The CFTC’s LabCFTC recently released “A Primer on Smart Contracts” as part of LabCFTC’s initiative to engage with stakeholders on FinTech topics. The primer explains smart contracts, and explores their potential benefits — with a particular focus on the financial sector — and challenges. The CFTC has an interest in smart contracts because,

On August 3, 2017, the International Swaps and Derivatives Association (“ISDA”) and Linklaters LLP released a whitepaper titled “Smart Contracts and Distributed Ledger – A Legal Perspective.” The whitepaper sets out to define the terms “smart contract” and “distributed ledger,” to analyze their applications to the derivatives industry, and to highlight potential legal

The Federal Reserve Board released a staff research paper on Monday, December 5, 2016, addressing the potential use of distributed ledger technology (DLT) in payments, clearing, and settlement (PCS) processes.  A distributed ledger is a type of database in which identical copies of information are distributed and maintained among multiple parties or multiple nodes in a computer network.  Uses of DLT include the transfer of cryptocurrencies, like Bitcoin.

The paper (i) describes the current state of DLT; (ii) identifies opportunities to use digital ledgers in PCS processes; (iii) delineates the practical challenges to implementing DLT; and (iv) outlines potential legal and risk management concerns related to DLT.
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Financial services companies, software developers and governments alike are exploring opportunities to automate a wide range of legacy processes using smart contracts and blockchain technology.

What are smart contracts?

Smart contracts are “computable” legal contracts that execute automatically (without verification by a third party) when a set of pre-programmed conditions are satisfied.  Unlike traditional legal contracts, smart contracts are written in source code.  They can be stored on distributed ledger platforms and secured using cryptographic keys to make them immutable and tamper resistant.

One example of a smart contract is a simple derivatives contract that settles automatically upon certain specified changes in a reference financial index. When the financial index undergoes specified changes, pre-programmed rules in the smart contract automatically trigger contract settlement (for example, a payment from one account to another).  This automatic settlement of smart contracts in accordance with pre-programmed rules eliminates the need for a trusted intermediary (such as a lawyer or escrow agent) to verify that the conditions precedent to settlement have been satisfied.  As a result, smart contracts have the potential to eliminate third party intermediaries, and to reduce transaction costs, in certain commercial arrangements that today are managed and settled manually.

Continue Reading Smart Contracts: Opportunities and Legal Risks