Blockchain to change law firms' routines

As blockchain use in derivatives develops, handling the legal side of futures and options trading will have to adapt as well.

The promise of blockchain is that distributed ledger technology could lead to a world with faster processing of derivatives trades, spurred by automatic verification and implementation of digital contracts. But for law firms that deal with derivatives trading, electronic contracts and verification also will mean a change in how they do business.

“The legal impacts are certainly significant from a number of aspects,” said Terry Roche, principal and head of fintech research, TABB Group, New York. “Blockchain itself isn't really introducing any new technologies. Distributed ledger technology, cryptology, cryptanalysis have all been around for some time. What's new is that it's a different construct. It's the architectural approach that's different. Blockchain is distributed and open, not vertical like other systems.”

One legal question involves use of smart contracts, which are computer protocols that facilitate, verify or enforce the terms of a contract.

“The concept of smart contracts has been with us forever in computing, but it's been based on vertical systems,” Mr. Roche said. “With a change in that architecture, it could impact fund transfers, settlements, ownership of security contracts. There are all sorts of things out there that are legal agreements, all bespoke or for specific customers. What about those legal documents?”

That's the issue law firms are facing. As an industry, blockchain could mean a change in what those firms provide to their financial services clients, affecting, say, those that generate paper contracts to comply with myriad laws and regulations to others that primarily provide advice, said Yvette Valdez, New York-based counsel, derivatives practice group at the law firm of Latham & Watkins LLP.

“At some level, folks lose sight that until the leveraged finance industry grew up and made us documentation machines, we really just served as advisers,” Ms. Valdez said. “I think that we'll probably be going back to our original role as advisers. Blockchain will have the ability to innovate. That means the role of the lawyer will have to change, but with that change, we'll need to give regulators some time to catch up.”

Regulators already are starting that catch-up effort, but basically by following as observers as blockchain developers test applications for derivatives use. Some testing has proven successful; Barclays PLC in April said it had successfully tested a way to trade derivatives using smart contracts and blockchain-like technology being developed by a consortium of the world's leading banks led by financial services technology developer R3CEV.

Regulators like the Commodity Futures Trading Commission and its counterparts in the U.K., Europe and Asia have taken a “benign or do-no-harm” approach to block-chain regulations, including possibly waiving record-keeping obligations that require that contracts be kept in “native” form - usually on paper documents, said Eamonn Maguire, managing director, financial services, at KPMG, New York.

“That would be quite meaningful for the emergence of blockchain as the contracts and record keeping could all be digital, not physical,” said Mr. Maguire.

Officials at the CFTC did not respond to requests for comment.

But long term, said TABB's Mr. Roche, the question of how contracts and settlement terms are digitized will need to be answered before blockchain can truly function — but it's more a matter of when than if.

“How long it will take for the law and regulation to catch up, we don't know,” Mr. Roche said. Market participants “can start by embedding the legal documents in the blockchain record, so it's all together. I do believe that eventually there will be a legal construct that will consider blockchain contracts as legal agreements. I believe it will be fully digitized eventually.”

The process of change could be complex, Mr. Roche added.

“It has to begin with legislation, on the state and federal level,” he said. “Then the courts will be able to enforce those laws. Regulations also will have to be changed, but that's the job of the agencies involved. But it all starts with the laws.”

Joan Warner, New York-based senior analyst for financial services at Oxford Economics, a quantitative economic research and analysis firm, said law firms will have a tough time adapting to blockchain.

“My sense is that the legal profession will have to figure out how to stay in this game, like the big banks trying to figure out what to do with blockchain that won't keep them from becoming obsolete,” Ms. Warner said. “Can the legal system keep up with it? My sense is the legal system doesn't like change even more so than the financial system. But once the cost savings can be seen (by market participants) with contracts through the blockchain, the legal world will have to come up with a new value proposition. I'm not so sure they can do this.”

But Willa Cohen Bruckner, partner, Alston & Bird LLP, New York, said legal agreements will still need to be struck between counterparties — even in a fully digitized trading world. “Contracts won't go away,” Ms. Bruckner said. “Digitizing is more a change in their form rather than their substance. ... What will be the areas of negotiation? There will still be a lot of use for legal assistance. That said, we will have to adapt. It's not going to take us out of the practice. We'll adapt.”

Latham & Watkins' Ms. Valdez agreed. “You'll still need contracts, whether that's just check the box or some sort of electronic approval,” she said. “There may be less paper pushed in the derivatives industry, but in my mind there will still be some need. Is this the Industrial Revolution for lawyers? I don't think so. New technology always brings new questions, new struggles.”

The nature of derivatives trading will always require contracts, said KPMG's Mr. Maguire. “The question with blockchain becomes how will those contracts be signed and validated,” he said. “Parties will still need to agree on a contract, but once that's done, the execution of the contract will be done easier.”

Ms. Valdez and Ms. Bruckner both said that along with contract implementation, another major issue that will have to be addressed in blockchain use for derivatives is maintaining the anonymity of counterparties. Such anonymity guards other market participants against getting reads on how market participants tend to trade and then taking advantage of those moves, much like what some high-frequency traders have been accused of doing on the equities market. The blockchain, with verification based on transparency among all participants, seems contrary to maintaining anonymity.

“Futures contracts are made on an anonymous basis,” said Ms. Valdez. “How do you replace that with a transparent market? Futures by their nature can't be anything but an anonymous market.”

Ms. Bruckner agreed that the issue of counterparty anonymity “is one that will have to be worked out both on the legal and the operational sides.”

However, KPMG's Mr. Maguire said that blockchain developers are aware of the issue and are looking at design modifications that will enable derivative market participants to maintain anonymity and not tip the market to trading preferences. n