Probabilistic Settlement Finality in Proof-of-Work Blockchains: Legal Considerations
The concept of settlement finality sits at the heart of any type of commercial transaction, whether the transaction is in physical or electronic form or is mediated by fiat currencies or cryptocurrencies. Transaction finality refers to the exact moment in time when proprietary interests in the object or medium of transaction pass from one party to his counterparty, and the obligations of the parties to a transaction are discharged in an unconditional and irrevocable manner, ie, in a way that cannot be retroactively reversed even by the subsequent legal defenses or actions against the counterparty.
Given the benefits of finality in terms of legal certainty and its potential systemic implications, legal systems throughout the globe have devised mechanisms to determine the exact moment of the finality of a transaction and settlement of obligations conducted using fiat currencies as a medium of exchange. However, as the transactions involving cryptocurrencies fall outside the scope of such rules, they introduce new challenges to determining the exact moment of finality in on-chain cryptocurrency transactions. This complexity arises because the finality of the transactions in the cryptocurrencies that rely on certain types of proof-of-work (PoW) consensus algorithms is probabilistic. The probabilistic finality makes the determination of the exact moment of operational finality nearly impossible and may render such cryptocurrency networks unsuitable for use as payment or securities settlement systems.
To identify the roots of the problem of probabilistic finality in PoW blockchains, my paper highlights the key distinctions between legal finality and operational finality. It argues that, since operational finality cannot be realistically ensured in any payment and settlement system, ultimately it is the law that should fill the gap by devising the concept of legal finality as opposed to operational finality. However, after studying the concept of legal finality in private law and in payment and settlement systems, the paper concludes that the concept of settlement finality in law is at best a non-deterministic concept, and neither the law nor technology can provide for deterministic finality. This is because the exigencies of certainty, finality, efficiency, and financial stability may give way to the requisites of justice and fairness ingrained in the insolvency laws. Accordingly, legal systems have gone as far as the law can go to provide certainty to the parties to a transaction and to avoid potential systemic implications of settlement fails in the payment and securities settlement systems.
Therefore, rather than taking a strong position to provide deterministic finality, in the case of the most systemically important financial markets infrastructures (FMIs), the law aims to provide the maximum achievable degree of finality. To manage the risks stemming from the remaining degree of uncertainty, the law requires alternative legal and institutional arrangements (eg, settlement discipline regimes) that could mitigate the risks emanating from the potential unraveling of transactions. These mechanisms range from—among others—fail monitoring and reporting mechanisms, technical pre-settlement measures, (close-out) netting mechanisms, the existence of central clearing counterparties (CCPs) and the methods they use to avoid settlement fails, including stringent membership requirements, arrangements for reducing liquidity risks such as access to credit and liquidity facilities (of central banks), securities lending arrangements, transaction shaping mechanisms, partial delivery solutions, and other mechanisms such as the mandatory buy-in tool, whereby, in case of delivery fails beyond a certain period, the buyer can purchase the securities from other sellers and charge the failing party for the additional costs.
The reason for highlighting the importance of institutional arrangements that help ensure settlement finality is that the law is unable to provide deterministic settlement finality. The paper argues that this institutional backstop for the finality of transactions is what differentiates the PoW blockchains from conventional financial systems. As the law may be unable to provide deterministic finality, it resorts to alternative mechanisms by establishing arrangements that could minimize the instances of settlement fails, and, in case a settlement fails, provides for remedies which can be relied on.
The same line of reasoning could be applied to PoW blockchains. In the absence of deterministic finality, the role of institutional arrangements akin to the settlement discipline regime in centralized FMIs becomes important. However, similar institutional arrangements can hardly be imposed on PoW cryptocurrencies because establishing such institutional mechanisms to deal with the remaining risks of settlement finality requires a certain level of centralization in the PoW blockchains. Given the anti-institutional and libertarian ethos of PoW blockchains, adapting the technology to the established institutional constraints of settlement regimes would go squarely against the main value proposition of such cryptocurrencies. Therefore, the main contribution of this paper is to identify the real source of concern about the probabilistic finality in the PoW blockchains. As it turns out, the real cause of concern has little to do with the operational or even legal finality, but originates from the incompatibility of PoW blockchains with the institutional arrangements (akin to the settlement discipline regime) that deal with the remaining risks that neither legal nor operational finality can address.
In the absence of such mechanisms and centralized control, the law may be unable or unwilling to extend its traditional protections to settlement finality in PoW blockchains, and such PoW networks may continue to suffer from the finality issues in the absence of any market-driven mechanisms to remedy the potential settlement fails. Along with other reasons, this may be a legitimate reason for pessimism about the potential use-cases of decentralized PoW blockchains in conventional post-trade processes.
Hossein Nabilou is an Assistant Professor of Law & Finance at the University of Amsterdam, Amsterdam Law School, and the UNIDROIT - Bank of Italy Chair at the International Institute for the Unification of Private Law (UNIDROIT).
YOU MAY ALSO BE INTERESTED IN