19 July 2019

When Blockchain Immutability Meets Bankruptcy

This article was first published in Digital Asset.

“Immutable” is a term that is frequently used when people talk about blockchain and the benefit of using this technology for record-keeping.

Blockchain is designed to provide an immutable, indelible, unalterable, and untamperable source of truth. Many other benefits associated with blockchain technology, such as, data integrity, security, and transparency are built upon this fundamental quality. The application of this technology to record financial transactions seems like a panacea -- imagine a crowd-sourced golden record of all transactions of value between two or more participants that’s mutual, immutable, indisputable and permanent.

But, the reality is that financial transactions are not immutable. Why? 

Bankruptcy

In addition to instances where one party may simply intentionally or unintentionally default on a transaction, bankruptcies may create forced defaults on agreed-upon but pending transactions.  Once a party files for bankruptcy or is declared insolvent, a bankruptcy stay prevents most pending transaction from moving forward. Even previously settled transactions may be voidable as a result of bankruptcy and may be clawed back. We witnessed how devastating bankruptcy and default can be on the financial system when Lehman Brothers collapsed in 2008: the current financial system is not immutable.

The havoc created by a bankruptcy judge and the bankruptcy trustee in stopping, unwinding, or clawing back transactions on an immutable blockchain would be even more devastating.

What if We Could Make Financial Transactions Immutable? 

Instead of questioning what happens when an immovable object meets an unstoppable force, what if blockchains and smart contracts were utilized to make transactions bankruptcy remote, using existing bankruptcy laws and safe harbor statutes to structure transactions in ways to protect them from bankruptcy that are not currently feasible or efficient with existing technology?

If this can be done, blockchain can in fact provide an immutable record of financial transactions, and financial transactions could benefit from all of the efficiencies of blockchain.

How? Committed Settlement

A first step in this process towards true immutability is Committed Settlement, a smart contract method conceived by Digital Asset.

Committed Settlement enables users to replicate control accounts (accounts used for over a century to hold collateral pledged by a pledgor to protect the secured party against a default or bankruptcy of the pledgor), by locking digitized assets to a specific purpose. While control accounts are commonly used to shield pledged collateral from bankruptcy, they are slow (taking several months to set up), costly (thousands of dollars in maintenance fees), and inefficient (placing onerous reporting, reconciliation, and maintenance obligations on all of the parties involved).  

In contrast, by using DAML, an open source programming language created by Digital Asset, Committed Settlement could be accomplished by writing a few lines of code into a smart contract (the digital representation of a physical contract) between counterparties. By using smart contracts, Committed Settlement also utilizes the built in reporting and maintenance routines and avoids reconciliation burdens.

While there are additional steps from control accounts to true bankruptcy protection, this is a large and important first step towards the ability to use blockchain for immutable record-keeping of financial transactions.

Legal Considerations

To substantiate our patent-pending Committed Settlement methodology, we’ve collaborated with trusted law firms to analyze the local legal frameworks in a variety of jurisdictions.  The first of our collaborations is with King & Wood Mallesons, one of the world’s most innovative law firms. The following thought piece looks at whether Digital Asset’s implementation of Committed Settlement would work under the legal framework of Hong Kong and Australia.

Click here to read our thought piece with KWM, Committed Settlement in Hong Kong and Australia.

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