Smart Contracts and the Automation of Trust

Blockchain and its related technology has gained significant attention across industries. The financial industry has begun to realize the potential of it. It’s very well known that blockchain technology decentralizes decision making and fosters decision by consensus (in technical terms, proof of works where all participating miners are expected to solve a given mathematical problem). Here, let’s focus on “smart contracts” and a few use cases involving the most revolutionizing aspect of this technology which is enabling banks to automate trust and take greater steps towards transparency.

Traditionally, every relationship in the financial world is bounded by legal contracts, which are executed by both parties based on a defined/expected business event. Each of us sign these various contracts in daily life for services we consume from a service provider. Most of the time we blindly sign T&Cs (which are foundation agreements and legally binding) without reading through in detail. Simply put, the end consumer has no great wisdom to interpret them effectively.

Smart contracts has been defined and interpreted differently by various communities:

In the technical community, a smart contract is like a self-executing code in a given event. An example would be “Send XXX GBP to contractor on last day of month.” This similar self-executing code ability is available across existing technologies like Oracle, where Trigger objects / smart agents are executed on various events. Hence we can call this smart contract code.

In the legal community, smart contracts are known as smart legal contracts, where two or more counterparties have agreed for execution of legal terms and reflect those across their systems. They are obliged to stand by these.

One important thing to note is that these smart contracts are executed on blockchain and, inherently, they adopt the characteristics of permanence – i.e. no-reversible. This makes a compelling case for legal contracts to adopt the smart contract technology. Smart legal contracts would contain a combination of smart contract code and more traditional legal language. For instance, a supplier enters into a smart legal contract with a retailer where payment terms are defined in a code and are self-executed when a goods delivery is made but the retailer will insist on the inclusion of an indemnification clause in events of faulty material/late delivery (legal wordings). Now such a scenario can’t be coded and the matter has to be settled in court in the event of litigations.

There are also potential use cases in the financial services sector (as stated, each contract can be reimagined in financial services industry):

  • Capital Markets: This is a very popular use case being evaluated, where securities based on payments and rights that are executed can be written as smart contracts. Some of the world’s leading banks are conducting experiments with smart bonds.
  • Bankruptcy/Delinquency: Smart contracts are executed in a given scenario and customer records are reflected on blockchain, which then becomes immediately accessible to financial institutions to take further credit agreements with a given corporate/retail customer.
  • Escrow: The contract would be able to release the funds if the defined criteria has been met (i.e. transfer of goods from a supplier)
  • Loans: These can be converted as smart contracts in the event of missed payments/breach of terms where the customer loses access to digital assets through the revocation of their digital keys. This use case can further be linked across customer risk profiling.

While smart contracts sound like the answer to every problem, their real word enforcement and adoption in the legal system would be critical for its success. There’s also a couple of other issues to consider, including establishing liability in a decentralized world and flexibility where contract terms are evolved and matured over a period in business.

In the future we may see that business parties will be automating and entering in smart contracts with each other, which does not mean that the legal system would completely be eliminated. However we can regard this technology as a step towards legal system evolution. We can imagine that there will be prescribed and acceptable smart contracts by the legal system, within a given territory or across the globe, which are interconnected and monitored through wrapped up smart contracts. The financial industry is well-poised for smart contracts considering the former is highly regulated, and operates per given legal norms. Smart contracts can facilitate the elimination of intermediaries which were established mainly to cement the trust among contract counterparties and promote greater transparency.

 

The article was originally published on Payments Source on September 9, 2016 and is re-posted here by permission.

Anil Awasthi

Director - Client Services for Cards & Payments, Virtusa. Anil has over 15 years’ experience in the IT industry, specifically in financial services. He has developed and architected end-to-end systems for banks and financial services institutions, focusing on information security and standards and compliance. Anil now concentrates on applying his hands-on experience to developing best-in-class solutions for his clients. Anil holds a Bachelor of Technology from the Open University of British Columbia.

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