Smart Contracts and Financial Services

With Ethereum, the world was brought a whole new system of smart contracts, and they offer many benefits.  Smart contracts are tamper-resistant, self-executing, and self-verifying.  They are already changing banking, allowing error-free insurance claim processing, peer-to-peer transactions, seamless KYC processing, transparent audits, and more.  We will be discussing the changes to finance smart contracts bring.

Smart Contracts Short and Sweet

While Nick Szabo came up with the idea for smart contracts in 1994, they did not come into reality until the release of Ethereum, which allowed easy embedding of contracts into computer code with security and transparency.

Smart contracts are programmable contracts encoding an agreement between two or more parties that self execute when defined criteria are met.  The transaction’s terms are written as a protocol on a blockchain network which means they have neither paperwork nor a middleman for validation.  The compliance is made through the blockchain’s validation process, which is autonomous when the contract’s terms are completed.  Smart contracts are helpful for many manual banking processes like compliance, loan eligibility validation, and claims processing.

Smart Contacts Main Features and Benefits

Smart contracts allow two parties to interact with “if-when-then” conditions, and they can be anonymous.

• Smart contracts have compliance and control built-in with independence and self-execution.
• They can source from external data to make them self verifying.
• With no intermediaries, they are safer and have additional tamper resistance.
• They provide immediate resolution with fast verification, saving both parties time.
• Their transparency removes many trust issues.
• Their setup is very cheap, and execution is free.
• They handle sensitive data with the data remaining on the blockchain for future use.
• Encrypted digital signatures verify contract participation, making them ideal for high-end contracts.

Types of Smart Contracts

There are three general types of smart contracts:

Legal Contracts – These smart contracts are created to simplify legal processes.  They ensure adherence to regulatory guidelines and can be used for financial, real estate, and international trade contracts.  While the current legal system has an insufficient structure to support totally autonomous blockchain-based contracts, as laws and structures improve, more of these will be utilized.

Decentralized Autonomous Organizations (DAOs) –Smart contracts built for blockchain communities where the community’s participants must abide by the rules of the code.  Many crowdfunding platforms are DAOs.  There are many smart contracts employed for the management, and they are used to supervise and police the community’s participants while ensuring support among the community.

Application Logic Contracts (ALCs)– These contracts are behind the internet of things (IoT).  They are application-specific codes working in conjunction with other programs that are on the same blockchain.  They are used to establish and validate the communication of IoT devices, merging IoT and blockchain technologies.  Every multifunctional smart contract will have a managing program, and under this, it will be made up of ALCs.

Smart Contracts and the Financial Services Industry

Most sectors of our economy are beginning to see the changes in speed and transparency brought by smart contracts.  Financial Services is no exception and has become the leader in blockchain innovation.  Here are some of the ways and processes where banks and other financial institutions are utilizing smart contracts.

Reduced transaction costs- Because money is always a business consideration, smart contracts are beneficial because of their lowered transaction costs for self-regulating and record-keeping, with reduced or eliminated manual intervention.

Error-free insurance claim processing– The process of assessing an insurance claim’s legitimacy is a tedious one.  Manually counterchecking the terms of a contract and then validation of the claim can take time.  Smart contracts can supply automated insurance claim processes to the finance industry.  Automatic validation via decentralized ledgers on a blockchain network can be done with smart contracts.  This process will reduce the risk of fraudulent claim compensation by insurers.

Quick, cost-effective, and advanced remittance– The adoption of digital payment services like PayPal and Zelle has increased the demand for safe and speedy international remittance services.  Two different blockchain protocols have filled this role.  The stellar network and the ripple network; one is more centralized than the other, but both have similar international remittance services through established and newer financial institutions allowing real-time fund transfers for pennies rather than the high prices and multiple days that are common with traditional remittance services.  They are even adding smart contract functionality making advanced remittances like Letters of Credit possible.

Transparent audits– Traditional contracts involve significant paperwork, and proper record-keeping is essential for financial auditing.  The resources needed to manage records are significant.  Smart contracts can support advanced bookkeeping solutions because they are tied to the distributed incorruptible code of the blockchain network.  Smart contract solutions can eliminate infiltration and enhance blockchain stored record transparency.

Speed of automation- Replacing manual tasks with smart contracts reduces transaction processing times and optimizes operations.  For example, pay stubs, W-2s, and tax returns for loan applications can be automatically verified and then info kept on the blockchain to recall later.

Improved KYC processing– KYC is a required function of banks and financial services.  The process of customer identification is now being conducted by smart contract-based blockchain solutions like KYC-chain.  Separate parts of the KYC process, such as identification and credit score verification, can be saved and recalled with Blockchain records.  Other compliance requirements such as tax returns can be processed in real-time, which helps financial institutions and accounting firms.

Peer to Peer transactions– To be service-oriented, banks looking to implement new technologies want to be sure that the new tech will improve the outcomes for clients.  Smart contracts on distributed blockchains eliminate the need for third-party mediation.  This attribute is a cost reduction and can simplify transactions for users, even the unbanked.  The slow adoption of cryptos by retailers is gradually building the net of payments.  Smart contracts are quite beneficial for all trustless payments, especially international trade, that involves foreign currencies, inspections of goods, and funds in escrow, without the need for trust while providing convenience and stability.

Contract Accuracy– Smart contract transactions are self-executable and transparent.  They eliminate errors by removing human intervention, which cultivates trust between the parties involved in the contract even if they are anonymous.

Win-Win relationships– Financial institutions and their clients benefit from smart contract implementation.  Banks can reduce their costs and streamline their processes which ensures regulatory compliance.  Clients gain from simple, safe, and reduced-cost transactions.

Simple Services for Smart Contract Development

The Ethereum blockchain is the grandfather of smart contracts and is still the most widely used.  It supports the building of advanced and customized smart contracts making it the choice for most.  Solidity, the primary language on Ethereum, is a high-level Turing complete language executed through the Ethereum Virtual Machine.

SIla is a simple system for banks to utilize their Software Development Kit (SDK) or integrate Sila’s already created application program interfaces (APIs) which make it simple to store value and transfer money between bank accounts, crypto and digital wallets from inside the banks own application while most importantly maintaining compliance with U.S. regulations.  They can integrate payment functions of banks such as ACH, KYC, and digital payments.  Simple Sila smart contracts can be created by putting in the assets and requesting a code to automatically execute and deliver those assets.

Financial Institution Smart Contract Opportunities

With financial instruments and assets digitized, and the growing use of cryptocurrencies, the uses for smart contracts and blockchain technologies in finance are growing.  As the levels of connectivity increase, this will advance further.  We have listed some of the top opportunities for smart contracts going forward into the world of DeFi.

Process simplification– Institutions should review their internal processes to determine where manual procedures can be simplified with smart contracts.  Automation of manual workflows and linking interdependent transactions with smart contracts will have an upfront cost but, over the long run, will be a competitive advantage.  Trust can be built among participants of multiparty agreements through blockchain transparency.

Clearing and settlement streamlining- F.I.s can use smart contracts to streamline their trade clearing and Settlement (TCS).  TCS is historically a labor-intensive process that, due to the involvement of several parties whose roles are to approve, audit, and reconcile, is prone to errors.

Smart contracts can be utilized to create an efficient equity settlement program that prevents discrepancies and saves costs.

An Accenture survey of eight global banks found that clearing and settling costs could be reduced by $10B annually through blockchain technology.  Wall Street has successfully tested smart contracts for clearing and settlement, and the Australian Securities Exchange and the Depository Trust & Clearing Corporation (DTCC) are developing a smart contract-based clearing and settlement system.

Trade finance and supply chain documentation streamlining- Because they are more efficient than paper-based systems, smart contracts can reduce processing times of supply chains and trade finance.  While digitizing letters of credit and bills of lading means an opportunity for forgery, blockchains can be used to secure public receipts and transactions and ease workflow management with digital signatures.  Bank of America, Barclays Corporate Bank, Standard Chartered, and the Development Bank of Singapore have all been testing uses smart contracts to automate log change of ownership and payment processes for their organizations.

Securities Settlement and Clearance- current settlement and clearance systems mean that market participants must accept opaque methods with money trapped for unknown durations.  Smart contracts can make this process transparent reducing settlement timelines to minutes or even seconds.

Well-defined Terms and Conditions for Lending- traditional lending revenue is generally the difference between interest paid to investors and that from borrowers.  Many borrowers cannot meet traditional lending criteria.  Smart contracts can monitor the loans to these borrowers directly from investors, reducing the time needed to procure these loans.  Lending can be done with cryptocurrency as collateral and programmed interest payment terms.

Lowered barriers to entry for SMBs– Onboarding processes that once had multi-step verification and significant documentation needs reduced access for SMBs.  Smart contracts can provide blockchain solutions accelerating the systems of traditional banking, matching the agility of small businesses.  Traditional finance models can be reshaped with new instruments matched with decentralized ledgers.

Tokenization- Smart contracts can deliver stable and secure processes, with the tokenization of USD and other fiat Stablecoins can prevent the fluctuations of most cryptos and help institutions avoid risks.

Online giving- Smart contracts can improve donations with stipulation clauses requiring specific trigger conditions must be fulfilled before funds are released.  These contracts can increase supporter trust and improve fund transparency in giving.  Donation processing, auditing, and tax reporting costs can also be reduced with smart contracts.

Smart Contract Disrupting Finance

Traditional banking models can be upended with smart contracts.  There are several companies creating security tokens that will tokenize what is generally thought of as a stock certificate or other asset and then build markets for the trade of these.  Banks that adopt smart contracts can minimize their operational costs, risk, and errors.  These reductions added to the relationship-building possible with smart contract transparency can give consistency needed for long relationships.

There will be a need for broader adoption by banks to create scale and the network effect that takes smart contracts to the next level.  There will be a need to develop a set of rules and regulations that make the banking system safer which includes smart contracts.  If banks can make these improvements behind the scenes and provide services to clients at the same level or better than any disrupters, they should have no fears.

Summary

Smart contracts have the ability to unlock new features that are beneficial to finance and to the clients.  Smart contracts can provide several services that are efficient, cost-effective, and smooth.  The exact thing that a bank’s customers are in search of.  Blockchain technology leaders see a future with nearly limitless DeFi smart contracts.  It is now up to regulators and the legacy banking system to catch up and give users what they expect.

Disclaimer:  The author of this text, Jean Chalopin, is a global business leader with a background encompassing banking, biotech, and entertainment.  Mr. Chalopin is Chairman of Deltec International Group, deltecbankstag.wpengine.com.

The co-author of this text, Robin Trehan, has a bachelor’s degree in economics, a master’s in international business and finance, and an MBA in electronic business.  Mr. Trehan is a Senior VP at Deltec International Group, deltecbankstag.wpengine.com.

The views, thoughts, and opinions expressed in this text are solely the views of the authors, and do not necessarily reflect those of Deltec International Group, its subsidiaries, and/or its employees.