08 Sep 2016

Dynamic purchasing or procurement, driven by IoT-enabled devices, promises a fundamental shift in supply chain relationships. At its simplest, dynamic purchasing streamlines ordering procedures in existing bilateral supply contracts. Rather than providing for regular or occasional orders using manual forms, dynamic procurement uses IoT-enabled sensors to monitor and transmit in real time details of raw material, components or stock levels. Existing levels are checked against orders, with algorithms driving orders on a machine-to-machine basis to ensure that they are placed on a “just in time” basis. Commercial benefits include the ability to maintain stocks at the leanest level consistent with production or distribution needs, promising substantial savings in inventory and warehousing.

Dynamic procurement goes even further. Rather than merely streamlining elements of existing contracts, fully dynamic procurement would result in the formation of a fresh contract for each transaction, potentially breaking the link between supplier and purchaser. The purchaser’s requirement would be transmitted, either directly to a range of existing suppliers or via an online platform accessible to a much wider range of potential suppliers. As well as clear specification of the required goods, key parameters might include price, current location, guaranteed delivery date. Relevant data might be gathered from suppliers’ IoT-enabled facilities. For example, an IoT-enabled shipping container could draw on GPS data to feed information about its current location, direction and speed of travel. Sensors might also gather and transmit data concerning environmental conditions within the container – potentially very significant if the contents are perishable. From there, prices might be provided by way of data feeds from each supplier, with the contract going to the supplier whose data best meets the purchaser’s requirement.

Each scenario is credible.  IoT is not a future prospect, but a current reality. It is an increasingly valuable element of supply chain and contract management. It is also a crucial driver for the development of “smart contracts”.

What is a “smart contract”?

A smart contract is fully “self-executing”, which means that it is written (or, perhaps more accurately, coded) using a series of “IF/THEN” statements to describe every relevant state of the contract.

For example: IF [Advertising Network #564445] sends [1,000,000 clicks] that [convert to purchases at a rate of 15% or more] THEN release [[$0.002] for each of those clicks] to User/Account #899782392

Performance – here defined by the number of clicks and the sales conversion rate – would be verified by data feeds respectively generated by the Advertising Network and the User. Where that data is gathered and transmitted on a machine-to-machine basis there would be no need for human intervention once the contract has been set up, and it would be an easy matter to apply a further element to the IF/THEN statement so that it becomes a recurring/periodic procedure.

The key to “smart contracts”, then is to break the commercial elements down into a series of IF/THEN statements and to agree on data feeds that will verify performance. 

In the simple example, payment would be “released” immediately on satisfaction of the conditions contained in the “IF” element of the provision. That suggests a radical change in the practice of many businesses – particularly large-scale purchasers – whose current invoice procedures often impose as long a period as possible before payment is made.  For a fully “smart” contract, payments might be placed in escrow, or access might be given to the paying account. However, given their commercial leverage, large-scale purchasers might simply incorporate their usual payment terms into the “THEN” element of the provision, perpetuating the imbalance in cashflow terms that often characterises the relationship between large organisations and their suppliers.

Why is Bitcoin relevant?

The technology underpinning Bitcoin is often referred to as “blockchain” or “distributed ledger”. An element of value is identified and given a unique identifier known as a “hash”. That hash is carried into the next transaction involving transmission of that element of value. Each subsequent transaction is added to the original “block”, giving a complete, unalterable and objectively verifiable record in relation to that element of value. The blockchain is open to inspection, and is the “public” element. The detailed contents of each “block” or transaction remain confidential, protected by a private key.

The blockchain provides a full replicated copy of the data underlying the transactions making up the chain at each node (account (for these purposes a bank)). Each node will hold a full copy of the ledger.

Blockchain, as a distributed ledger, is shared across a broad business network. This means that the blockchain provides the opportunity to re-engineer business methods. At present, businesses keep lists of everything they own and then change these lists in a specific way when ownership of assets changes. Blockchain is a standardised list for all assts. Smart contracts can be used as transactions for making changes to those lists of assets.

The blockchain is visible to all participants in the network. The participants can see the transactions that other participants in the network have entered into. Although the identity of the participants is not visible, being able to see what each participant is doing allows the participants to an educated guess regarding each other’s identity.

Companies such as Elliptic use the visibility of the blockchain to:

  • Flag suspicious patterns to their FS clients; and
  • Help law enforcement agencies with criminal bitcoin enquiries.

There is a tension between identity and privacy for blockchain users. You need an identity to enter into a contract (smart or otherwise). Regulation also requires participants in transactions to have an identity. Bitcoin is not anonymous.

Users can tell a lot about the organisations transacting by how they use bitcoin. It is however possible to build a new blockchain which focusses more on privacy. Blockchain can be adapted for numerous business scenarios.

The decentralisation of data means that participants in the blockchain should have more control over their own identity. Various organisations will be able to validate different aspects of a participant’s identity. The identity of a participant will not be held with one provider.

Blockchain also allows participants to view transactions in real time. This provides opportunities for businesses (and regulators) to collect valuable data and cut processing times.

The principles of:

  • Permission (the participant setting up the network can determine which parts of the ledger the other participants can see and give a regulator the right to see everything if necessary (it is worth noting that the regulator will be able to see all transactions flowing across the business network in real time));
  • Consensus (all participants in the network must validate the blockchain as correct);
  • Provenance (blockchain provides a full transaction chain showing the transactions participants in the network have entered into);
  • Immutability (the record of transactions cannot be altered);
  • Finality (participants cannot add to the chain until it has been validated as correct) 

This means that the blockchain has the potential to change the way businesses operate for the better. 

The participants in the network are the same as they are at present. It is the way that businesses interact, exchange data and transact that will change as a result of using the blockchain.

Blockchain is being incorporated into smart contracts – for example, providing a verifiable record of transactions affecting a particular asset, such as a parcel of land. Confidence in the ability of the current owner to transfer value stems from the blockchain or distributed ledger, rather than from a record maintained and updated by a central authority or agency. Consequently, where smart contracts are based on blockchain, the way is open for a radical shift in the relationship between assets such as land and the role of State bodies such as Land Registries or (possibly) Revenue authorities. 

Are these developments commercially viable?

Greater efficiency in transactions bring obvious advantages – not least through reduced transaction costs. However, the developments discussed in this chapter reach much further than that, and may require a radical rethink of key commercial relationships.

It is worth considering those developments in a broader context, bringing in the perspective of lenders and potential investors. When deciding whether to provide banking facilities, ranging from accounts to loans, guarantees and performance bonds lenders are rightly concerned to assess business prospects and revenue projections as part of any overall security package. Healthy order books and multi-year contracts provide good evidence to support lending decisions. In a world of dynamic purchasing, and even more in a world of dynamic procurement, those elements are likely to fall away – perhaps even taking with them contractual protection such as “take or pay” clauses. 

That does not necessarily mean that businesses would lose viability from a lender’s or investor’s perspective. However, it does require substantial recalibration of the factors that underpin lending or investment decisions. If every contract – or even a significant proportion of contracts – becomes “smart” and agile, assessing business performance will inevitably become more difficult: but then risk assessment is a fundamental part of lending and investment, and when they must do so, markets are well-able to adapt to new conditions. 

Conditional contracts?

Many of the early models of blockchain-based smart contracts assume a single transaction. That model becomes more complex when a deal involves or requires coordination of several transactions. For example, a manufacturer might seek to order critical components from a supplier. That supplier might in turn have to order elements from other parts of the supply chain, eventually reaching back to the extractive industries to source raw materials. If each link in the supply chain were to seek to operate on a “just in time” basis, then their ability to meet an order might well depend on dynamic procurement all along the chain. One result might be a need for the immediate contract between the manufacturer and the component supplier forming the next link in the supply chain to be conditional upon the conclusion of contracts back to the root of the supply chain. Alternatively, the contract between the manufacturer and the component supplier might be concluded, and have legal force, only if the component supplier’s system can give an assurance (probably supported by a warranty and/or an indemnity) that it has in place the contractual chain necessary to meet the order.

There is nothing insurmountably complicated in that picture. In practice, it would simply require the smart contract to be formed only when the supplier’s system can generate a confirmatory message. However, methods for ensuring the validity of any such message – and providing for the consequences of default – would have to be an explicit element of any smart contract system. 

Dispute resolution?

A key selling point in relation to smart contracts is the promise that they can be “self-executing”. Consistent and comprehensive use of “IF/THEN” statements should mean that the contract anticipates every possible state, with performance being verified by previously agreed data feeds.

In that model, there is little or no room for dispute, leading some promoters of smart contract platforms to suggest that they offer either a wholly new approach to dispute resolution, or that they spell the end of any need for dispute resolution through arbitration or litigation. Such claims might well be met with scepticism. However, there is no reason in principle to doubt that a contract could accurately anticipate and cater for at least a high proportion of issues likely to arise in a commercial relationship. If smart contracts were to develop on industry- or sector-wide bases, and with the benefits of the consensus arising from distributed ledger technology, then it is quite credible to suggest that smart contracts might materially reduce the scope for dispute. Certainly, smart contracts have the potential to provide a viable alternative to current models of arbitration or litigation – but only if (and to the extent) that they fulfil their own objective of catering for all possible “states” of the contract.

Any widespread move towards smart contracts would also have broader implications for lawyers and legal services. If smart contracts were to be adopted across sectors, one result might well be a substantial reduction in the volumes of transactional work requiring legal input. Contractual disputes might also diminish where contractual performance is verified by objective data feeds. That is not to say that all deals could easily or cost-effectively be rendered into smart contract form, or that contractual disputes would become a thing of the past. It does, however, support the view that an increasing proportion of the work traditionally carried out by law firms might be commoditised or dealt with on a “do it yourself” basis by clients. In response, law firms may well have to re-examine and overhaul their business models – perhaps even making a long-overdue attempt to close the gap that has opened up between law firms, largely still locked into a model dominated by specific transactions and disputes, and the broader advisory practices that have emerged largely uncontested from the major accountancy practices. IoT, blockchain and smart contracts might well compel law firms to reconsider what it means to be a lawyer, and to focus on areas in which legal input genuinely adds value.