Blockchain-based platforms create exciting possibilities for financial inclusion: widespread ownership of deposit accounts and access to payments services. From a macro-level perspective, however, these platforms can aggravate systemic risks. Systemic instability, in turn, threatens financial inclusion and sustainability.

Sustainable finance, as used here, means continuously providing financial inclusion and access to credit. Emerging financial technologies, or fintech, such as cryptocurrencies and blockchain-based financing platforms, have potential to create access to banking services, investment possibilities, and capital for those currently underserved in these areas.

Yet blockchain-based financial activity has the potential to threaten market stability in two different ways. First, it facilitates synthesizing financial assets into arcane financial products, the trading of which can escalate in volume and speed seemingly without limit. Second, it enables self-executing transactions that may defy private-law doctrines and regulatory requirements in ways that are difficult to undo. These two sources of risk deserve lawmakers’ attention as blockchain-based markets develop.

Macro-level regulatory concerns that emerging fintech platforms present implicate financial inclusion and sustainability. If the financial crisis of 2007-2008 is any guide, excessive systemic risk and resulting market failures undermine financial inclusion and sustainability. They most hurt those who are striving for financial security.

Smart contracts are agreements that are self-executing and self-enforcing, expressed in code. Different forms of blockchain-based smart contracts accomplish different ends. The smart contracts at issue here are single smart contracts for trade transactions, executed on a decentralized ledger. They reflect a decentralized commitment between two or more parties on a blockchain, operating in response to financial incentives.

Recent legal scholarship observes that blockchain-based platforms enable increasingly complex pooling and compounding of claims and acceleration and compression of trades. The shift in recent decades of the financial system’s center of gravity from primary to secondary markets, when coupled with fintech platforms’ capacity for risk generation and untethered growth within secondary markets, threatens the efficacy of existing regulatory paradigms. As such, the advent of blockchain-based platforms for financial markets challenges policy makers to determine how, in the future, we will achieve a functional balance between private risk-taking and public welfare.

In addition to risk associated with increased trading and the synthesizing of claims, blockchain-based smart contracts can aggravate systemic risk by detaching financial transactions from private-law rules, creating markets that expand despite incoherent legal foundations. The topic of financial regulation often conjures a public/private dynamic in which private actors generate and trade financial claims and public agencies control for excessive risks. Focusing on this public/private dynamic can obscure the regulatory role of complex private-law doctrines (contract and property) that enable enforceable deals in the first place.

Blockchain-based smart contracts are a device for transacting, not a type of transaction. But this device has a legal effect in that it dedicates assets to specific transactional counterparties. Blockchain-based smart contracts are self-executing; they partition assets much as security interests or entities do. Lawmakers tend to treat this technology as a new platform for executing established forms of transactions. Yet, blockchain-based smart contracts can be difficult to fit into existing legal frameworks because they combine contract and property law features and mimic both security interests and entities. As such, emerging platforms enable market actors to exploit the difficulty of challenging a transaction’s characterization, allowing them to side-step statutory boundaries that reflect longstanding policy choices.

For example, it may be possible for a fintech-enabled transaction to assign assets for purposes of securitizing them with a high degree of recourse that, if subject to a characterization challenge, would make the assets reachable by the originator’s creditors. In the off-chain, traditional world, creditors would have, through the bankruptcy process, a legal point of intervention at which to challenge the true-sale status of an assignment for the issuance of asset-backed securities. In a blockchain-based transaction, however, there may be no such legal intervention point. The code expressing the transaction may automatically transfer assets to the investors upon the occurrence of an originator bankruptcy. The originator may try to contest and eventually undo the disposition, but there is no space to seek an order permitting access to the assets pending the determination of their status in private-law terms.

The narrative around legal treatment of blockchain-based smart contracts implies that existing legal infrastructure can accommodate this market activity so long as laws are sufficiently technology neutral. This narrative disregards the complexity of applying established legal doctrines to transactions that can defy straightforward legal characterization and force transacting parties to contest outcomes only after execution. The cumulative effect of this complexity could be markets that grow despite inconsistent or incoherent legal status. Legal uncertainty surrounding dominant transactions comprising markets integral to the economy is a source of systemic instability.

How do we ensure that private-law norms persist in fintech-enabled markets? How do we better enable federal regulatory bodies to preserve financial stability in the face of compounding speed, complexity, and growth in secondary markets? Lawmakers’ approaches to these questions will affect whether fintech developments fulfill their promise of greater financial inclusion and sustainability. To foster financial inclusion, we must harness the best of fintech for the provision of banking services and access to credit, while protecting against its challenges to financial systems.

This post comes to us from Professor Heather Hughes at American University’s Washington College of Law. It is based on her recent article, “The Complex Implications of Fintech for Financial Inclusion,” available here.