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Smart Contracts - A revolution in the Financial industry

Contracts vs. Smart Contracts

Smart Contracts are going to revolutionize many industries, and notably financial services. Currently, much of the underpinnings behind plain vanilla financial transactions boil down to repetitively processing excessively mundane tasks. We shell out huge fees for middlemen to coordinate with each other and process sequences of logical statements in the pseudocode traditionally known as law. What if we could replace all this waste with simple computerized tasks that automate the communication and bookkeeping?

More generally, what if we could avoid errors, delays, frauds, disputes and misunderstandings in the execution of contracts? What if we could replace antiquated physical contracts execution to fit with the digital world of real time commerce?

Well, today we can and the technology is known as Smart Contracts.


The genesis of the technology

In 1997, Nick Szabo came out with the idea of Smart Contracts. He gave a definition of Smart Contracts based on a simple idea:

Smart Contract: A set of promises, including protocols within which the parties perform on the other promises. The protocols are usually implemented with programs on a computer network, or in other forms of digital electronics, thus these contracts are “smarter” than their paper-based ancestors.

In simple terms, a Smart Contract is a program that captures all the obligations of legal contracts and executes them automatically if predetermined events occur. Smart Contracts have then no vocation to replace existing legal contracts, but simply make their executions much more efficient.


Smart Contracts and distributed ledger technologies

If the idea of Smart Contracts was theorized back in the 1990’s, they have lacked ever since from an underlying technology. The development of distributed ledger technologies have enabled Smart Contracts to move from conceptual theory to the business world. By being deployed on distributed ledgers, Smart Contracts provide the security, transparency and immutability their theory requires.


Which practical applications are ideally suited for these programs?

As explained above, Smart Contracts particularly fit the needs of the Financial industry and notably the Investment Banking and Retail Banking sectors. For example, Smart Contracts could strongly reduce the settlement and clearing time for trading transactions. Indeed, the security and immutability of Smart Contracts deployed on distributed ledgers combined with the automated reconciliation enabled by these programs would eliminate the need for third parties to authenticate and settle transactions, considerably decreasing the costs and time of settlement and clearing of transactions.

But as Capgemini points out in a recent research report on the subject, the scope of application is much wider and notably includes: Insurance, Internet of Things and Regulatory Technology.


The DAO hack: are these programs secure?

You might have heard about the DAO hack that took place in June 2016 and hit the headlines. Let’s try to understand what happened.

A decentralized investment fund was created by slock.it, based on Ethereum distributed ledger (see Blog Post #6 - Who are the major providers of Distributed Ledgers Technologies?) and its underlying programming language: Solidity. This fund was a Decentralized Autonomous Organization, an organization without centralized control, and was built on Smart Contracts to automate organizational governance and decision-making. It raised up to $150m.

A “hacker” found flaws in the Smart Contract code of this DAO enabling him to drain about $50m.

But could we consider this as real hacking? If the morality of the action can be discussed, one thing is certain: there was a mistake in the program and the hacker took advantage of it. That enunciates the fact that Smart Contracts are only as secure and efficient as their underlying code.