Predicting the Viability of Blockchain Startups Requires Understanding the Legal Landscape

A lot of the enthusiasm for blockchain is well-deserved as the technology is revolutionary and promises to transform society as we know it. However, much of the enthusiasm is also based on a narrow perspective only focussed on the tech and/or untapped profits. What’s missing is a perspective that puts these in the context of the broader legal landscape in which they are embedded. This ‘techno-legal’ perspective is essential for predicting the viability of new blockchain startups.

This article discusses two examples of economic sectors touted as ripe for ‘disruption’ by blockchain technology but that face significant challenges because of variance in local laws and regulations. One of these is the lending sector. The other is the use of smart contracts to automate aspects of business transactions.

Digital Assets as Loan Collateral

In 2018, the financial value of the cryptocurrency market was estimated at roughly $400 billion. Of course, most of this value is not integrated into the mainstream financial system. This means it cannot be used as collateral for loans. Considering the magnitude of under-leveraged value in the crypto space, it is no surprise the financial industry has started looking at digital assets as a potential source of collateral. In addition to newly created blockchain assets, startups are exploring blockchain digitalization of assets from the traditional economy. Soon, all commercial assets and shares, and most corporate bonds, government securities and globally-traded derivatives could be digitized or tokenized.

However, for startups trying to enter the lending market today, the technical side of asset digitization is only half the equation. There is also a legal hurdle to overcome, which is not how to digitize assets but how to secure digital assets so they can be legally used as collateral in a viable marketplace. Currently, the vast majority of countries have laws that require financial institutions to use depository banks for securing asset collateral. No such depositories exist for digital assets. This means there are no legal means for digital assets to be secured for use in the mainstream financial sector, regardless of the state of the technology. Thus, before any protocol that enables digitization of assets to succeed, there need to be depository banks in place that are legally able to secure such assets. I have read several white papers and not one addresses this issue.

Automated Smart Contracts

Another area where there is talk about blockchain's potential is in using smart contracts to replace contract lawyers and other intermediaries in financial transactions. While there are significant technological challenges in providing such a service, I think the bigger issue is the fact that smart contracts are not legal contracts. Smart contracts rely on third-party data provided by ‘oracles’ (supposedly trusted information sources) to monitor the status of smart contracts. Yet, we know that the data from these sources is not necessarily reliable, which means that the terms of a smart contract cannot be determined with certainty in the real world. Moreover, there are lots of contextual factors central to applying the law that the so-called oracles cannot determine. For instance, whether a borrower has made reasonable best efforts to cure an event of default, or whether a lender acted in bad faith. These legal standards are inherently subjective, and until the advent of more advanced forms of AI, these standards require human intellect to be accurately interpreted.

Another concern with the legality of smart contracts relates to the immutability problem. Transactions on the blockchain are immutable, and therefore final. If a fraudulent lender (or another third party) exploited a bug in the code of a smart contract or a blockchain protocol and stole collateral funds, there is limited recourse that the parties could take to recover the funds. Such a scenario is not outside the realm of possibility, as those who follow cryptocurrency news are well aware. New blockchain projects such as Tezos attempt to address this through an on-chain governance structure. But until the security of smart contracts is proven, lenders will hesitant to incorporate them into their business.

Conclusion

One of the central challenges faced by any blockchain startup that wants to enter a sector of the economy is that to truly replace the status quo, one of the many obstacles is fitting into the existing laws of the modern economy. If the technology just can’t adapt to the law, then the limits of existing blockchain technologies will undoubtedly require an evolution in legal thinking.

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