The evolution of blockchain technology over the last couple of years is nothing short of a whirlwind. From Bitcoin enabler to distributed ledger and now a possible platform for automation, this rising digital darling has presented a variety of interesting – albeit often novel – use cases.
As much as I prefer to avoid buzzwords and applications that never really catch on, I must admit that the budding adoption of blockchain-driven smart contracts has caught my attention. Could it be that commercial use of this nearly 25-year-old concept will finally become a reality – for example, for smart contracts? And if it does, what does this mean for the finance function?
First things first: What it means to engage smart contracts
In theory, a smart contract is any agreement that can automatically enforce terms between two or more individuals or entities without the need for a third party. Embedded, repeatable, and data-driven logic triggers transactions in response to predefined conditions. Written as a computer program rather than legal language on a printed document, the agreement is executed against strict rules and consequences in the same manner as a paper-based document. Information is captured and monitored for compliance, and the smart contract can actually take action on behalf of the offended party if any terms are breached.
Although smart contracts as a blockchain-enabled technology is a new idea, the concept itself is not. Cryptographer Nick Szabo first defined the smart contracts model in 1994, but the innovation was unrealized because the technological infrastructure it required did not exist. Thanks to the advent of crypto protocols and blockchain, all of that is changing now.
How smart contracts will change how finance creates and manages agreements
With the programming language of blockchain technology, smart contracts can drive actions such as securing collateral, determining futures, and structuring repayment prioritization. But there are still limitations until the technology matures. For example, the process is suited only for repetitive agreements, not one-offs that are subject to significant changes during negotiations. And since blockchain has yet to establish blind trust in the legal arena, it may be prudent to restrict smart contracting to consensual relationships and agreements that are unlikely to be disputed, with clause conditions and consequences that are digital in nature.
Nevertheless, like other digital technology, the promises of smart contracts may be as endless as our imaginations. Here are three near-term opportunities that finance organizations should consider now.
1. Make fair contracting more equitable
No one wants to take a customer or partner to court to settle noncompliance. Reputations are at stake, and the relationship is often irreparable. With smart contracting, the terms are laid out and digitally monitored without bias. If a violation occurs, the predefined consequence, ideally agreed on by both parties, is automatically triggered. For example, by storing loan terms as well as collateral ownership information in the blockchain, the lending entity can revoke the borrower’s digital keys that grant access to collateral if a payment is missed.
2. Ease the exchange of funds
Smart contracts can be used to set up escrow accounts, control wallets, and handle stocks and bonds. The buyer of a good or service can transfer payments to a particular account. The blockchain would then monitor services rendered and determine whether ownership has been transferred properly. If all defined rules are followed, payment is released to the seller. Plus, withdrawal limits can be set so that portions of the total amount are released based on the progress of the service being rendered.
3. Increase the effectiveness of fraud detection
Unfortunately, fraud is a fact of life. Research from Association for Financial Professionals, underwritten by JP Morgan, echoes this reality by noting that 74% of business leaders report that their organization was exposed to attempted or actual payment fraud in 2016. Through smart contracts, companies can establish a distributed registry to validate product authenticity and goods ownership, and authenticate complaints and warranty claims. The process can also verify the identification of authorized persons and detect patterns of potentially fraudulent behavior.
Contract management in the digital era: immutable, yet still evolving
While it’s true that blockchain was developed to support crypto-currency transactions, it is starting to show promise in the form of smart contracts. Self-validated, self-monitored, and self-enforced, smart contracts can bridge the trust gap in many contract-creation and management processes without the need for a third-party intermediary. While time will tell what difficult legal and compliance challenges may emerge as the technology matures, finance organizations have a significant opportunity to strengthen transaction security, increase contract compliance, and reduce the risk of term manipulation.