Europe's financial markets regulator, the European Securities and Markets Authority (ESMA), has published a working paper on the categorisation of smart contracts on the Ethereum blockchain, in which the authors acknowledge smart contracts' significant potential for financial innovation, while noting their risks to financial stability and investor protection.
In this paper, smart contracts are defined as
Immutable computer programs that run deterministically on the blockchain and execute automatically, interacting with other accounts on the blockchain according to the code that defines their actions.
Since smart contracts were introduced on the Ethereum blockchain in 2015, they have garnered significant interest, as demonstrated by a surge of google searches:
Many DeFi (decentralised finance) advocates argue that the ‘trustless’ nature of smart contracts is set to alter the financial landscape - by eliminating the need for intermediaries such as banks and brokers, smart contracts could potentially grant individuals complete autonomy over their finances, lessening their reliance on centralised agencies and making central institutions, including supervisors and standard setters, obsolete.
However, the paper points out that these features, coupled with the immutability of smart contracts, can have both positive and negative impacts - the latter include potential threats to investor protection and to financial stability. To better study the issues, the paper identified five categories of smart contracts: Financial, Operational, Token, Wallet, and Infrastructure.
Financial: smart contracts belonging to this category serve primarily to gather and redistribute funds, thus enabling basic financial operations. They include:
simple borrowing and lending protocols to initial coin offerings (ICOs);
complex DAO (decentralized autonomous organizations) project;
airdrop smart contracts;
contracts that serve insurance purposes (since they are able to store funds and release them upon the fulfilment of predefined conditions);
contracts that enable ponzi schemes, lotteries, and other sort of ‘gambling’ activities on the blockchain concern the storing and redistribution of funds;
financial smart contracts are usually the infrastructure of automated market makers (AMMs) and pools for decentralised exchanges (DEXs).
Operational: this category comprises smart contracts that, performing general purpose operations, facilitate the functioning of other smart contracts or the interaction between other smart contracts. For instance, operational smart contracts are deployed onto the blockchain to host libraries. These smart contracts play crucial role in optimising resource allocation and utilisation, as well as in handling errors.
Token: these smart contracts enable the generation of new tokens, their indexing, and their dismissal. The most common standards are ERC20 and ERC721:
ERC20 defines the standard interface for fungible tokens, which are identical and interchangeable units of value, commonly used for cryptocurrencies and utility tokens;
ERC721 specifies the standard for non-fungible tokens (NFTs), which represent unique and indivisible assets like collectibles, digital art, and in-game items.
Wallet: smart contracts within this category concern the management of fees, sender accounts, balances, public access, requirements, and permission control. They serve primarily to simplify users’ interaction with the blockchain, for instance by batching transactions and defining transfer limits.
Infrastructure: smart contracts belonging to this category can be considered as the underlying infrastructure for other smart contracts. This category comprises contracts that deal with the manipulation and processing of string data, Boolean values, signatures, encoding and decoding operations, ABI (Application Binary Interface) functionality, viewing operations, memory usage, sending operations, and payload handling. Such operations are essential building blocks that contribute to the underlying infrastructure of smart contracts and dApps (decentralised applications).
Overall, the paper observes a shift from predominantly financial smart contracts to a broader range of applications, including tokens, operational and infrastructure categories.
While the European Union's Markets in Crypto Assets Regulation (MiCA) entering into force from June, the paper points out that it does not directly regulate "fully decentralised" crypto-asset services (true DeFI). The paper notes that the OECD has called for closer, consistent monitoring of the DeFi ecosystem, which has been echoed by legislators and the European Commission. The European Commission has acknowledged the limited enforcement power that can be exerted on DeFi, suggesting “a public observatory of DeFi activity operated by a public authority” that “would deploy public investigations and issue opinions and warnings publicly about specific DeFi protocols”.
ESMA's paper represents a first step in a deeper research project to understand the risks and benefits of smart contracts in finance and more broadly. The paper's emphasis on the breadth of potential applications for smart contracts is well noted. Having regard to the potential impacts of MiCA on the regulation of smart contracts and dApps, the paper is a welcome contribution in progressing risk-based regulation of decentralised technologies which promise significant consumer and efficiency benefits for markets.
Written by S Pettigrove, J Huang and M Norton
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