, govern what, when and how much collateral the parties exchange. Everything happens fast, deus ex machina, and there is no articled clerk with a quill monitoring the data flows and cross-checking each transfer against the agreed eligibility criteria written in the CSA. All of that coded into the machine. All a smart contract amounts to is the insight that that operational handshake, rather than the bit of paper you first wrote it down on, practically governs. It is no big leap to ditch the need for abstract textual reflections of operating parameters in separately executed "legal terms".
But, blockchain, you know?
And consider this: if, in that CSA, due to a mutual mis-key when you set up the operating parameters in 1998, you allowed a wider range of collateral through than the CSA formally mandated, and no-one noticed until your counterparty blew up in 2008 and the ropey collateral it had been posting for a decade suddenly tanked, what good is your sainted piece of paper then? Not much, in this commentator’s humble opinion.
So, where the contract is of a highly operational nature — and much of the machinery of finance is — smart contracts aren’t so much a revolutionary idea as an obvious one. We already have them.
But the problem is this: while 80% of your contract is electronic and suitably “smart” already, the other 20% — all the things that matter only when things turn growlish — isn’t. The close out rights, termination triggers and events of default: matters that can hardly be coded into anything, much less ascertained by electronic transmission between the parties. They require judgment, experience and evaluation, both of their existence (is that adverse change really “material”? Hey, legal eagles! What does “material” mean?) and in terms of your reaction to them: Ok, the NAV trigger has been hit. But is this the real thing or is this drill? Do we want to close out? How is our overall position? What do we think of the counterparty’s forward prospects? What are the pros and cons?
No smart contract will be able to measure these things, much less make an executory decision about them.