Smart financial contracts: major implications of recognizing their uniqueness within the universe of
The role of contracts in economics has recently received some high-profile attention. On the academic side the 2016 Nobel Memorial Prize in Economics was awarded to two distinguished economists for parsing the challenges of contracts in a market economy. On the technological side the concept of “smart contracts” has taken center stage in FinTech and especially Blockchain (BC) (or more generally Distributed Ledger Technology (DLT)).
In this blog we discuss several issues of critical importance about financial contracts, Smart Contracts, and the confusion about Smart Contracts within the BC/DLT community:
The DLT community has developed several general views of Smart Contracts that are far too limiting:
The perception that there is a stringent ontological relationship between Smart Contracts and DL technology
The narrow definition of Smart Contracts
The DLT community has failed to recognize the uniqueness of Smart Financial Contracts and the most important implications of that uniqueness:
Financial contracts are the prime candidates for successful deployment as Smart Contracts
On the relationship of smart contracts and BC/DLT:
With the introduction of the concept of smart contracts on Ethereum the terms “smart contract” and “block chain” have almost become inexorably linked for many people. This view has been challenged by Pardolesi/Davola. They correctly point out that there is a too “stringent ontological relation between blockchain and smart contract (which) should be dissipated”.
A smart contract according to Szabo’s 1996 definition is a computer executable contract with aspects in common with other types of contracts: observability, privity, verifiability and enforceability. As Pardolesi/Davola correctly observe, such a contract is not “… ontologically derived from the use of the blockchain, being rather the result of the parties’ choice to devote an informatic technology the performance of the (previously concluded) arrangement.”
In our article ‘Smart Contracts, Distributed Ledgers, and the Need for an Algorithmic Financial Contract Standard’ we discuss how the deployment of a Smart Contract on a DL contributes to the realization of the four aspects of contracts cited by Szabo. We show that BC/DLT does indeed make contracts more observable since every recorded payment is difficult or even impossible to dispute. However, deployment of a Smart Contract on a DL does not offer any specific advantages with respect to privity, verifiability, and enforceability. We make the case that the most effective and efficient way to assure verifiability is through the use of a contract standard as defined by ACTUS. This, in combination with the observability that DLTs offer, will maximize enforceability. We will return to further develop this argument in the last section of the blog.
On the narrow definition of smart contracts:
So far, the only sustained application of BC/DLT has been for single payment transactions in a crypto currency. This fact combined with the current ontological relation discussed above contributed to a very narrow definition of what a smart contract would look like: basically the automated execution of a single payment on a DL from party A to B.
On the failure to recognize the uniqueness of financial contracts within the contract universe:
What has been missing in these discussions is the recognition of the uniqueness of financial contracts within the broader category of economic contracts. Understanding this uniqueness is critical to understanding how to represent financial contracts in real world applications of BC/DLT and Fintech. Furthermore, understanding this uniqueness is critical to being able to realize the promised benefits of Fintech.
The uniqueness of financial contracts starts with the nature of what is being exchanged under the contracts and proceeds logically from there:
Most economic contracts consist of an agreement to make a payment (money) in exchange for the receipt of goods and/or services. Financial contracts – in contrast - are agreements to exchange only cash flows on the part of all the counterparties to a contract without the exchange of any goods or services. That is, in a typical financial contract, I agree to give you some money today in return for your promise to give me some money back in the future. The contract defines how the amounts and timing of the payments are determined.
Such payments (or as we generally refer to them - cash flows) are in the final analysis just numbers. Such numbers precisely represent the payment obligations contained in a financial contract.
Financial contracts typically require the payment of a series of cash-flow obligations that are most precisely represented by a mathematical expression rather than the words of a natural language contract. In fact, financial contracts – the exchange of cash flows – are the only contracts that can be perfectly represented mathematically for all counterparties to a financial contract.
As an empirical observation, the exchange of cash-flows follows a limited set of patterns. An overview of the patterns can be found on here.
Because the obligations of financial contracts can be represented mathematically with greater precision than natural language contracts, such contracts are programmable and, therefore, the prime candidates for implementation as smart contracts.
Because the cash flow patterns of the universe of widely used financial contracts are limited to less than three dozen, financial contracts are most readily represented by a financial contract standard.
The deployment of smart financial contracts based on a tested and validated financial contract standard – whether on a DL or legacy systems - is the most important component of a smart financial contract needed to insure verifiability and – as a consequence – enforceability.
Willi Brammertz, ACTUS Users Association
Allan I. Mendelowitz, ACTUS Financial Research Foundation