In a forthcoming paper in the Yale Journal on Regulation, Stefan Bechtold, Giuseppe Dari-Mattiacci, Edoardo Martino, and Gideon Parchomovsky examine how smart contracts are transforming financial contracting by creating enforceable rights that bind third parties without the legal formalities property law has always required. This “property without law” phenomenon enhances financial efficiency while exposing the public to systemic risks beyond the reach of existing regulation.
Contractual agreements are typically effective only between the parties to a contract. Think of the many covenants that accompany a loan and may allow the lender to, say, obtain an earlier repayment when predetermined conditions are met. Some agreements, however, are recognized by the law as having property status and are hence enforceable against any third party who comes in contact with the underlying asset, regardless of their involvement in the original deal. For example, an agreement between a borrower and a lender that creates a security interest on a particular asset has the effect of allowing the secured creditor to collect on that asset prior to other creditors. The agreement has an effect for third parties, which in this case are the other (unsecured) creditors. But can a borrower and a lender simply write a contract at the expense of other creditors? As a counterbalance, the legal system requires formalities to establish such rights, giving notice of their existence to third parties through (generally, but not exclusively) public registries. In contrast, precisely because they bind only the parties to the contract, contracts are generally not subject to notice.
In a recent paper forthcoming in the Yale Journal on Regulation, we show that parties can use technology-enabled applications, such as smart contracts, to blur the divide between property and contractual rights and create de facto property rights beyond what the law currently allows. We call this phenomenon “property without law” and document its emergence in several fields, including in financial contracting.
Before turning to specific applications, it is worth briefly outlining the technological architecture enabling property without law. Smart contracts translate contractual promises into code that can be fed to a machine for automatic enforcement when predetermined conditions are met. A distributed ledger records all transactions and provides validation without a central institution. Since enforcement through smart contracts takes place outside the legal system, this architecture can mimic the real effects of property rights.
Rights in financial contracting
The distinction between property and contractual rights has far-reaching consequences in the context of financial contracting. Some arrangements that a lender makes with a borrower can bind subsequent lenders and thereby affect future borrowing decisions. Kenneth Ayotte and Patrick Bolton have previously examined this problem. Consider a promise by a borrower to a lender not to pledge the same asset as collateral to another lender—or to do so in a subordinate way, meaning that the first lender has priority if the borrower defaults.
If that promise is embedded in a property right (say, a security interest), and the borrower subsequently borrows from a different lender, the second lender is subordinated to the first (secured) one. If the same promise is instead embedded in a contractual covenant, the two lenders have the same priority, and the first lender might have a merely monetary claim against the borrower for violating their initial agreement. This simple case highlights the key difference between contractual promises and property entitlements: while a property right is enforceable against the second—and in fact any future—lender, a contractual right is not. In a sense, property rights are “stronger” than mere contractual rights and that additional strength is a prerogative determined by law. Traditionally, private parties cannot freely create new property rights; they can only rely on the limited set of property rights explicitly provided by the law. In contrast, there is a general principle of freedom of contracts whereby parties can freely design their contractual agreements.
Ayotte and Bolton’s analysis further shows that limiting the ability of private parties to create new property interests can be desirable when it is difficult for lenders to discover if prior claims already exist and when privately negotiated rights between borrowers and lenders to accelerate repayment or enforce collateral risk draining liquidity in bad times. This can potentially trigger fire sales of assets. The resulting losses are borne also by other borrowers and, possibly, by the public in cases of bailout. Notice requirements¾such as the duty to record a security interest in a publicly available registry¾allow third parties to internalize this risk in the pricing of their claims.
Recent years have seen an increasing “propertization” of financial contracts. The financial industry has pushed lawmakers around the world to blur the traditional contract-property divide described so far and recognize third-party effects of financial contracts, while simultaneously limiting notice requirements. The most relevant example is the expansion of bankruptcy safe harbors. While most creditors are stayed during a bankruptcy procedure, meaning that they cannot collect on the borrower’s assets, some financial contracts are exempted from these rules. Safe harbors have two key features: they allow for the creation of property interests with limited or no notice to the market, and they allow lenders to repossess and sell financial collateral outside of the bankruptcy procedure and without court supervision. Safe harbors have markedly enhanced the liquidity of financial instruments, but, absent adequate notice, they have also made the financial system far more prone to reducing liquidity for other creditors.
Crucially, safe harbors are a legal creation: the state ultimately defines their scope. For example, Title 11 of the United States Code introduced some key safe harbors exempting financial contracts featuring security interests from automatic stay.
Property without law
To understand how disruptive “property without law” can be, note that leveraging on smart contracts, private parties can now generate new property rights without the need for legislation, thereby pushing the propertization of financial contracts even further while simultaneously bypassing regulatory oversight.
We analyze three applications of property without law in financial contracting: covenants, deposits, and collaterals.
Tokenized covenants
The first application relates to the ways in which counterparty risk is addressed in long-term debt contracts. Covenants constitute a key tool in this context, allowing parties to contingently allocate control to the creditor upon the deterioration of the debtor’s situation. For example, if the borrower’s debt exceeds a specified threshold, the covenant might transfer control over certain business decisions to the creditor. Unlike the use of collateral, covenants are contractual in nature, so they bind only the contracting parties and not third parties (e.g., a subsequent creditor). Smart contracts can give such covenants property-like bite without traditional safeguards such as notice or stay. Consider a common negative covenant restricting dividend distributions until a certain debt-to-equity ratio is reached. If the borrower breaches this covenant, the lender can demand early repayment, but it cannot recover dividends already paid to shareholders. However, if this covenant is encoded and automatically enforced, the smart contract can prevent the dividend payment from occurring in the first place. In this situation, the encoded covenant extends its effects to shareholders even though they are not part of the debt contract. This example also underscores the importance of digital or digitalized assets: the borrower’s equity must itself be tokenized for the mechanism to operate. Currently, virtually all tokenized bond issuances are exempt from SEC disclosure, so this frontier remains largely opaque.
Tokenized deposits
Property without law can also affect deposits in banks. If tokenized, deposits could become freely redeemable at any time, allowing for frictionless redemptions which can even be programmed ex-ante and simply executed upon bad news. This, in turn, can amplify the risk of bank runs, leaving supervisors with virtually no tool to slow withdrawals. Banks are currently experimenting with such instruments, especially with wholesale deposits running on permissioned networks—that is, on blockchains owned and controlled by a private player—as opposed to permissionless and distributed ledgers, such as Bitcoin and Ethereum.
On the positive side, programmability can also contain runs. Smart contracts encoding tokenized deposit can include clauses aiming at neutralizing a bank run. For example, the smart contract could feature contingent redemption fees whereby, in times of stress, depositors are charged a fee to withdraw their money, so to disincentivize panic-driven withdrawals and neutralize the advantage of those who run. But doing so effectively requires regulation mandating anti-run code in every tokenized smart deposit contract. For example, this could be considered a necessary condition for deposit insurance eligibility.
Tokenized collateral
Legally, the ability to pledge high-quality collateral and realize it upon default is key to ensuring safety and liquidity of financial markets. This is achieved through (partial) property transfers and, accordingly, is bound by the procedural safeguards of property rights such as notice and stay. Property without law can disrupt this crucial part of financial contracting as well: the party who is given control over tokenized assets can achieve third-party effects similar to a security interest but without being bound by traditional formalities. Current experiments with permissioned infrastructures are already showing how ownership interests can be transferred without moving the underlying assets on traditional financial records. Tokenization widens the scope for collateral, making some previously ineligible assets, such as money-market fund shares, pledgeable. The result is greater collateral mobility and broader pledgeability.
Conclusion
As more assets take a purely digital, tokenized form, the scope for smart contractual arrangements with automatic enforcement continues to expand, bringing a larger part of the value traded in financial systems within the reach of property without law.
Authors’ Disclosures: The authors report no conflicts of interest. You can read our disclosure policy here.
Articles represent the opinions of their writers, not necessarily those of the University of Chicago, the Booth School of Business, or its faculty.
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