In this article, Adv. Shamika Vaidya, practising lawyer in Bombay HC and NCLT, pursuing Diploma in Entrepreneurship Administration and Business Laws from NUJS, Kolkata discusses how lending startups are using blockchain and the possible legal issues regarding the same.
Introduction
Blockchain Technology
Blockchain consists of data batches called blocks which are digital ledgers containing information and cryptographic hash which links them to the previous chain of blocks. Each block comes with a timestamp, and information of cryptographic hash of itself and the previous block, public keys of both the parties and is restricted to the modifications.
A block contains:
- Hash
- Hash of the previous block
- An Index
- A nonce
- a timestamp
- The data
- Hash representation of the data
Decentralisation
Blockchain technology is decentralised, there is no particular entity or an intermediary like a bank that is running or controlling or regulating it, making it more distributed and resilient. The documents, transaction get copied and updated in many nodes in a P2P network. However, they cannot be changed or edited making it highly secured.
Keys
An account of every user is known as his public address or public key. A Private key is like a password and has to be kept discretionary and is already saved in the account of the user. Both keys are a complex alphanumeric combination. For the peer networks to understand that the transaction is genuine one there is a digital signature that is new for every transaction and proof that the user has the private key for the nodes to verify it. Digital Signature is the combination of private key and transaction details. The digital signature cannot be reused and any alterations in message invalidates the digital signature.
Consensus Protocol
A consensus protocol is set of rules that describe the mode of transmission and the communication of data between the electronic devices such as node network. Consensus protocols are governing rules that allows devices that are scattered across the world to factually come to an agreement allowing the network to function without being corrupted. In case of conflicting versions at the same time. Majority of network agreeing to the data is called consensus which is the base of the security.
Hash Functions and Smart Contracts
Hash function takes any digital media like documents, PPTs and runs an algorithm on it to produce a unique digital output known as Hash, which is much smaller than the original input. Thus, the hash is representing the document in a small and different form and will be unique for every media. Even when the slightest change that is change in a single bit of digital data will result in a totally different output to the original one. There is no way to derive the original media from its function making hash function one way.
Smart Contracts are also known as Self implicating, Blockchain and Digital Contracts. As the name suggest the smart contracts are automatic enforcement of the obligations and are secured and irreversible without third party involvement. Verification, negotiation and performance is possible through these contracts. Suppose in a clause in the contract a particular date is mentioned where A has to pay B a certain amount, date the same will be performed automatically, neither A or B has to do anything for performance.
Mining
The document in the blockchain is copied and stored into the systems of many networkers all over the world. Which means the copies of the single document are in the systems of many users. Now, if there is a new information that is to be added then there has to be a creation of new block. Here comes the role of miners, who solve a complex mathematical puzzle. The solution is called proof of work. There are special computers which are used by the miners. The difficulty of Math problems increases with the number of miners, the purpose is only one miner solves the problem at a time. The one who is able to solve the complex puzzle gets to publish the update on the ledger which is updated by the other peer networks in their systems. There are rewards for the solving of the puzzle is getting newly created coin (Bitcoins) on the blockchain.
Lending Companies
Benefits
NBFC
Non-Banking Financial Companies are regulated by the Reserve Bank of India and are registered under the Companies Act. They differ from the banks in ways like they cannot accept demand deposit, cannot issue cheque drawn on itself and for settlement of debt, their liabilities unlike banks cannot be used for settlement.
P2P Lending Companies and Blockchain Benefits
Lending companies which are mere platforms that connect the lenders referred as investors to the borrowers are called Peer 2 Peer(P2P) Lending Companies. This type of lending is not government regulated and there is no intermediary like a bank, the lender, loans the money to borrowers the medium being the P2P. The company is not involved in lending any money themselves. The loans are unsecured, totally online and the loans can be converted into securities and sold to others lenders. Investors look forward to P2P platforms, as the risk is distributed, as one loan can be lent by various investors with the amount they desire to. Due to the following reasons, P2Ps are burgeoning.
Many new startups have started with using the Blockchain technology in the lending market. Some of them are
- Coinloan
- Lendoit
- ETHlend
- Inspeer
- SALT
SALT
Every official SALT lender must pass SALT Lending Suitability Test to become an Accredited Investor. SALT lends money to the borrowers allowing them to keep their cryptocurrency (blockchain asset) as collateral. One need not exchange it but simply keep it collateral.
ETHlend
ETHlend is a platform for both borrowers and lenders. They can meet and decide on the interest rate. The platform runs on Ethereum network and tokens are the deposit for the loan.
Benefits of Blockchain Technology
Curtail menace of NPA
Non-Performing Assets are defaults in payment that is non-payment of loans on the principal or interest for a period of more than 90 days in most of the cases. There are severe effects of NPA, like reducing the cash flows and reduction in the available capital thus disrupting the whole budget. The measures that the lenders can take is turning bad loans in equity, possessing the collateral security. Blockchain technology will be considerably help in reducing the NPA by providing a centralised information and the present liabilities on the applicant.
Transaction Cost as less as Zero
Presently, due to operation complexity, the transaction setup costs the lending companies about 35%, it can come down to as low as zero with Smart Contracts as analysing data, completing scoring, calculating the interest rate and scheduling of the payment.
Handling Defaulters
Smart contracts can automatically withdraw monthly payments from the lenders account when payments are due. As per the conditions in the contract, appropriate penalties can be imposed or it can be referred further to arbitration. Recognition of person or institute with the history of defaults is traceable easily, either appropriate collateral can be taken or they can be rejected. Settlements of payment is one of the most painful area for lending companies.
Centralised Details
In a typical system details like KYC, credit history of a borrower, financial transactions of the customer are maintained by the supplier, logistic company, producer, retailer, insurance company, bank, audit agent which gives a space for fraudulent transactions due to individual records and also puzzling for a financial institute, tax department. Cases where one property in mortgaged multiple times or sold to multiple buyer does not have a clear title and ends in litigation dispute for years can be very easily avoided.
Over Valuation & Window Dressing
In order to achieve the targets most of the times property that has to be mortgaged is over valued by the sales representatives of the lending companies and the loan sanctioned is comparatively high than the value of the property mortgaged which is troublesome in case of default. It can also help in cases where the company misrepresents its assets to be greater than they are (window dressing).
For P2P Platforms
One of the main challenges for the P2P companies is unlike banking system they do not accept collateral for the loans they advance making them more vulnerable to risk. With blockchain, it is possible to tokenize assets like branding and intellectual property which gives interest to the investors to earn interest on the collateral and gives better value even for the borrowers being placed in the global market and can be used as a collateral which is not possible in mainstream lending.
Fraud monitoring
Public Sector Banks in India lost at least 227.43 billion (Rs 22,743 crore) owing to fraudulent banking activities between 2012 and 2016, according to an IIM-Bangalore study. Frauds can be avoided by blockchain technology because of the centralized information and a check on past records before advancing unsecured loans and LOU would not had been issued or transaction would not had been approved by all in the Peer network.
Some other benefits
- High End Security
- Accuracy
- No Intermediary
Legal issues
Jurisdiction and Dispute Resolution
The technology being operated on a global level and in a decentralized form where there is no single point of operation it can be a challenge for the legal framework to regularise the transactions in case of any dispute. In case of a bank, where one can sue it on the basis of jurisdiction. It will be difficult to decide the jurisdiction as to whether it shall be the one where transaction initiated that is a request by the borrower or the one where the borrowers meet the lenders that is the platform or the one where it was published by the miner or the relevant computer servers.
Adaptation
Even to bring a set of laws set for determining the duties and obligations of the parties will be a challenging task. Not only the law framers have to understand the complex technology but all the possible repercussions and a very efficient system to safeguard the legal rights. Let’s say, even if such set of laws is ready it will take considerable time for the judges to understand and study the technology which opens the door for the probability of error and a considerable delay.
Liability & Enforceability
DAO are Decentralized Autonomous Organisation which, as of now do not come under legal personality frame. However, they have been given with some rights in few countries like getting in contractual obligations. The basic question that arises is of liability and enforceability. Who is to be held liable for any defects in the whole transaction chain, the miner, the controller, the owner, the one who initiated the transaction. The second question is how one would enforce performances if there is no legal framework.
Results of Amendments
Law changes with time, the new regulations that will come into existence, leaves with the question as to changes in the prior documents and transactions that are already in the chain and are not in compliance with new laws.
Irreversibility
In traditional law system mistakes can be rectified, let’s say with something like Deed of Rectification, however in Smart Contracts it is irreversible, if there is a mistake one cannot rectify it and has to perform the contract. In case of losing the private key, there is nothing one can do about, maybe eat few almonds every day to sharpen the memory!
Conclusion
Blockchain technology will make transaction hassle free and faster, increase the cash flows and maximise the profits.
