Eugene Grygo, Chief Content Officer, FTF News
Through its LabCFTC extension for FinTech innovation, the CFTC has issued a primer “intended to be an educational tool” to explain what a “smart contract” actually is (in case you’re not certain), and to point out some of its shortcomings.
“Fundamentally, a ‘smart contract’ is a set of coded computer functions,” according to the primer. “Such a contract could incorporate the elements of a binding contract (e.g., offer, acceptance, and consideration), or may simply execute certain terms of a contract.”
The primer does acknowledge the biggest promise of distributed ledger technology (DLT) and the ultimate blockchain: “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,” according to the primer. “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.”
The promise is based upon DLT systems that form a blockchain, which “is a continuously growing database of permanent records, ‘blocks,’ which are linked and secured using cryptography,” according to the primer. “The attributes of a smart contract give rise to potential benefits throughout an economic transaction lifecycle, e.g., formation, execution, settlement.”
One key benefit close to the hearts of regulatory staff members is the “built-in regulatory compliance (e.g., cannot sell to a non-eligible contract participant (ECP); cannot sell until mandated period has passed; or must report certain data).”
The new technology will also yield new regulatory reporting models because “smart contracts automatically report data at pre-determined intervals,” according to the primer. Stress testing is part of smart contracts and regulatory nodes because they are able to “execute scenarios on smart contracts to determine payouts across the network.”
Smart contracts could also have several uses for key financial markets participants:
- For derivatives, they could “streamline post-trade processes, real-time valuations and margin calls;”
- For securities, they could “simplify capitalization table maintenance (e.g., automate dividends, stock splits);”
- For trade clearing and settlement, they can “improve efficiency and speed of settlement with less misunderstandings of terms;”
- And, for data reporting and recordkeeping, there could be “greater standardization and accuracy (e.g., swaps data reporting, regulator nodes for real time risk analysis); [and] automated retention and destruction.”
The regulator also charts some of the serious downsides of smart contracts such as:
- How they could enhance market activity and efficiency, but could also unlawfully circumvent rules and protections;
- How they ensure accurate books and recordkeeping but also introduce risk, including operational, technical and cybersecurity;
- And how smart contracts could complete the process of prompt regulatory reporting but also be subject to fraud and manipulation.
In addition, the primer also noted many operational risks such as:
- The lack of “appropriate or sufficient backup/failover mechanisms in case something goes awry;”
- How smart contract platforms may lack “critical system safeguards and customer protections;”
- And poor governance that may mean that smart contracts will need extra “attention, action, and possible revision subject to appropriate governance and liability mechanisms.”
The primer, CFTC officials remind us, “is not intended to state the official policy or position of the CFTC, or to limit the CFTC’s current or future positions or actions. The CFTC does not endorse the use or effectiveness of any of the financial products or technologies in this presentation.”
The primer in full can be found here.
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