CFTC on Smart Contracts: Not Always Smart or Legally Binding

Siamak Masnavi

On Tuesday (November 27th), the U.S. Commodity Futures Trading Commission (CFTC), released an excellent primer on smart contracts, as part of an effort by its LabCFTC division "to engage with innovators and market participants on a range of financial technology (FinTech) topics.

Here, we focus on some of the main highlights from this guide.

Overview of Smart Contracts

  • A smart contract "may incorporate the elements of a binding contract ( e.g. , offer, acceptance, and consideration), or may simply execute certain terms of a contract"; it "allows self -executing computer code to take actions at specified times and/or based on reference to the occurrence or non -occurrence of an action or event ( e.g. , delivery of an asset, weather conditions, or change in a reference rate)."
  • "A 'smart contract' is not necessarily 'smart'."
  • "A 'smart contract' may not be a legally binding contract."
  • Key attributes of a smart contract are digital signatures ("private cryptographic keys held by each party to verify participation and assent to agreed terms"), oracles ("a mutually agreed upon, network - authenticated reference data provider"), and i.e. self-execution (i.e. "will take actions , e.g. , disperse payments, without further action by the counterparties").
  • "Smart contracts can be stored and executed on a distributed ledger , an electronic record that is updated in real -time and intended to be maintained on geographically disperse servers or nodes."
  • "Through decentralization , evidence of the smart contract is deployed to all nodes on a network, which effectively prevents modifications not authorized or agreed by the parties."
  • "Blockchain is a continuously growing database of permanent records, “blocks,” which are linked and secured using cryptography."
  • Examples of processes in everyday life that kind of behave like smart contracts: "touch to pay systems"; "instant money transfer apps"; "the ATM"; and "vending machines".
  • Potential benefits of smart contracts: "standardization"; "security"; "economy and speed"; business innovation"; "regulatory innovation"; and "certainty".
  • A few example use cases: "self-executing insurance"; "transprtation rental"; and "credit default swap".
  • Vitalik Buterin's definition:

“A smart contract is a mechanism involving digital assets and two or more parties, where some or all of the parties put assets in, and assets are automatically redistributed among those parties according to a formula based on certain data that is not known at the time the contract is initiated.”

Challenges and Risks

For every potential benefit, there is a potential risk. For example, although smart contracts have the potential to "enhance market activity and efficiency", they could also be used to "unlawfully circumvent rules and protections."

Operational Risks

A few examples:

  • "Smart contracts may not include appropriate or sufficient backup / failover mechanisms in case something goes awry."
  • "Smart contracts may depend on other systems to fulfill contract terms. These other systems may have vulnerabilities that could prevent the smart contract from functioning as intended."
  • "In case of an operational failure, recourse may be limited or non -existent – complete loss of a virtual asset is possible."

Technical Risks

Some examples:

  • "Unintended software vulnerabilities."
  • "Humans! – make mi$taak3s when K0diNg."
  • "Divergent/Forked Blockchains – such events can create multiple smart contracts where only one existed, or may disrupt the functioning of a smart contract."
  • "Technology failures – internet service can go down, user interfaces may become incompatible, or computers/servers can stop working."

Fraud and Manipulation

A couple of examples:

  • "Smart contracts can include nefarious code."
  • "Smart contracts may be manipulated by insiders who may have “backdoors” or “kill switches” to the code or a deeper understanding of how the smart contract will react to particular events or inputs."
  • "Oracles may accept or distribute unexpected information, resulting in outcomes that do not reflect the intent of one or more of the contracting parties when entering into the contract."

 

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