All about smart contracts
Blockchain will transform many branches of human activity. The technology underlying cryptocurrencies such as Bitcoin uses blocks of data that are linked in a chain.
This technology can be used to create a distributed registry – a database shared by several sites, regions or participants, in which information can be accessed in different places, accessible to everyone and reliable, but, thanks to the encryption algorithm, visible only to authorized persons. For others, it’s just a collection of meaningless bits and bytes.
Another strength of this technology is: it can also embed software to perform actions representing contracts between counterparties. These contracts are visible to their holders, who can also allow others to see them. They cannot be corrupted or edited, except by those who have permission to do so.
This solution based on blockchain technology is smart contract.
What is a smart contract?
The concept of a “smart contract” was first formulated by engineer Nick Szabo in 1994. He defined it as “a computer capable of fulfilling the points of the protocol of the contract.”
Simply put, Szabo himself used the example of vending machines, where one side inserts a coin into a slot, then selects a product, and the machine finally delivers it to him.
Now imagine the same functionality with financial products, but instead of using an ATM, we will use a virtual machine that is in the block chain.
That’s where our imagination can play out. It is not uncommon to hear some smart contract gurus talk about a “Philosopher’s Stone” that can solve almost any problem facing humanity, from corruption to global poverty. Unfortunately, this is not the case.
A smart contract is nothing more than a small computer program. What makes them significantly different from other programs is their ability to transfer value (money or other digital assets) initially and without resorting to intermediaries. This is the same as financial technology.
Smart contracts are self-executing digital documents that use technologies that ensure the fulfillment of signed agreements. Before creating a document, its terms and penalties are programmed.
When the parties sign an agreement online, the requirements are activated automatically, which simplifies billing and process tracking.
Verification of the rules of the smart contract is carried out through the blockchain. Blockchain technology tracks the data exchanged by one or both parties, providing direct communication and greater security of the process using encryption. Thanks to the automatically updated information in the agreement, appropriate actions are taken without the risk of change or fraud.
Smart contracts have 3 characteristics, as determined by lawyer and cryptographer Nick Szabo:
- Observability, that is, the ability to monitor the execution of the contract;
- Verifiability, which confirms the execution of the document;
- Confidentiality, ensuring that only responsible persons have access to the execution of processes.
Using this method, the company is freed from intermediary institutions, and has greater freedom to manage its affairs with the client or supplier in the way it considers most effective and correct. In addition, there is no risk of document loss or bureaucratic problems with billing or processing.
What is the purpose of smart contracts
Using smart contracts, organizations try to automate the safe fulfillment of the terms and conditions of contracts. In other words, it allows you to track agreements digitally from the very beginning. When forming documents, payment data is automatically included after their electronic signature.
Smart contracts also aim to allow the user to monitor the expiration of the contract, create reminders and conduct research using artificial intelligence in the document. In addition, they offer a language other than legal vocabulary
Since everything is done using programming, the points should be clear so that the system can interpret the recommendations and follow them. This eliminates questionable points and reduces the number of manual errors in contract management, making the new method safer and more reliable than the traditional method.
How to apply a smart contract?
There are different technologies that allow the company to comply with the clauses of the contract and the rules. For example, insurance contracts require an information base to know the degree of risk, and an integrated payment system that automatically pays compensation after receiving information about claims.
There are other tools that can also be applied:
- Artificial intelligence
Every technology that provides automation, digitization and intelligence is well integrated into the world of smart contracts. By integrating with artificial intelligence systems, you can identify the associated risk and even block, for example, the conclusion of a contract.
- Controlled form
The managed form can be used to direct the affected parties to the best type of settlement for a particular case. This increases the accuracy of information and allows you to respond faster, reducing the time between document creation and signing.
- Electronic payments
Electronic payments allow you to automatically collect or settle a payment at the end of the contract if an overdue payment related to the document is detected.
- Adaptive signature
Adaptive signature is a feature that provides access from any device, regardless of screen size or source format. There is no scaling or complex actions to view the contract, which makes signing the agreement quick and easy.
In fact, using this digital process in any business will speed up invoicing. With the application connected to the Internet, you can monitor the data and take appropriate actions in accordance with the terms of the contract.
Everything will depend on the type of control your business needs to comply with applicable regulations and rules. Various associated technologies are needed, such as an information database for contract regulation, integration with third-party systems and digital execution of contracts.
With these types of contracts, there are no documents to confirm agreements. You will reduce the number of errors in contract management, and also get more time to read it.
Advantages of using smart contracts
- Autonomy: If you are the one who makes the transaction, then you do not need to rely on a broker, lawyer or other intermediaries to confirm it. The danger of manipulation by third parties is excluded.
- Trust: Your documents are encrypted in a shared registry.
- Backup: Your documents are duplicated multiple times.
- Security: cryptography, website encryption, protects your documents.
- Speed: Smart contracts use software code to automate tasks. Thus, they reduce the number of hours for a number of business processes.
- Economy: smart contracts save you money by eliminating the need for intermediaries. For example, you will have to pay a notary to help with your transaction.
- Accuracy: Automated contracts are not only faster and cheaper, but also prevent mistakes.
Smart Contract Applications
Contracts can be applied in new forms of financing and crowdfunding. For example, let’s choose any project on Coinmarketrate.com where there is the issuance of tokens on the Ethereum network with ERC20-type contracts, the creation of payment channels such as those used in the Lightning Network, or the decentralization of the joint economy.
In addition, there is the possibility of providing guarantees related to input data outside the blockchain, through oracles or services that “inject” data from the outside world into the blockchain so that they can be used by smart contracts.
How Smart Contracts Can Transform Banking
Now let’s see how this concept can be applied to banking and finance.
Everything the bank does has a legal basis. Today they have to manage many financial contracts: this is the role of back offices. Almost everything they do should be related to contracts: calculating and paying interest, sending confirmations, reconciling refunds with current contracts, calculating transactions, etc. Banks spend about 80% of their income on operations and IT. Is this really the bank’s mission?
Theoretically, yes. In practice, probably not. Why? Imagine a loan with accrued interest. This is a standard calculation. Instead of encoding the algorithm in a contract, it would be better if this smart contract sent data to the right department to get the right number.
Today, banks can use collaboration platforms to apply functions “as a service” in a scalable model using applications offered by fintech companies. As more and more financial technology joins these platforms, this “as a service” model means that banks can outsource even complex administrative tasks as the number of APIs grows. Banks will increasingly resemble the automotive industry: the brand provides customer service, and the product consists of many first-class third-party components.
Is it possible to go even further?
Banks still need to store and manage financial contract lifecycle events, and this is where smart contracts can come in handy, as they are able to perform actions and functions based on various inputs and triggers. If they represent the legal obligations of financial contracts, they can perform their own life cycle events, such as settlements and interest payments.
As for banks, relieved of the need to manage complex back-office operations, they can focus on product development and customer relationships.
It is clear that the future of finance is open.
However, smart contracts also create new problems from a legal point of view. They are not subject to any particular jurisdiction and are not subject to interpretation.
What lawyers and engineers agree on is that blockchain will bring with it new opportunities. They also bring new business models and radical changes that can improve the processes faced by intermediaries.