The near term boom in the $300 billion legal industry.is obvious to anybody involved with cryptocurrencies and ICOs where a substantial legal budget gets allocated early in a startup life, alongside tech and marketing. Baby boomer lawyers will be just fine if they have some tech savvy, but few would advise youngsters to choose this profession as some time during their career the entry level jobs will be destroyed by Smart Contracts.
This is Part Two (Chapter 8) of the Blockchain Economy book. This serialised book is a practical guidebook for investors, entrepreneurs and employees who want to learn how to prosper during the transition to an economy where value exchange is permissionless and disintermediated. For the index/table of contents please click here.
Smart Contracts are disruptive to the legal industry. They are also enablers for a lot of the other innovation in the Blockchain Economy. So, Smart Contracts can also be considered part of the infrastructure layer (covered in Part 1 of this book).
This chapter looks at:
- 101 Guide to Smart Contracts.
- Three generations of Legal Tech.
- Fundamentals of “law is code”.
- Limitations of “code is law” and the resilience of the high end.
- Impact of Business Process Elimination on the legal industry.
- What the future Smart Contract based legal industry may look like.
101 Guide to Smart Contracts
- A Smart Contract is like a paper contract, except that it is enforced/executed automatically by code. Example: a contract that says Pay XXX person/entity YYY amount when AAA is true (product delivered or whatever). The terms are the same whether it is an old/analog/dumb contract or a modern/digital/smart contract. What is different is automated execution of the terms. In the old old/analog/dumb contract we went through processes such as Contract, Purchase Order, Invoice, Accounts Receivable, Accounts Payable, Payment, Receipt. In a Smart Contract, all those process are eliminated (with vestiges required to integrate with legacy systems, so a Smart Contract may need to create digital artefacts that mimic the old way of doing things).
- The ICO market is one domain/use case where Smart Contracts are changing the way business is done today. We cover this in the chapter on the disruption to the Venture Capital and IPO industry.
- Most Smart Contracts today run on the Ethereum Blockchain. In theory they can run on any Blockchain (including Bitcoin via Sidechain technology). In practice, Ethereum is the platform with the traction/adoption today.
Three generations of Legal Tech
Version 1 = Selling Tech to Legal firms. This is like the Pre Fintech era when vendors sold technology to banks.
Version 2 = Selling Tech and content via services direct to consumers. This includes services such as Legal Zoom. This is like selling financial services such as lending to consumers in competition with banks (aka what we call Emergent Fintech today).
Version 3 = Blockchain based Smart Contracts. This what this chapter is about.
“The future is already here — it’s just not very evenly distributed (quote from William Gibson). We already have all three versions and the earlier versions will morph and adapt and will still be with us in some form for a long time.
Legal Tech versions 1 and 2 is a big business that is tracked by many firms and conferences. This post by BlueHillResearch is a good starting point and has good data on the market structure. Out of a $300 billion legal industry about $98 billion (33%) = 200 big firms and $200 billion (66%) = from 170,000 smaller firms (incl. solo practitioners) The top three Legal Tech vendors – Thomson Reuters, LexisNexis, and Wolters Kluwer – dominate the market. The $300 billion market size data does not include internal legal departments.
Fundamentals of “law is code”
Smart Contract aficionados talk about “code is law”, the idea that law can be written in machine-readable code and executed by application code.
The opposite is also true – “law is code” – as I learned in 1990. I had moved from London to New York. In London in the 1980s few deals had lawyers in the negotiation for many reasons (a clubby small world where everybody knew everybody was one reason). In New York, the customer negotiation team often had lots of lawyers and a more adversarial approach. Being a startup, I had limited legal budget. So I asked advice from a friend who was both a techie and a great negotiator. He advised me to look at contracts like a computer program:
- components that interact with each other (aka dependencies in code speak). You can read a clause standalone and that is simple enough. What is complex is seeing how a clause interacts with other clauses in the contract.
- a language that was hard to understand but which was very precise. Words might have to be “parsed” by another lawyer or judge much later and ambiguity was the enemy.
That insight led to some very practical techniques to keep legal expenses within budget:
- Focus hard on the clauses that impact revenue, cash flow and P&L.
- Get a lawyer to review individual clauses where there might be a risk that I did not understand.
- Get a lawyer to do a last run through to identify any dependencies and risks that I might have missed.
It also gave me a conceptual framework for understanding the “code is law” idea behind Smart Contracts.
Limitations of “code is law” and the resilience of the high end
The idea of “law is code” is based on the need for precision. If there is a dispute, can another lawyer or judge look at it and say with certainty what was intended? Often the clause leaves room for a clever lawyer to renegotiate.
The more complex the contract, the more room for interpretation. However even the simplest contract can be open to interpretation. Look at that ultra simple example referenced earlier – contract that says Pay XXX person/entity YYY amount when AAA is true (product delivered or whatever). Now talk to any small business that sells to big retailers and ask about how returns are handled. Unless you personally build and deliver the goods, the person in charge of receiving goods may declare some % to have quality defects that prevent/reduce payment. That can be resolved in one of three ways:
- Legal battle (really expensive in cash and relationship damage).
- Relationship negotiation (if consumers really love the product, the vendor has some clout).
- Totally precise contract that leaves no room for ambiguity (good luck with that).
Smart Contracts work well today for situations where the product is a) digital b) simple c) with real time settlement. For example, pay XXX to Entity AAA when Entity AAA delivers YYY Tokens (an ICO contract). The moment you introduce settlement latency, there are complications; or example, what is the risk of non-delivery or non-payment. That is why real time settlement, enabled by Smart Contracts, is such a game-changer. Delivery and payment happen simultaneously which eliminates a lot of risk and fraud.
More complex contracts cannot be managed today in this way and attempts at doing so have ended in court battles.One example of this was the subject of an earlier post/chapter entitled – Why Non State Governance For Bitcoin Ethereum And Other Cryptocurrencies Is So Hard – which highlighted two inconvenient truths:
- Humans write the code that is law and humans are not omniscient and perfect code is impossible.
- Humans are needed if something comes up that the code developers did not envisage and a dispute has to be settled.
One example was the Tezos debacle, which was a feast for irony aficionados (a crypto platform touting governance as a core proposition collapsing into law suits and bitter court battles).
Impact of Business Process Elimination on the legal industry
Real Time Settlement (the trade/contract, delivery and payment all happen concurrently) eliminates back office processes in lots of industries. The biggest industry for lawyers is the global capital markets, which is why New York has so many lawyers. Equities Post Trade Processing is one example of the Business Process Elimination (BPE) that happens after Real Time Settlement. Concurrent Delivery Versus Payment (CDVP) is the more technically precise term for what usually gets called Real Time Settlement. For a description of real projects working on this, please see this post.
Bank of International Settlements (BIS) defined Real Time Settlement as Delivery Versus Payment (DVP) Model 1. That definition was 23 years ago in 1992, but we had to wait all this time for Blockchain technology to make it feasible. The key points as defined by BIS are:
- Transfer has to be final & unconditional. This concurrency requirement is absolute, because any time lag is an opening for fraud and that requires a lot of process to prevent.
- Must be on a gross (trade for trade) basis. Any attempt at netting creates delay and creates a multi-tier market infrastructure that will impede innovation.
We have Real Time Gross Settlement (RTGS) today – between Central Banks. The disruptive change is RTGS between individuals and companies in a permissionless network; this is the way that the Internet works and this is how an ICO works.
The point about Business Process Elimination (BPE) is that most of the things we do in Post Trade Processing are no longer needed when we move to Concurrent Delivery Versus Payment. The processes are not optimized, they are eliminated.
Equities Settlement is only one example. Almost every asset class and every value exchange will move in this direction. For example, the notoriously complex triparty Insurance claims process (customer, provider, insurance company) will also move to a trustless blockchain network.
Without all the post trade processing, a lot of the entry level work that the legal industry depends upon will disappear. It is hard to envisage what the future legal industry will look like once this entry level work disappears.
What the future Smart Contract legal industry will look like
About 1/3 (33%) of the $300 billion legal industry is the big legal firms doing work for big firms. Call it AL200 (the Am Law 200) sells to F500 (Fortune 500).
These firms make money by guiding and selling the young lawyers who do the entry level work. The entry level lawyers are billed at rates that provide the partners (the senior lawyers) with a lot of money.
Short term, everything is rosy at these firms. As one commentator points out:
“the mathematical precision of smart contracts stand in stark contrast to the fuzziness of our human relations with which lawyers are well acquainted.”
Short term, lots of Tezos style blow ups will make lawyers very wealthy.
In addition, F500 is hiring AL200 firms to figure out what to do about smart contracts. Law firms are hiring developers to meet this need, but there are also many small specialist firms entering the market as Smart Contract specialists and it is hard to tell if they are a tech company or a legal company.
One way or another, the entry level jobs that sustained the legal industry will disappear. One way to think about this is, would you recommend to a young person who is considering what to study and what career to pursue to go into the law? For somebody considering a 40 year career, many other career options look better.
The 2/3 that is small firms selling consumers and small business is also not immune to disruption. That segment of the $300 billion legal industry is being hit by firms like Legal Zoom and hundreds of legal tech startups. The reality for most consumers is that their interaction with the law is mostly restricted to clicking “I agree” on a site, where they are agreeing to a big, complex, one sided, non-negotiable contract. However some work is still needed and that is where Legal Zoom type firms take the low end. This will leave the low end high street firms struggling with a few winning some big class action deals.
The future of the 1/3 enterprise legal industry (AL 200 selling to F500) is likely to look like this:
- Small, agile tech savvy firms writing the Smart Contracts. The customers are often smaller (eg startups doing an ICO) but they want to play in the big league so they hire top tier, expensive lawyers – they are F500 aspirational.
- A few big AL200 type firms that become tech firms and handle all the processing for both smart and paper contracts. The old paper contracts will take a long time to disappear – the past is always with us as any Cobol programmer can attest. So customers will need somebody to manage both and to manage the transition.
- Lots of high end solo practitioners or small partnerships of senior lawyers. They can make a good living on the complex nuanced issues, without the headache of managing thousands of entry level lawyers.
Bernard Lunn is the CEO of Daily Fintech and author of The Blockchain Economy. He provides advisory services to companies involved with Fintech (reach out to julia at daily fintech dot com to discuss his services).