LegalTech 3.0: how blockchain and smart contracts can revolutionise compliance

July 2020 | SPOTLIGHT | RISK MANAGEMENT

Financier Worldwide Magazine

July 2020 Issue

In the contemporary business environment, compliance is one of the most crucial departments for many companies, especially in the financial sector. Studies have shown that compliance officers are frequently under significant stress, which leads them to have trouble sleeping or even consider changing their profession. Underlying reasons are lack of resources as well as stress factors such as the obligation to prevent violations of laws and policies and constantly keeping up with relevant regulations.

In addition, it seems that compliance officers are frequently isolated within organisations, being viewed as enforcers and therefore avoided by co-workers. With the increasing density of regulations in both the financial and other sectors it is important that companies avoid compliance breaches, otherwise impending sanctions and negative publicity could cause significant damage. At the same time, an increase in regulations will likely result in increased stress levels for compliance officers. In recent years, new and innovative technologies, such as blockchain and smart contracts, have been on the rise.

Companies and their compliance departments can tremendously benefit from these technologies, as they can be used to simplify complex and sometimes tedious processes. However, the benefits of innovative technologies can only be exhausted when appropriate regulations and international standards are in place.

Blockchain and smart contracts

Blockchain is a decentralised public ledger that irrevocably records transaction data. Therefore, blockchains warrant high levels of transparency. Transactions are conducted peer-to-peer between two individuals or companies without the interference of an intermediary. Blockchains are based on encryption mechanisms and can hardly be hacked. The technology has recently earned much criticism for allegedly facilitating fraud, money laundering and terrorism financing.

Ultimately, these accusations apply mainly to cryptocurrencies which are only one possible application of blockchain technology. From a corporate perspective, blockchain could be a valuable investment as the system facilitates quick and uncomplicated transfers of data. In addition, said data can, due to the blockchain’s inherent characteristics, not be manipulated, which makes the blockchain highly secure.

When it comes to compliance, smart contracts could soon become a feasible support system for attorneys and notaries. Smart contracts are based on blockchain technology and facilitate automated contracts that enter into force in certain predefined circumstances and do not require monitoring. Within the scope of smart contracts, contracts are translated into a code and then saved and reproduced.

The procedure is overseen by the decentralised blockchain network which consists of a multitude of computers. All smart contracts consist of three entities, namely signatures, the subject of the agreement and its specific conditions. Via signatures, all parties that use the smart contract agree or disagree with its terms and conditions. If the subject of the agreement does not exist in the immediate environment of the contract, the smart contract must have unlimited access to it. The specific conditions of the smart contract are defined mathematically via a suitable programming language. Smart contracts can be used to transfer property, stocks, money and other assets without the interference of an intermediary.

Moreover, smart contracts can be used either individually or interdependently with any number of other smart contracts. For instance, the successful conclusion of one smart contract can trigger the implementation of another smart contract. In theory, these mechanisms can run entire systems and organisations.

Smart contracts not only define rules and sanctions within the scope of a contract but automatically effect their implementation. In particular, smart contracts facilitate the transfer of assets or currencies into a programme which then implements the code and verifies whether all prerequisites are met. Smart contracts operate according to the ‘if... then…’ principle, which means that within the scope of a transaction, say the sale of a share, the share will only pass into the buyer’s possession when the agreed upon purchase price has been transferred.

Accordingly, both the money and the ownership are recorded in the system and are distributed to the involved parties at the exact same time. Due to decentralisation, the transaction is verified by countless other users in the system who monitor the transfer. Meanwhile, the blockchain saves and reproduces the transaction’s receipt, thereby offering users security.

In addition, smart contracts can be programmed to enter into force automatically if certain requirements are met. With smart contracts, the monitoring of and compliance with contracts is automatised and can be operated at any time without human interference. Because of the blockchain’s resistance to manipulation, trust between the parties is not required. This also makes intermediaries redundant, which helps users save time and money.

Benefits

To ensure appropriate compliance with the existing legal framework, companies must undertake significant efforts. Frequently, however, these efforts are aggravated by a lack of reference data or resources. With the help of so-called ‘LegalTech’ (legal technology), procedures can be automatised via the integration of rules and control mechanisms into smart contracts. These mechanisms could include sanctions screenings or licence verifications. Within the scope of corporate governance, blockchain technology can improve internal communication and processes. Normally, the course of business is frequently interrupted by waiting periods, for instance when certain permits are required, or internal questions must be settled. The inherent features of blockchain make it possible to manage processes more efficiently.

From a corporate perspective, it generally seems reasonable to store data on the blockchain. Companies that are obligated to store their data over a certain time period are often confronted with significant bureaucratic expenditure, if documents are mainly paper based. Even if documents are digitalised, they cannot be 100 percent secure from hackers or technical malfunctions. The blockchain, on the other hand, is both immutable and decentralised, which means data can easily be recovered.

When utilised in banking, is it important that smart contracts comply with all national and – depending on the situation – international compliance regulations so they are legally valid. Smart contracts could facilitate customer due diligence and Know Your Customer procedures by limiting the time required for filling out and processing forms. The blockchain could serve as a database that documents and stores verified customer data and facilitates the exchange of data with other companies and authorities.

Thus, banks could ensure that all relevant updates on their customers are made available to all relevant entities instantly. By using blockchain and smart contracts, banks will thus be able to save time and money. Within the blockchain system, compliance officers’ duty could be comprised of designing compliant processes and smart contracts.

Risks

Although smart contracts come with many advantages, they are also subject to certain risks and limitations. One disadvantage of smart contracts is that the technology is still in its infancy, which means that it can be associated with complications. For instance, programming errors could accidently be incorporated in the encryption. Such bugs could be abused by imposters. In particular, if money is transferred to an intelligent account with a fraudulent code, the funds could be stolen.

In addition, smart contracts continue to be surrounded by legal uncertainty as most jurisdictions have not yet established appropriate regulations or rules for their taxation. It is also unclear how users of smart contracts would be able to appeal against a decision, for instance if property that was transferred via smart contract were to be seized before the physical transfer has taken place. Innovative technologies frequently outpace any regulation that has been implemented, which makes it difficult for companies to use them. It is not advisable for corporations to act in legal grey areas, which is why most firms will likely refrain from implementing blockchain and smart contracts until they are sufficiently regulated. Unfortunately, legal uncertainty can therefore lead to a standstill in innovation.

However, it is undeniable that smart contracts have the potential to revolutionise compliance and other areas and could soon become an integral part of society. They have the potential to significantly disburden compliance officers by making complex processes less tedious and ensuring that all conditions of a contract are met. It can be expected that with time and increasing use of the technology appropriate legislation will follow. Some jurisdictions – spearheaded by Liechtenstein – have already begun to regulate blockchain.

Most regulatory efforts, however, focus exclusively on cryptocurrencies. From a corporate perspective, it is important that any jurisdictions in which the company operates are not opposed to blockchain so that the implementation of smart contracts within the scope of LegalTech continues to be an option. At the same time, a certain degree of regulation is necessary as otherwise, potential risks arising from legal uncertainty would likely outweigh the benefits of blockchain and smart contracts.

Dr Fabian Teichmann is an attorney at law and public notary and Marie-Christin Falker is a research associate at Teichmann International (Schweiz) AG. Mr Teichmann can be contacted on +41 (71) 260 2440 or by email: teichmann@post.harvard.edu. Ms Falker can be contacted by email: falker@teichmann-law.ch.

Fabian Teichmann and Marie-Christin Falker

Teichmann International (Schweiz) AG