The financial services industry is rapidly evolving. The mass adoption of online banking, mobile payments, APPS and Application Programming Interfaces (APIs) has accelerated rapidly in the last five years.
The pandemic acted as a catalyst for change, speeding up digital transformation, altering customer behaviour, and increasing the focus on risk management and sustainability.
Challenger banks and digitally native new entrants who were unencumbered by legacy technology and powered by innovative thinking transformed how customers accessed services. The whole sector had to embrace technology to keep up.
Collaborating to innovate
As a result of this change, traditional lenders and new entrants have embraced collaboration and the use of trusted 3rd party suppliers and vendors as part of their operations. Benefits of this collaboration included rapid access to skills and specialisation, cost efficiencies, scalability and flexibility and access to cutting-edge technology and knowledge without the heavy investments in research and development, infrastructure, and resources.
From a partnership, new vendor or existing 3rd party supplier perspective, smart contracts have multiple benefits, not least monitoring the performance of service level agreements. Auto alerts can be triggered if performance falls below a pre-determined level. Lenders are also increasingly using smart contracts to support customer loan applications. In Decentralised Finance (DeFi), smart contracts are used with Distributed Ledger Technology (DLT), particularly in the peer-to-peer lending space, but that’s a blog for another day. So, let’s look at the fundamentals of a smart contract as it relates to supplier relationships.
Goodbye bureaucracy, hello hyper-efficiency
Contracts are evolving to serve this changing landscape. Smart contracts are self-executing when rules are met, with the terms of the agreement written into lines of code. They’re also tamper proof, as they’re powered by blockchain technology to provide a secure, transparent, and efficient alternative to conventional paper-based agreements. Smart contracts look to overcome the inherent problems of traditional contracts: these include manual processing and delays, lack of transparency, difficulties with tracking and verification, minimal system integration, increased intermediary reliance and a lack of compliance, something of utmost importance in an FCA-regulated and customer-focused environment.
Smart contracts look to address the bureaucratic problems of the past and offer many digital benefits in this increasingly collaborative post-pandemic world.
The super six, smart contract wins
- Enhanced efficiency and automation: A key advantage of smart contracts is their ability to automate contract execution and reduce the need for intermediaries while still being legally compliant. They can utilise self-executing code stored on a blockchain, effectively enforcing contractual obligations based on predefined conditions. This significantly reduces manual effort, paperwork, and processing time, leading to faster contract execution and settlement.
- Transparency and trust: Smart contracts run on distributed ledger technology, such as blockchain, which provides an immutable and transparent record of all contract-related transactions. This transparency enhances trust between parties, as the entire transaction history is publicly accessible and verifiable. Being immutable also reduces the risk of fraud or manipulation.
- Increased accuracy: Manual entry and interpretation errors are common in traditional contracts. Smart contracts, being self-executing and based on predefined code, remove human error as long as the initial code is set up correctly!
- Cost reduction: Traditional paper contracts are admin-heavy. With smart contracts, the need for intermediaries, legal professionals, and costly administration is reduced, increasing cost savings for all parties.
- Increased security: Smart contracts employ advanced cryptographic techniques to ensure the security and integrity of the contract data. Blockchain's decentralised nature makes it highly resistant to hacking and unauthorised alterations. The use of digital signatures further enhances security, providing authentication and ‘non-repudiation’, meaning it provides proof of the origin, authenticity and integrity of signatures. So, neither party can dispute the agreement.
- Improved accessibility: Smart contracts can potentially improve accessibility to financial services, especially for underserved populations. By leveraging blockchain technology, smart contracts can enable secure and low-cost financial transactions, removing barriers to access and supporting financial inclusion.
Mind the gap!
Of course, all new technology comes with inherent risks, especially for early adopters or movers. But as learnings are fed back into design in an iterative improvement loop, these should be significantly ironed out by the time they reach mass adoption.
The risky six, buyer beware:
- Code vulnerabilities: Smart contracts start with a human! So, any flaws or vulnerabilities in the human code can have serious consequences. Bugs, coding errors, or vulnerabilities in the smart contract's logic can lead to unintended behaviours or security breaches.
- Immutability and irreversibility: Once a smart contract is deployed on a blockchain, it becomes immutable, meaning it can’t be easily modified or reversed. This is both a benefit and a risk as an error or a dispute arises; it can be challenging to make changes to the contract.
- Legal and regulatory compliance: Legal and regulatory frameworks often don't move at the same pace as innovation. It's vital to ensure compliance with applicable laws and regulations to mitigate legal risks.
- Dependency on blockchain infrastructure: Smart contracts rely on blockchain infrastructure, and any weaknesses or vulnerabilities in the underlying blockchain technology can affect their functionality and security.
- Oracles and external data feeds: Smart contracts may need to interact with real-world data or external systems through oracles. Oracles provide input to the smart contracts, and their integrity and reliability are crucial to ensure a robust contract
- Lack of standardisation: The smart contract ecosystem is still evolving, so there needs to be more standardisation of programming languages, frameworks, and best practices. This can lead to inconsistencies, interoperability issues, and challenges when working with different smart contract platforms.
To mitigate these risks, it's essential to thoroughly plan, design, test, and audit smart contracts before deployment. In my next blog, I'll delve deeper into how to prepare for smart contracts within your business or as a response to a vendor request, so keep your eyes peeled!
So, who's using smart contracts?
Several financial services firms have recognised the potential of smart contracts and are actively exploring their implementation. These include:
- JPMorgan Chase has developed their own blockchain platform called Quorum, which enables the execution of smart contracts in a secure and scalable manner.
- AXA has been experimenting with smart contracts to streamline claims processing and automate insurance policies. They aim to leverage smart contracts to enhance transparency, reduce paperwork, and improve the efficiency of their insurance operations.
- Santander has explored the use of smart contracts for trade finance, enabling secure and automated processing of trade transactions.
Embracing contract evolution
As we embrace the increasing digitalisation of financial services, smart contracts could pave the way for more efficient, transparent, and secure contracts. By automating processes, enhancing transparency, reducing costs, and increasing security, smart contracts bring substantial benefits to all parties. It's true there are challenges to overcome, but I’ll be keeping a keen eye on developments and working closely with internal functions to understand how smart contracts can support our clients, enhance supplier relationships, and aid vendor collaboration.