This is a guest post written by Shannon Flynn, managing editor at ReHack.com.
People in the fintech industry have inevitably heard about smart contracts. Here’s how they’re shaping the sector and why some parties may ultimately decide not to adopt them yet.
How do smart contracts tie into the rise of decentralized finance?
Anyone who asks a search engine “What is a smart contract?” will quickly discover it’s a computer code on the decentralized digital ledger system called the blockchain.
Entities ranging from utility to health insurance companies are investigating how smart contracts could help them do business while keeping information safe. Their increasing popularity helped spark the creation of the decentralized finance sector — DeFi for short.
A person located anywhere in the world could access a DeFi account with an internet connection. They can then carry out transactions typically associated with banks without going through those entities or intermediary influences.
Estimates say there are about a billion dollars connected to the DeFi industry now. That’s a relatively small amount compared to centralized finance, but DeFi is worth people’s attention. It offers new opportunities to invest, borrow, and lend, appealing to parties unhappy with traditional investment options. Some DeFi companies using smart contracts let individuals earn cryptocurrency tokens redeemable for platform governance rights.
What’s happening with smart contracts so far?
You can think of smart contracts as business rules translated into software since they work on an if-then basis. One required action triggers a related event. The parties involved set the parameters, and the smart contract automatically upholds them.
In one trial, Spanish banks investigated using smart contracts to administer instant credit transfers. The company that assisted with the rollout clarified the system could work for sending money for any reason.
Similarly, in Singapore, financial authorities recently completed the fifth phase of an initiative called Project Ubin by examining blockchain-based options across a multicurrency payments network. Real-world tests validated smart contracts for various arrangements, including conditional payments and escrow for trade.
IBM announced an upgrade to its smart contracts offering, too. It allows multiple parties to propose and amend alterations to existing smart contracts instead of only accepting or denying others’ proposals.
How do smart contracts work when used with property purchases or loans?
People in the fintech industry often encounter individuals who need business loans or want to take out mortgages for their dream homes. Research indicates about 83% of people are slightly or not at all familiar with cryptocurrencies. Education could show them that smart contracts and related technologies ease the stress of milestone transactions.
Increased speed is one smart contract benefit. However, advantages span beyond the initial signing of paperwork. Once a person’s loan gets approved, they could use an encrypted key to sign the offer, and their signature becomes a unique blockchain entry. Funding and property title transfers also become entries on the ledger. Mortgage approvals and loan term agreements take days, not months.
Smart contracts and the blockchain can help mortgage servicers track borrowers’ payments, too. Plus, if a homeowner wants to refinance a mortgage or sell their property, the blockchain records for the duration of the smart contract to confirm ownership.
What other benefits exist?
Ironing out financial agreements with smart contracts could also make good cost sense. One company offering smart contract-based mortgages in California and New York plans to offer lower rates than banks, and customers may get loans packaged together and sold as securities.
Some analysts think smart contracts could help the economy stave off a recession, preventing prolonged challenges in the housing market. Each intermediary that finalizes a home-buying process adds 1% to 2% of the total property value to the transaction costs, statistics show. Smart contract automation can reduce third-party involvement, cutting costs and delays.
Efforts to use smart contracts could close the gap between investors and investment managers as well. An investment manager might initiate a smart contract that carries out a client’s wishes and avoids missed opportunities.
Several companies are investigating smart contracts to facilitate vacation rentals at lower-than-average rates. They believe the smart contracts would settle disputes faster and facilitate speedier cross-border payments.
What are the downsides of smart contracts?
Smart contracts aren’t without potential faults. One investigation showed that 25% of smart contracts studied contained critical bugs, with 60% having at least one security flaw.
Moreover, these contracts are only as “smart” as the programmers creating them. The code cannot recognize and bypass mistakes. Although errors could be less frequent than traditional contracts — especially with experienced, meticulous developers — the possibility remains.
A World Bank examination of smart contracts concluded they’re not always the best choice for every scenario. One example was that they could lower the cost of providing insurance and perhaps automate payouts. However, if used with short-term unsecured loans, smart contracts would not significantly improve a borrower’s creditworthiness.
Not all analysts agree that the benefits of smart contracts surpass those associated with conventional ones. They see them as an interesting idea that works best in the experimental realm instead of the real world. Smart contracts are still relatively rare, too. People in fintech and other industries may balk at using them since they’re newer and could introduce unforeseen issues. That could change if overall adoption rates rise, however.
Food for thought in fintech
This overview introduces how smart contracts work and proposes appealing ways to use them in the financial sector. Given the associated limitations, you may still have some unanswered questions, and that’s okay. The ideal approach is to view smart contracts as options that could positively change the industry but are not problem-free.
Shannon Flynn is a technology and culture writer with two plus years of experience writing about consumer trends and tech news.