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Updated: 4/14/2022

Blockchain technology has sparked interest in the finance sphere, and among other industries, from sports to art. Industry leaders are trying to customize smart contracts to fit particular uses in finance. 

According to Juniper’s research1 blockchain will become critical for all financial institutions working to automate banking processes. Banks and financial institutions could save up to $27 billion per year by 2030 as compliance costs continue to rise in North American and European markets. 

In this article, we want to examine why blockchain-based smart contracts are important for the future of finance and how they can be used to automate business processes. 

What Is a Blockchain-Based Smart Contract?

In 1994, Nick Szabo proposed the idea of smart contracts:

“A smart contract is a computerized transaction protocol that executes the terms of a contract. The general objectives of smart contract design are to satisfy common contractual conditions (such as payment terms, liens, confidentiality, and even enforcement), minimize exceptions both malicious and accidental, and minimize the need for trusted intermediaries.”

Smart contracts are pieces of self-executing code on a blockchain. They are able to put in place the terms of an agreement automatically. This technology has an immense potential to streamline any process that demands access to multiple databases and resource planning systems. 

As for benefits, this level of automation ensures a reduced risk of error or contract manipulation. With a shared database running on a blockchain protocol, the smart contracts remove the need for third-party intermediaries as the contracts are automatically executed.

Traditional vs. Smart Contracts

Understanding the benefits of smart contracts is closely connected to a proper comprehension of how blockchain works and what it brings to the table in finance.

Blockchain-based smart contracts contain the same level of detail as physical contracts. They do something no conventional contract can: perform tasks such as negotiating prices and monitoring inventory levels. This capability replaces expensive, manual effort with dynamic, automated tracking of supply chains, inventory levels, and expenses, to reduce costs and maximize profits.

Written Contracts vs Smart Contracts

Source: Cointelegraph

How Do Smart Contracts Work

In more technical terms, the process of creating a smart contract can be broken down into a few steps. First, a smart contract forms as an agreement between two or more parties. Once established, the two sides can agree on conditions for the smart contract to be considered complete. The conditions are written into the smart contract, then encrypted and stored in the blockchain network.
 

Building smart contracts

Once the contract is complete, the transaction is recorded on the blockchain. Then, all nodes would update their copy of the blockchain with this transaction, updating the new “state” of the network.

Smart contracts are used to control the transfer of digital currencies or assets between parties. They define rules and conditions around an agreement, including penalties, and automatically enforce all contractual obligations. 

Where smart contracts can be used:

Benefits and Challenges of Using Blockchain-Enabled Contracts

Smart contracts can be a worthwhile option in environments where a massive number of transactions happen within a network, and manual tasks need to be performed for every application. Blockchain becomes a type of shared database, as it provides a secure source of information and enables faster approvals and calculations with minimal errors.

Blockchain-based smart contracts come with many benefits:

High accuracy and reliability. Smart contracts can significantly increase the efficiency of various business processes typically done manually. 

Real-time updates. Automated transactions are quickly executed and both parties are able to follow the live status of the contract. 

Reduced number of intermediaries. Standard contracts require intermediaries to ensure the validity of each transaction, but smart contracts don’t require an arbitrator.

Lower cost. Smart contracts can significantly reduce dependency on human intermediaries and reduce the overall cost of the transaction. 

Adaptability to different business models. Contracts are a fundamental part of business as they provide a way for transactions to be performed as agreed upon, regardless of the industry. 

Due to its early development stages, smart contract technology still needs to advance in certain aspects: 

Processing speed and scalability. Currently, blockchains have issues with latency , as it takes time for a block of transactions to become a part of the ledger. 

Dependance on programmers. All blockchain-based smart contracts are unchangeable, which means developers need to anticipate every single case that might require changes in the contract. 

Privacy. Code within smart contracts is visible to everyone in the network and some applications cannot risk outside parties accessing their sensitive data.  

High latency. Ethereum, the most popular blockchain technology for smart contracts, takes 17 seconds to add verified blocks to the ledger. Compared to milliseconds that are standard for storing non-blockchain data, it's clear that this technology still has a need for improvement.

When it's Time to Consider Using Smart Contracts

Industry leaders that are not focusing on the development of blockchain technology should keep an eye on smart contracts and evaluate how we can use this technology to make the process more efficient. Operations executives of big companies are already investing in smart contract projects to assess their efficiency. 

Factors to look into if you are thinking about implementing smart contracts:

  • Manual workflows
  • Complex workflows
  • Multiparty agreements
  • Number of independent transactions

Smart Contract-Powered Applications in Financial Institutions

The Ethereum blockchain transforms conventional banking services through the implementation of smart contracts and DApps. Thus, smart contracts are promoting the benefits of the Ethereum blockchain for attracting a large number of crypto investments as well as payment transactions from crypto investors. 

There are some use cases that show the importance of smart contracts and decentralized applications (DApps) on the Ethereum blockchain, such as multi-signature accounts, agreements made externally, storage, and many more. Any crypto investor can start using smart contracts if there is an investment in Ethereum’s native token ETH.

Smart contracts are offering banks and other financial institutions an opportunity to streamline trade clearing and replace this labor-intensive work with an automated system. They are useful to financial institutions as they detect discrepancies in settlement systems. And a few Wall Street banks are currently testing settlement systems based on smart contracts. 

Benefits of smart contracts for banks and financial institutions:

  • Documentation of supply chain and trade finance
  • Easier settlement and trade clearing
  • Process simplification
  • Versatile tokenization
  • Easy online donations
  • Fewer barriers for SMBs
  • Improved security

What is the Future of Smart Contracts

Blockchain-based contracts are undoubtedly moving the finance industry forward. Yet, without regulatory clarity, they cannot offer any law-supported guarantees. 

As B2B cross-border payments stored on blockchain are set to increase in value from $122.2 million in 2020 to $1,8 billion in 2025,2 the market for smart contracts will only keep expanding. 

The biggest blockchain vendors like IBM, Deloitte, Digital Asset, and Interbit are already testing and introducing blockchain-based products to further improve the security of their data. Many smaller banks are testing smart contract solutions in their daily operations to unlock valuable insights. 

Curious to know if smart contracts would make your processes more efficient? Our experienced team is happy to answer any questions about this quickly-evolving finance technology.
 

1. Smart Contracts Investopedia
2. SMART CONTRACTS: TRANSFORMING ETHEREUM BLOCKCHAIN IN 2022 Analytics Insight
3. Szabo N. (1994). Smart Contracts [Article].
5. The global smart contracts market is expected to reach approximately $300 Million USD by the end of 2023 with 32% CAGR during the forecasted period from 2017–2023.
6. The survey was conducted online in 2016. For more information read here
7. What is a smart contract Coinbase
8. What are smart contracts in blockchain and how do they work? Cointelegraph
9. Getting smart about smart contracts Deloitte
10. Understanding Smart contracts - Definition, pros, cons and application dev.to
11. How smart contracts are transforming banks and financial institutions Business of apps