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Smart Contracts and Regulatory Compliance

Introduction to Smart Contracts and Regulatory Compliance

SMART CONTRACTS

Smart contracts are computer protocols that facilitate, verify, or enforce the negotiation or performance of a contract, or that make the contractual clause unnecessary. Even though the term “smart” does not justify for all the contract that are out there, we are still far from having truly contracts that are smart.

Quite the contrary, at this point in time they are quite “dumb” and full of vulnerabilities that can make people lose tons of millions of dollars. Within the context of the Distributed Ledger Technology (DLT from now on), such protocol or application also uses the ledger to store information and to achieve consensus among peers.

This means that one can implement a smart contract without a distributed ledger since from the functional point of view, the protocol is not more capable depending on how the information is stored, or how the consensus is reached. The key is, again, trust. An application is as trustworthy as it is its infrastructure and provider. Some companies decide to use Gmail or Outlook 365 because they trust Google and Microsoft to store their private or sensitive information. The email service provider would be the equivalent of the central authority.

DLT allows the implementation of a smart contract between parts that neither do not trust each other nor the broker, in the context where a central authority used to be a fundamental requirement, is no longer required as long as all the information stored within the ledger is public. Bitcoin can be defined as a smart contract implemented using the Blockchain as a means of obtaining storage and consensus.

All the technology described so far is only the storage and peer consensus part. It all lacks any business logic to be useful for any purpose. Any modern DLT exposes an API to create a smart contract, where the inner workings of the storage and the consensus are hidden to the developer and the user. Writing a smart contract feels like writing a program.

Some API may be more feature-extensive than others. Some may allow a node to subscribe to events and react to them, changing the state of the contract accordingly. Or they may provide some sort of authentication and user permissions system. In any case, the application layer is way beyond the details of data persistence and the consensus protocol.

It is key to emphasize that applications are as complex as they need to be, and a DLT may not reduce that complexity at all if it comes from the functional requirements. The main contribution of the DLT is that some algorithms that had to be run on a single computer, and where the data was stored, can now be distributed over a network of computer with a limited amount of trust between each one of them.

One should understand that this reduced amount of trust in peers does not mean that the application is any less robust against real-life attacks, like stealing keys or credentials. What it means is that users can now use a trustless system without a central party telling them what or who to trust.

Current platforms for DLT-based smart contracts

There are two major platforms of DLT-based smart contract platforms contemporary to this document: Hyperledger and Ethereum. The underlying design of both platforms is similar, being Ethereum the first to blueprint such a structure. The main idea is that the ledger must store the status of the contract and the program itself.

This is kind of a revolutionary idea. The database stores the state of the system and the code necessary to mutate it. The main difficulty of this approach comes from one essential characteristic of DLT: any node must be able to verify all the states of the contract. This means that all the nodes should be able to run the program too and obtain exactly the same results as any other node that participates in the network.

This requires the implementation of a small virtual machine that is fully deterministic on all its results, avoiding some important hardware optimizations. This means that the DLT is a distributed computer, a particularly slow one at the moment. On the other hand, this allows full generality of a smart contract: a modern DLT may run any kind of program without affecting the consensus in any way.

The primary goal of DLT with built-in Smart Contracts is to create self-enforcing agreements that independently control and automate the exchange of value according to predetermined rules based on predefined inputs recorded into a smart contract. In simpler words, the end goal is to create a contract that cannot be changed, reversed or controlled by any party. Smart Contracts are software applications that are shared and run on all the nodes (computers) across the DLT network.

Smart Contract platforms like Ethereum were designed to lower the trust needed in third parties and, enable users that did not know each other to enter into a software-enforced agreements that are censorship resistant, meaning that no party can alter the code or prevent its enforcement. Below, an illustrative image of the life cycle of a smart contract.

Figure 1: Smart Contract life cycle
Figure 1: Smart Contract life cycle

Smart contracts are still immature and need much development and research before we fully automate high tasks and peg valuable assets to them. As other reports have mentioned, there have been many hacks that have profited from the vulnerabilities found on certain smart contracts. Remind yourself, that technology used to develop smart contracts,public blockchains or DLTs has a little track record.

We still need to figure out many things before we move to a complete automated contractual world. From our point of view, this market segment can be divided into two categories, Smart Contracts for common “contractual agreements” and Smart Contracts applied to the Financial industry.

Within the Smart Contracts for common contractual agreements, these are the companies that stand out the most:

Gnosis

It is a decentralized prediction market that runs on Ethereum. You can create smart contracts between peers being able to record “price bets” in any thinkable market (aka: sports, elections, financial markets… etc). Their platform allows users to create a contract for any real-world event. For example, Alice bets against Bob that Atletico de Madrid will win the Champions League next year.

Once they have signed the contract they do not have to worry about anything else but their bet. Once the information with the results is given or uploaded to the contract using oracles (technical name for the data source), the execution of the contract will be automatic, settling the contract according to the predefined conditions. Although “bets” may be considered the principal application of gnosis, it can also be used for price discovery, governance, and insurance. Gnosis is constantly updating their platform to provide a better playful environment for their community.

Oyente

Announced in collaboration with Melonport, Oyente wants to become the tool needed for security smart contract testing. They allow users to run the smart contract in testing mode in order to identify possible bugs or typos in their codes. Making it a very powerful tool for analyzing smart contracts security.

This tool will have an enormous impact on smart contracts development and adoption, as it will allow any developer to check for any possible vulnerabilities their contract may have, preventing this ones from possible future vulnerabilities. As one of their leed developers says “Oyente can be used to detect many common bugs found in smart contacts like reentrancy, transaction ordering dependence and so on. What’s more interesting is that Oyente’s design is modularized, so this allows advanced users to implement and plug in their own detection logic to check self-defined properties in their contracts.

Agrello

Legally bind smart contracts powered by Artificial Intelligence, that allow a user to formalize multi party agreements, in an incredibly easy way. Your agreement is translated to Agrello’s smart agreement markup language and reflected in a public blockchain.

In parallel, a legally binding document, written in natural language, is created and digitally signed. The Agrello team is working on developing AI that can serve as a legal agent and act for the users personal interests. The AI will help the user to navigate through all the agreement conditions, it will also notify them of all the legal implications derived from the contract and will automate the execution of the contract for your behalf.

RSK

It’s the first open-source smart contract platform with a 2-way peg to Bitcoin that also rewards the Bitcoin miners via merge-mining, allowing them to actively participate in the Smart Contract revolution. RSK goal is to add value and functionality to the Bitcoin ecosystem by enabling the development of smart-contracts on the largest and most secure blockchain up to date.

The implementation of smart contracts on top of the Bitcoin Blockchain is achieved using a sidechain, which allows to move bitcoins from the main chain to the sidechain. This new addition on top of the Bitcoin blockchain, will allow developers to implement smart contracts on it while using a turing complete programming language.

Augur

It combines the magic of prediction markets with the wisdom and power of a decentralized network to create a stunningly accurate forecasting tool. Their goal is to give their users the chance for making real money trading profits betting on the outcomes of future events.

A user makes predictions by trading virtual shares in the outcome of events happening in the real world. A user from anywhere in the world can know the outcome of an event as well have access to buy and sell the shares of the outcome in any market they would like to participate in.

Aeternity

The æternity blockchain is designed to deliver unmatched efficiency, transparent governance, and global scalability. Smart contracts exist only inside off chain state channels. Just in case of disagreement the smart contract code gets enforced by the æternity blockchain. An oracle machine connects public real-world data with smart contracts.

Aeternity allows its users to connect real word data with the smart contracts deployed on their Blockchain through the use of oracles. Given the fact that Aeternity has a decentralized and trustable network of oraclues, the number of smart contract use cases using such connectivity is quite staggering.

Kleros

It’s the blockchain dispute resolution layer. Their goal is to become the Jurors of the digital world, resolving juridical problems users may encounter while using smart contracts. Kleros connects users who need to solve dispute, with jurors who have the skills to fairly settle them, making this process fast, secure and affordable.

The process is fairly simple, users who have a smart contract dispute have to create a new smart contract and choose Kleros as its adjudication protocol. Then a tribunal is drawn from the Kleros crowd so they can evaluate the evidence and cast their votes to resolve the smart contract dispute. Once all the votes have been casted, the winning decision is enforced by the second smart contract created with Kleros.

Out of all the industries that are going to be disrupted by blockchain technology, the financial industry is going to be the one that suffers the biggest disruption. This is neither because blockchain technology works best for this industry, nor because the first use of the technology was a cash electronic system, but because is one of the sectors that hasn’t changed much since the advent of the internet.

Blockchain technology will change the whole trading and settlement process in a way we have never seen before. Business functions like over the counter derivatives and bonds trading will be massively benefited through the use of blockchain technology.

It can provide financial institutions real-time, cost-effective, secure and instant settlement trade models that can be global, decentralized and transparent. This will help a large number of companies to cut out transactions costs and explore better ways of increasing their cost efficiency. As BlockchainCan points out, if you can “speed up the process in which assets change hands, capital requirements drop because there is a resulting lower rate of operational risk and counterparty risk.

As an added bonus these environments are cryptographically secure and since they are distributed they are less vulnerable to single-point-of-error due to operational failure or due to cyber attacks. The concept of Smart Contracts is extraordinary. They create value not only for financial entities alone but to society itself by serving as codified rules that once agreed, no one can alter. Whether we like it or not, this technology is gonna have a profound impact on how we interact with each other both financially and legally.

Within the Smart Contracts that apply to the financial industry, these are the companies that stand out the most:

Velocity

Velocity is a smart contract based derivatives platform that allows anyone to speculate in any price bid.  Velocity hedges risks by eliminating the need for centralized third parties. Instead, funds are held in fully backed smart contracts that execute automatically once the outcome of each bid is determined. It is a decentralized options platform that gives their users the chance to contract a collar option using a smart contract. This will automate the bet on whether the user thinks that the price will rise in the long term, or could fall in the short term. The users whose bets output is correct, will earn the reward.

Clearmatics

Clearmatics is already building out financial market applications with top-tier financial services partners to streamline payments and clearing and settlement processes. Their platform brings together all the participants on a single platform, where members can settle instruments and automate any post-trade processes using our Decentralized Clearing Network (DCN) technology.

All of their technology is build upon a “Distributed Virtual Machine”, which combines logic and the ledger itself, to achieve a greater automation of business logics. The platform uses a Utility Settlement Coin, which will allow for the trades of the platform to be settled with synthetic “central bank money”. Their solution will allow entrepreneurs to create entirely new business models around financial market applications.

Equibit

Equibit is the world’s first peer-to-peer OTC capital market and a complete platform for issuers to manage their investor relations without the need for depositories and transfer agents. Equibit allows issuers to use cryptocurrency tokens, called ‘equibits’, to authorize and disseminate their securities. It also includes a secure, P2P communications system allowing for private messages and polls to be instantly sent to individuals and groups on the network.

Barclay’s smart contracts platform

Barclays banks was one of the first big banks to embrace the technology and potential of smart contracts. They have been working on a very simple but useful interface for attaching complex financial products, like derivatives, swaps or futures with smart contracts.

Their goal is to create somewhat of a template for all of the financial products to allow any entity to modify such contracts according to their needs. These newly created templates can translate three lines of a contractual agreement into three lines of code that the smart contract would need to execute.

AXA

The giant insurer, AXA is one of the companies pioneering the use of this technology to improve their business model. They are using the Ethereum Blockchain to pilot a project on the handling the payment of delayed flights. Their clients can insure the plane ticket that gets tied to a smart contract. In case of a flight delay, the contract executes automatically, returning the funds and a premium instantly to the user.

REGULATORY COMPLIANCE

An astronomical increase in regulation has left the financial markets in a huge uncertain operational fields. Compliance teams are overloaded with work, while struggling to meet the constant increase of the regulatory demands. That’s why they see Blockchain technology as the best ally for regulatory agencies due to the transparency and traceability that brings into the table. Even Though many people in the space see the regulatory agencies as the enemy, regulatory agencies and blockchain are a fantastical match.

Blockchain promises to disrupt the way companies deal with compliance requisites, allowing them to have the speed and flexibility needed to stay alive in the new global digital era. Thank to the use of blockchain technology we can create an environment where market players and regulators have access to a trustable and audiatable dataset. An access to such thing, would allow firms to get rid of all compliance duties and risks, as the regulator would have full access to all the data, instead of having to wait  for the firms to send it.

There are three main areas in which blockchain technology will impact mostly the regulatory compliance industry: reduction of fraud, knowing your customer rules, and auditability.

Reduction of fraud: New banks created on top a blockchain or distributed ledger, will allow to prevent false information to be replicated as the records held in a blockchain are encrypted and verified every time a transactions occurs. If someone tries to alter such records, the rest of the network participants will find out what type of data is trying to be changed.

KYC: Know Your Customer procedures have become one of the most painful areas to Financial Institutions have to comply with. In order to comply with all the existing regulations, banks have to spend absurd amounts of money. Thank to blockchain and the developing of new compliance platforms on top of these networks, banks will be able to reduce huge operational costs while increasing their efficiency to comply with the existing regulations. It will also help to build a healthier relationship between the institutions and the regulators as they would be working together instead of against each other.

Auditability: Blockchain or DLT technology will also help the reduction of fraud by giving the network participants the chance to trace where the money comes from, where it goes and who has is the real owner of the funds. The digital token will erase the actual paper document solutions. The process will be transparent, secure and immutable, which will allow to create and audit log of someones historic to check the authenticity of each one of them. All of these characteristics of trading between peers using blockchain or DLT technology will give a new level of trust between network participants that has not been seen before.

Little by little we are seeing how the regulatory agencies are getting involved in the development of this new decentralized world. Many people foresee a future where the code deployed in a blockchain is the actual rule of law. While we are far away from such world, step by step we are getting closer to a rule of law much more transparent, efficient and autonomous that the existing one.

That is why recently, formed an alliance on top of the R3 alliance to create a program to train lawyers for the future that is upon us.

From our point of view, these are the companies that stand out the most in this market segment:

Libra

Libra is a universal control, compliance, and reporting solution for distributed ledger technology. It allows companies to use the latest software for monitoring, auditing, reporting, and compliance capabilities. Libra Enterprise is also a protocol agnostic and connects to any external data source, which means the platform serves as an aggregator housing entirely new and valuable datasets.

Blockverify

Blockverify wants to have a global, positive social impact by using blockchain technology to “make the world more honest and authentic”. Its technology provides a distributed ledger solution, which allows companies to prove exactly where their products are in the supply chain at any given time, and for businesses and end consumers to trace the source, establish authenticity and prove ownership of their purchases. They provide a blockchain solution for anti-counterfeit goods.

Elliptic

Elliptic aims to help authorities to fight crimes by tracing those transactions made by users who wish to buy illegal products or services. Elliptic tracks transactions across hundreds of entities to connect Bitcoin addresses with real world actos.

Their proprietary database links millions of Bitcoin address to thousands of clear web and dark web entities, delivering actionable evidence in cases involving international arms trafficking, money laundering, theft or drug offences for example. Elliptic monitoring capabilities will help law enforcers to catch those actors that put a bad reputation on this decentralized networks by profiting from the pseudo anonymous nature of them.

Coinfirm

It focuses on managing risk and compliance. Coinfirm AML/CTF platforms increases efficiency and receives structured data in the form of reports with compliance conclusions so business can monitor and protect wallets, get notifications on suspicious wallet activities, as well as risk ratings regarding the transactions the business has conducted. Thank to the use of APIs, users can connect to Coinfirms platform that will integrate them with almost any blockchain network, providing them with automated AML assessments on the network transactions.  

Auditchain

It’s the world’s first decentralized continuous audit and real time reporting ecosystem for enterprise and token statistics disclosure enabling enterprises to provide stakeholders and regulators with the highest levels of audit assurance.  Auditchain uses their compliant smart contract platform to provide in real time data such as a company’s balance sheet, income statement, cash flow or equity reports. Their goal is to make the cryptocurrency space much more transparent and compliant with existing financial regulations.

Crystal

Recently announced the Bitfury group, Crystal is a tool to provide a comprehensive view of the Bitcoin Blockchain and uses advanced analytics and data scraping to map suspicious transactions and related entities and also offers a proprietary risk scoring system to assist investigators in revealing and tracking malicious behavior. With this tool, Crystal aims to become the number one solution for regulatory agencies and entities interested into tracing the malleability of funds or assets across multiple blockchain networks.

Even though Smart Contracts brings the chance of changing many aspects, most of the changes are still far ahead from today. Smart Contracts still need many hours of development to improve the security and other aspects.

Once the security issues are more or less controlled and it’s very hard to find a vulnerability on well-written code, smart contracts will be more and more adopted. Its then, when we will see a different way of interacting with one another since we know that the contract we establish is we agree on.

By law, we mean that it will execute no matter what, no third party can deny it or alter the contents of such contract, and people will not need to trust each other to establish contractual agreements since the contract is all the trust they need.