The Legal Engine of DeFi

The following is a preview for a global clearing system, we are developing at Tau to bring financial instruments natively on-chain.

Decentralised finance aims to make financial services more open, efficient, and resilient than its traditional alternatives. One of its largest barriers in adoption is its detachment from real economies. There are two prominent causes for this: first, on-chain financial instruments are currently implemented through imperfect financial agreements, thereby carrying a legal risk premium; second, financial instruments in DeFi cannot be integrated into off-chain financial law without sacrificing their decentralisation, thereby limiting the addressable application space. Together, these causes currently bar DeFi from being integrated into real economies and traditional financial systems. To close the gap between code and law in a decentralised manner there needs to be a connection layer between public blockchains and legal systems. This layer would take the role of a global communication and clearing system, ensuring the adherence to the rules of law, keeping track of on-chain movements and agreements, and reporting to regulatory bodies.
The legal protocol we propose creates this link through decentralised consensus mechanisms, on-chain codified agreements, and capital markets licenses. It enables the creation of on-chain agreements without a legal risk premium and the integration of DeFi and Crypto applications into off-chain financial law.

Motivation

Finance's objectives are to allocate capital and to redistribute risk in the real economy . For this, financial technology has traditionally relied on trusted institutions to process transactions and secure value. By allowing trustless transaction execution and safekeeping of value, blockchains and smart contracts challenge this paradigm. Global financial systems will transition onto public blockchains Law is a concept humanity has invented to govern social consensus. Law in itself is technology agnostic and only defines a set of rules, a society agrees on for the purpose of large-scale collaboration. The law of public blockchain regulation will change to entail the possibility of the integration of code into its fabric. Legislators are already making this adaption in two ways. First, new legislation reimagines on-chain tokens as genuine, securitisable financial instruments. Second, new legislation respects blockchains as genuine, regulated financial market infrastructure. The upshot of these legislative developments has led to the abstraction of a financial instrument’s legally recognized form. A financial instrument need not have a specific, arbitrarily chosen form (e.g., a document printed on paper); it can take any form that maintains its function as a security or valid financial agreement. As an example of such an abstraction in practice, the German Electronic Securities Act allows a bond or share to be registered as a token and subsequent transactions to be settled on any transparent and secure infrastructure—including public blockchains. Public blockchains and finance need to be connected by a decentralised legal layer Until today, only “decentralised brokers” have been devised to bridge the gap between off-chain law and on-chain code. They are centralised, regulated entry points, in control of applications using the broker. This architecture resembles the traditional intermediated set up in financial markets. The solution fundamentally violates the principles underlying DeFi: decentralisation and permissionlessness. As a consequence, it limits the extent to which financial systems can benefit from the openness, efficiency, and resilience of DeFi. To connect on-chain code with off-chain law there needs to be a decentralised communication layer between the two worlds.

Introducing Tau

Tau is built as a non-custodial legal protocol that enables DeFi and crypto applications to integrate their smart contracts into real-world law in a trust-minimising and decentralised manner. Put differently, Tau is a global decentralised and licensed legal clearing system for on-chain agreements. Ultimately, these agreements can be used to facilitate the reallocation of capital and redistribution of risk in the real economy. The protocol is comprised of five key components: legal contracts represented as token that exist on-chain; decentralised node operators; immutable rules stored on the Inter-Planetary File System (IPFS); a legal engine that monitors and initiates on-chain contracts and transactions; and the Tau Aggregator that manages communications and ensures synchronisation between the on-chain and off-chain elements of the ecosystem. A novel feature of the Tau Protocol is the introduction of ‘Regulatory Hooks’, which serve as checkpoints within a transaction workflow to assess and enforce legal and regulatory compliance, thereby integrating on-chain transactions with off-chain legal systems. A regulatory hook brings legal enforceability to on-chain agreements through the combination of the Tau’s protocols licenses, the legal smart contract structure and off-chain validation and communication with legal systems. Tau does not only allow for the creation of on-chain financial instruments, it also provides a global settlement system for the created financial instruments. Thereby, Tau enables the creation of exchanges on decentralised infrastructure that fully respects laws and regulations. Tau is structured and built as the comprehensive legal layer for any financial and non-financial agreement on-chain that benefits from legal enforceability and recognition in real-world jurisdictions and economies. On top of Tau, applications ranging from institutional grade decentralised credit protocols, security exchanges and native tokenisation of off-chain collateral, can be built, expanding the application space of DeFi into the realm of traditional finance. Additionally, as crypto native products such as cryptocurrencies and NFTs are integrated into the law, Tau enables the integration of these rules. The Tau protocol is built for a future in which the financial system functions as a decentralised public good, built on public blockchains, and integrated into the legal fabric of the real economy.