Josias N. Dewey, Partner, Holland & Knight LLP
While the bitcoin community is still robust, there is no denying that the focus today is on the collection of technologies that form the underpinnings of Bitcoin—known as blockchain or distributed ledger technology (DLT). While bitcoin is still the most battle-tested and used blockchain implementation today, it was intended to be a digital currency that solved a host of past impediments for adoption, including the classic “double spend” dilemma. Fast forward to the present and you’ll find everyone from the largest global banks to the smallest start-ups working on blockchain applications to solve a host of problems across virtually every industry, including financial services, trade supply, regulatory tools for KYC compliance, and even licensing for music, art, and other intellectual property.
While there is plenty of debate on when blockchain technology will be felt from industry to industry, it’s almost a given that the technology will permeate most industries within the next several years. The general consensus is that finance will be one of the first industries to feel its impact. Digital currencies and related payments systems, however, will only be part of the implementation of blockchain in finance. There are also many nonpayment-related applications that will also affect finance. It’s this subset of applications where both finance and law will be significantly impacted by blockchain technology, much of its impact being at the intersection of both disciplines. This means law firms and financial institutions will need to work together to develop many of these blockchain-based solutions.
Below are five possible projects that could add value at the intersection of law and finance and significantly improve not only the client-lawyer relationship, but the economic bottom line for both financial institutions and law firms. In each case, I’ve defined not only the problem and solution, but also how blockchain adds value beyond that found in a traditional centralized ledger.
Regulatory examination portal
Problem: Routine bank examinations. This could be very useful for small to mid-size banks that are still struggling with examiners questioning particular loan exceptions and missing documents. The current arrangement often requires a bank officer to rummage through boxes and ad hoc scanning of in-house document portals in hopes of finding the requested document. After that fails, inquiries are sent to the bank’s outside legal counsel, who in turn is often stuck hounding third parties for the missing item.
Solution: Create a permissioned ledger among a group of banks and the law firms that routinely act as counsel for them. The ledger would catalogue all documents from the closing, including post-closing items, with each item having a link to a decentralized storage solution where the document resides.
Why blockchain: Blockchain is highly secure. All information is encrypted and access is controlled by private keys, which can be stored in physical multifactor tokens. Regulators only need one private key or access token to gain access to all of the information for all of the participating banks. Participating banks and legal counsel only have access to their respect transactions – so banks can’t see each other’s deal files. Access and design of the solution should be supervised by legal counsel to ensure compliance with all applicable regulations and internal bank policy.
KYC and AML compliance portal
Problem: The cost of existing programs to comply with KYC and AML requirements is significant. While there are a number of technology-based solutions for KYC/AML, the application of the rules in many financial institutions is inconsistent, and for many in management, it seems downright incoherent – especially in the context of establishing new customer relationships.
Solution: Create a permissioned or public ledger among a group of regulated companies. This group could include anyone who is subject to KYC/AML compliance and other companies who may not be regulated, but nevertheless could suffer reputational harm by doing business with the wrong people. If these companies, law firms, and one or more outside data providers (e.g., see Thomson Reuters’ proposed BlockOne ID for Ethereum) collectively approached this problem, greater consistency would develop in the application of KYC and AML requirements, and the coordination of those involved would certainly lead to greater innovation in this area, and ironically, lower costs by eliminating redundant expenses.
Why blockchain: All of the information on the blockchain is immutable and tamper proof, thereby eliminating any ability of bad actors to scrub themselves or associates from the ledger. The most knowledgeable individuals in the world on this topic would be working together to solve a common problem. In addition, smart applications could be deployed with built-in consensus algorithms that would permit only those changes to the compliance workflow achieving sufficient support from the maintaining community. Ultimately, the entire KYC/AML process could be distilled down to making a call to a “smart contract” deployed on the blockchain, which in turn would respond with all of the information and guidance necessary for the interested party to make a decision.
Transferable records (eNotes) programs
Problem: While many legal obligations exist solely in digital format, promissory notes are for the most part still confined to the paper world. The difficulties faced by numerous lenders during and following the financial crises highlight the burdens of requiring physical promissory notes in a digital world.
Solution: Both the Federal E-Sign Act and the Uniform Electronic Transactions Act (UETA) established the concept of a “transferable record,” which is a digital instrument that, if in written form, would be a negotiable instrument under Article 3 of the UCC. Establish a permissioned ledger pursuant to which transferable records (eNotes) can be stored and ownership tracked.
Why blockchain: Immutability and security based on public key encryption, both of which are inherent in blockchain technology, easily meet the requirements under E-Sign and the UETA to establish a transferable record. Recent caselaw also suggests that courts are strongly behind implementing the policy of digital instruments. It’s worth noting that even real estate secured loans can be accomplished with digital signatures, including notary acknowledgments, which can even be done online now with services like notarize.com.
A smart contract ledger for routine transactions
Problem: There are a number of transactions routinely entered into between financial institutions every day, such as loan participations and intercreditor agreements, that should be standardized. That’s not to say all loan participations and intercreditor agreements are the same, but there is certainly a subset of each for which general consensus exists.
Solution: For those transactions that fall within the routine subset, develop a series of smart contracts implementing those relationships on the blockchain. The ability to enter into such agreements and store them on a decentralized ledger will significantly reduce transactional costs and materially increase the speed at which such transactions can be effectuated.
Why blockchain: In order to maximize the reduction in transaction costs, all participants need to be operating under uniform rules rather than disparate systems. By developing and designing a decentralized system together, the users of the platform ensure agreement on the rules governing these routine transactions and share the cost to build one system rather than each participant needing to build its own platform.
Creation of an industry-specific DAO to foster innovation
Problem: One of the more interesting (but certainly difficult) uses of blockchain technology is the development of smart contracts that replicate corporate-like structures on a blockchain. Instead of a traditional corporation which is owned by holders of stock certificates and managed by a board of directors, decentralized autonomous organizations (DAOs) issue digital tokens that evidence an interest in the DAO and are governed by the holders of those tokens. Attempts at creating successful DAOs have proved difficult (Google or Bing “The DAO hack”).
Solution: The creation of experimental DAOs that are owned and controlled by a consortium of industry participants. The purpose of such a DAO would be to foster development and research in this area, which is really needed.
Why blockchain: In this case, the entire concept of a DAO is premised on blockchain technology. Efforts like this could go a long way towards making DAOs a valuable tool in the future.
Do the above projects sound too ambitious? While much work needs to be done and enterprises wishing to pursue these projects must be willing to commit resources, they are achievable. I know that for a fact because we have built out prototypes of many of these systems and are nearing completion on others. Through cooperation with our in-house lab (yes, the day has come when law firms have tech labs), we’ve had great success designing prototypes that not only work, but are more secure than existing systems and solutions. Again, the above is just a small sliver of achievable blockchain systems that can be implemented and tested today. If you can think of others, please let the community know – spread the word. Education and discussion are key to the advancement of blockchain technology in finance and law. Who knows, you might hold the key to the next revolution in finance or law.