Blockchain, smart contracts and DAO

A few words about governance

Maciej Jędrzejczyk, Karolina Marzantowicz (IBM)

In school they used to tell us that mathematics was the queen of the sciences. The development of distributed technologies (DLT) shows how true this is. One of the main advantages of this technology is the decentralised trust written into the source code of the IT programme. With this, in the age of the digital economy, we can move from a state where central persons, institutions and organisations serve as trusted third parties, to a state where their role is assumed by algorithms of decentralised consensus, i.e. mathematics.

One form of DLT is blockchain. The network (numbers of participants) within the blockchain technology is leading the growth of main roles that will be involved in the information systems and digital commun- implemented process served by the function- ications in the direction of large-scale ing network. This has to do particularly with decentralisation. The human factor is mini- “miners,” who solve increasingly difficult mised, and trust and accuracy of transactions mathematical tasks in order to take part in the are ensured through cryptography. process of verifying transactions and entering With the significance of this technology, it a block in the ledger. The person who solves needs to be examined in terms of the the task first is rewarded by adding the appro- governance under which new models priate value in to his wallet. and sectors of the economy will arise. This will The proof-of-work algorithm assumes that the allow us to identify the fundamental accumulation of resources in the network will characteristics and risks of solutions based on not exceed 51%. But as the degree of the tasks public and private . rises, miners group together into “mining Public blockchain, or creeping pools” in which each miner solves only part of oligarchisation the problem and the reward is divided among all of them. Currently the four largest mining A characteristic feature of a public blockchain pools include over 65% of all miners involved is the lack of components for managing this in solving problems in the network. If solution. This influences the functioning and one entity took control over the majority of maintenance of the whole system. Decentral- the resources verifying transactions, it could isation and distributed architecture counteract exploit these resources to dictate conditions to the concentration of power that could be the rest of the network. gathered by a single person, role or organisa- tion. This also increases the reliability of the The increasing number of mining pools is system because of the lack of critical a serious threat to decentralisation and the components (no single point of failure). fundamental principles of a public blockchain. A group (or organisation) possessing most of Unfortunately, this solution does not exclude the resources performing proof-of-work grouping and accumulation of resources of the calculations could manipulate the value of

12 verified blocks (insert false transactions or management of privacy is required. A private throw out true transactions). This is not just or “permissioned” blockchain provides the a hypothesis, as demonstrated by the recent possibility of extending DLT to include unsuccessful attack on the Krypton network, components such as management of where the attackers relied on computing participants and privacy. A private blockchain power rented in the cloud to interfere with the is most often created by a consortium or integrity of the blockchain and the state of defined group of participants. They determine holdings of the KR. who can function in the network and under Moreover, public networks cannot choose what rules. Moreover, a network in which the who decides on consensus, or expose and participants are not anonymous can use algorithms other than for monitor the identity of the nodes. For many business organisations subject to strict regula- distributed verification of transactions, such as tions this rules a public blockchain out of their Practical Byzantine Fault Tolerance. consideration. An example is the open project , Anonymity and privacy – the fundamental realised by the Linux Foundation. In the difference between public and private proposed Hyperledger Fabric architecture, blockchain governance there are functioning components responsible A public blockchain affords participants in the for management of the participants and their network anonymity secured by cryptography. privacy and for issuance of certificates used for The irreversible ledger may be a repository for signing transactions and smart contracts so documents, contracts, title deeds and other that the details are visible only to the parties to assets. Blockchain may be used to place the given transaction. The functions of information and instructions with a wide range verifying node and passive node have also of applications. The potential applications of been separated, enabling greater oversight of this technology extend far beyond actors participating in the consensus and like Bitcoin. The fields of holding a full copy of the register based on the application of the DLT paradigm are blockchain. As transactions are recognised potentially countless, because it enables only after authorisation at numerous levels decentralisation of verification and storage of (signing of certificates, authentication of transactions of all kinds between parties on identity), “membership services” generally a global scale. permit controlled access to the network, thus eliminating the anonymity of the nodes. At the But in many sectors of the economy where the same time, this type of service can guarantee blockchain technology could have the privacy of transactions by distribution of applications, the participants cannot remain anonymous. transaction certificates which encrypt a confidential transaction between two specific When conducting business or providing public parties, rendering it illegible to others. It services, we typically know (and want to know) should be pointed out that all these features our supplier and customer. Anonymity is are integrated with the traditional advantages neither necessary nor desired. In solutions that of the and consensus are divided and distributed among all algorithms. participants in the network, appropriate

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Business logic entered in blockchain, or Other problems should also be mentioned, smart contracts arising out of the ability of business One of the new features popularised with the organisations to comply with existing legal project is the concept of smart regulations, which often require that certain contracts, i.e. compiled programming code specific behaviours be included in the business a copy of which is entered in the blockchain process, such as disclosure of the parties to the ledger and whose content represents the rules contract, the privacy of transactions, or for executing transactions between the parties. regulated access to data. Once distributed in the decentralised network, Smart contracts in public and private the is launched on all nodes as blockchains an executable programme, and the specific In the case of networks based on a public function provided for by the author is blockchain, the correctness of the transaction launched. between the parties is determined exclusively It can thus be said that a smart contract is by the consensus of the network. The a digital representation of the rules or influence of organisations making up the processes functioning within a given business membership of the given network is negligible, organisation that regulate the execution and and without obtaining a supermajority of the course of transactions. The blockchain capacity of the network (e.g. 51% of the hash technology serves here as an irrefutable ledger rate in the case of networks based on proof- of contracts governed by smart contracts. This of-work consensus) there is no practical context also raises the possibility of instant possibility of recognition of certain (and practically cost-free) execution of transactions or agreements executed by smart transactions between parties seeking to main- contracts as defective or invalid. This problem tain anonymity, resolution of disputes without lay at the heart of the incident of The DAO in involving a trusted third party but relying on June/July 2016. The discovery of a smart the transparency of the blockchain, and even contract susceptible to an attack by hackers automatic conclusion of contracts without (and exploitation of that susceptibility by an involvement of the human factor. unknown perpetrator to drain over USD 60 New technology, new problems, new million in cryptocurrency) caused a battle challenges lasting several weeks for agreement on what remediation (if any) should be applied. The irrefutability of contracts unfortunately A problem in and of itself was to achieve the does not eliminate potential legal problems. As agreement of the entire community, which in the case of any entity operating in displayed irreconcilable interests. Without commercial life, fundamental aspects of a process in place for dealing with an incident a comparative analysis of public and private of a defectively written smart contract, a blockchains in this context include: decision was taken for direct intervention in  Clear identification of the entity the addresses registered in the Ethereum responsible for a defectively prepared blockchain used to store the stolen funds. On contract, and one hand this allowed the funds to be restored  Identification of the process enabling to their owners and blocked them from being quick remediation. taken over by the hackers. On the other hand,

14 this was clearly a change in the rules in the on decentralised ledgers, distributed consensus middle of the game, and as such met with and decentralised management. Depending on resistance from a large segment of the the needs and requirements, these could be community faithful to the ideal of the integrity networks for anonymous participants, where of the blockchain (more on this in the article the details of transactions are publicly “What the history of The DAO says about the accessible to all, or private networks open to law” at p. 25). a defined group of participants, enabling Solutions enabling implementation of management of privacy. In either case, blockchain technology in a closed, private mathematics and cryptography will enable the environment are coming to the rescue. The rules governing how the network executes and confirms transactions to be locked away in greater level of trust a priori between the parties permits simplification of the consensus computer code. mechanism, a clear delineation of roles, and This does not mean that the professions of assignment of responsibility to specific units. advocates or notaries are condemned to The appearance of specialised auditors and extinction. To the contrary, the digitisation of administrators of identity with special assets, transactions, agreements and business entitlements allows for more effective control logic between the parties within blockchain over transactions in the network based on the and smart contracts opens up new possibilities blockchain technology. In the event of defec- and perspectives. On one hand, the most tively functioning transactions based on smart basic, repetitive legal actions can easily be contracts, and with the small scale of the programmed and automated. This will allow private network (typically some 10–20 nodes), lawyers to focus on more complex and labour- there is a possibility for immediate interven- intensive matters. On the other hand, tion, and with simpler consensus a change can familiarity with the governing law will be the be accepted must faster by the entire network. key to entirely new fields of activity, such as Law locked in code – the future of the legal formulation of smart contracts describing an professions in a world of blockchain and agreement or new type of business, or drafting smart contracts legal opinions for planning to base their activity on blockchain. Consequently, The neutrality of the principles of distributed a knowledge of programming and algorithms consensus and verifiability of transactions may may prove to be a key skill for the lawyers of significantly contribute to a redefinition of the future. current decisional processes, both in central organisations and in implementation of solutions covering all participants of a given market. Many new business models may rely

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What is DAO from the legal perspective?

Krzysztof Wojdyło

The question posed in the title would be moot if DAO functioned in complete isolation from the existing legal and economic context. But that is not the case, at least not at the current stage of development of DAO. Given the existing connections with the real world (forced at the very least by existing tax systems), there is a need to grasp the essence of DAO for purposes of current legal and commercial structures.

Exceptional nature of DAO foundation. DAO also lacks traditional representatives comparable for example to the DAO (decentralised autonomous organisa- directors and officers of a corporation. tion) is undoubtedly an intangible creature. But that hardly makes DAO unique from a legal Nonetheless, DAO and its participants enter perspective. For centuries the law has into external relations with entities from out- recognised the existence of immaterial entities, side the DAO. This occurs for example with and the significance of such entities continues respect to developers of the DAO program- to grow. In this context we could mention ming or external providers of content to the intellectual property rights or receivables, DAO (e.g. “oracles”—trusted providers of which do not have any material form but may data on the value of assets relevant to smart carry great value. contracts concluded via DAO).

DAO is a type of smart contract, but it should Many of the legal relations formed via DAO be distinguished from the smart contracts that could no doubt be classified as relations may be concluded via DAO. DAO should be recognised by traditional legal systems treated as a type of meta-contract that (e.g. a sale contract or lease agreement). But organises the scheme for conclusion of target the legal treatment of the DAO itself presents contracts between participants in the given much greater difficulties. It is hard to assign DAO. Thus a DAO can form legal a DAO to a specific jurisdiction when current relationships between its participants (that is, legal systems don’t recognise the existence of the participants in the given DAO hold certain DAO at all. In this sense DAO is an abstract rights and obligations). The legal relations in being that eludes simple legal classifications this case are created using non-standard and is difficult to ascribe to a specific legal methods, but thanks to DAO legal relations order. are effectively established between its Legal capacity participants. This is also the approach to DAO presented The exceptional nature of DAO is also found by current Polish law. One of the fundamental in the far-reaching autonomy of its operation. concepts of civil law is legal capacity. Although DAOs function in an automated manner it is not defined in the Civil Code, it is assumed through execution of the code that is their to mean the capability of holding rights or

19 bearing obligations. Such capacity is possessed of the DAO’s participants. Identifying all these only by entities defined by law. These are persons is not feasible. Moreover, this presents natural persons, legal persons (the law a major barrier to formation of any legal provides for a fixed catalogue of types of legal relations with DAO by external suppliers. persons), and organisational units that are not Suppliers acting with due care seek to precisely legal persons but are nonetheless vested with identify their customers. They must know who legal capacity by specific statutory provisions. they are actually entering into a transaction DAO is none of these entities, and therefore with, whom they might have to seek payment under Polish law it does not have legal capacity from and so on. and cannot be the subject of rights and Short-term solution obligations. Recognition of DAO as a legal entity by the Polish legal system would require To overcome these difficulties, creation of legislative intervention expressly endowing structures linking the legal relations arising in DAO with legal capacity. DAO with a traditional entity possessing legal capacity as recognised by traditional legal Essence of the issue systems should be considered. The terms of The lack of legal capacity of DAO makes it the DAO might expressly indicate, for transparent from the point of view of current example, that a specific company or law. Thus any legal relations occurring in or foundation is the party to relations with the with the DAO are theoretically relations DAO. This approach would certainly make it occurring directly between the end users of the easier to form legal relations with the DAO. It DAO. At first glance this might seem neutral. would enable identification of the entity that is As long as the DAO functions properly, these a party to the relations with the DAO and considerations seem like moot, academic determine the legal system that will apply to discussions. relations with the DAO. But the problem is that DAO is not, and in the This solution would undoubtedly provide near term probably will not be, entirely greater certainty in dealings with DAO. It is abstracted from the reality conceived of in advantageous for the initiators of the DAO as traditional, formal legal terms. This is primarily it allows them to estimate with some precision because the end users of DAO are natural and the potential legal risks connected with legal persons who are subject to specific legal launching the DAO in question. The DAO in systems. For example, for tax purposes it may this solution ceases to be suspended in a legal be necessary to precisely identify the source of and regulatory vacuum. The first examples of income from a DAO. Moreover, for its DAO attempting to follow this scheme are functioning and growth a DAO will often appearing. It seems that in the short term, this need to have dealings with external service is the only chance to ensure safe development providers (such as the creators of the of DAO and exploitation of its potential. programming). Long-term solution In such instances, the legal transparency of DAO presents serious practical problems. The But considering the nature of DAO, the parties to legal relations formed within the solution indicated above should be regarded as DAO or the parties to legal relations with the makeshift. Ultimately, a special new DAO would have to be identified as being all construction of legal capacity should be 20 created for the purposes of DAO. This DAO is that it cannot be identified with any solution would much better reflect the true specific jurisdiction, because DAO functions nature of DAO. By adopting the interim in a decentralised network. Meanwhile, the solution outlined above, we sanction a legal current legal system still functions on the basis fiction. The traditional entity that is associated of a paradigm assuming the need to associate with the DAO for the purposes of the existing every legal event with a concrete, traditionally legal order will often not be in any position to understood jurisdiction. Looking at the control the activity of the DAO. The essence examples of the challenges brought by the of DAO, after all, is largely found in its Internet (e.g. cybercrime, e-commerce and autonomous character. So the most natural cloud computing), it is clear that this paradigm solution would be to vest DAO with legal is not entirely suited to the realities of the capacity. global net. Many online events already raise thorny conflicts between legal systems (such as DAO has a great many features in common problems determining which law governs with other immaterial entities which the legal processing of data in cloud computing system vests with legal capacity. The argu- services). DAO accentuates the imperfections ments in favour of ascribing legal capacity to of the existing legal order even more. entities such as legal persons do not differ that much from the case of DAO. Both legal It seems that the solution that would best suit persons and DAO are intangible creatures. the nature of DAO would be to ascribe Legal persons were invented to enable efficient a special type of legal personality to DAO dealings by ascribing subjectivity to an artificial while at the same time developing for the entity between the end participants and purposes of DAO a conception of a special stakeholders in economic exchange (such as “distributed” jurisdiction, different from shareholders, employees, consumers and jurisdictions as traditionally understood. But suppliers). Thanks to this construction, each this approach is so far from the current order group of stakeholders in the exchange, such as it can hardly be expected to be adopted within suppliers, does not have to enter into direct the foreseeable future. relations with each other group, such as the owners of the means of production.

But it must also be acknowledged that giving legal capacity to DAO would present a huge challenge for the current legal system. As indicated above, one of the characteristics of

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