“From Digital Currencies to Digital Finance: The Case for a Smart Financial Contract Standard.” Dr. Paolo Tasca, Journal of Risk Finance.
This excellent article uses the perspective of the blockchain movement to analyze a very complex conventional financial ecosystem: the management of financial contracts by banks and their suppliers.  It identifies major failings, notably gaps in the layers of management.  Because of the historic, organic development of separate transactional and analytical systems, there is a vast array of dissimilar systems that perform similar work, producing dissimilar results, creating the need for imperfect systems of reconciliation, consuming profits and embedding risk.
This bracing perspective can be described as part of the “technology deficit” of banks.  Because banks were among the first users of IT systems, they have among the least modern and most complex systems.  Their systems evolved patch by patch, becoming systems of systems.  See also the “Digital Banking Manifesto: The End of Banks?” (https://cdn.www.getsmarter.com/career-advice/wp-content/uploads/2016/12/mit_digital_bank_manifesto_report.pdf)
The great merit of this piece is to bring the radically simplifying perspective of the blockchain movement, and a nuanced approach to the problem and solutions.  The author identifies that the banks already use “smart contracts” in their automated transacting systems.  The financial contracts are mathematically modeled and algorithmically acted on.  The problem is that different banks use different models and algorithms, indeed many banks use multiplicities of models.
The author calls for these to be standardized via open source.  Note that the author focuses on the substantive standard for financial model – ACTUS – and not on the database level – such as blockchains.  The major, practical impact can come from standardization of the model and algorithms, without industry-wide adoption of a particular database system or replacement of the actors in the sector.   The fintech/blockchain revolution may be about the financial industry discovering open source, not any particular technology.  As the author says, ACTUS is “not an invention, but a discovery.”
The author identifies adoption as the major barrier to standards.  The current system works inefficiently, but it works everyday, and it is critical infrastructure.  Incumbent intermediaries have vested interests to protect and mindsets to overcome.  The author remarks that the fintech revolution has focused minds in the financial sector.
As an advocate for open source applied to legal documentation (CommonAccord.org), I add that adoption may be facilitated by open sourcing the documents of finance.  The efficiency and risk-reduction advantages for incumbents of a systematic approach to legal documents are powerful and immediate.  Symbiotically, open source mathematical models and algorithms can emerge from and contribute to standardized financial documents.
Advertisements

Electrons normally encounter resistance as they move along wires, the pathways that we create for them.  Traveling over a transmission line, there is some loss of power and some heat is generated as the electrons bounce along the path, hopping from one atom to another.  While wires may look straight to us, for the electrons the path is only a bit better than random.  There is resistance in navigating the chaotic pathway.

If the conductive material is made really, really cold, the electricity can pass with almost no resistance at all.  The atoms slow down and stop dancing.  The electrons pass straight through.

In law we can perceive a similar phenomenon.  When a legal pathway is well-established, it becomes smooth.  Events pass through the pathway without ambiguity and they can be made to pass through with little delay or cost.  (Cost and delay can be imposed, as gating rather than friction.)

For example, the transmission of a fractional interest in a business enterprise is very complex conceptually.  If done freehand, the transmission may be documented with hundreds of pages of legal text and description.  In contrast, a sale of a block of shares on a stock exchange has  theoretically equally complicated effects, but the path is clear, execution is rapid and cheap.  The difference between these two situations can be understood in a number of ways; one way is that the second involves a smooth pipe, a well-cooled wire, that connects buyer and seller.

Legal pathways of fixed materials – text building blocks with words that stay still – can become increasingly friction-less pathways by which people wire up their relationships.  The friction will drop – the words will cool – as they are re-used, become known, evolve into standards.

The European GDPR imposes powerful obligations on custodians of personal data to handle that data respectfully. Among the obligations is the right of the persons concerned to demand deletion of the data when no longer needed, and the right to receive a copy in structured format.  The logic of this leads to a P2P data model.  Business and political interests suggest that there is no reason for Europe to pull back when insisting that this logic be applied to its logical end – data, computing and control at the edge rather than the center.  Europe is sensitive to the dangers of too much information being aggregated and European companies have not been winners in the race to create and monetize large aggregations.

Some may doubt whether a system of technologies and actors can exist in which most of the benefits of hub-based transacting can be enjoyed even without massive aggregations of data.

IoT shows the way.  A really functional system of “things” working with one another requires that they be able to do so “locally” – by communicating either directly with one another or via an intermediary who is nearby.  An IoT-equipped furnace must be able to authenticate an IoT-thermostat, verify that the thermostat is who it claims to be and has authority to direct the furnace.  The furnace also needs to verify that the thermostat has the funds – some kind of balance of some kind of currency – and transfers the funds to the account of the furnace, so the furnace can pay for the fuel.  All this needs to be able to occur even if neither furnace nor thermostat can communicate with the outside world.  The internet connection might be down.  For security reasons, too, it is better if the information doesn’t leave the house, except as needed to coordinate with others.

The problem of the thermostat and furnace of course can be scaled up.  The parties might be two ships or two banks.  Their need for action might be less urgent, but ideally they would want the same reliability in dealing with others as the thermostat and furnace enjoy. Their problem is technically less demanding, a lesser-included case.

Governments might want the same independence for their operations and for their economies, companies and citizens.  The technology that solves the problem of IoT interactions can assure the independence of communities, including even countries.

 

 

On Friday, March 3, I attended a conference organized by the Stanford Technology Law Review whose title was “Regulating Disruption.”Foot Note

“Disruption” is intended in the Silicon Valley sense of “innovation.” With only a mild stretch, “regulating disruption” can be parsed two ways:

The disruption of regulation, and
The regulation of disruptive activities.

The two parsings join in at least one place:

Effective regulation of disruptive activities will require disrupting regulation.

Digging into this a bit:

Innovative activities can push boundaries, upset relationships, newly expose or aggregate weaknesses, and otherwise cause mayhem.

Innovative activities can be broadly banned, at least in some places and for some time.  But some innovations are genuinely helpful and desired, and some arrive uninvited.

Ideally, a regulatory system would respond rapidly and narrowly to curb the most deleterious effects, and take fuller shape as knowledge of the advantages and dangers accumulates. Regulation would distinguish among different situations and  would respond to “experience.”

The open source community’s iterative system of text sharing can help.  Let’s start with a look at the structure of regulation.  Regulation has layers, including:

  • Quasi global – treaties and community rules such as the EU
  • National – legislation, regulation and precedents
  • Local – like national, and often multi-layered – e.g., state, county, municipality or region, department, city.
  • Trade group or marketplace – membership in an association or market may impose duties, which may be expressed as rules or contracts.
  • Insurers, brokers and others who expect or require conformance.
  • Peer-to-peer agreements and forms – documents “signed” by pairs (or groups) of persons. These are often intermediated by counsel.  Legal departments and law firms nudge transactions into patterns by their forms and expectations.

CommonAccord is addressed to the bottom layer – P2P documents such as contracts, permits, organizational documents. Modularity and reuse as practiced by software developers permits radical improvements in efficiency, transparency and precision. Sharing those materials via git (and GitHub) allows bottom-up quasi-codification that can rise up the chain to wider adoption.  The dynamic is not novel, there are many forms that currently work as quasi-standards, but the new tools can make it radically more efficient, rapid and flexible.

Handling legal text as “prose objects” allows:  i) very efficient use of standards, ii) full flexibility of customization and iii) organic migration of customizations into standards.

In the 19th Century, the common law courts, overwhelmed by the complexities of contract arrangements caused by the industrial revolution, and influenced by economic thinking, declared themselves incompetent to judge the merits of those arrangements and retreated to formalisms such “offer,” “acceptance,” and “plain meaning.” The assumption was that parties were in the best position to judge the fairness and best structure of relationships.  Through experience and diligence, parties in markets would self-regulate. Reality fell short of the theory, in some respects quite substantially.   The consequences of that abstention and wave of innovation are still being worked out in contract practice.

The collaboration methods of the open source software community provide a way to bring reality closer to the theory of parties wisdom embedded in contracts.

Foot Note:  The subtitle of the conference may resolve the dual meanings of the title. The full title is  “Regulating Disruption: Responding to Emerging Technologies” .

The codification of legal and a simple peer-based approach to transacting may be the way that civil society exercises control over the coming, concentrated and largely automated system of production.  Codified legal could be the lever, the “place to stand,” for efforts such as The Future of Life that seek to move (preserve) the earth.

Santi Siri asked about “understanding.”  It appears that the issue of collaborative legal codification is solved, but how to scale understanding by non-experts?

The short answer might be that codification allows the inexperienced to follow paths beaten by the more expert crowd.

Here is a longer, layered answer.

Ian Grigg (@iang_fc) has written an excellent piece on smart contracts, blockchains, Ricardian Contracts,  the role of legal, etc.  It is long, with a lot of history, and brings the discussion back to basics of an ideal transacting system.  In a nutshell: Ian Grigg’s Ricardian contracts and digital assets prehistory – an interview by Anthony Lewis of R3.

Ian mentions the link between Ricardian Contracts and CommonAccord in The Sum of All Chains.

The core is two “triples.”

Data Model Triple

The first triple is the data model.  He expresses the order differently, but it is the same as: 1) a record with parameters, 2) some legal prose, and 3) some software code.  We express this as two jumps:

  1. A record has parameters and references its context.
  2. The context includes i) prior step and other materials, ii) prose and iii) code.

Record and Context

The technical reader will notice that the linkage among records is a semantic triple.

Triple Entry

The second triple is Triple Entry bookkeeping – a somewhat confusing phrase IMHO, but simple idea.  To have a good system of record (proof), the minimum viable configuration is for there to be three copies of the transaction.  Mine, yours, and one kept in trusted hands.   Just two copies is not enough because one of us could alter theirs, and make a false claim.  How could an arbiter resolve that argument?  By looking into the eyes of each party?  Eye-gazing can be reduced if there is a third copy in the hands of someone whose reputation is more important to them than their stake in the transaction.

But the additional copy creates a confidentiality and data security problem, and this gets bigger with each additional copy.   So the ideal is one copy for me, one for you and one in a trusted place.  The confidentiality and security problem can be further reduced by writing just the hash of the record to a trusted place.

Generalizing this further, is is something like the number of parties plus 1.  Parties +1  copies.  Parties +a hash.

I find the “triple entry” to be confusing because I understand the “double” in “double entry” bookkeeping to refer to the left-side and right-side of a T account.  It seems that the triple (and therefore double) of Triple Entry refers to the fact that each party keeps a T account, with mirroring entries vis-à-vis the other party’s T account. https://en.wikipedia.org/wiki/Debits_and_credits#T-accounts