US Commodities Regulator suggests potential liability for derivatives smart contract developers

Commissioner Brian Quintenz of the US Commodity Futures Trading Commission (CFTC) recently commented that smart contracts that have the defining features of a swap, future or option could be subject to CFTC regulation, implying potential liability for smart contract developers for any violations of those regulations.

Smart contracts for financial transactions

A smart contract is a piece of computer code that is capable of monitoring, executing and enforcing an agreement without human oversight or intervention.  Smart contracts have characteristics that are clearly appealing - primarily, the ability to interact with multiple financial systems and asset registers through blockchain technology - and the potential uses for smart contracts in finance are numerous, for example:

  • title to property could be transferred automatically upon receipt of funds;
  • fees under service level agreements could be automatically paid upon satisfaction of preset conditions; and
  • securities could be traded directly between parties without the need for central securities depositories).

However the US Commodity Futures Trading Commission (CFTC) is concerned that executing financial transactions via smart contract could have unintended consequences for market participants. CFTC comments.

At a recent technology conference, CFTC Commissioner Brian Quintenz commented that smart contracts that have the defining features of a swap, future or option would be subject to CFTC regulation. For example, a smart contract could be considered a financial product subject to the CFTC’s exchange trading requirements. 

Who is liable for breach?

Commissioner Quintez went on to pose a hypothetical: “if a smart contract is violative of CFTC regulation, then who is subject to an enforcement action?” The answer, it would seem for now, is that it is unreasonable to hold the core developers of the blockchain and the general users responsible, as they are typically unable to assess or police the legality of each application of the blockchain.

Instead, both the particular users and the developers of the smart contract could, and should, be subject to enforcement action.

To support the idea that smart contract developers should be liable for aiding and abetting violations of CFTC regulations, the Commissioner argued that these individuals may, at times, be able to reasonably foresee that their code would likely be used by US persons in violation of CFTC regulations. 

Wider regulation

Readers should note that issues of liability in relation to smart contracts and blockchain technology are not limited to CFTC regulations. The question of liability for regulatory violations is integral to both US securities laws and banking regulation such as Know-Your-Customer / Anti-money Laundering laws.

Collaboration between developers and lawyers is key

Lawyers and software developers have, until now, worked together to develop smart contracts to meet legal and business needs.  The Commissioner’s statements imply that collaboration between lawyers and developers will also be key to the complex task of navigating potential liability when writing code. 

The role of lawyers in smart contract development should extend beyond how to make a smart contract useful for lawyers to include ensuring the coding process, from its initiation, to considering all potential liability issues and specifically to avoiding potential CFTC enforcement.

Collaboration with the CFTC

The Commissioner, helpfully, provided some suggestions regarding how developers can avoid potential liability.  He suggested that smart contract developers should engage, and collaborate, with the CFTC.

One potential solution of interest would be the integration of regulatory requirements into the code of the smart contract such that the code would not execute until applicable regulatory requirements are satisfied.

What happens next?

It is easy to imagine developers failing to contemplate the potential regulatory consequences for the future uses of their product. 

As a result, and because smart contracts combine legal and technological expertise in a unique way, lawyers should inform developers of the regulatory risks of their creations at the onset of such projects.