What are Smart Contracts?

Smart contracts are programmable contracts that automatically run when certain conditions are met. These contracts utilize blockchain or distributed ledgers to perform their functions and are capable of enforcing themselves when used between two first parties. There is no need for a third party to oversee the transaction. Rather than using paper, these contracts are real programs and can take inputs from the users and act on them according to rules set forth within the programming.

How Smart Contracts Work?

Smart contracts work by utilizing blockchains or permission ledgers whichremove the need for a central intermediary which would usually provide the trust in the system. The smart contract is stored at a defined address in the blockchain. When an event triggers the need for the contract, the transaction will go to that particular address and runs the smart contract script, usually with the data provided by the transaction.

For example, let’s say two parties wish to enter a contract. The smart contract records the contract on a distributed ledger that will be shared by all the parties involved. It will be validated by the prescribed validators such as auditors, regulators, banks, insurers, and capital markets. It then connects with external and internal systems, such as internal bank systems, external share prices or other data. The smart contract will then wait for an event to trigger its set of conditions. It then evaluates those terms and acts on them while providing the necessary data to regulators and auditors. Those triggers that fulfill the right conditions will cause the smart contract to self-execute.

Potential Uses for Smart Contracts

Smart contracts may revolutionize the way that contracts are executed. Unlike conventional documents, smart contracts can respond once a set of conditions are met, thus saving companies billions of dollars by eliminating the need for extra paperwork, an intermediary, and a dedicated staff to handle all the requirements to fulfill the contract. Because smart contracts are flexible and yet secure, they can work in several different areas of financial businesses. Some of the areas where smart contracts may be used:

• Mortgage Industry (mortgage contracts).
• Insurance Industry (insurance claims, fraud prevention, providing new contracts for new technology such as driverless vehicles, sharing economy, and cyber insurance).
• Initial Public Offerings (IPOs).
• Corporate Finance.
• Loans (syndicated and leveraged loans included).
• Stock exchange (trades, offerings).
• Crowdfunding.
• Trade Financing, (including invoicing, payments, and documentation).
• Inheritances — once a death occurs, the smart contract allocated the assets upon death.
• Escrow accounts.

Smart Contracts Could Save Billions

Not surprisingly, smart contracts could save companies and clients/customers billions of dollars and offer faster, more secure transactions. According to Capgemini Consulting, smart contracts could save each customer between $480 and $960 in mortgage loan origination processing fees and lower the yearly operating costs between $3 to $11 billion USD in the United States and Europe. In the insurance industry, smart contracts could save insurance companies $21 billion USD by lowering claims settlement costs. Customers would also see a savings benefit due to lower insurance premiums each year. Itis projected that insurance premiums would decrease between $45 and $90 USD yearly per customer. With business syndicated loans, customers could see a faster trade settlement and investment banks could see an increase or $2 billion to $7 billion USD yearly in revenue from fees.

Smart contracts enable people to create contracts over the Internet without an intermediary. They can create contracts between individuals or companies that are anywhere across the globe. There is no longer a need for oversight or even a physical meeting. The transaction moves smoothly and without oversight.

Problems that Need to Be Addressed in Smart Contracts to Make them a Reality

Although smart contracts offer a way to automate and enforce contracts, thus saving companies money, there are issues that mustbe overcome if they are to become a reality. Here are some points to consider:

• The first problem is their overall inflexibility. While they can be flexible when written, they are still code and do not rewrite themselves if new circumstances and variables arise that were not anticipated when the code was written.
• A major issue issecurity, especially the security of the blockchains. Given that these deal with financial transactions, they are at risk.
• How are they going to run and interact with legacy systems? Many legacy systems are not set up to handle this type of interaction.
• How scalable are the systems that smart contracts use? Smart contracts rely on speed, and if the systems are not fast enough for scores of smart contracts residing and operating on them, they could seriously harm the clients’ or financial institutions’ bottom line.
• The laws and regulations do not account for smart contracts. These regulations and laws will have to change to accommodate them.
• Most people in financial institutions (and IT) are unfamiliar with smart contracts. There will be a need for programmers who can build them according to requirements.
• Who controls the Blockchain? Given that there are many players, the problem arises as to who actually controls and maintains them.
• Not very enforceable outside of cyberspace. Smart contracts cannot enforce themselves outside of the Internet. Their reach is severely limited. Because of this, they are not suitable for all contracts, or contracts which require oversight.

Smart contracts save companies and clients money by providing a contract that enforces the conditions, depending on the event or trigger. They eliminate the need for oversight in most cases. It handles the conditions and reporting so that it is not necessary for an intermediary. However, there are many issues that need to be addressed for them to work flawlessly in financial services.