Smart contracts, self-executing code that runs on blockchains like Ethereum, are poised to become a transformative force across the banking and financial services sector. By encoding complex contractual logic and workflows into auditable software, smart contracts unlock automation, speed and transparency benefits.
Leading banks have already begun exploring how smart contract applications can streamline processes, reduce costs and risks, improve compliance and enable new digitally-driven financial products. The technology represents a cornerstone capability for reshaping operations, customer experiences and business models as the industry undergoes unprecedented digital disruption.
We examine key opportunities emerging for leveraging smart contract technology across banking, along with implementation challenges that must still be overcome on the road to large-scale adoption.
Streamlining Back Office Functions
Many core bank back office capabilities spanning payments, custody, regulatory reporting and data reconciliation are prime candidates for automation using self-executing smart contracts. In particular, blockchain-based smart contracts can drastically improve efficiency and accuracy of interbank reconciliations.
“Smart contracts will have some of their biggest impacts streamlining post-trade processing and interbank information sharing,” said McKinsey in a report on the technology’s financial services impacts. “Self-executing contracts with inbuilt business logic can greatly reduce manual efforts and associated risks.”
By embedding key data, rules and settlement instructions into code, smart contracts remove the need for extraneous reconciliation steps between banks. This allows leveraging shared tamper-proof ledger data to automate confirmation and consensus on trade details, reducing errors and minutes taken compared to prevailing repetitive manual processes.
The Depository Trust & Clearing Corporation (DTCC) and Australia’s ASX are trialing blockchain infrastructure for netting and settling equities transactions in near real-time by formalizing post-trade lifecycles using smart contracts. Hyperledger’s Marco Polo trade finance consortium also uses smart contracts to synchronize trade data and automate contract execution between members.
Such efforts demonstrate smart contracts’ potential to collapse complex multi-party banking workflows into seamless end-to-end digital experiences. As blockchain-based networks expand across the interconnected financial system, smart contracts will increasingly “orchestrate the entire post-trade value chain” predicts McKinsey.
Transforming Customer Experiences
Smart contracts also create opportunities to simplify and enhance how customers experience common banking services from loans to insurance. Digital self-service journeys can be radically streamlined by embedding terms in executable code rather than legal prose.
For example, by representing credit agreements as smart contracts, loan origination and administration can be near-instant and fully automated. Applicants transparently see loan eligibility and terms upfront via the encoded scoring algorithms and interest rate logic. On approval, funds are automatically disbursed to the borrower’s account per the contract.
The borrower’s repayments are subsequently managed entirely programmatically based on the repayment schedule inscribed in the smart contract. This automation and transparency using smart contracts for standard lending reduces overheads and errors compared to manual loan fulfillment across disjointed legacy systems.
Insurance also stands to benefit through ‘parametric policies’ that pay claims triggered by data inputs to smart contracts rather than lengthy assessments. If an IoT weather sensor reports conditions breaching policy terms encoded in a smart contract, payouts instantly process via blockchain. This automation delivers efficiency gains and improves customer experience.
While still a developing area, smart contracts are similarly being explored to streamline historically document-heavy processes around account openings, payments, trade finance and identity verification using encrypted digital identifiers. By embedding compliance in code, onboarding can be near-instant with reduced risk.
“Any process requiring signatures, paperwork and reconciliation is ripe for smart contract transformation,” said Bob Reid, a Blockchain VP at Oracle. “We foresee embedded code replacing traditional contracts and paperwork across many banking processes and products.”
Improving Compliance and Security
Financial institutions spend an estimated $270 billion annually on compliance according to Accenture. This immense overhead results from ever more stringent and complex regulations that fragment data trails across legacy systems not designed for auditability.
By codifying regulations like identity verification rules directly into executable smart contracts, compliance can be enforced in real-time within banking processes themselves. Identitymind is one company providing KYC and AML smart contract templates for this purpose.
Similarly, loan origination policies and capital reserve requirements can be embedded in smart contracts that prevent transactions violating encoded regulatory logic. This prevents bad actions rather than trying to detect them after the fact, with all activity traceable on blockchain.
“Embedding compliance checks in business transactions through smart contract-based architectures dramatically reduces compliance risks,” said Nitin Gaur, Director of IBM’s Financial Sciences research lab.
Smart contracts also offer new options for managing permissioning and access control across banking systems. Roles, privileges and data governance policies can be implemented as unalterable code regulating user powers. This limits insider security risks and enforces segregation of duties.
“Smart contracts bring finance-grade identity, security, governance and compliance management to blockchain networks on which banks operate and transact,” noted blockchain identity firm Metaco. As banking processes and infrastructure decentralize, smart contracts will provide trust mechanisms.
Transforming Market Infrastructure
Looking beyond immediate operational improvements for incumbent institutions, smart contract capabilities offer longer-term potential to fundamentally transform market structures underpinning global finance.
Permissionless blockchains allow creating decentralized financial instruments, exchanges and intermediaries governed completely transparently via open smart contracts. Rather than banks, financial processes can be orchestrated collectively by networked participants.
Entrepreneur Naval Ravikant calls this possibility of radically disintermediating finance through blockchain protocols “the decentralized business model of the 21st century.”
Decentralized finance (DeFi) platforms have already used smart contracts to create alternatives to services from banking to asset trading, investment management and insurance outside traditional institutions. DeFi projects aim to rearchitect financial plumbing to be collectively accessible, transparent and programmable.
“We foresee a coming proliferation of open decentralized financial services replacing much of the backend infrastructure of traditional finance,” said Matteo Leibowitz, a Blockchain researcher at Stanford University. “This will be enabled by smart contract-powered inversion of closed systems.”
While still emerging, such open models point to a future of community-owned and operated market infrastructure that may redefine the role of today’s financial intermediaries. Smart contracts appear set to orchestrate this seismic transition.
Challenges to Address for Adoption
Despite promising applications, experts caution smart contracts remain an emerging technology with adoption challenges to overcome before reaching their transformative potential across banking.
A primary constraint is integrating smart contracts with existing core banking systems, many of which rely on outdated legacy infrastructure. Without exposing data and APIs for smart contracts to hook into, driving end-to-end process change is limited.
Banks also face technology and skills gaps implementing smart contracts given their novelty. “Integrating code-based contracts with existing IT environments is no small feat for those lacking blockchain experience,” cautions Gartner research director Fabio Chesini. Training developers on Ethereum and Solidity programming is essential.
Data quality and governance issues must also be addressed. Smart contracts are only as reliable as the external inputs they depend on. Connecting them to messy real-world data sources prone to gaps, ambiguities and errors risks unintended outcomes. Garbage in still means garbage out.
Many banks thus view smart contracts warily as an unproven bleeding edge technology. According to Accenture, 88% see adopting emerging technologies like blockchain as risky. Risk and compliance concerns are preventing many from accepting programmatic execution of sensitive functions.
Contract law also remains ambiguous concerning the standing of blockchain-based smart contracts. This creates uncertainty around recognition and enforceability until legislative frameworks catch up. Additionally, coding complex legal logic often requires compromise between precision and performance.
However proponents argue banking encapsulates ideal smart contract use cases where reduced contractual ambiguity benefits all parties. Standardization of data, processes and agreement terms within banking facilitates embedding logic reliably in code.
And computational enforceability of smart contracts represents progress. According to Professor Christopher D. Clack of University College London, “The certainty provided by smart contract execution may outweigh its inflexibility.”
Smart contracts are unlikely to blanket replace written legal agreements anytime soon. But their automation, transparency and auditability benefits make smart contracts a potentially profound advancement for streamlining many banking processes.
“Financial services companies across payments, insurance, lending and capital markets can benefit from judiciously applying smart contracts for their most rules-based, data-intensive activities,” advised McKinsey.
To this end, incumbent institutions must invest in modernizing legacy IT environments, upskilling technologists and collaborating with blockchain platform developers to harness smart contracts. They also need to help shape emerging legal frameworks recognizing digitized contractual architectures.
For their part, regulators must balance smart contract innovation opportunities with common sense controls against risks like coding errors and data dependencies gone awry. But overall, thoughtful adoption promises to unlock tremendous efficiency and experience gains.
Entirely new de-centralized financial rails built on smart contract foundations will also open universal access to financial services beyond traditional intermediaries. However the long-term societal impacts remain unpredictable.
In closing, smart contracts are a disruptive but promising technology innovation requiring careful governance to steer towards equitable outcomes. Financial institutions who quickly build capabilities today will be best positioned to lead rather than stagnate as the revolutionizing impacts of programmable agreements propagate through the economic system.