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Click to view the latestMarch 2016 Business Law TODAY BUSINESS LAW TODAY Understanding Block Chain and Distributed Financial Technology: New Rails for Payments and an Analysis of Article 4A of the UCC By Jessie Cheng and Benjamin Geva Introduction be interpreted to cover the typical payment The distributed ledger is designed to allow Although the hype around bitcoin has large- of an interbank payment order using dis- validated information to be put in and never ly abated, the underlying technology behind tributed financial technology—namely, by deleted. Everyone can inspect that ledger, it, distributed financial technology, is taking means other than a debit or credit to the ac- but no single user controls it. center stage. Against that backdrop this ar- count of a bank. In particular, we examine The Bitcoin block chain accomplishes this ticle discusses the application of distributed the application of UCC Article 4A to the through cryptography. A payor initiates a bit- financial technology to funds transfers, as completion of the funds transfer and the coin payment to the payee by submitting the a new payment rail. Traditional payment discharge of the underlying debt paid. transaction to its local node, which checks, service providers, such as banks, can use among other things, that the payor has the this technology as a decentralized payment Distributed Financial Technology as a bitcoins it now wants to spend, and confirms mechanism to potentially make settlement Payments Rail that the transaction is likely to succeed. If quicker, less expensive, and safer. Distrib- The Bitcoin block chain represents but one the proposed transaction is confirmed, the uted financial technology can be adapted specific application of distributed financial local node broadcasts the transaction to oth- to payment systems without necessarily in- technology—as a decentralized ledger. The er nodes and the transaction quickly propa- volving the issuance of a digital currency, block chain is a decentralized and shared gates through the entire distributed network. instead using fiat currencies (such as U.S. public database that verifies and permanent- Bitcoin miners are constantly seeking trans- dollars, euros, or yen) to settle cross-border ly records transactions. It was first born out actions that are broadcast through the net- transactions. However, it is only with robust of a need to create and track bitcoin balances work. Every 10 minutes on average, a miner payment rules, such as state-law rules adopt- in the absence of trust between the parties solves a mathematical problem involving a ing the Uniform Commercial Code (UCC), involved and without the need for interme- set of recently broadcast transactions; doing that such payments using distributed finan- diaries. Specifically, all parties involved in a so bundles the transactions together into a cial technology can effect a discharge of the bitcoin transaction must agree to a trustwor- block. The mathematical problem is hard to underlying obligation to pay. thy record of ownership. Enter the distrib- solve, but it is easy for the network to con- This article explains how distributed fi- uted ledger known as the block chain: every firm that the answer is correct once found. nancial technology can be used to effect a bitcoin transaction is chained to each previ- Each time a miner solves the mathemati- funds transfer in fiat currency and gives an ous transaction with the goal of preventing cal problem that produces a new block, the example of what such an application looks anyone from fraudulently duplicating or block is “hashed” together with the previ- like. It discusses how UCC Article 4A can tampering with the ownership of a bitcoin. ous block. In other words, miners take the Published in Business Law Today, March 2016. © 2016 by the American Bar Association. Reproduced with permission. All rights reserved. This information or any 1 portion thereof may not be copied or disseminated in any form or by any means or stored in an electronic database or retrieval system without the express written consent of the American Bar Association. trusted third-party banks. In a typical of the amount of the payment orders they is certainty and clarity as to rights and lia- funds transfer. model (where Alpha Bank and Beta Bank ing a block that had already been stored in count of Beta Corp with its bank and the each have accounts with Sigma Bank). accurate. the transaction fully understand the conse- Corp on the books of its bank. they ed. here the block chain. at the heart bilities. It cause another bank to pay Beta Corp (the central ledger. count with the other. More generally. record their credit and debit to the connec- a payment of $5. including when certain rights arise instructs its bank (Alpha Bank) to pay. Beta Bank ultimately crediting Beta Corp’s amounts of energy) to validate transactions. pha Bank and with Beta Bank. tity that has accounts on the books of both network. on distributed financial technology rails. In a hash from a collection of data in a block. ucts that it purchased and opts to make banks to authenticate and maintain a record Critical to this funds transfer framework that payment by wire transfer. among other things. what In contrast to the common correspondent if one tries to fake a transaction by chang. requires trust ing Alpha Corp’s account on its books and rely on mining (or its consumption of large that Sigma Bank will. without in a reliable. March 2016. This coordination requires trust. central third parties to clear and settle and debit Alpha Bank’s account at the right will use distributed financial technology to payments. and honest way. which call in a secure manner. Alpha Bank and Beta Bank intermediaries such as common correspon. The Bitcoin above. they do not share the same bank (which. let’s call it Sigma Bank.000 to Beta Corp for prod. Banks may choose to use a block chain is but one manifestation of that rely on a third party with which they both different connector for each transaction. which rely on trust. willing to act in this capac- ing trust among parties that does not re. Thus. which tor can be an institutional customer of Alpha At its heart. This connec- having been tampered with. at the same time. services. All these a $5. distributed financial technol. Alpha Bank and Beta Bank would use using the hash of the block before it. using the example above of but going from the hash back to the data is aries (adding even more parties). also allow tor’s accounts. or of this well-established arrangement is a and certain liabilities are extinguished. Reproduced with permission. Each block’s hash is produced parties must take a series of coordinated Corp. course. replacing the need for the trust. technology. which transforms the information case). the transaction would also involve technology developed by Ripple is one such into a hexadecimal string of characters. Alpha Corp (the originator) send and receive. Beta payment system to establish trust and oper.000 payment from Alpha Corp to Beta impossible. time and in the correct amount. Similar to the example above this funds verification processes exist—for example. nancial Telecommunication). with settlement taking place is important that the parties involved in beneficiary) by crediting an account of Beta on the books of Sigma Bank. remains is the increased balance in the ac. coordinate. © 2016 by the American Bar Association. properly authenticate the transaction and account on its books. All rights reserved. and do this coordinate certain account entries involving border payments in particular. would more often be the between Alpha Bank and Beta Bank. such as a com. through any en- containing the first transaction in the Bitcoin ment from the bank upstream. if neither bank maintains an ac. These pay. broker dealer. Alpha Bank and Beta Bank would Bank to do so.Click to view the latest March 2016 Business Law TODAY information in the block and apply a math. global interbank communication would use distributed financial technology dent banks. pay the bank downstream and receive pay. cient funds). like those provided by SWIFT to communicate.. Of the connector. central third party (Sigma Bank) to the first Bitcoin block (the genesis block). . anism to effect a discharge of monetary ob- Published in Business Law Today. validate. that block’s hash would be decreased balance in the account of Alpha it is the connector that has accounts with Al- different and ought to be apparent to all as Corp with its bank. Specifically. and settle with each other. as ed third-party bank (Sigma Bank) positioned ematical formula to it (a cryptographic hash a practical matter. The function). that Sigma Bank will maintain this record Bank would decrease the balance it owes to ate in an entirely decentralized way. this new model. like a hedge fund or ogy represents a mechanism for establish. Alpha to take a series of coordinated actions. steps in order for the payment to Beta Corp distributed financial technology to replace ing a “chain” of blocks that stretches back to be made: each bank in the chain must the trusted. Bank would increase the balance it owes to tributed financial technology would allow a finitive record of their balance of funds and the connector and. Alpha the connector’s accounts on each of their for multiple parties in different jurisdictions Bank and Beta Bank trust Sigma Bank to own respective books. This reliance on a common correspondent transfer would involve Alpha Bank debit- distributed financial technology need not bank. As between Alpha One application for distributed financial perform appropriate checks (e. and Suppose that Alpha Corp wishes to make (the Society for Worldwide Interbank Fi. Alpha Distributed financial technology could quences of using the distributed financial Corp and Beta Corp would be only two of revolutionize this traditional funds transfer technology framework as a payment mech- the many parties to that payment. make the Bitcoin block chain tamperproof: the end of the series of transactions. Bank and Beta Bank—instead of settling technology is payments. even more intermedi. This information or any 2 portion thereof may not be copied or disseminated in any form or by any means or stored in an electronic database or retrieval system without the express written consent of the American Bar Association.g. In the example ity and authorized by Alpha Bank and Beta quire a single central authority. Trust is imperative for cross. maintain a ledger that represents the de. Nevertheless. suffi. This Alpha Bank and Beta Corp’s bank (Beta example of how a funds transfer could run hash function is one way: one can produce Bank) and. and other cryptography-based maintain accounts to settle with each other. This construction is designed to ments must offset each other such that at Alpha Bank and of Beta Bank (a connector). credit Beta Bank’s account with each other through Sigma Bank. Where framework. Dis. mon correspondent bank. creat. payment systems have achieved through Bank and Beta Bank. “the system is deemed to be an agent” amount of money to Beta Corp). ogy to settle with each other. system” includes CHIPS. for Corp to Beta Corp is discharged when a timely notice of rejection of the payment or- some reason. Section 4A. In the example above. to know when it has discharged its obliga. Bank. override) the system to Beta Bank. If they and other par. Ac- financial technology is used. then it is deemed to accept the payment the payment is later reversed or there are is “accepted” by Beta Bank.” According to Official Comment 3 implicitly an agent of Alpha Bank. In obligations in connection with funds trans. Alpha Bank and Beta fers. Under Section relying on the payment from Alpha Corp to 406(b)). The concept of implicit agency is not alien choose to use distributed financial technol. transmitted over that framework which to the system and the terms transmitted by cial technology to communicate and settle supplement (or. the soonest of which would dis. made for the purpose of making pay. order if either (a) the amount of the order doubts to its finality. Reproduced with permission. Section “funds-transfer system” to include a “com. bank like Beta Bank may accept a payment balance in an authorized account” of Alpha Article 4A of the UCC is a comprehen. Beta Corp. beginning with framework as a means to communicate the receiving bank) is “transmitted to a funds- Alpha Corp’s payment order (Alpha Corp’s payment order with each other. is by passive acceptance. or (b) Beta Bank has “otherwise re- sive set of rules that defines the rights and charge Alpha Corp of its obligation to pay ceived full payment from” Alpha Bank. Bank. Alpha Bank. the terms trans- with each other does not remove the transfer Article 4A. as well as transfer system or other third-party com- instructions to Alpha Bank to pay or cause to coordinate and settle with each other munication system for transmittal” to Beta another bank. Argu. other association of banks through which a increase in Alpha Bank’s obligation to pay tor’s payment order (that is. not that of The threshold question is whether payments specified in Section 4A-403(a)(1). payment of its amount under Section 4A. to accept the payment order its debt to Beta Corp. in some cases. How might Beta Bank accept a the example above. payment order by a bank may be transmit. Arguably however. to Section 4A-105. Corp wishes to make a payment of $5. The ex. Specifically. and (2) Beta Bank decreases to payment transactions where distributed pha Bank’s payment order is by receiving the amount it owes to the connector. albeit in an au- Application of Article 4A through “a funds-transfer system. the underlying obligation of Alpha 4A-209(b)(3). order. For example.” the transfer of bank credit from Article 4A. struction to its bank to pay or cause another ted to the bank to which the order is ad. That transfer is agreed-upon distributed ledger technology if a payment addressed to Beta Bank (the still a series of transactions. if there purpose of making payment to Beta Corp. its reliance is misplaced and payment order for the benefit of Beta Corp der. beginning with the origina. made for the ticipant banks that use the same settlement of Alpha Bank (the sender). © 2016 by the American Bar Association. tion that those rules are a “funds-transfer 4A-206(a). Alpha Corp needs Returning to the original scenario. as a practical matter.Click to view the latest March 2016 Business Law TODAY ligations. framework together promulgate and agree is a discrepancy between the terms of the the beneficiary of the order. This information or any 3 portion thereof may not be copied or disseminated in any form or by any means or stored in an electronic database or retrieval system without the express written consent of the American Bar Association. a settlement framework running on has “otherwise received full payment from” rails are within the scope of Article 4A. . Alpha system rule” under Section 4A-501(b). In fact. which provide only trans.000 Another way for Beta Bank. the connector. the order amount is covered by a 209(b)(2) by means of “final settlement” withdrawable credit balance. to pay a fixed through a connector. the connector. such payee). the payor’s in. like Beta Bank. Could one argue that the connector is bank to pay a fixed amount of money to the dressed.” This like SWIFT. Beta Bank running on distributed financial technology ably. which provides ered by a withdrawable credit balance in amples above—where Alpha Corp transmits for transmission of the payment order as an authorized account” of the connector an instruction to its bank. if Beta Bank does not give satisfy its own monetary obligations. and organizations thereby falling more squarely within Sec- within the definition of “funds transfer. offset by an of transactions. the term “funds-transfer that the order amount would be “fully cov- ment to the beneficiary of the order. is decreased by the amount of the payment 4A-104 defines “funds transfer” as the series munication system of a clearing house or order and. All rights reserved. 209(b) specifies four ways a beneficiary is “fully covered by a withdrawable credit pectedly find itself short of liquidity. The distributed financial technology rails can be Alpha Bank through these simultaneous en- primary focus of Article 4A is the “funds considered a “funds-transfer system” under tries coordinated by the distributed ledger: transfer. Alpha Bank and Beta Bank use a certain to Article 4A. Beta Corp is likely been made? Under Article 4A (Section 4A. The next sec. if. Beta Corp may unex. Alpha Bank. deeming an agency Published in Business Law Today. It was drafted specifically to facilitate payment order where distributed financial Bank use distributed financial technology high-value commercial payments and has technology is used? There are two potential to coordinate two account entries: (1) Al- been adopted by all 50 states. to pay well as settlement of the obligation of the and therefore its principal Alpha Bank— or cause another bank to pay Beta Corp—fall sender to pay the order. as benefi- tion to pay and no longer has to worry about to Beta Corp—when has that payment ciary’s bank. cordingly. Section 4A-105(a)(5) defines Beta Bank’s obligation to pay the connector the payor to the payee. mitted by the system trump under Section from the ambit of Article 4A. March 2016. tion 4A-209(b)(3)’s passive acceptance? is so even where Alpha Bank and Beta Bank mission services. However. Alpha Bank and to rules governing their payment orders payment order that Alpha Bank transmitted Beta Bank’s choice to use distributed finan. Under Section 4A-206(a). ways. pha Bank increases the balance it owes to tion examines the application of Article 4A One way for Beta Bank to accept Al.” as thorized account of the connector. one could take the similar posi. member of the Ontario Bar. Such a delay instead cross-border payments in different fiat cur- terms. This information or any 4 portion thereof may not be copied or disseminated in any form or by any means or stored in an electronic database or retrieval system without the express written consent of the American Bar Association. a framework.” extent third-party rights are significant and Bender). funds in the sender’s account. freedom of contract can accommodate payment law including the Law of Some of these transactions may occur late in this technological revolution—but not to the Electronic Funds Transfer (Matthew the day or after the close of the banking day. 501(b). prior to that.” Deeming the connector to be ning on distributed financial technology rails in one currency (e. A settlement framework countries. Published in Business Law Today. Jessie Cheng is currently deputy sons. Association. component. “[t]he chair of the Payments Subcommittee financial technology is used only by passive ability of a funds transfer system to make a of the ABA Business Law Section’s acceptance under Section 4A-209(b)(3). interpreting Article choice may bind not only participating banks decentralized funds transfer framework is 4A’s definition of “funds-transfer system” but also other remote participants in the funds certainty and clarity as to the rights and li- to cover settlement frameworks running on transfer (such as the originator/payor and abilities. exchange rate previously agreed to between would fall within the definition of “funds... until Article 4A deems Beta Bank to have traditional funds transfer system apply just Lipton. Beta Bank could tant provision in regard to creating uniformity general counsel at Ripple and vice accept a payment order where distributed of law in funds transfers. with an embedded foreign exchange agency relationship to being only “for the in speed and efficiency. Offi. Cryptocur- transfer system” discussed above—particu. provision. Critical to realizing the potential of this In the final analysis. fall within Article 4A’s definition of “funds.” participant banks in that the connector in a different currency (e. on behalf of rails. All rights reserved. extends far beyond the simplistic scenario in payment law reform in developing nated account entries are made (Alpha Bank described above. dollar) and Beta an agent of Alpha Bank for account struc. Bank would decrease the balance it owes to ture and settlement purposes as described transfer system. as well in the context of distributed financial cial Comment 7 to Section 4A-209 explains technology. Benjamin Geva is a graduate of the that the delay in this deemed acceptance is Hebrew University of Jerusalem in designed to accommodate a situation where: Conclusion Israel and has LLM and SJD degrees “it may not be possible for the bank to de. tion. increases the balance it owes to the connec. Committee of the International Law running on distributed financial technology Moreover. that subsection (c) may be the most impor.g. tributed financial technology to payments the IMF. including when certain rights arise distributed financial technology rails so as beneficiary/payee) provided they have notice. above goes beyond these boundaries. some amount of time must pass unitary law governing all transfers made on an associate at the law firm Wachtell. framework (like Alpha Bank and Beta Bank) euro).” That is. Such acceptance occurs at “the opening of dispensing with individual agreements and Previously. Official Comment 4 to Section 4A-507 notes 209(b)(2) is practically sensible for two rea. if settlement frameworks run. as noted above. it is unclear that the connector can together promulgate and agree to “funds.g. Ad. accepted Alpha Bank’s payment order. There may be how its fundamental concepts map onto such counsel with Torys LLP Toronto. running on distributed financial technology pha Bank as described above based on Sec.Click to view the latest March 2016 Business Law TODAY relationship between the connector and Al. Section 4A-206(a) limits its implicit undermines the technology’s enhancements rencies. By its own owes to the connector). the potential impact of dis. In the absence of new legisla. Bank of New York and. Although Article 4A can be read to apply to from Harvard. a transfer over distributed financial technol. © 2016 by the American Bar Association. Alpha Bank and the connector. increase the balance it owes to the connector to the bank. He is a professor of termine until the end of the day on the pay. to allow for acceptance under Section 4A. and a member of Monetary This rationale does not apply to a transfer standardization or other rules are required. Rosen & Katz. choice of law by rule is a convenient way of Uniform Commercial Code Committee. Such a funds transfer rency. . where there is no reason to delay ac. could also be used as larly given that banks may choose to use rule may include a choice of applicable law an intermediary asset to bridge any currency a different connector for each transaction. and certain liabilities are extinguished. tor and Beta Bank decreases the amount it rails can be similarly structured to make tion 4A-206(a) is rather tenuous. some uncertainty remains as to Toronto. he advised on and assisted ceptance beyond the time the two coordi. For example. Reproduced with permission. law at Osgoode Hall Law School in ment date whether there are sufficient good ogy rails. feasible.” The benefits to having a consistent. March 2016. If it were otherwise. formerly. the author of books and articles on ing funds going into and out of the account. she was counsel in the the next funds-transfer business day of the to cover cases in which agreements are not legal group of the Federal Reserve bank following the payment date of the or. transfer system rules” under Section 4A. Alpha Bank would purpose of transmitting the payment order Additionally. In particular. U. der. and under Section 4A-507(c) that pair. various transactions during the day involv.S. with such account entries based on an ditionally. such as XRP. This prim- er is an introduction to Article 4A and walks the reader through each step of a large-dollar. ABA Web Store The ABCs of the UCC Article 4A: Funds Transfers. * * * Business Law Section Program Library How the Blockchain Technology May Reshape Financial Services (PDF) Presented by: Cyberspace Law Location: 2016 Committee Meeting Developments in New Products and Processes (PDF) (Audio) Presented by: Derivatives and Futures Location: 2016 Committee Meeting Published in Business Law Today. Third Edition Article 4A brings certainty to funds transfers and provides rules that foster speed. March 2016. This information or any 5 portion thereof may not be copied or disseminated in any form or by any means or stored in an electronic database or retrieval system without the express written consent of the American Bar Association. security. and low cost. © 2016 by the American Bar Association.Click to view the latest March 2016 Business Law TODAY ADDITIONAL RESOURCES For other materials related to this topic. please refer to the following. . wholesale funds transfer. All rights reserved. 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