Introduction
The modern financial era is characterised by technological innovation and has therefore changed the manner in which business is conducted whether in banking investment or insurance. One innovation that has received much attention within this space is smart contracts. Hailed as the future of financial services based on the blockchain revolution smart contracts promise to change the face of financial services through automation and simplification reduced reliance on gobetween the parties security and transparency.
This elaborate guide explores how smart contracts are used in finance the benefits they have bestowed the challenges they are facing and the future potential that this revolutionary technology may hold.
What are Smart Contracts?
A smart contract is a self enforceable contract whose terms of the agreement are written as lines of code directly into it. While traditional contracts rely on the enforcement and monitoring of intermediaries such as lawyers notaries and banks a smart contract is run on decentralised blockchain networks meaning that once predetermined conditions are met they will automatically enforce themselves.
Smart contracts were first conceptualised by computer scientist Nick Szabo way back in the mid1990s even before blockchain technology had been developed. Szabo envisioned a world with contracts instituted into computer codes and therefore enforced automatically bypassing human interference. Until blockchain came into the picture especially Ethereum smart contracts were not possible on a large scale.
Essential Characteristics of Smart Contracts
Self Execution
The contract automatically executes once the preprogrammed conditions are met
Immutable
After deployment it can’t be changed which implies that once terms are set they’re safe and tamper proof.
Distributed
Smart contracts run on decentralised blockchain networks meaning no single individual or organisation has control over them.
Transparent
All parties have access to the contract which increases trust and accountability.
Smart contracts take their place on a blockchain distributed ledger technology whereby transactions are recorded across multiple computers in a secure transparent and unmodifiable way.
How Do Smart Contracts Work in Finance?
Smart contracts in finance are applied to automate several processes that are hitherto considered to be traditionally dependent on intermediaries. Such contracts can now be applied to financial products and services trading lending insurance asset management and even governance.
Structure of Smart Contract in Finance
Smart contracts rely on three key elements such as
Digital Assets
The amount of monetary value being transferred or dealt with can be in money tokens securities or other financial assets.
Conditions
Predetermined rules governing when and how the assets are transferred.
Execution and Settlement
The actual movement or transfer of assets when the conditions of the contract are met.
It is the Ethereum blockchain that is most often used to deploy financial smart contracts however other blockchain platforms like Solana Binance Smart Chain and Hyperledger are also used nowadays.
Smart Contract Use Cases in Finance
Smart contracts are a way to transform some of the sectors of the financial industry completely. Some of the popular use cases include
Decentralised Finance (DeFi)
DeFi which is derived from a portmanteau of decentralised finance is a movement toward an open permissionless financial system using blockchain and smart contracts. It abolishes all the intermediaries and traditional banks by directly giving users access to the peer to peer dApps these were asset lending and borrowing systems and later assets could be freely traded and invested.
Lending and Borrowing
Lending and borrowing assets to earn interest or borrowing against the value of one’s holdings can be performed in smart contracts much like on Aave or Compound. These contracts determine collateral requirements interest rates and repayments.
Distributed Ledger Technology
Decentralised exchanges like Uniswap use smart contracts and have decentralised trading through a mechanism where users can trade assets directly without a centralised authority. The liquid pools and settlement of trade will be solely conducted by code with no intermediate parties.
Automated Settlement
In conventional finance even a simple transaction takes days to settle because the settlement process involves at least two middlemen usually clearinghouses and banks. Smart contracts settle practically immediately. Once preconditions are satisfied in the case of a transaction between two parties their deposits are deposited into the appropriate accounts and the transaction is performed.
Securities and Derivatives
Smart contracts can be applied to automate the issuance management and settlement of securities like stocks bonds and derivatives. For instance a derivative contract might be totally autonomous depending on the conditions that will trigger payments such as when the price of an underlying asset hits a certain threshold.
Insurance
Smart contracts in insurance can automate claim processing. For instance smart contracts can facilitate payout solely based on the occurrence of some specific conditions such as a natural disaster. This would omit tedious manual processes for claims reducing operational costs and fraud.
Asset Management and Tokenization
Traditional asset management relies on very complex structures in the management of assets and transaction processing. Smart contracts go an easier way by merely automating the portfolios and turning real assets such as property or art into digital tokens for use in exchange within a blockchain.
Benefits of Smart Contracts in Finance
Lower Costs
Smart contracts save costs related to transactions mainly because no intermediary such as banks brokers or clearinghouses is involved in the transaction due to the fact that contract conditions no longer require any third party to validate or enforce them.
Speed and Efficiency
Also the automation of smart contracts affects the carrying out of transactions at a faster settlement and execution time. Indeed it may take days for the banking system of traditional banking to settle while smart contracts take minutes or even a second. It is especially useful when time counts such as in securities trade or crossborder payments.
Transparency
Smart contracts operate on public blockchains so they are transparent. All participants have the same information therefore they cannot commit fraud or mislead one another. In finance for instance where trust is the basis the transparency created by smart contracts instils confidence between parties involved in the transaction.
Security
Smart contracts inherit security features of blockchain technology The data on the blockchain is immutable and distributed. Therefore no single party can alter or change the terms once they have been deployed. So fraud hacking etc. becomes almost impossible.
Trustless Execution
Smart contracts operate within a trustless environment this means parties do not have to rely on each other or a third party to guarantee contract enforcement. Their code ensures a contract is met on all terms in the agreement thus building a foundation of reliability and further eliminating conflicts.
Accessibility
Decentralized applications based on smart contracts are usually opensource and permissionless meaning that a person has to have an internet connection to access them. As such finance is democratized opening up this financial services gate to many more members of the population who otherwise would be barred from accessing traditional bank accounts.
Challenges and Limitations of Smart Contracts
Although smart contracts have strong advantages they do include some challenges that have to be met before smart contracts become popular.
Legal and Regulatory Uncertainty
Smart contracts are a litmus test in terms of regulatory clarification. Financial regulations vary extensively across jurisdictions and where smart contracts stand in the existing legal framework needs to be clarified. What happens for example when a contract is executed autonomously if a dispute arises? Who bears the blame in case things do go wrong? Governments and regulatory authorities still need help with these questions.
Self Executing in Smart Contracts
While smart contracts are termed to be self executing and autonomous their reliability is only as good as the code that governs them. Bugs or vulnerabilities in a code can wreak havoc locking money inside the contract or distributing it by malicious means. The high profile events and losses such as that of the DAO hacking in 2016 with millions of dollars going up in smoke because of a bug in a smart contract make code audits and security measures essential.
Immutability
Immutability is both a strength and a weakness of smart contracts. While there cannot be any modification in the contract terms one of its significant cons is that errors in the contract cannot be rectified easily. The chance of finding a mistake after launching the contract is highly remote hence a small mistake can only be corrected if another contract is released.
Scalability
While large scale use of smart contracts means scalability is a problem within blockchain networks especially Ethereum this increases network congestion at high levels. With network congestion transactions are more expensive and processing time becomes slower and even less viable for highfrequency or largescale financial applications.
Complexity in Coding Financial Products
Financial sectors are complex. To start with they have numerous regulations financial instruments and terms of contract. It is highly expertized work and once more requires careful planning to code all these intricacies into a smart contract. Indeed for more customized financial products benefits from automation might be smothered under this type of complexity.
Legacy System Integration
Most of the financial institutions are still working using older systems and infrastructure. These older systems and infrastructure require difficult and expensive integration when integrated with blockchain based smart contracts. It is also shown that handling contracts that span across both traditional and decentralized financial systems presents a difficulty.
Privacy Concerns
In finance which requires confidentiality and privacy revealing all the details of a contract on the public blockchain may become a threat to privacy. Solutions for some of these issues include zeroknowledge proofs and privacyfocused blockchain platforms which are being studied.
Future of Smart Contracts in Finance
Despite these and other challenges the future of smart contracts is promising in finance. A number of trends are currently emerging that may help overcome existing limitations and drive further adoption.
Layer 2 Solutions
Layer 2 should address the problem of scalability technologies like roll ups and side chains are also under development. These technologies roll off chain multiples of transactions or process those transactions in parallel to not overload the main blockchain and hence reduce the cost of a transaction. Scalability issues will also be addressed as Ethereum makes the transition to Proof of Stake and future upgrades like sharding.
Interoperability
The need for cross chain interoperability is increasing with the utilisation of smart contracts on multiple chains including Ethereum Solana and Binance Smart Chain. To make this possible Polkadot and Cosmos are developing a platform to enable smooth communication between blockchains so that smart contracts may run on various networks.
Regulatory Advance
Regulatory bodies worldwide are beginning to test the waters by introducing or proposing frameworks on blockchain technology and smart contracts. Europe is finally able to provide legal clarity to its citizens regarding digital assets and decentralized finance through the proposed MiCA regulation. In the United States the SEC and CFTC agencies have begun to explore how the existing laws apply to this smart contract and broader DeFi space.
As the regulatory landscape clarifies institutional adoption of smart contracts in finance may accelerate.
Tokenization of Real World Assets
Tokenizing realworld assets such as real estate commodities or intellectual property will be mainstream representing the asset as tokens on a blockchain with smart contracts governing the issuance transfer and settlement of the asset.
Artificial Intelligence and Smart Contracts
AI can be very significant in the inclusion of smart contracts. AI may enhance decision making by analysing conditions and automatically suggesting improvements for smart contract conditions. It will particularly be helpful in the dynamic financial environment where terms for contracts may require adjustments according to volatile circumstances.
Prospects of Smart Contracts
With deep penetration within the financial ecosystem smart contracts reach far beyond the horizon of financial services. Being a blockchainbased innovation though transforming banking lending and asset management smart contracts are at the cusp of making a huge difference in various other industries be it real estate healthcare or supply chain management. It sheds light on the wider implications of this technology in the exploration of smart contracts beyond finance.
Smart Contracts in the Real Estate Sector
Real estate is marred by inefficiencies longwinded processes and dependence on middle men like real estate agents lawyers and notaries. The transfer of property is usually quite complex and lengthy requiring contracts due diligence financial verification and transfers of title with associated voluminous documentation and expensive fees.
This will revolutionize this industry by automating most of these steps. Take for example a scenario where the entirety of the sale process is accomplished on the blockchainfrom listing all the way through to transfer of ownership. The smart contract would immediately transfer ownership of the property to the buyer when funds agreed upon are received with the transaction recorded immutably on the blockchain.
Benefits to Real Estate
Efficiency
Smart contracts can speed things up thereby saving time to consummate transactions.
Reduction in Costs
Intermediaries being kept at a minimum there would be substantial fee savings paid on transactions and litigation costs.
Increased Transparency and Trust
Since transactions would be recorded on a decentralised ledger parties to the transaction would easily verify the authenticity of property titles thereby discounting the risk of fraud.
Second tokenization and smart contracts might let smaller investors access more traditional markets for real estate which otherwise only large institutions or high networth individuals can participate in. In this way real estate investments become democratised.
Smart Contract in Healthcare
It would greatly benefit the healthcare industry with the automation security and transparency involved in the smart contracts. Health Related systems worldwide incur inefficiencies and high costs and lack interoperability between different actors within hospitals insurance companies and patients. Most of these processes can be streamlined by smart contracts when applied to health insurance claims patient data management and clinical trials.
Key Healthcare Applications
Health Insurance Claims
Under smart contracts claims processing can be automated for example by checking whether insurance conditions are met for instance coverage by a policy and medical documentation before payments are automatically released to recipients without any human involvement. This might significantly lower processing times and reduce errors and fraud.
Patient Data Management
Smart contracts will ensure secure storage and management of patient data with the buzz about privacy in health care. Patient information could be stored on a blockchain with the help of smart contracts. This would ensure that only a particular healthcare provider can access it if certain conditions are met thus ensuring privacy while allowing a fair amount of data sharing when needed among providers.
Clinical Trials
Data integrity and transparency issues complicate the clinical trial process. Smart contracts could manage the clinical trial data by automating data collection and ensuring that the participants information is kept confidential but accessible to authorised researchers. The data could be improved in their integrity and not tampered with.
Intellectual Property (IP) Management using Smart Contracts
Smart contracts could also be applied to intellectual property for the protection of creators artists and content developers rights. The digital environment has become increasingly exposed to unauthorised use and piracy and smart contracts will help ensure that content developers are rewarded for their work.
Digital content such as paintings music or writing can be filed on a blockchain and licensing agreements among others royalties can be enforced automatically by a smart contract. In such a case the smart contract can ensure immediate payment to the owner or creator upon the use reproduction or sale of content. This significantly reduces the time and effort that creators must expend to track and administrate their IP rights.
IP Management Benefits
Auto Royalties
The creators get paid automatically for the usage of their content minus the intermediary or publisher/agency.
Immutable Record of Ownership
Blockchain ensures the reduction of disputes over the rights of intellectual properties at a vast scale. Smart contracts allow creators to sell and licence work effortlessly with anyone around the globe without checking the legal system of their country.
Conclusion
With smart contracts much can be transformed such as the finance industry offering far speedier cheaper and more secure alternatives than traditional financial processes. The various uses of smart contracts are decentralised finance (DeFi) automated settlement insurance and asset management among others.
However regulatory uncertainty technical vulnerabilities and legacy systems integration will have to be addressed before smart contracts can come of age in the mainstream arena. Smart contracts could become a cornerstone component of the financial landscape of the future with ongoing technology improvements and adjusting legal frameworks.
