Blockchain can be a disruptive technology for the administration of smart contracts in the financial sector if some regulatory hurdles are cleared, writes Sanmit Seth

Earlier this year, the National Payment Corporation of India, with a view to automate payment clearing and settlement processes, launched a distributed ledger technology-based payments platform called Vajra. It’s interesting to note that the use of distributed ledger technology will benefit different segments of businesses.

Companies around the world have started experimenting in this direction to harness the capabilities associated with distributed ledger technology. This article sheds light on the use of blockchain technology in the way traditional contracts in India have been executed, and the adoption of smart contracts over traditional contracts. It also looks at the current statutory provisions applicable to smart contracts in India, and whether such provisions under their current form and structure provide legal sanctity to executed smart contracts.

What is blockchain?

The terms “blockchain” and “distributed ledger technology” are often used interchangeably. Blockchain stems from the idea of addressing the double-spending problem of digital money. Put simply, digital money is a sequence of bits, or computer-readable files, that can be copied and transferred between two parties without having any intermediaries maintaining the ledger of account holder’s balances. Without having intermediaries recording a transaction in a ledger, the transferor of the digital money can send the file and retain a copy of it, giving rise to the problem of double-spending.

The blockchain is an electronic public ledger that allows transacting parties to create an immutable record of transactions through a decentralized and distributed peer-to-peer network of several computers. The record of transaction on the distributed peer-to-peer network is packaged into a block built on a cryptographic hash function, which further links with other blocks of similar information to form a chain of blocks.

Such records of transactions can be accessed anytime in order to determine the exact sequence of events. The information recorded in the ledger can never be erased, and can only be updated with the consensus of the transacting parties in the system. The usage of blockchain eliminates intermediaries and provides a high level of security and integrity by acting as a database that contains the records of each transaction executed on the network.

The blockchain’s overarching potential can be extended to other traditional ledger-keeping methods including land titles, loans, identities, etc., and further to facilitate self-executing contracts between two or more parties, also called a “smart contract”.

What is smart contract?

In 1994, Nick Szabo, a computer scientist, legal scholar and cryptologist, envisaged the concept of a smart contract to automate the traditional contract making process. Since then, the contours of the smart contract have evolved to include self-execution of contracts over distributed ledger technology, eliminating the role of third-party intermediaries.

A white paper was published in 2017 by the Institute for Development and Research in Banking Technology titled “Applications of Blockchain Technology to the Banking and Financial Sector in India”, where the smart contract was described as “pieces of software that extend blockchains’ utility from simply keeping a record of financial transaction entries to automatically implementing terms of multi-party agreements. Smart contracts are executed by a computer network that uses consensus protocols to agree upon the sequence of actions resulting from the contract’s code. With a shared database running a blockchain protocol, smart contracts auto-execute, and all parties validate the outcome instantaneously and without need for a third-party intermediary.”

Uses in finance agreements

Blockchain has a use in the way we execute traditional financing contracts. Blockchain infrastructure can be encoded through programable computer codes for creating a smart self-executing contract, which will trigger itself upon meeting the requisite predetermined terms and conditions. Smart contracts will streamline this complex process, which involves several intermediaries in a transaction. It also provides better security performance than the traditional contract law, and reduces transactional costs associated with the negotiation, verification and enforcement of agreements.

To understand this, let’s take an example where party A is an individual who wishes to purchase a flat in a building that is being constructed by party B. Party A cannot pay the full price of the flat and hence makes use of a loan facility from party C, a bank. In the traditional course of events, party A will be required to provide personal and other information to verify his or her identity, and also have to undergo a credit check process. This process will involve several different people who will be compensated through a small commission for their work, which further adds up to the purchase price of the flat.

However, using blockchain technology, party C has the ability to download the desired information from one of the blocks of party A to make a quick decision about his/her identity and credit, reducing the turnaround time for all parties to the transaction.

After the initial process of identity establishment and credit assessment of party A, all transacting parties enter into a smart contract where the loan money will be disbursed by party C to party B, and ownership of the flat will be transferred in favour of party A, with party C holding charge on the flat until full and final repayment of the loan is made. The transfer of ownership is automatic as the transaction gets recorded into a blockchain, which is shared among the participants and can be checked at any time.

Smart contracts and the law

Parties to a contract are not only free to choose and agree on the contents of their contract, they are also free to choose its form (except when the law requires a special form, such as in the case of sale of real estate). For smart contracts to be valid and enforceable in India, the requirements laid out in the following statutes must be fulfilled:

  • The Indian Contract Act, 1872 (Contract Act): According to section 10 of the Contract Act, any agreement enforceable by law is a contract if it fulfils essential elements such as: (i) offer and acceptance; (ii) free consent; (iii) competent parties; (iv) lawful consideration; and (v) lawful object. A smart contract, if executed via blockchain while meeting the above-mentioned elements, will be an enforceable legal contract under the Contract Act;
  • The Information Technology Act, 2000 (IT Act): Joint reading of sections 5 and 10A of the IT Act provide that a contract shall be deemed to have been executed if it is authenticated by means of digital signature, in accordance with the procedure as set out in the IT Act. Such authentication is effected by the use of asymmetric crypto system and hash function. Section 35 of the act states that an electronic signature can only be obtained from a designated certifying authority of the central government. Therefore, a smart contract executed using a hash key that is to be used as an identifier to authenticate on blockchain will not be a digital signature, since the signature has not been obtained in accordance with the IT Act;
  • The Indian Evidence Act, 1872 (Evidence Act): Section 65B of the Evidence Act stipulates that any information contained in an electronic record that is printed on a paper, stored, recorded, or copied in optical or magnetic media produced by a computer, shall be deemed to be a document if it satisfies certain conditions envisaged, and shall be admissible in any proceedings without further proof or production of the original, as evidence of any contents of the original or of any fact stated thereof where direct evidence would be admissible. However, according to section 85B of the Evidence Act, an electronic agreement would be considered as a valid agreement only if it is authenticated using an electronic signature obtained in accordance with the provisions of the act. Section 88A further states that the court presumes that an electronic record produced in court is genuine, but does not make any presumptions about the sender of the contract. Therefore, a smart contract authenticated through blockchain will not be admissible evidence in a court of law, since digital signatures that will be used for execution would not have been obtained in accordance with the provisions of the IT Act;
  • The Indian Stamp Act, 1899 (Stamp Act): As per the provisions of the Stamp Act and other state-specific stamp-related legislation, the payment of stamp duty is essential for treating an instrument admissible in evidence before a court of law. The definition of “instrument” under section 2(14) of the Stamp Act means and includes every document by which any right or liability is, or purports to be, created, transferred, limited, extended, extinguished or recorded. Therefore, a smart contract, if it fulfils the ingredient of “instrument”, will be required to be stamped under the relevant provisions of the Stamp Act and other state-specific legislation.

The way forward

Blockchain can be a disruptive technology in the administration of contracts for the financial sector. However, in the absence of a regulatory framework that recognizes the enforceability and admissibility of a smart contract under the existing provisions of laws, the current implementation remains difficult.

Considering that information is being shared in a decentralized environment over blockchain, and the lack of a single body corporate entity handling data arising out of any transaction, it is difficult to impose “reasonable security practices and procedures” as prescribed under the Information Technology (Reasonable Security Practices and Procedures and Sensitive Personal Data or Information) Rules, 2011, which sets out various rules for the purpose of safeguarding sensitive personal data, and protecting such data from unauthorized access, use, alteration, disclosure or damage through a computer resource.

The implementation of blockchain is today an uphill task, but if we wish its use to become a reality tomorrow, then the government will need to amend several existing statutory provisions for recognizing the enforceability and admissibility of smart contracts executed using blockchain networks.

Sanmit Seth is assistant vice president, legal, at Kissht, a digital platform operated by ONEMi Technology Solutions Private Limited to provide credit financing