50 Pages Posted: 22 Aug 2015
Date Written: March 26, 2015
We show that the fundamental legal structure of a well-written financial contract follows a state transition logic that can be formalized mathematically as a finite-state machine (also known as a finite state automaton). The automaton defines the states that a financial relationship can be in, such as “default,” “delinquency,” “performing,” etc., and it defines an “alphabet” of events that can trigger state transitions, such as “payment arrives,” “due date passes,” etc. The core of a contract describes the rules by which different sequences of event arrivals trigger particular sequences of state transitions in the relationship between the counter parties. By conceptualizing and representing the legal structure of a contract in this way, we expose it to a range of powerful tools and results from the theory of computation. These allow, for example, automated reasoning to determine whether a contract is internally coherent and whether it is complete relative to a particular event alphabet. We illustrate the process by representing a simple loan agreement as an automaton.
Suggested Citation: Suggested Citation
Flood, Mark D. and Goodenough, Oliver R., Contract as Automaton: The Computational Representation of Financial Agreements (March 26, 2015). Office of Financial Research Working Paper No. 15-04. Available at SSRN: https://ssrn.com/abstract=2648460 or http://dx.doi.org/10.2139/ssrn.2648460