What Are Smart Contracts and How Do They Apply to FinTech?
Smart contracts. As one of the most hyped words being thrown around by blockchain developers and FinTech engineers, it combines two simple concepts into one surprisingly complex and powerful idea.
Ask any Ethereum enthusiast about smart contracts and you’ll get an excited — if sometimes vague — answer. Some will say it can automate financial transactions, others will say it allows individuals to level the playing field with financial institutions.
Some will also say it decentralizes the authority of contract law while allowing people to enter with absolute trust into agreements with one another, even across continent-wide distances.
The truth is that this technology willdo all of those things, and the world’s most ambitious developers are creating sophisticated platforms expressly for all the purposes listed above.
But what exactly is a smart contract? Let’s break down the term and dive into a deeper understanding of one of the FinTech world’s most provocative technologies.
What Are Smart Contracts?
A smart contract is a self-executing computer code that is publicly viewable, tamper-proof, and guaranteed to execute in a predictable manner. The term itself is controversial, but it conjures up a rough idea of what smart contract technology is capable of.
The “smart” in smart contracts represents the same great leap forward that it meant when the term “smartphone” was invented. Devices that once barely fit in briefcases now offer the sum total of all available human knowledge in the palm of a user’s hand.
And the “contract” part seems uncomplicated at first. While the idea behind contracts is at least as old as Plato’s “The Laws”, the modern contract is a surprisingly recent phenomenon.
Smart contracts represent a completely different way of approaching contracts. Instead of having two parties sign duplicate copies of a paper agreement and mutually threaten one another with legal action if the other side doesn’t comply, smart contracts ensure compliance using blockchain technology.
In other words, once you “sign” a smart contract, there is no going back on your agreement. The computer code that implements the contract will always execute the way it is programmed, and the result is a new way for public and private agreements to be made between individuals, organizations, and even governments.
How Do Smart Contracts Actually Work?
There is no exaggeration in the claim that smart contracts carry the potential to completely revolutionize nearly every aspect of commerce, industry, finance, and law. The way this technology works is what makes it such a versatile arbiter of trust.
Consider two parties who agree to the terms of a transaction and create a smart contract to fulfill that transaction. The contract itself would live on a public blockchain that guarantees both its authenticity and its execution. Each party would use private cryptographic keys as a digital signature.
Blockchain technology ensures the authenticity of the contract by copying it to a large number of computers on a network. Every device on that network acts as an automatic witness to the contract — much in the way a notary public works.
The smart contract would essentially tell all of the devices on the node to look for evidence that the contract’s terms were fulfilled. They could look at a third-party data provider (called an oracle) that indicates when an event has occurred, such as a payment being made, or an item being shipped.
Key Features of Smart Contracts
At first glance, it seems like smart contracts are not fundamentally different than other computer programs. They simply apply conditional logic to integrated systems like bank accounts, stock tickers, commercial databases, and other complex systems.
The reason why smart contracts represent such an innovation is because they solve the problem of trust in conditional transactions. By decentralizing the verification of contract terms, they make it almost impossible for contractual partners to deceive one another.
The potential applications of smart contracts are nearly limitless. In order to narrow down the definition, it’s useful to define them by the three main features all smart contracts must share:
- Digital Signatures. Each party to a smart contract verifies their participation in the contract using a cryptographic digital signature.
- Oracles. Mutually agreed-upon data sources inform the logic of the contract. Both parties rely on something to indicate whether the contract is to be fulfilled or not.
- Self-Execution. When the right conditions are met, the contract is capable of automatically fulfilling itself without requiring any further action on either party’s behalf.
These capabilities are what make blockchain platforms and cryptocurrencies like Ether so attractive. By assessing smart contracts through a trusted, decentralized digital source, individuals can transact nearly anything of value — from money to actions or even bets — without worrying about whether the other party will hold its end of the deal.
Sila supports smart contract-based systems in a few ways:
1. The Sila application program interfaces (APIs) provide an easy way to integrate real world payment systems such as the automated clearing house (ACH). Most pineapple farmers are not going to have Ethereum addresses or hold cryptocurrencies such as Ether. The ability to integrate the Sila APIs and use them for debiting and crediting bank accounts via ACH makes it vastly easier to roll out a smart contract-based system to a mass-market audience.
2. Most financial applications have regulatory requirements to know your customer (KYC) and screen them against regulatory watch-lists such as the Office of Foreign Assets Control (OFAC) Specially Designated Nationals (SDN) list. Sila’s APIs take care of all of this for customers.
3. The high volatility of crypto-currencies such as Ether makes it impossible to use them as a substitute for money. By providing a stable token that is pegged to the dollar and guaranteed to be stable and redeemable in all market conditions, smart contracts can be used in many more money-like use cases.
Smart Contracts in Fintech
Stored procedures, immutable code, or whatever you want to call them — the potential for remaking the world of financial contracts is clear. What is less understood is how smart contracts can be used in FinTech application development.
Let’s consider the case of a hypothetical insurtech startup that wants to offer weather insurance to pineapple farmers. The startup could build a system that utilizes traditional rails — using ACH to debit the customer’s bank account, specifying when it would pay in a legal contract, and leaving it up to farmers to file claims in the event of bad weather.
Alternatively, it could encapsulate much of the insurance logic in a smart contract on Ethereum. The smart contract would debit a farmer’s Ethereum address on a regular basis to collect payments, rely on a trusted oracle to report the weather, and automatically initiate payouts to farmers when the appropriate weather event is reported by the oracle. As noted by the Commodity Futures Trading Commission (CFTC), building such a system on a smart contract has several benefits:
- Standardization: Standardized code and execution may reduce costs of negotiations and agreements.
- Security: Transactions are encrypted and stored on a distributed ledger intended to be immutable.
- Economy and Speed:Automation reduces transaction times and
unnecessary manual processes.
- Certainty: Well-designed smart contracts execute automatically thereby reducing counterparty risk and settlement risk.
- Innovation: Automating flow of digital assets and payments may foster new products and business models. Specifically in this scenario, it is easy to tweak the code and create new versions of the contract that enable daily payments rather than weekly or monthly, for example.
- Regulatory Innovation: Built-in regulatory compliance (e.g., cannot sell to a non-Eligible Contract Participant (ECP); cannot sell until mandated period has passed; or must report certain data). Also, new regulatory reporting models (e.g., smart contracts automatically report data at predetermined intervals) and stress testing built into smart contracts and regulatory nodes (e.g., execute scenarios on smart contracts to determine payouts across the network).
Smart contracts are still proving their value in the FinTech world but their validity is becoming more and more apparent. It’s exciting to watch as this new form of agreement improves the accuracy and verification of worldwide transactions.
Sila provides Banking and Payments Infrastructure-as-a-Service for teams building the next generation of financial products and services. Our banking API replaces the need for integrating with legacy financial institutions saving you months of development time and thousands in legal and regulatory expenses.
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