Exploring smart contract use cases in finance
Smart contracts have been touted for several years as one of the more practically applicable aspects of distributed ledger technology (DLT). We outline exactly what a smart contract is, how they work, and discuss some use cases of smart contracts in financial services.
What are smart contracts?
Smart contracts are technologically sophisticated versions of traditional contracts. While any sort of contract between two or more parties is an agreement to deliver or provide something in return for payment, smart contracts automate certain aspects of the underlying agreement.
Smart contracts are digital contracts which execute automatically when specific conditions are fulfilled. These contracts are stored on a blockchain which links all signing parties together and provides the mechanism throughout which the smart contract operates. This reduces and potentially eliminates the need for intermediaries, who would traditionally have been required to check that each side was keeping to the agreed terms of the contract.
While there has always been scepticism about the final utility of cryptocurrencies, the potential of the underlying blockchain technology has seldom been called into question. Today, numerous innovative blockchain-based solutions are either already live or are in final stage testing, with everyone from start-ups to multinational investment banks taking part in what could be dubbed the ‘digital gold rush’.
How do smart contracts work?
Smart contracts are best thought of as decision-tree systems. Given a certain input, they carry out a certain action on an ‘if input x, then execute action y’ basis. Once the input has been registered and verified by the network of computers maintaining the relevant blockchain, the program then carries out the required action automatically. This is where the significance of smart contracts becomes apparent; the range and diversity of decisions that can be automated is extensive and as we will see below, new use-cases are emerging all the time.
After the stated action has been completed, the blockchain is updated and henceforth provides an immutable record of this and all previous transactions. The sequential and unalterable nature of how data is stored on a blockchain protects against interference or tampering, and only users with the correct permissions can view the live chain.
What are the benefits of smart contracts?
- The first key benefit is adaptability. Importantly, smart contracts are a highly flexible mechanism and can be adapted to meet all kinds of user requirements. Far from just simple devices that would be unable to distinguish between tasks being completed satisfactorily or not, it is possible to engineer smart contracts to contain explicit terms over how and when actions will take place, and how they will be registered on the blockchain. The modular nature of the interfaces used often means service providers supplying templates and easily editable contracts that clients can then mould to their specific requirements.
- Automation is the ultimate efficiency booster. Once the relevant input is received, the contract executes automatically and immediately. There is no need for any employee time to be allocated to completing paperwork or actioning the decision, it simply happens of its own accord in the predictable fashion it was programmed to happen once the input conditions are met.
- This results in substantial savings for companies. Both in terms of money and employee time that can be redeployed to more productive tasks. Similarly, the comparative ease with which smart contracts can be built and used reduces the need for lawyers and other intermediaries who add time and cost to business processes.
- Finally, the visibility and security of records are greatly improved through the use of smart contracts. All data that is stored on a blockchain has had to pass verification by all computers connected to the network, and in this way, it becomes almost impossible to falsify or hack into such distributed networks. However, because the blockchain provides a public and communal record of all the transactions, anyone with the right permissions is free to view but not edit this data. As such, trust between business partners can be augmented due to the inherent transparency of the system.
Smart contract use-cases in finance
One of the first areas of finance where smart contracts have been deployed is in improving the monitoring and execution of derivatives contracts. Potentially highly complex and technical in nature, the pay-outs from derivatives contracts are determined by an exogenous set of inputs from which the final result is calculated at a specific time.
By building derivatives contracts on standardised smart contract templates, all of the inputs can be gathered and systematised quicker and final payments processed automatically once the holder of the contract has chosen to exercise their right as stipulated in the contract. The use of APIs makes it comparatively easy to integrate external data into the smart contract as and when needed, and the International Swaps and Derivatives Association has been at the forefront in calling for further regulatory development to galvanise the uptake of smart contracts.
Settlement issues which can be solved via smart contract automation are especially acute in the syndicated loan market. Settlement of such loans can be tortuously slow, especially when leverage is involved, and this generates risk and liquidity challenges for all participants.
Capgemini research has revealed how the use of smart contracts can speed up and streamline these transactions by utilising built-in automation to move documentation, KYC and AML checks, and other regulatory necessities along much quicker. By bringing the settlement date forward, counter-party risk is reduced and liquidity increased, thus encouraging further participation in this market.
A comparatively small portion of global trade is settled in cash prior to the goods being shipped and received. Almost always, buyers prefer to receive and inspect the goods and only then process the payment. This means exporters are regularly in need of short-term financing to bridge this gap between delivery and payment, which may only follow one month after the invoice has been sent. Banks have previously provided this service via a ‘letter of credit,’ a formal statement issued by the buyer’s bank guaranteeing the agreed payment will in fact be made on time and in full. This means the bank is exposed to the risk that their client won’t make the final payment, and they accordingly charge for this service.
The granting of a letter of credit, therefore, involves extensive and detailed due diligence on the part of the participating bank or banks, and it takes a great deal of time and effort for the appropriate documents to be assembled, assessed and verified. According to research conducted by the Boston Consulting Group and SWIFT, this process often involves at least 20 separate organisations coordinating to share between 10 and 20 documents and creating around 5,000 data field interactions.
By digitising and then automating these operations via smart contracts, the time required to grant a letter of credit can be reduced from days to mere hours.