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Legal hurdles in blockchain and digital finance systems

By Amrit Soar

The words Bitcoin or Ethereum may not fall within our everyday lingo but most of us know they are digital currencies or “cryptocurrencies” that are not controlled by the Central Bank of Kenya (“CBK”) and can be sent to anyone without the need of an intermediary.

Cryptocurrency can be traced to the cypherpunk movement of the early 1990s that brought together libertarian ideology based on the need for people to interact among themselves away from governments and big corporations. Currently, the finance ecosystem is centralized, and this extends to related services such as lending, insurance, and the stock market.

In centralization, decision making is entrusted and retained at top level management. The custodians of these institutions often take risks that may not necessarily yield good results. Indeed, between 2007 to 2009, the US financial crisis happened. The genesis of it was the proliferation of home loans by financial institutions to individuals with poor, incomplete, or non-existent credit histories with the hope of making good returns through high interest rates. Default rates went on the rise and the US economy tanked. In response, the Federal Reserve Bank enacted a slew of measures to stem the crisis including emergency liquidity lending using taxpayers’ funds which resulted in widespread public discontent.

So, how is decentralization any better? The technology that enables decentralization is known as blockchain. Every time someone buys, sells, or transfers cryptocurrency on a decentralized exchange, or buys a good or service with cryptocurrency, a ledger records that transaction, often in an encrypted fashion, to protect it from cybercriminals. These transactions are also recorded and processed without a third-party provider, which is usually a bank.

In Decentralized Financial (“DeFi”) systems there is no central authority and anyone with internet connectivity can access them. How do these systems come to be? First, an infrastructure, on which such services are often programmed and run, is needed. For example, Ethereum is not just a cryptocurrency, but an open-source, blockchain-based platform that anybody with the technical skills can use to write smart contracts.

Once information gets to a blockchain, it cannot be edited or altered. Essentially, once the rules on how a given service will work is deployed on Ethereum, no one retains control, meaning those rules are absolute, creating a public, transparent, permanent system.

With DeFi there is no custodian, only the consumers involved in a transaction can retain control of their crypto assets. Some of the popular DeFi projects are executed in decentralized exchanges that facilitate insurance, derivatives, data analytics, margin trading, and payments.

While there are many benefits to DeFi, there are several legal implications that one needs to be aware of. Firstly, blockchain optimists believe that since the smart contracts perform their tasks automatically and cannot be stopped, there is no risk of a dispute arising. However, if there is an error in the smart contract code, there is no way of reversing a transaction once deployed. This can lead to challenges as nobody can modify the code. Consequently, this would present a dispute resolution nightmare for lawyers.

Enforcing smart contracts in the current legal framework would also be a challenge because  a smart contract  is not a contract in the sense of a document or a communication that can be evidence of legally binding rights and duties.  There is little information or precedents that address the enforceability of smart contracts. Scholars claim that they are a means of performing obligations deriving from other agreements. Also, it would be difficult to identify the person against whom the claim should be made. To put this into context, nobody still knows the identity of Satoshi Nakamoto – the creator of bitcoin. Further, smart contracts operate through distributed computers across the world making it very difficult to determine the jurisdiction and applicable law.

Building a mediation or arbitration framework for the blockchain network is a practical solution to mitigating some of the risks associated with the immutability of smart contract codes. Unfortunately, this is not achievable with the current legal system. Keeping up with rapidly evolving technology continues to be the bane of the legal system and DeFi, albeit an appealing option, only makes it worse. Imagine a scenario where someone enters a smart contract with a foreign partner in a transaction that overhauls traditional escrow. If a dispute occurs, conventional courts will have difficulty defining the nature of their transaction because it is limited to the statutory definition of escrow.

There will be need for innovative legal tech practitioners to find a viable way of integrating an arbitrable issue management clause in DeFi smart contracts. This will ensure that the parties involved have a dispute resolution option if anything goes amiss with the automated and self-executing codes. 

DeFi is a highly attractive concept, and it is quickly gaining ground but the inability to resolve disputes, and errors in the smart contracts are some of the most glaring challenges with the DeFi systems. However, there is an opportunity for lawyers to leverage their understanding of dispute resolution to develop a legal framework for settling the issues arising from DeFi systems. 

The article was featured in the Business Daily on 24 August 2021 and can be accessed here .