A Cost-Benefit Analysis of Using Smart Contracts in Banking

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A Cost-Benefit Analysis of Using Smart Contracts in Banking

Smart contracts are one of the most talked about new technologies in financial services today. Blockchain-based smart contracts can be used for two or more parties to electronically agree on terms and conditions of a contract involved in a financial transaction. In the case of banking and financial services, the applicability of smart contracts is very broad and ranges from issuing bonds to improving KYC processes as well as settling and clearing securities, among others.

The whitepaper published by the UK FinTech Network in cooperation with technology consulting company Zerado titled ‘Smart Contracts – From Ethereum to Potential Banking Use Cases’ discusses the potential use cases of smart contracts in banking as well as weighing both the costs and benefits of implementing this new technology in the financial industry.

The original definition of smart contracts dates back to 1994 when computer scientist Nick Szabo defined them as “a computerized transaction protocol that executes the terms of a contract. The general objectives 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. Related economic goals include lowering fraud loss, arbitrations and enforcement costs, and other transaction costs.” Despite this definition being over 20 years old, it hasn’t changed much since. The only difference is that through blockchain technology, smart contracts are now a reality.

A distributed ledger-based smart contract allows all parties in a transaction to agree to the terms and conditions of the transaction, including automated payments when certain conditions are met. The terms of the contract are written in a programming code and then the code is then used to define the rules and legal consequences in the same way a traditional legal document would. This includes obligations, benefits and legal penalties for all involved parties. This contract is then stored on an immutable ledger that all involved parties can view and if necessary audit, and requires no further input from any party. This is why smart contracts carry such big potential in the financial services industry where the need for fast, secure and transparent transactions is pressing.

The aim of smart contracts is to deliver superior security than traditional legal contracts and to reduce the administrative and transactional costs involved in legal transactions. While smart contracts will most likely not universally replace traditional legal contracts in the near future, they can reduce the burden, time and complexity of writing new legal documents for each new transaction as smart contracts can automate this process to a large degree.

Ethereum: the Leading Smart Contract Platform

The Ethereum blockchain was built to enable self-executing smart contracts and decentralized apps (DApps) to be developed for any industry or purpose. Ethereum is open source and decentralized and, therefore, allows any developer to use the technology to develop new solutions.

The financial industry has taken a substantial interest in Ethereum and as it stands Ethereum looks to become the standard smart contract technology the financial industry will end up using given the number of ethereum blockchain trials financial institutions are currently running.

Potential Benefits of Smart Contracts in Banking

Given the flexible and immutable nature of blockchain-based smart contracts, it is not difficult to see how the financial industry could benefit from their use. In the whitepaper published by the UK FinTech Network, four key smart contract use cases have been highlighted. They include mortgages, clearing and settlement, KYC, and bonds.

Financial institutions could potentially save a substantial amount of money by digitizing mortgages and utilizing smart contract technology to create and execute mortgage contracts. The entire mortgage process could be made much more efficient through automation and shared digital access to the required legal documents, such as title deeds and land registry records. These savings could then be passed onto the consumer who would benefit from better interest rates on their mortgages.

According to a Capgemini paper titled ‘Smart Contracts in Financial Services: Getting from Hype to Reality,’ “consumers could potentially expect savings of $480 to $960 per loan” and that financial institutions would be able to “cut costs in the range of $3 billion to $11 billion annually” by reducing processing costs in the origination process in the US and Europe.

The securities clearing and settlement process could made more efficient and cost-effective through the implementation of smart contracts as they “can take over the onerous administrative task of managing approvals between participants, calculating trade settlement amounts and then transferring the funds automatically once the transaction embedded within the smart contract has been verified and approved”, according to UK FinTech’s whitepaper.

The KYC (Know Your Customer) process could also greatly benefit from smart contracts implementation as smart contracts could replace the lengthy and document heavy onboarding process for new banking customers. The information of new customers could be cross-checked and verified against approved central records on a blockchain that permissioned third parties can access when needing to onboard new clients. This would also allow changes in customers’ information or circumstances to be automatically updated once verified by the network and, thereby, greatly reducing the time and resources need in the KYC process.

Another potential use case for smart contracts in banking is to create so-called “smart bonds”. Bonds could be digitized and created as smart contracts on the blockchain that pay out coupon payments automatically on each payment date to each investor. While bonds seem like a perfect for smart contract use case, there is the issue of how an issuer default would be handling and where the automated payments would come from if the company does not have enough liquidity to make them.

This leads us to the potential costs and challenges associated with smart contract implementation in banking.

Potential Costs of Smart Contracts in Banking

The potential problems of smart contracts in the financial services industry that the UK FinTech Network has identified in its whitepaper include inflexibility, contractual secrecy, and legal jurisdiction.

Once a smart contract is agreed upon and verified by the blockchain it can not be altered. This inflexibility prevents smart contracts from being amended, novated or terminated which are requirements that are necessary for financial transactions. Smart contracts would require similar provision to be useful as the contractual basis of a financial transaction.

The other challenge that smart contracts face is contractual secrecy. As smart contracts are visible by all involved parties in a transaction, the issue of confidentiality (especially related to pricing) would be an issue. This, however, could be addressed by implemented cryptographic structures that only allow certain parties to access certain information.

Probably the biggest challenge for smart contracts in banking is that there is currently no legal framework for smart contracts as this technology is so new. Hence, conflict resolution would be an issue as the legality of financial smart contracts is not yet recognized. Until smart contracts are legally recognized as bona fide legal contracts, they will most likely not be used in the financial industry.

Looking at the key challenges that smart contract technology faces in this industry, it is easy to see that while the cost reductions of using smart contracts will be high, the cost of implementing them in the first place will also be high.

Banks and other financial institutions will have to spend a substantial amount of money in developing new platforms and systems that allow for the use of smart contracts. That includes hiring the right staff and investing heavily in new systems.

Furthermore, financial institutions will need to hire more compliance and legal staff to work closely with both their systems developers as well as financial regulators and lawmakers to ensure smart contracts are in line with regulations and legal requirements.

While the long-term trajectory speaks for mass implementation of smart contracts in banking, there are still several hurdles that need to be overcome before widespread adoption of this new technology will take place. This will involve educating businesses, regulators, and lawmakers on the possible uses and benefits of smart contracts in the financial sector.