The 'fintech' space in India has seen a dramatic boom in terms of technological developments over the past few years. Add to that the government's continuous push to embrace a digital economy post the demonetization measures in November 2016. India's central bank, The Reserve Bank of India ("RBI") has also been in the forefront, almost keeping pace with the technological advancements in the fintech space, by considering various fintech developments that are taking place in India as well as globally.

Earlier this year, the RBI successfully tested Blockchain Technology ("BCT") for a trade application in collaboration with a technology partner in what is reported to be the first ever end-to-end test of BCT using existing banking protocols, including regulators, banks, financial institutions and clearing houses at a global level1. Around the same time, a white paper on the application and adoption of BCT by banks and financial institutions was released. The white paper sets out the cryptographic components, protocols and ledger classifications of BCT along with its advantages and the potential areas of its application, both in currency and non-currency areas. Commendably, crucial features required in banking and financial sectors – security, privacy, traceability and scalability have also been addressed to a reasonable extent.

Blockchain technology

Entities participating in a blockchain transaction give their inputs with regard to the transaction in the form of blocks, and when more than one block is incorporated in a transaction, each separate block is chained together to form a blockchain, which allows the entities to use the blockchain as a ledger. Every transaction is enforced through the blockchain when all participating entities approve of it and therefore, no payment facilitator is required in the process, thus making any transaction performed using BCT secure, transparent and decentralized.

The Evolution of Smart Contracts

Smart contracts are nothing but the ability of BCT to attach business logic to the transactions. For executing smart contracts, computer protocols with the terms and conditions of a contract are embedded in the blockchain database. The terms of a contract as agreed to between the parties are fed into an executable computer code that can run on a network. Many contractual clauses are made partially or fully self-executing, self-enforcing, or both.

For example, under traditional contracts, a vendor will have to raise invoices after providing goods/services to their customers following which the payment will be processed by the customer. The entire process takes at least four to five days. What a smart contract does is: as soon as the vendor performs their part of the contract, the customer will release a key signifying the completion of the vendor's obligations, which would automatically release the payment as per the terms of the smart contract from the customer's blockchain ledger associated with a bank.

From a bank's point of view, a smart contract is expected to be more convenient given the minimal "Know your customer" checks required to approve a transaction. The entire BCT ledger is encrypted and the key to execute a smart contract is only generated to the parties to the contract, therefore, significantly limiting the scope for unauthorized use.

Now the next question becomes: Is a smart contract an enforceable contract under Indian law? One may argue that a s smart contract meets the traditional contract law requirements such as offer, acceptance, free consent and valid consideration. The BCT associated with the smart contract will be programmed in such a way that the payment mechanism is carried out through the blockchain as per the terms of the smart contract. More importantly, there can be no means of unilateral non-performance/non-payment under a smart contract, as each party to the contract has to give their respective approvals to sanction the performance under the same. Moreover, from the point of view of stamping and registration of a smart contract, respective government entities may also be made a participant in the blockchain network, thus, enabling the performance of an entire contract without the need for any paperwork.

The Bitcoin debate

While RBI has been open to considering BCT applications, it has not been receptive to virtual currencies or crypto-currencies such as bitcoins that use BCT.  In fact, RBI has explicitly denied the status of 'legal-tender' to virtual currencies like bitcoin pretty much on the lines of other central banks throughout the world. Bitcoins enable the facilitation of online peer to peer electronic cash transactions without going through a financial institution (such as the central bank of a country), and therefore, the source of the currency is encrypted. As the source of the transaction or the currency is untraceable, BCT has been used as a backend of Bitcoin for maintaining the distributed transaction ledger in a peer-to-peer fashion that is anonymous and permissionless.

To understand it better, when a transaction is performed via traditional online banking, it is facilitated through a payment gateway that verifies the identity of the user to the bank through a One Time Password, when it is carried out through BCT the transactions are traceable (while being verified directly by the parties to the transaction), and the entire blockchain keeps permanent records of these transactions with the respective banks. On the other hand, in case of bitcoins, the entire transaction takes place in complete anonymity as they are a mere entry in the blockchain ledger, the source for which is not known. The ease of use and transfer of this virtual currency (with minimal KYC & AML checks) that leaves no trail behind has rightly been a nightmarish situation for central banks all over the world with suspicion cast on the source of funds and if this could be misused for terrorist financing or money laundering purposes. In fact, the entire illicit business empire over the internet uses bitcoins for these specific reasons.

Perhaps it is then time to radically weigh in the pros and cons of BCT and bring about a new set of laws governing these new technologies considering the costs and benefits involved here.

Footnote

1 Indian Central Bank Research Institute Completes Blockchain Test  https://bitcoinmagazine.com/articles/indian-central-bank-research-institute-completes-blockchain-test/

May 20, 2017

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