legal / regulatory overview of blockchain …...2015 - 2016: so called blockchain technology of...

LEGAL / REGULATORY OVERVIEW OF BLOCKCHAINAPPLICATIONS

Luxembourg26-27 November 2018

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1. BLOCKCHAIN: DEFINITION AND CHARACTERISTICS

2. SMART CONTRACTS

3. SMART CONTRACTS IN THE FINANCIAL SERVICES FIELD

4. GUIDANCE PROVIDED BY THE SUPERVISORY AUTHORITIES

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BLOCKCHAIN:

DEFINITION AND CHARACTERISTICS

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1. Blockchain: definition and characteristics.

* The peer-to-peer architecture is different from the client-server architecture, as it allows all the involved players to participate in using the registry. In fact, each of such player hasan integral copy of the registry and all players are connected in an equal way.

*** By way of example, next to the Bitcoin Blockchain, other Blockchain applications are under analysis, from the insurance to the agri-food sector.

EVOLUTION OF BLOCKCHAIN.

✓ In the ‘90s: the concept of “distributed register” commenced to be used

✓ 2008 - 2014: so called Blockchain technology of first generation The concept of distributed register managed inter pares through a consensus mechanism was introduced. Blockchain is associated almostexclusively with crypto-currencies.

The first description of the new technology dates back to the announcement - made in a white paper in 2008 by the inventor, Satoshi Nakamoto - regarding therising of a new electronic currency “peer-to-peer*, that will allow online payments sent directly from one side to the other without the need of a financialinstitution”.

According to some scholars, blockchain could be deemed to be not only a new technology, but rather «An extraordinary combination of several alreadyexisting technologies, some of which existed for several decades (cryptography, digital signature, distributed databases and consensus mechanisms), whichhave been “assembled” in a new way to solve problems related to the adoption and diffusion of digital currencies».**

✓ 2015 - 2016: so called Blockchain Technology of second generation.Distributed Ledger Technology (DLT) and DLT platforms (i.e. Blockchain) came into use to manage «smart contracts». These latter aredigital contracts, including clauses that can be automatically performed by blockchain, once they have been digitally finalized by the parties.

Blockchain thus became a technology potentially able to be used in a variety of fields, with modalities and applications that required in-depth study andanalysis. ***

✓ Next step: Blockchain to integrate with Internet of Things (IOT).

IOT consists of DLT platforms that connect “informatically” various objects of daily use and manage some processes in total or partial autonomy.

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DEFINITION OF BLOCKCHAIN.

DEFINITION ADOPTED BY EXPERTS:

➢ FAIOLI*

Blockchain is a so called “trustless technology”, i.e., «with or without the intervention of the rules of a state system, and therefore beyondthe rules set out under the law, there is a transnational private system that, having allowed the download of a data in digital computing,makes it truthful, for all operators, always monitorable, unmodifiable, without the contribution or control of a third public authority».

Smart contracts are defined as such since they “auto-define their own contents, on the basis of the object and the cause agreed upon by theparties («computer programs that autonomously execute the terms of a contract»)».

Data feeds are, rather, «contracts that allow the circulation of information between smart contracts” («contracts on the blockchain thatserve data requests by other contracts»)».

→Metaphorically: Blockchain is the rail, smart contracts are the wagons, data feeds are the goods / services that circulate.

➢ COGLIANO**

Blockchain is «a ledger made of several blocks containing digital information of any type as data, ownership rights,pictures, or any other data having a digital nature; blocks are connected sequentially and chained immutably».

→ Metaphorically, the ledger of which blockchain is composed can be imagined as a paper register (for example a journal book for double-entry accounting records) made of pages that can not be torn. Each of such pages contains a kind of summary of the previous pages, which factmakes the previous pages, as well as a single page, unalterable, unless the content of all previous pages is modified.

1. Blockchain: definition and characteristics

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DEFINITION OF BLOCKCHAIN ADOPTED BY THE EUROPEAN INSTITUTIONS:

➢ The European Network and Information Security Agency (ENISA) has defined blockchain as:

“A public register containing all the transactions that took place in a peer-to-peer network. This is a decentralizedtechnology that allows participants in peer to peer networks to perform operations, such as online payments, without using theintermediation of a central trust authority”.*

➢ This Definition was also recalled by the European Commission in its Communication no. 228 of 10 May 2017 to the EuropeanParliament, the Council and the Committee of the Regions on the mid-term review of the implementation of the Digital SingleMarket Strategy (“A Connected Digital Single Market for All”).

On this occasion, the European Commission, envisaged the creation of a EU Blockchain Observatory and Forum(Osservatorio e forum dell’UE sulla blockchain), which was finally launched on February 1st 2018 and organizedinto two working groups, with the task of:

(i) monitoring the developments of blockchain,

(ii) developing the relating skills,

(iii) disseminating information on concrete cases

➢ The Economic and Social Committee of the European Union (EESC) has highlighted the absence of central control as a typical feature of blockchain. In particular, in an opinion focusing on this matter,** the EESC specified that «blockchain works without any centralized control body, in a transparent and secure manner. Both companies and individuals can use this system to carry out certain operations and bypass the financial sector, in particular usingcryptocurrencies».

1. Blokchain: definition and characteristics

* See ENISA’s Glossary on blockchain, available on the web site: https://www.enisa.europa.eu/topics/csirts-in-europe/glossary/blockchain

** See Opinion of the European Economic and Social Committee on 'Digitization and innovative economic models in the European financial sector: impact on employment andcustomers', (2017 / C 246/02), Art. 3.4, July 28, 2017.

https://www.enisa.europa.eu/topics/csirts-in-europe/glossary/blockchain

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➢ The European Parliament, in a study carried out in 2017 by the European Parliamentary Research Service (EPRS)focusing on “How blockchain technology could change our lives”, highlighted the possible applications of blockchainin the following sectors:

- Distribution of digital contents: through the management of individual rights associated with the trade of digitalproducts;

- Patents: blockchain technology could be used to achieve greater efficiency over time and recording modalities;

- E-voting: through the creation of voting systems characterized by a high level of transparency and democracy;

- Supply chain, providing a low cost infrastructure for the registration, certification and monitoring of goods andproducts to be transferred between parties;

- Public administration: ensuring a greater security, transparency and speed of consultation of public registers.


BLOCKCHAIN ARCHITECTURE.

From the above definitions, it emerges that blocks are the fundamental units of blockchain technology. Each block contains:

i. A series of information concerning a fixed number of transactions;

ii. A connection with the preceding block of the chain;

iii. An answer to a complex maths query used to validate and confirm the data contained in each block.*

The configuration of a blockchain is based on the so called consensus mechanism, i.e., a set of rules through which blockchain usersreach an agreement on the content of a block and decide to add it to the chain. Decisions are thus connected reciprocally and renderedunalterable.

Speaking of Bitcoin, for instance, as a consensus mechanism it used the so called Proof of Work, i.e., a proof of the work which hasbeen made. Proof of Work requires that certain computers included in the network (so called, miners) solve complex maths problems,in order to validate the block and confirm that it can be added to the chain.

Each transaction within the blockchain technology is validated through an electronic signature system** created through a specific hashfunction, aimed at comprising all the transactions of a single block in a sole and immutable data string. Each computer belonging to thenetwork contains a copy of all the transactions recorded in the blockchain and a periodic syncronization ensures that all computershave the same distributed ledger.

TYPES OF BLOCKCHAIN.

➢ BLOCKCHAIN BASED ON TOKEN VS BLOCKCHAIN BASED ON SHARING OF INFORMATION BETWEEN ALL PARTICIPANTS.

Blockchain based on tokens, i.e. based on digital assets (as bitcoin), which can be exchanged, differ from blockchain based on the sharingof information between all participants, where assets are not exchanged (potentially applicable for the recording of information).

➢ PUBLIC, PRIVATE AND HYBRID BLOCKCHAIN.

- Public blockchain, so called blockchain permissionless, allow the access by all internet users who can operate unconditionally. This is the mostcommon type of blockchain. Public blockchains are open, and thus have not an «owner» or key-player, and are conceived as under no kind ofcontrol. The most significant examples of public blockchain are Bitcoin and Ethereum.

- Private blockchain, so called blockchain permissioned, requiring a validation from the central authority – which created blockchain – on theadding of new blocks to the chain and, thus, of the relating transactions. Private blockchains are accessible to a limited group of people, so called«trusted», involved in a network. Private blockchain thus introduces a concept of governance and definition of behavioral rules, being particularlytailored to the needs of institutions and big enterprises. For instance, let’s consider the blockchain which can be used in the financial instrumentsmarket (See ESMA Report of 7 February 2017).

- Hybrid models, so called consortium blockchains, which base the consensus mechanism on the adhesion of specific subjects involved in thecomputer network on top of subjects of the network. These models are particularly tailored to the development of processes requiring theidentification of subjects participating to the network.*

➢ OTHER VARIABLES AFFECTING THE TYPE OF BLOCKCHAIN: consensus mechanisms (proof-of-work, proof-of-stake etc.), offer of coin / token (of a pre-defined or variable amount), speed and volume of performed transactions.

Classification Example**:Bitcoin is a blockchain based on a token, public, with a Proof-of-work consensus mechanism, having a fixed maximum amount of coin which thesystem allows to create and a limitation of transactions involved in each block and a block generation on about every 10 minutes.


1. Blockchain: definizione e caratteristiche.

CHARACTERISTICS OF BLOCKCHAIN.

The characteristics of the blockchain can be summarized under 6 main points*:

➢ Reliability: all participants are part of blockchain. When one of the chain’s hubs is under attack, all the other hubscontinue functioning, soldering the chain and impeding the loss of important information.

➢ Transparency: transactions performed through blockchain are visible to all participants.

➢ Convenience: different from traditional transactions, blockchain does not require the presence of third parties, asbanks, thus rendering the transactions direct and more convenient for the involved parties.

➢ Solidity: information included in the blockchain are characterized by a high degree of reliability since they cannot bemodified in any manner.

➢ Irrevocability: transactions performed through blockchain are final and cannot be changed or voidened.

➢ Digital Nature: blockchain is a full digital technology, which can be applied to an indefinite number of sectors.

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SMART CONTRACTS.

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2. Smart contracts.

SMART CONTRACTS AS IT PROTOCOLS APPLIED TO CONTRACTS.

The concept of «smart contract" has been first introduced in the ‘90s by the researcher Nick Szabo. The relating practical developmenttook place, however, only after the implementation and diffusion of blockchain.

The definition of smart contracts is not simple as these latter combine a series of legal and IT components. Therefore, twocomplementary definitions of smart contracts can be identified:

• From a legal viewpoint, smart contracts are simply «contracts with certain elements which can be activated automatically»;

• From an IT viewpoint, smart contracts are «code rows which are self-executing upon the occurrence of a specific condition».

In the scholars’ opinion, the term “smart contracts” identifies, jointly:

«computer protocols through which the elements of a relationship (usually, of exchange) are formalized,

which are able to autonomously perform the programmed terms once the predetermined conditions are satisfied».*

Smart contracts are instruments of negotiation and conclusion of contractual relationships.

Smart contracts are independent agents entrusted with digital assets to be managed in compliance with the instructions issued by theprogrammer.

Performance of smart contracts is fully automatic: once the agreement is reached, it cannot be terminated nor amended by the partiesuntil its complete performance.

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2. Smart contracts.

Smart contracts thus transpose the contractual will of the parties into an IT code.

They are characterized by two components:

1. Code rows, i.e., software, written on an immutable support which is the blockchain.

Each article, term and condition contained in the smart contracts, regulating performance, exist only under the form of cryptographic codes.

Reading of cryptographic codes and access to the contracts can be made not only by individuals, but also by hardware, i.e. "Internet of things".

2. Terms and conditions – representing the parties’ will – which must be intelligible by the software.

Through smart contracts, the parties can target several aims, so long as the purposes aimed by the parties can be automatically performed, ortranslated into a binary decision. Thus, all terms and conditions determined by the parties need to be translated into a binary option. In light of this:

- A facere performance based on intuitus personae (as, for instance, the performance of an intellectual or material activity) can not be includedinto a smart contract,

- A bank or insurance contract can be included in a smart contract and have an automatic performance.

A big insurance company is testing the offer of a new insurance product on damages through smart contracts, by using the Ethereum publicblockchain.

According to the insurance company, the use of this instrument will trigger two benefits:

(a) Rationalization of the payment process for both suppliers and principals. Once the client purchases the insurance product on the insurancecompany’s platform, the purchase will be automatically recorded on Ethereum and the smart contract will be created on the blockchain. Thesmart contract is connected to the risk source covered by the policy. Whenever the insurance risk occurs (according to the policy), damages areautomatically paid to the client (according to the amount agreed upon through the execution of the policy).

(b) Improvement of the relationship between insurers and client. Thanks to the automatic performance of the smart contract, first, the client will no longer be required to submit a request for reimbursement to the insurance company to obtain the payment of damages; secondly, the decision on such payment is entirely up to an automated third party (the smart contract), which fact prevents any potential dispute between the insured person and the insurance company. In addition, an entirely automated procedure increases the transparency of the damages compensationprocess and increases the confidence towards the insurance company.

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2. Smart contracts.

Formation and structure of a smart contract: the IFTTT (if this than that) model.

Smart contract can be summarized in the IFTTT (if this than that) scheme, i.e., a binary choice, simple and conditioned to an event (this) connectedto a conditional clause (if) triggering the occurrance of a cause (that).

More in detail:

I. Smart contracts are developed on the blockchain protocol.

II. Conditions posed by the parties are codified, i.e., translated into a binary decision. The condition, therefore, must be mathematicallyascertainable and non-objectable.

III. During the performance of the smart contract, the system verifies whether the event-condition has occurred and applies the agreed uponconsequences.

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Scope of Application.

The scope of application of smart contracts is, thus, wide:

- Contractual undertaking conditioned to a future and uncertain event, to which the parties condition the legal effects of the contract (i.e.effectiveness of the contract - condition precedent, or termination of the contract - resolutory condition);

- Contractual undertaking conditioned to a future and certain event, to which the parties condition the legal effect of the contract (i.e. initial termor final term);

- Agreements on option rights, i.e. undertakings whereby the parties agree that one of them (offeror) is bound by its declaration and the other(offeree) can accept it or not. The offeror’s declaration is deemed to be an irrevocable offer. The irrevocability arises out of the fact that acontractual arrangement is in place with a twofold content, aimed at regulating the preliminary and final relationship.

- Performances represented by a payment which is due in the presence of a possible event (e.g., installment, penalty).

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Similar legal figures: Offer to the Public (i.e., offer containing the essential elements of the contract to the conclusion of whichthe offer is aimed, which has the same effects of a proposal)

Certain scholars deem that the automatic performance of smart contracts would be comparable to the figure of Offer to the public. Automaticperformance means the performance of the contract without the direct consent of distributor and purchaser. The contracting party receives theoffered performance through an automated mechanisms and the performance is suitable, satisfactory and deemed to be a valid performance as itwould occur for a typical sale and purchase.

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2. Smart Contracts.

SMART CONTRACTS: FEATURES

SMART CONTRACTS, ALSO IN RELATION TO THE DIGITAL ECOSYSTEM AND THE BLOCKCHAIN IN WHICH THEY OPERATE, ARE

CHARACTERIZED BY:

A) EFFECTIVENESS AND BINDING NATURE;

B) FORM AND EXECUTION;

C) ACCESS TO THE BLOCKCHAIN PLATFORM;

D) CONTRACTUAL LEXICON;

E) UNALTERABILITY OF THE CONTRACT;

F) GOVERNABILITY.

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2. Smart contracts.

A) Effectiveness and Binding nature

The undertakings agreed by the parties through smart contracts have a digital form.

According to the civil law approach, the contract, as «the agreement between two or more parties aimed at establishing, regulating orterminating a legal economic relationship between them», has a binding nature.

The parties may voluntarily breach the promises previously made, amend or voiden the agreement. On the contrary, the agreement reached viablockchain has a binding nature, albeit not through reference to an external source.

Academics tried to express the implicit legal nature of digital ecosystems, by including the blockchain architecture among the regulatorylimits which influence the individuals’ behaviors (so called law theory).*

The functioning of blockchain, in fact, does not allow in any way the breach of the conditions agreed upon by the parties, since the performance ofthe relationships contemplated under smart contracts arises out directly and automatically from the technological structure where they areincluded. As a consequence, the blockchain puts a sort of limitation, from the beginning, to the possibility for the parties to comply with theirobligations and at the same time to the risk of non-compliance.

However, it is important to outline that, although blockchain represents a revolutionary technological innovation, waiting for aspecific regulation, smart contracts can be difficultly reported to the specific regulation of contracts.**

The IT properties of smart contracts in fact trigger several issues while considering the presence of certain essential elements in those jurisdictionswhere such elements are envisaged as necessary for the purposes of a contractual arrangement.*** In this respect, for instance, art. 1325 of theItalian Civil Code indicates (i) the agreement between the parties, (ii) the cause (iii) the subject matter and (iv) the form, as essentialrequirements of contracts.

These elements cannot be identified and interpreted easily in smart contracts, which are characterized by full immateriality.

The advantages arising out of the process of conclusion of contractual undertakings through blockchain are, however, various.

For instance, considering e-commerce, performance by a contractual party is subject to the performance by the counterparty, in light of aperformance of the contractual obligations which takes place almost contemporaneously, which fact can prevent the occurrence of the so calledchargeback frauds, i.e., on-line frauds where one party retains the payment without delivering the good.

In addition, the circumstance that the agreement will be performed in modalities which have been already programmed puts a strong limitation tothe arising of disputes between the parties and problems arising out of the online international commerce, such as the choice of competent courtand governing law, and also restricts the costs of a potential litigation.

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2. Smart contracts.

B) Form and execution

An issue which may trigger significant consequences from a legal standpoint concerns the relationship between the contracts executedin a cryptographic form and legal provisions which mandate the written form of certain agreements, ab substantiam.*

Specific contract law provisions in fact provide for a series of acts which require the written form in order not to be void.

It is difficult to say how the written form requirement can be abided by in a context which is totally immaterial and digitalized asblockchain.

The same problem exists with regard to other formal requirements provided by the law, e.g., in Italy, the mandatory recording of amortgage with the immovable ledger of the place where the immovable is located.

A further significant aspect concerns the modalities and effectiveness of execution of smart contracts. If these are executed through adigital signature, they would have the same effectiveness of a private writing (in the countries where private writings are contemplated)and, thus, would be a «full proof» of the source of the declarations made by the subscriber, if not denied by this latter.

Last, blockchain allows the secure identification of the moment and place where the agreement is reached, avoiding uncertainty onthese two factors. In fact, such contractual elements are placed digitally whenever new information is included in the blockchain, and soallow the maintenance of an exhaustive trace of the events characterizing each single digital information.**

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2. Smart contracts.

C) Access to the blockchain platform

Smart contracts allow users to access the ditigal blockchain technology. Access to the platform through smart contracts isstrongly connected to the «de-centralization» concept.

This latter indicates the freedom of users in accessing the platform and participating to the authorization process of suchtransactions. This freedom depends on the stability and certainty of smart contracts which are included in the blockchain.*Therefore, the more open is the blockchain, the more binding the instructions incorporated in the same.

As a consequence, in the systems where de-centralization is higher, as for open blockchains (e.g. Bitcoin), inflexibility is asits maximum degree.

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2. Smart contracts.

D) Contractual lexicon

The decentalized architecture where smart contracts operate, through blockchain, triggers certain limitations to the drafting and degreeof understanding of the same.*

In fact, digital language (binary) on which smart contracts are based, creates an automatic distance with the proper language used bylegal operators and by the parties in the context of a common agreement. In fact, as analyzed above, a smart contract may include onlyconditions which meet the IFTTT scheme.

Once a clause is encoded, then it is not possible to amend it.

This creates some diffidence towards blockchain by legal operators.* Thus, the development of this technology will require anincreasingly stronger cooperation between all legal operators and IT technicians, to translate the parties’ will into digital codes ofblockchain.

This triggers:

- a re-emerging of the role of online intermediation – which is able to jeopardize the cost reduction obtained through the use ofblockchain;

- the need of a specific expertise and ability of IT operators in accurately putting into a digital language the legal terms andconditions included under a common agreement.

Smart contracts may have a more immediate application with regard to simple legal undertakings, as for instance the highlystandardized templates provided by professionals, firms and service providers.**

In a favourable sense, the dissemination of smart contracts and the relating binary language may determine:

- A reduction of the disputes arising out of a divergent interpretation of the wording used in a common agreement,

- An increase in the efficiency of the contractual relationship, thanks to a performance which is almost immediate and a significantreduction of the ligitation risk between the parties.

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2. Smart contracts.

E) Unalterability of the agreement

The blockchain technology on which smart contracts are based does not allow the parties to amend the content of theagreement after its execution. The scope of smart contracts is, thus, limited to the original conditions and clauses agreedupon by the parties.

This «rigidity» is typical of decentralized and open systems, as Bitcoin, where the computer network performs instantly andindependently the instructions included in the blockchain, without any possibility to amend or stop the self-performance ofthe smart contract. This performance is almost irreversible and impenetrable. The irreversibility indicates «the absolutecertainty of the an of the performance, and thus of the positive finalization of the programmed instructions. Theimpenetrability, on the contrary, refers to the possibility to intervene and amend the quomodo of the smart relationshiponce this latter has been formalized into the blockchain architecture».*

Therefore, any possiblity of amendment to the original agreement is prevented, even if lawful, and the same for certainfundamental doctrines of the contracts, as the right of withdrawal.** Certain definitions, in fact, need a judgement(sometimes discretional), which can be difficultly translated solely in a cryptographic code. For instance, let’s consider thefollowing legal definitions:

- bona fide;

- best efforts;

- material adverse change;

- best endeavours;

- reasonable endeavours.

In addition, the parties would see the impossibility to use mechanisms of contractual protection, while public authoritiescould not intervene in case of breach of mandatory rules (norme imperative) (for instance, let’s consider the potentialunlawful use by the technology in connection with the diffusion of pornography material and online piracy practices).

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2. Smart contracts.

F) Governability

Speaking of governability, the open blockchain is characterized by the absence of a central authority regulating thefunctioning of the ledger. At the same time, the immediacy and automaticity typical of smart contracts wouldrender an external control by a judicial authority impossible.

The absence of governability of blockchain could be mitigated in the so called «blockchain permissioned», whereaccess is restricted to certain individuals and hubs can be identified into the chain. The possibility to identify hubsoperative in the blockchain, in relation to the problems connected with smart contracts, may thus allow theidentification of a target-subject of the judicial decisions, requests of the parties and legal novelties. Privateblockchain thus represent a compromise solution, able to limit the rigidity of blockchain and the needs of aregulation and interests of the parties.*

«Blockchain permissioned» may thus be deemed as the most suitable structures for the commercial market. Infact, it seems unlikely that decentralized ledgers can establish themselves into the market without their priorrecognition as a lawful instrument of conclusion of agreements. This acknowledgement in fact is stronglyconditioned to the possibiloty to govern the technology which, to date, can be ensured only for private and hybridblockchains. The presence of a manager, in fact, justifies the expectation of the user to have the possibility toidentify a subject able to take the responsibilities arising from a potential malfunctioning of the service.**

The scholars, in any event, have outlined that the success of blockchain will strictly depend on the possibility tobalance the decentralization typical of blockchain with the governability and possibility of an external judgementover the conditions included into smart contracts.***

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2. Smart contracts.

PROS CONS

Simplification of performance.Smart contracts, in theory, reduce at minimum the risk of lack of performance by theparties. This is due to the implicit legal nature of the blockchain architecture throughwhich they operate ("code-is-law" theory).

Hard control and governability.The absence of an operative centrer/responsible key person is a potential obstacle toany external intervention and/or judgment, including the application of legal provisionsand contractual safeguard systems.

Reduction of online fraud risk.As part of blockchain, the smart contract is independent from the subsequent will of theparties.

Limitation of understanding.The terms of an agreement must be expressed as a «code». The understanding ofwriting codes (codici di scrittura) of smart contracts requires the specific technicalknowledge of IT programmers which neither the parties, nor legal counsels can have.

Reduction of costs (also with regard to confidentiality) and possibility oferror.In the smart contracts, the performance is delegated to a decentralized network ofcomputers, which fact makes the intervention of third parties and online intermediarionservice providers unnecessary.

Unalterability.Instructions included in the blockchain are unalterable. The correction of any error isthus impossible.

Reduction of potential disputes.The agreement contained in the smart contract will be performed in the programmedmodalities.

Need of support given by subjects with high technical and IT knowledge(such as programmers, providers of services of translation of encoced rules), both inthe negotiation and in the drafting phase.

Simplification of negotiations.The smart contract will be performed in full compliance with the programmed modalities,so there is no need to include in the agreement choice of court and governing law clausesand penalties/mechanisms of surveillance of the agreement.

Lack of flexibility.The encoded language of smart contracts does not allow the inclusion of flexible ordiscretionary clauses.

Unequivocal interpretation of the contract.Smart contracts work on the basis of a formal and unequivocal language, which does notleave room to an interpretation activity.

Formal certainty (date and time of execution).

Proof of transactions.Blockchain retains all the transactions made by the parties.

The features of the digital system and blockchain where smart contracts operate trigger the following Pros and Cons:

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SMART CONTRACTS

IN THE FINANCIAL SERVICES FIELD

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3. Smart contracts in the financial services field

Considering the characteristics of smart contracts, as described above, academics have identified the financial services field as “an

excellent test bench” for such contracts.*

For instance, it is worth considering the Offer and Management of some financial contracts both in spot and in futures markets.

Banks and financial companies, in fact:

1. While drafting contracts setting out the general conditions on products and services offered by the same, use standardizedclauses, contemplating mathematical variables which are defined and easily measured by IT systems;

2. Do not require a high level of discretion in the performance of contracts, since these latter do not provide for spaces for freeinterpretation;

3. Use organizational structures that are composed of complex accounting systems, a multiplicity of registers and a bureaucraticapparatus that – daily – verifies, compares and exchanges an enormous amount of data.

Smart contracts seem able to meet the abovementioned needs. In fact, while operating through hybrid blockchain platforms, smartcontracts offer:

a) Standardized clauses;b) Measurable conditions which can be easily performed by computers;c) Conditions included in a centralized database allowing stability and security and offering, at the same time, governability and the

possibility of external intervention.

Therefore, smart contracts and the decentralized architecture could be a valuable support - on one hand - to reduce time and costs and - on the other hand - to eliminate any connected errors.

The Supervisory Authorities have expressed interesting positions on this subject matter, also with a view to analyzing andunderstanding the connected risks and to identifying future potential areas of regulation.

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GUIDANCE PROVIDED BY THE SUPERVISORY AUTHORITIES

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1. Position of the European Securities and Markets Authority (ESMA)

➢ ESMA Report of 7 February 2017, “The Distributed Ledger Technology Applied to Securities Markets“

The European Securities and Markets Authority (ESMA), in its Report of February 7, 2017, analyzed the “Distributed LedgerTechnology” (DLT), of which the blockchain represents the most widespread form, in order to understand:

- Risks and benefits that DLT may bring into the financial services market and

- How DLT interacts with the existing EU legislation.

In brief, the position adopted by ESMA can be summarized in the following main points of attention:

1) Benefits of DLT.

ESMA deems that DLT could bring a lot of benefits to the financial services markets, as:

• More efficient negotiation processes;

• Advanced reporting and data management functions;

• Cost reduction.

2) Challenges to be faced (necessary to get the benefits).

Benefits brought by DLT will not be immediate, considering that significant challenges have still to be faced and solved, in relation to:

• Interoperability and use of common standards;

• Access to the liquidity granted by Central Banks;

• Issues connected with governance, privacy and progressive increase of business.

In this respect, according to ESMA, being blockchain “an early stage” technology, the possibility that DLT overcomes and solves theabovementioned challenges/issues remains uncertain. At the same time, it must be considered that DLT could also bring new risksand/or increase the existing one.

4. Position of the Supervisory Authorities

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3) Risks connected with DLT.

• IT risk: the "cracking" of the cryptographic algorithms on which the DLT is based, although unlikely, appears possible.

• Risk of fraudulent activity and money laundering practices: the security of the use of private keys in a DLT context could be lost ifsuch keys were lost or stolen, as they could be used for illicit purposes.

• Operational risks: DLT could trigger mistakes. In fact, if not promptly corrected, an error in the coding of smart contracts, or ofreference data, could involve a greater number of participants.

• Risk to fair competition: for the ‘new members’ could be particularly difficult to join the system, because the DLT’s ‘existingparticipants’ could refuse them or impose hard conditions to get in.

• Systemic risk: it could lead to increased market volatility, greater interconnections between market participants and liquidity risk.

4) Impacts of existing EU legislation on DLT

DLT promoters and developers should be aware of the existing legislation when designing new DLT solutions. In fact, the DLT doesnot exempt users from the duty to abide by the rules of the existing regulatory framework, which provides significant guarantees forthe good functioning of financial markets.

It i unlikely that DLT could eliminate the need for financial market infrastructures, such as Central Counterparties Clearing (CCPs)and Central Securities Depositories (CSDs), although DLT may make some processes redundant.

DLT could be used to carry out regulatory reporting activities.

5) Inter-disciplinary impacts of DLT

Albeit, so far, ESMA has not identified "major impediments" in the existing regulatory framework that prevent the development ofDLT in the short term, it should be noted that - beyond the scope of the financial regulation - there are other legal areas that couldhave repercussions on the future development of the DLT, including company law, contract law, competition law and bankruptcy law.


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2. Position of the European Central Bank (ECB).

➢Occasional Paper No. 172 / April 2016, "Distributed ledger technologies in securities post-trading.Revolution or evolution?"

➢ “Distributed ledger technology”, In Focus, Issue 1, 22 of April 2016.

➢ “The potential impact of DLT on securities post-trading harmonisation and on the wider EU financialmarket integration”, of the Advisory Group on Market Infrastructures for Securities and Collateral,September 2017.


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➢Occasional Paper No. 172 / April 2016, "Distributed ledger technologies in securities post-trading.Revolution or evolution?"

Through its Occasional Paper, the ECB analyzed:

I. The main characteristics of Distributed Ledger Technologies (including blockchain) that can trigger the relating use by the financialinstitutions;

II. The ways through which the use of these technologies can affect the European post-trade market for securities. *

Conclusions reached by the ECB

“Based on the analysis in this paper, it can be concluded that there is potential in distributed ledger technology.

Furthermore, innovation is, in general, welcome in the European post-trade market for securities, wherever it can bring safety andefficiency.

A number of factors could, however, pose potential barriers to the widespread uptake and use of DLTs.

First, the technology is not yet mature; second, the clarification of critical legal, operational and governance issues will take time;and third, even were DLTs to be adopted widely, certain post-trade functions will continue to be performed by institutions.

It is not yet, therefore, clear whether DLTs will cause a major revolution in mainstream financial markets or whether their use willremain limited to particular niches.

It is possible that a DLT may find its way into the mainstream market, but should this happen, it is more likely to cause agradual change in processes, rather than a revolution in the market”.


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➢Article “Distributed ledger technology”, In Focus, Issue 1, 22 of April 2016.

Based on the analysis set out under the Occasional Paper, the ECB has published an article entitled "Distributed ledger technology"where the ECB analyzes the implications of blockchain technology on the financial sector.In particular, ECB asks itself:

—> “A brave new world? What impact will distributed ledger technology have on the financial industry?”

The following main definitions arise out of the Report:

- Distributed Ledger Technology (DLT): “essentially a record of information, or database, that is shared across a network.It may be an open, publicly accessible database or access may be restricted to a specified group of users. From a technicalperspective it can be used, for example, to record transactions across different locations”.

- Blockchain: “The best-known type of distributed ledger”. More in detail, “some DLT solutions store all individualtransactions in groups, or blocks, which are attached to each other in chronological order to create a long chain. This long chainis put together using a mathematical formula – complex cryptography – which ensures the security and integrity of the data.This chain then forms a register of transactions that its users consider to be the official record”.

- Consensus Ledgers: “another type of DLT whereby, instead of grouping and chaining transactions, only the balance ofmembers’ accounts is updated after each validation round”.

- Smart contracts: “can be used to process transactions based on agreements of “if this happens, then do this...” and ownershipof the underlying value or asset can be automatically transferred. The terms of the contract are written in computer language.It is like having a paper contract that can read itself and carries out the agreed terms as and when they come into effect”.

The two main advantages of the new technology would be:

1. Reduced risk of cyber attacks on the financial market. A cyber attack, in fact, should not be directed against a single central entity,but rather against the whole network part of the chain of blocks.

2. The possibility of "automating" contracts, through smart contracts.


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The ECB then tries to answer the question :”What will the future look like?" , by proposing three possible scenarios, consequent tothe use of DLT:

- SCENARIO 1 – “AS IS”: institutions use the new DLT technology to improve their internal efficiency, but the commercial practicesin the financial instrument market remain unchanged. The consequence would be a further fragmentation of the system and nointeroperability between the DLTs.

- SCENARIO 2 – “ADOPTION MODEL”: the so-called "Core players" enter the DLT. Some services, such as "asset servicing, safekeeping arrangements and account segregation" could take place directly in the DLT. For example, regulatory reporting can bemade automatically and "real time", the "segregation of assets" could be carried out at no additional cost. It follows that the roleand function of some intermediaries may be redundant.

- SCENARIO 3 – “NEW WORLD”: issuers and "financial technology companies" overcome the financial institutions and create a"peer-to-peer" trading system, thus transforming the post-trade industry. As a consequence, the existing post-trade processeswould be replaced by automatic compensations and agreements between issuers and investors, and the role of the institutionswould be voidened.

In light of the above mentioned scenarios and the possible consequences, the ECB reached the following conclusions:

“DLT is a very new technology and it is therefore still difficult to predict exactly what kind of an impact it will have onthe financial market infrastructure.However, it certainly presents a number of interesting possibilities that deserve further investigation.The Eurosystem is closely following developments and considering all of the possible implications for its role as operator, catalystand overseer”.


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➢ “The potential impact of DLT on securities post-trading harmonization and on the wider EU financialmarket integration”, September 2017*.

In the September 2017 Report of the Advisory Group on Market Infrastructures for Securities and Collateral of the ECB, entitled "Thepotential impact of DLT on securities post-trading harmonization and on the wider EU financial market integration", the Authorityadopted a position on certain issues related to blockchain technology: *

• Blockchain technology has the potential of promoting the sharing of data and business processes beyond the level reached bycurrent databases.

• The technology can be useful to the market, providing a more efficient sharing and update of information. The blockchain is still atan early stage of its development, but may represent an infrastructure of primary importance for financial market operators.

• It is still unclear whether technology is the best solution to control access to data on financial markets. In fact, the needs related toknow-your-customer (KYC) and anti-money laundering (AML) controls could represent an obstacle to the development oftechnology;

• Among the various blockchain models, mixed and private models are the best examples for the financial sector. In fact, to dateonly through such models an adequate level of governance and external control can be guaranteed.

• The blockchain will need to be regulated in the future to govern the use of networks and to prevent future risks that could arise inconnection with this technology.

• A proper governance is important for any infrastructure on the digital market to ensure its security and efficiency. It is even moreimportant in the blockchain technology where different parties are responsible for processes and data.

• The potential adoption of this kind of technology in the financial market will require the development of appropriate governance toensure that responsibilities related to data management are clear to all stakeholders.

• It will be necessary to get the financial market ready for the use of the blockchain technology, with particular reference to theregulatory level.


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4. Position of the EU Parliament

On 3 October 2018, the European Parliament approved an official Resolution on «Distributed registertechnologies and blockchains: building trust with disintermediation».

The Resolution includes specific considerations on several areas where blockchain could be a valid tool: (i) Energy andenvironment-friendly applications; (ii) Transports; (iii) Healthcare sector; (iv) Supply chain; (v) Education; (vi) Creativeindustries and copyright; (vii) Financial sector.

With specific regard to smart contracts, the Parliament:

➢ Emphasised that smart contracts are an important element enabled by the DLT and can act as a key enabler ofdecentralised applications;

➢ Stressed that the Commission needs to undertake an in-depth assessment of the potential and legal implications,e.g. risks relating to jurisdiction; believing that use-case monitoring will be beneficial in exploring the potential ofsmart contracts;

➢ Emphasised that legal certainty surrounding the validity of a digital cryptographic signature is a critical step towardsfacilitating smart contracts;

➢ Calleds on the Commission to promote the development of technical standards with relevant internationalorganisations such as ISO, ITU and CEN-CELENEC, and to conduct an in-depth analysis of the existing legalframework in individual Member States in relation to the enforceability of smart contracts;

➢ Called on the Commission, should potential barriers arise to the use of smart contracts within the Digital SingleMarket, to take appropriate measures to assess whether such barriers are proportionate; noting however, that legalcertainty can be enhanced by means of legal coordination or mutual recognition between Member States regardingsmart contracts.

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4. Position of the EU Parliament

The European Parliament, in its Resolution, invited the European Commission to:

• Take appropriate measures and political initiatives that promote the EU's competitiveness in the field of DLT;

• Promote awareness of DLTs, to launch initiatives to educate citizens on technology and to address the digital dividebetween Member States;

• Promote close coordination of present and future initiatives on DLT and pilot projects carried out by the Commission,possibly under the guidance of the EU Blockchain Observatory, so as so as to realise synergy effects and ensure thecreation of real added value while avoiding costly double structures. Therefore, the Parliament invited the Commissionto undertake regular exchanges with Parliament itself on the progress achieved in DLT-related pilot projects;

• Evaluate and develop a European legal framework, in order to to assess and develop a European legal framework inorder to solve any jurisdictional problems that may arise in the event of fraudulent or criminal cases of DLT exchange;

• Foster convergence and harmonization of regulatory approaches adopted in the different Member States;

The European Parliament deems that the Union has an excellent opportunity to become the globalleader in the field of DLT and to be a credible actor in shaping its development and markets globally, incollaboration with our international partners. In the Parliament’s view, the Union should not regulate the DLTsby itself but should seek to eliminate the current barriers to the implementation of blockchains.

A good strategy: the Parliament welcomes the Commission’s approach of following a use-case methodin exploring the regulatory environment around the use of DLT and the actors using it by sector.

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4. Other developments made in the EU on blockchain

• During 2018 several EU Member States signed an alliance on Blockchain Technology, forming the new EuropeanBlockchain Partnership (currently counting 27 Member States) whose purpose is helping Member Statesin developing Blockchain technologies, sharing experiences/technical skills and regulatory solutions. Arepresentative of each Member States will work alongside the EU Commission to elaborate new strategies onBlockchain.

• June 2018: The European Parliament authorized the International Trade Commission (INTA) to draw up anon-legislative report on Blockchain. This legislative project, aimed at identifying the potential benefitsconnected with a large diffusion of blockchain in the commercial and customs fields, will be voted in plenary sessionon December 10, 2018;

• In the EU Program named “Horizon 2020”, the European Union has offered 5 million Euros to finance projectsconcerning "Blockchain for social good", i.e., innovative projects using blockchain to support social initiatives.The initiative starts from the consideration that the creation of centralized platforms, such as social networks,exposes personal data to abuse, both for political and commercial purposes. Through blockchain, the EuropeanUnion want to promote decentralized platforms mechanisms that allow social advantages, but at the same timeensure control over users’ data.

CONTACT:

Avv. Luigi [email protected]

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