Smart Contracts: Unlocking the power of blockchain technology
Alongside the meteoric rise in interest in Distributed Ledger Technology (DLT, “blockchain”) across the financial services industry, another term has entered the financial lexicon: smart contracts. The timing is not coincidental; DLT and smart contracts are inextricably linked. Smart contracts are essential to realising many of the benefits promised by DLT, whilst in turn depending on DLT’s consensus-generating capabilities.
A previous blog in our blockchain series described how distributed ledgers enable sharing of data between parties in a network. Smart contracts extend this idea to the sharing of rules that govern how such data is updated, specifically in the context of agreements between parties. By defining these rules in computer code, such agreements can be made executable on an automated basis.
In a financial context, smart contracts may range from executing simple, one-time transactions, to complex sequences of transactions over time (e.g. the cash flows of an interest rate swap). There is even potential to integrate other business processes, such as internal cash management, liquidity & risk management, or regulatory reporting, into their workflow. Requirements to perform complex operations, as well as interface with external systems (e.g. market data providers) for additional data, could see smart contracts becoming sophisticated pieces of software in their own right.
Such automation would give smart contracts numerous benefits:
- Operational efficiencies from reduced manual effort, both in the execution process and subsequent reconciliation of outputs with other counterparties;
- Reduced risk from the increased level of automation and repeatability;
- Increased innovation from the potential for a modular approach (see below) to developing new financial products.
In most meaningful use cases, smart contracts take on legal significance, with execution resulting in digital transfer of ownership of assets. It therefore becomes vital to keep relevant parties aligned on both terms of each contract, and the outcome (i.e. who owns what, when). This is the essential function of distributed ledger solutions, and the reason smart contracts are being explored in parallel with DLT.
The last few years have seen great strides in developing smart contract technology. The Ethereum Project, in particular, has shown how contract code can be stored on a blockchain, enforced and validated on a distributed basis. Now other platforms, such as Corda, are developing focused interpretations of the concept for financial services: frameworks for managing financial instruments in coded form.
The most bullish proponents of smart contracts predict that this will eventually see code replacing legal prose as the legally binding language of business agreements. However, from our work with legal experts in this area, it seems a remote prospect for now. Achieving legally-robust code quality remains a major issue, as does “deterministic” execution: code that behaves differently on different machines, or when run at different times, could lead to conflicts that critically undermine trust in the system.
Despite this, making smart contracts legally enforceable is seen as a priority for industry-wide implementations. At present, the most promising approaches look to package a contract’s legal prose and code in a way that aligns their parameters and minimises potential for discrepancies between them. Modularisation is emerging as a key principle: starting with simple building blocks for smart contracts, which can then be used to synthesise more complex agreements. This, alongside other forms of standardisation, should enable repeatable use of well-tested code, vital for smart contracts to deliver business benefit.
For the time being, much of the detail remains to be resolved in order for real industry traction to be achieved, namely a critical mass of market participants, trading real assets. Interoperability (also described in our last blog) may turn out to be the key to this. If third parties such as Murex or SWIFT are able to integrate their solutions with a smart contract framework, it may provide the much-needed bridge the industry is waiting for: one between the incumbent systems of today, and the blockchain-enabled infrastructure of tomorrow.