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Contracts bind people and companies to perform reciprocal actions, and invoke the force of law if they are formulated correctly. Some contracts are carried out immediately, like sales of goods, but the full power of the contract in society is seen in those which are carried out slowly over many years. These include the mortgages contracts which enable us to buy houses, the derivatives and options which mellow our economy, and the shipping orders which ensure our supermarkets are always stocked.
Lawyers are enlisted to draft and negotiate these contracts in part to ensure that the terms agreed are sufficiently foresighted and flexible to respond to the vagaries of life. Unfortunately, the pace of recent political and economic change has undermined some long-term contracts in such fundamental ways that lawyers, industry groups and regulators are struggling to provide solutions. The question arises: can contracts as we know them support the dynamic requirements of modern life?
Following the last financial crisis, the UK government decided that major UK banks should be split into two separate legal entities: the 'retail' bank and the 'risky' bank. The question of which contracts were 'risky' was often fraught. A 'grey zone' of contracts emerged (such as loans to universities and housing associations) which bore some but not all of the features of risky investment contracts. In order to squeeze them into the protected retail bank, many thousands of borrowers had to be contacted individually, informed of the changes to the legal landscape and asked to novate contracts they had agreed years previously to a new lender.
The LIBOR-rigging scandal has produced a similarly vexing and expensive situation. LIBOR was used for decades as a floating interest rate for mortgage repayments, but the rate will no longer be used after 2021. Mortgage contracts have long included clauses accommodating certain predictable events (such as requests to repay early). But no one expected the demise of LIBOR, and some mortgage contracts don't contain any general variation rights for use in truly unexpected situations. Whilst lenders can contact their borrowers and ask them to agree to calculate repayments using a new rate, what happens if the borrower refuses? It might be that the interest rate cannot be calculated at all, perhaps making the contract void for uncertainty. Not the result either party intended!
The solution which some hope will resolve the LIBOR problem is legislative intervention to give lenders the power unilaterally to move contracts to the replacement rate. But what about a contract which can't be altered by anyone? Smart contracts, such as those deployed on Ethereum or other blockchains, are designed to be 'trustless'. The aim is that the parties don't need to rely on each other or any legal system, and can be achieved because the obligations which the parties agree are 'locked in' on execution.
The pitfalls are obvious in light of the problems described above, but the tool which smart contracts use to avoid them is called an 'oracle'. An oracle is, in technical terms, an API to an outside information source, whether the stock market or the weather forecast, which feeds data to the contract. Use of the correct oracles, possibly including an arbitration service, may enable smart contracts both to respond to the unexpected and still be fully automated. But the message should be clear – even the smartest contracts can't predict the future.
Rory is a solicitor in the Financial Regulation team at Pinsent Masons LLP, with personal academic interests in private, public and international law approaches to emerging financial technologies. All opinions expressed are his own. You can find him on LinkedIn.
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Rory is a solicitor in the Financial Regulation team at Pinsent Masons LLP, with personal academic interests in private, public and international law approaches to emerging financial technologies.
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