Today, I want to discuss smart contracts. While the subject is a little far from traditional banking, smart contracts are essential to understand, especially with the rapid developments in cryptocurrency and blockchain technology. Smart contracts are closely connected to these concepts.
It seems like we add the word “smart” to everything these days—smartphones, smart fridges, smart devices—and generally, it means the addition of some technology to enhance functionality. However, smart contracts are distinct from these.
A smart contract is a contract that translates the terms of a traditional contract into self-executing code. For instance, a program might track interest rates, digital currency fluctuations, or completed transactions in cryptocurrency. When a specific event occurs, such as a transaction, the smart contract triggers subsequent actions automatically—often involving cryptocurrency or updates to a blockchain ledger.
Smart contracts remove the human element from transactions, making them self-executing.
WHY USE SMART CONTRACTS?
Smart contracts remove the human element from transactions, making them self-executing. This means you’re not waiting on someone to manually approve or process actions, like wiring or ACH transfers, or spending time reviewing contracts, documents, and signatures.
Smart contracts also prevent common practices, such as companies intentionally delaying payments to extend their payables timeline as a form of financing. As long as the transactions can be executed digitally, the code ensures that everything happens automatically and on time, without the need for manual intervention. This practice is often used in cryptocurrency and blockchain, where the transactions are digital, and can be tied to executable computer code.
ARE SMART CONTRACTS ENFORCEABLE?
Yes, they can be, but they must follow traditional contract principles. For a valid contract, there needs to be an offer from one party and acceptance by the other, meaning both parties must reach a meeting of the minds—a mutual understanding of the agreement. This means you can’t just write some code, have someone click an “I agree” button, and assume it’s enforceable. Even if the smart contract executes automatically, the involved parties might later dispute the agreement, arguing it doesn’t reflect their original intent.
Disputes or lawsuits could arise if one party claims, “This isn’t what we agreed to.” Enforcing a smart contract can also be complicated if the counterparty is located in another country or operates anonymously through blockchain. These factors make it challenging to identify the other party or resolve disputes through legal channels.
Another important element of any contract is consideration—an exchange of goods, services, money, or promises. For a smart contract to be valid, it must incorporate these elements. This can be straightforward, like exchanging $5 for an ice cream cone. Many smart contracts may involve similarly simple transactions, but the same principles must apply regardless of the medium.
USE CASES FOR SMART CONTRACTS
Smart contracts are particularly useful in hedging and digital currencies. A key example is flash loan transactions, where both borrowing and repayment occur almost instantaneously—faster than a human could input data into a computer. These contracts are valuable in hedging scenarios, where the goal is to minimize counterparty risk.
For instance, with a traditional interest rate hedge on a loan, a human typically determines cash transfers between the two parties at specific intervals. However, with a smart contract, these processes can be programmed into code, ensuring automatic execution. While smart contracts speed up transactions and remove human discretion, they aren’t infallible since they rely on data inputs, which can be manipulated.
SMART CONTRACT LIMITATIONS
Smart contracts have inherent limitations, particularly in handling complex transactions. Since they rely on computer programming, a developer must anticipate every possible scenario that could occur between the parties. While this works well for simple, well-defined transactions, it becomes much harder for more complex agreements.
In traditional contracts, much of an attorney’s role involves thinking through various possibilities and identifying key issues that need to be addressed. In complicated transactions, some aspects of performance are intentionally left to the discretion of the parties, since it’s impossible to predict every situation that might arise. Additionally, some tasks may require human judgment and adaptation over time, which smart contracts can’t replicate.
These limitations mean that smart contracts may struggle to account for unforeseen events or evolving needs between the parties, making them less suitable for agreements that require flexibility or subjective decision-making.
EXAMPLE OF USE
Smart contracts will likely remain prevalent in cryptocurrency and blockchain transactions, especially where the sequence of events needs to be predictable. A notable example is Siemens, a large multinational company, which issued bonds using blockchain-based smart contracts both this year and last year. By leveraging blockchain technology, Siemens managed to compress the bond settlement process from days or weeks to just minutes. This innovation not only accelerated the process but also reduced settlement risk, ensuring that funds were transferred promptly to fund the bond issuance.
This demonstrates the strong potential of smart contracts for speeding up transactions and minimizing risk, particularly in financial operations that require precise, automated execution.
FUTURE OF SMART CONTRACTS
Smart contracts offer exciting possibilities, but they also come with limitations. One idea gaining attention is tying land titles to a blockchain, which could allow smart contracts to automate property transfers. While this is theoretically possible, there are significant challenges.
Whether dealing with real estate or personal property titles, questions arise about how accurately a blockchain-based title can reflect ownership of a physical asset. This is particularly complex for land titles, which often involve multiple layers of ownership and rights. A single parcel of land could be subdivided into several lots with different owners. Additionally, rights such as easements or time-based ownership could be granted to multiple parties at various points. Ownership may change hands over time, and rights may overlap or shift.
The challenge lies in ensuring that a blockchain-based title accounts for all these nuances. It must reflect every aspect of conveyance, from dividing parcels to assigning easements, to ensure the smart contract accurately represents the true legal title being transferred. This complexity can feel overwhelming, especially when considering how many potential scenarios must be addressed.
These issues also apply to personal property titles. Since smart contracts rely on the digital representation of titles and rights, there are inherent difficulties in connecting the blockchain-based title to the physical good it represents.
However, smart contracts work well with digital currencies and simpler assets that are easier to digitize and track on a blockchain. This makes smart contracts a valuable tool for automating transactions in these areas. While this topic may feel distant from the concerns of many banking clients, it’s important to stay informed about developments in blockchain technology.
Over time, blockchain’s influence on mainstream banking will likely grow. Understanding how counterparties operate and identifying risks associated with their activities will be essential. Though many in the banking world remain cautious about cryptocurrency, and often for good reason, banks will need to engage with these technologies to some degree. At the very least, they must track the source of funds and assess risks associated with their clients’ operations to manage their exposure effectively.
CONCLUSION
In summary, while blockchain-based smart contracts offer opportunities, they also require careful management of the risks involved. I hope you enjoyed the discussion! We always welcome input from our clients regarding questions or topics of interest in the industry. Please feel free to reach out if you have a specific request for something you’d like us to cover.
Farley Law specializes in working with both community banks and small businesses. If you are interested in learning more about these or any other income-generating activities for banks, please feel free to contact us at Farley Law, where we help our client financial institutions develop new products and financial services. Have a question or a comment? Send us a note at business@farleylawpllc.com, or set up an introductory call using our bookings service.