Two major US regulators: The value of smart contracts is becoming more prominent, but The DAO precedent is worrying

Earlier this week, two members of the United States’ main regulatory agency publicly expressed the difficulties faced in regulating the explosive industry of smart contracts.

Representatives from the federal Commodity Futures Trading Commission (CFTC) and the independently run Financial Industry Regulatory Authority (FINRA) took turns explaining why they are closely monitoring the industry.

During a panel discussion at the ‘Smart Contracts Symposium’ hosted by the Chamber of Digital Commerce (CDC), representatives from both regulators agreed that while there is a need to take action on the development of smart contracts, there is no rush .

Speaking to more than 250 people at Microsoft’s New York headquarters, CFTC Chief Economist Sayee Srinivasan said that while exploration of the blockchain space has been slow over the past few years, rising capital costs are making the value of such investments more apparent at an increasingly rapid pace. In fact, Spain’s Santander Bank estimates that blockchain could save $20 billion in costs annually.

Srinivasan acknowledged that while regulators “will always lag behind market practices in the rapidly evolving financial institutions industry,” smart contracts could eventually help regulators address this problem.

If implemented nationwide, so-called “regulatory nodes” on a distributed ledger would give Srinivasan and his colleagues unprecedented auditing powers. Srinivasan has also discussed the issue with others in the industry, who believe that creating code that can execute itself could one day make regulators “unemployed.”

“Where there is money to be made, there is an incentive for people to challenge the existing ‘rules of the game.’ That’s when regulators need to step in, even though there is some idea that code is law.”

Earlier this year, CFTC Commissioner Christopher Giancarlo said blockchain could be the ‘biggest technological innovation to come to the financial services industry and financial markets regulation in the last 20 to 30 years.’

However, the agency’s speed in transitioning to regulation under the Trump administration has been questioned. Last month, the U.S. House of Representatives’ Agriculture Committee sent a letter to the CFTC asking it to clarify its regulatory policy on digital currencies.

Srinivasan said:

"This is a process that is not legally enforceable. This is a gradual process."

FINRA Application

Like the CFTC, FINRA has been slow to move forward with blockchain regulation.

Kavita Jain, director of emerging regulatory issues at FINRA, echoed Srinivasan’s stance, saying that while blockchain is certainly worthy of close attention, regulation needs to be slow to catch up.

Srinivasan has extended an open invitation to those interested in further exploring blockchain-based regulatory nodes, and Jain said FINRA — which writes and enforces regulations governing some 3,900 securities firms — has been looking into implementing smart contract regulation for its clients.

Jain, speaking on his own behalf, said:

“At FINRA, we have received several applications that give us the opportunity to engage with clients.”

Based on her investigations so far, Jain said she and other regulators are concerned that "regulated entities are operating in an environment of distrust."

Not only because these entities could break the law in new ways, but also because of concerns about the data sources used and what would happen if that data became corrupted.

She said:

“That alarm bell kept ringing in my head.”

The DAO’s Dangerous Precedent

Each entity expressed concerns about the precedent set by The DAO, the first large-scale smart contract implementation, when self-executing code on the Ethereum blockchain was tricked into sending its funds to an attacker account.

Sandra Ro, CME's head of digital implementation, said that as a regulated entity, the exchange was "well aware" of the need to proactively accommodate an environment that spans more than 150 different countries.

Ro recounted many examples of problems with financial infrastructure that must be corrected, and was curious about what would happen if the network was run through self-executing smart contracts.

She said:

“How do we code when things get crazy?”

Dax Hansen, a partner at Perkins Coie, a law firm specializing in blockchain, said the main difference between The DAO and future smart contract implementations is the need for the ability to undo actions.

Smart contracts that operate without being interpreted by regulators will put mainstream finance under attack.

He concluded:

“If this smart contract fails, it will be a disaster.”