Blockchain smart contracts result in fiscal crisis

At first glance, there may seem to be little commonality between OTC derivatives and smart contracts. The former is a financial technology that is based on written legal agreements, whereas the latter is an information technology based on digital ledger technology. Nevertheless, there are several similarities worth examining, as outlined in Table 2. These, in conjunction with other risks that are specific to smart contracts, could potentially threaten the integrity of the financial system under certain circumstances.

The proliferation of bilateral OTC derivative agreements, which led to critical financial dependencies between counterparties, could easily occur with smart contracts when the use and sophistication of smart contracts grows to the point where they are facilitate businesses transactions on a regular basis. Without a specific need or mandate to centrally clear or settle smart contract agreements, there is little reason why agreements should not be bilateral and thus, known only to the counterparties involved. Likewise, because of the relative ease of implementing smart contracts, the ultimate scale of the number of smart contract agreements could easily dwarf traditional contracts. Systemic risk could arise from failure or flaws with of the contractual mechanics, i.e. smart contract technology, rather than the agreements themselves. It is unclear how millions of bilateral agreements between thousands of counterparties could be dealt with, say in the case of the discovery of a cybersecurity vulnerability that was common to a large number of agreements, which could corrupt those transactions. The fact that the collapse of The DAO was a non-event systemically was largely due to its recent invention. Had it been established longer, with more investors, larger in financial size, or had it been used as the base source code for other smart contracts, the impact could have been much more severe. While, overall, the scale of smart contract use does not present an immediate concern, their impact would be significant if and when major business areas, such as trade finance, adopt and employ smart contracts on a wide-scale basis.

Concerns related to lack of transparency, which occurred with OTC derivatives, could be an issue for smart contracts. Without understanding who the counterparties are in different types of smart contract agreements, how many of those agreements are in place, what the aggregate financial risk that is represented by these agreements, it will be difficult to assess the systemic risk. Having a handle on such information would be critical in a situation in the future where there is a fault in the smart contract infrastructure. As seen in the case of The DAO, the investors were anonymous, and the individuals and corporate bodies affected could not be easily determined. Assessing the broader impact and entities affected would be paramount for avoiding a crisis of confidence, as occurred in the GFC. While the use of DLTs could provide a source of open and immutable records that could be used in such emergency situations, the value of this information would be dependent on how easily it could be accessed and interpreted.

Like OTC derivatives, smart contracts could potentially be used to circumvent regulatory oversight. Digital currencies provide an example of how DLT technology has been adopted by entities outside of the mainstream financial system. To avoid financial transaction monitoring and anti-money laundering (AML) checks instituted by banks, cybercriminals have leveraged digital currencies, such as bitcoin. Likewise, banks’ reluctance to facilitate digital currency transactions, has further led to the emergence and growth of digital currency exchanges. These exchanges, in some cases, have avoided regulatory oversight and thus have become part of the shadow banking system. In the case of smart contracts, they may inadvertently, or by design, taken on characteristics of other financial instruments but avoided treatment as such. This in turn could lead to significant off-balance-sheet exposures that are not readily apparent to auditors or regulators.

The fully automated nature of smart contracts, could greatly accelerate the speed at which a financial crisis related to them would unfold. If there was a large-scale failure related to smart contracts, it is unlikely that regulators would be able to manage the situation as it occurred; they may only be able to take remedial action after its course was run. As a case in point, the high degree of automation and interconnectedness of electronic trading in the financial markets have led to several “flash crashes” that occurred with such speed: it has not been possible to determine the underlying cause and remedies until long after the problem occurred (CFTC, 2010). Where regulators had hours and days to take actions to try to limit the damage in the GFC, a chain reaction that involved many interconnected smart contracts could be over in a matter of minutes or seconds. Likewise, while historically, regulators have had the ability to nullify paper-based legal agreements by fiat, they will likely find it more difficult to intervene and stop or alter the automated execution of smart contracts.