Finance Industry Ready for Smart Contract Rebuild
In 1994, computer scientist and legal scholar Nick Szabo publicly conceptualised the smart contract. Interestingly, Szabo’s idea lay dormant for many years because the technology did not yet exist to support the implementation of smart contracts. Then, in 2009, the Bitcoin blockchain emerged and laid down the platform for smart contracts to exist effectively. The idea of smart contracts was birthed by the idea that decentralised ledgers could be used for self-executing contracts that could be converted to computer code and performed automatically by computers, although some parts may require human input and control. These contracts would be enforceable either by legal enforcement of rights and obligations or via tamper-proof execution of computer code.
If we were to simplify the concept, smart contracts could be thought of as a vending machine — automated and self-executing. Drop $1.50 into a vending machine on a hot summers day and press a button, and as a result, you will get your drink of choice. This whole vending machine interaction was actually a small program (or contract) coded (written) into the machine, which ran when you hit the button (signed off on it). In other words, computer code is like a contract, though not necessarily in the classic legal definition that we are used to. Unlike a ‘contract’ in a legal sense, this is something both humans and machines can read. Therefore, instead of going to a lawyer to get the document, with smart contracts, you drop a token into the vending machine (i.e. a ledger) and the code formulates an output.
If we delve into greater detail it can be said that a smart contract has two key features that distinguish it from a traditional contract; automatization and enforceability.
1) Automatization — A smart contract is capable of at least partial performance by computers, without the parties’ direct intervention. This is in contrast to a traditional contract which is an inert text (or even a mere oral communication) and execution relies on the independent action of the parties.
2) Enforceability — Smart contracts are enforceable in two types of ways: either of the traditional legal kind (i.e. a court could enforce it) or of a novel kind — tamper-proof execution of computer code. By tamper-proof we mean that smart contracts create a record that neither the parties nor any third party can modify. In this sense, enforceability may not necessarily lie in the fact that the output can be enforced by a court, but, as an alternative sense of “enforceable”, that it may be affected by an autonomous technological process which, once initiated, cannot be interfered with. However, legal analysis will always trump the technological, therefore, it is important that regulations specifically recognise such electronic transfers of assets or value as valid.
Given these properties, smart contracts allow us to combine trustworthy properties of digital stone with the vending machine-like automation of traditional programming. However, the self-executing nature of smart contracts can cause problems. Even small errors in code can have significant consequences. For example, the Ethereum-based decentralised autonomous organization (DAO) operated pursuant to smart contracting computer code. The code contained a known bug which ultimately allowed one of the DAO’s participants to divert 3.6 million ether (ETH), roughly valued at $50 million (at the time), into a “child DAO” controlled only by that participant. The point here is that, in addition to any other substantive legal issues triggered by the particular smart contract use case, businesses offering smart contract-based services should remain mindful of potential legal liability arising from programming mistakes.
This, coupled with their potential when done right, has made smart contracts the subject of much debate and discussion in the financial services industry in particular, with smart contracts being heralded as the cure for many of the problems associated with traditional financial contracts which are not geared up for the digital age. Reliance still on physical documents continues to lead to delays, inefficiencies and increased exposure to errors and fraud. Banks for instance, receive thousands of orders every month via fax machine, a technology that has largely been abandoned almost everywhere else. Financial intermediaries, while providing interoperability for the finance system create overhead costs and increase compliance requirements. ASX for example, Australia’s largest financial exchange, estimate end-to-end costs in Australian equity markets of $4-$5 billion, which is ultimately paid for by the issuers and end-investors. Furthermore, settlements of financial contracts still rarely happen in real-time. For instance, the average settlement time for a syndicated loan in the U.S. is over 20 days, increasing to 48 days in Europe.
The adoption of smart contracts is likely to reduce or remove these issues, bringing clarity, predictability, auditability and ease of enforcement to contractual relations. As a result, smart contracts will help to reduce risks, lower administration and service costs, and create more efficient business processes across all major segments of the financial services industry. These benefits will accrue from process redesign as well as from fundamental changes in operating models, as they require a group of firms to share a common view of the contract between trading parties. Some of the largest financial institutions in the world have begun looking at and implementing ways to transform their business through the use of smart contracts. Deutsche Bank’s MD and Global Head Disruptive Technologies and Solutions, Roberto Mancone, is positive about the impact smart contracts could have on the industry, stating that they have “great potential and could transform the business model of many segments of the banks, solving many of the problems banks and regulators are facing”.
Although we are in a new era of technology, much of the finance sector has been slow to adapt. But now is the time for industry players to break out of this inefficiency and consider new technologies, like smart contracts, as an opportunity to first digitize in the short term and also leverage reduced operational costs and new business models in the long run. Lendflo aim to be at the forefront of this change which will enable better and fairer financial services around the world.