The potential of smart contracts in banking4 min read . Updated: 23 Nov 2017, 01:34 AM IST
Based on blockchain technology, smart contracts can make banking more secure and frictionless
On the one hand, bitcoin continues to elicit polarizing views from the banking and finance industry. On the other, the technology underpinning bitcoin—blockchain—is gaining mainstream acceptance. Bankchain is a consortium of 27 banks (22 of them are Indian) of which the State Bank of India (SBI) was the first Indian member. It is working to devise blockchain-based solutions for banking and, along with the SBI, planning to launch a beta program to use smart contracts next month.
It is difficult to appreciate the excitement surrounding blockchain and smart contracts without an understanding of the vacuum that these technologies seek to fill.
In late 2008, an unknown person (or group) named Satoshi Nakamoto created a crypto-currency, bitcoin, whose novelty consists in the fact that its operations are authorized without any trusted third-party carrying out administrative or security tasks, thus minimizing the transaction fees eventually weighing on users and considerably reducing the time for processing the operations.
Centralized networks rely on one or more trusted bodies (for example, banks) to keep a detailed record of transactions and update users’ balance. Bitcoin, on the other hand, decentralizes the administrative activity and lets “miners" process the transactions carried out in the system. The transparency, accessibility and stability of the transactions’ record are ensured by the public broadcasting of the operations throughout the nodes of the network (the computers running the software) and their subsequent addition to a shared database containing the complete transaction history for any given bitcoin. This shared ledger is called the “blockchain", i.e the sequence of all the verified “blocks" of transactions, recorded chronologically—timestamped—one after the other.
Just as bitcoin uses the blockchain to maintain a ledger of a crypto-currency, the blockchain can be used to keep track of the ownership of any asset or data that can be digitized and represented by computer code. Once the asset is on blockchain, users can compose smart contracts that contain the terms of the agreement, and automatically execute them once certain predetermined conditions are satisfied. They roughly follow the scheme of an “if-then" function. For example, if the smart contract relates to the acquisition of an intellectual property right licence, Party A creates a smart contract to which the licence X is permanently attached, programming that X is to be released upon certain conditions Y, and launches it into a blockchain. Whenever Party B wishes to obtain the information/licence, they transfer consideration y to the protocol. Automatically, the smart contract algorithm releases X to party B and delivers Y to Party A, eliminating delays and room for non-compliance: once the obligation is fulfilled on the one side (Y), the computer protocol autonomously performs the other side of the agreement (X). Similarly, smart contracts can be programmed to take into account external inputs from trustworthy sources. For example, the computer protocol might be programmed to pay the seller once the goods reach the buyer, verified by the signature of the receiver.
Traditional contracts are always subject to a degree of uncertainty with respect to their final outcome. Smart contracts, on the other hand, leave no room for voluntary breaches of the agreement. By entrusting the network with the performance of the agreed terms, they reduce the likelihood of expensive and time-consuming disputes.
But smart contracts on a decentralized, “permission-less" blockchain like bitcoin don’t allow any meddling by third parties. This is because in a permission-less system, any computer can join as a node to run the code and amending the leger will require access to all the nodes. Banks are uncomfortable with losing control of the system and they prefer “permissioned" blockchains like Bankchain. Bankchain restricts the access to nodes to other banks, while individual customers can join as users after complying with know your customer (KYC) norms. Pre-selected nodes allow banks to intervene between transactions, providing the ‘emergency entry’ into the system whenever interventions are deemed appropriate.
While the SBI has not clarified what applications they will have for smart contracts, there are many potential uses. For example, currently each bank carries out its own KYC process. This can be done by one bank and securely uploaded on the blockchain, thereafter shared with the other banks once the trigger is generated by the customer. Smart contracts can automatically release insurance payments for verifiable claims like delayed flights, motor accidents or death. This would involve bringing authorized third parties like hospitals and garages to join a single platform with insurers and the insured, and bring process efficiencies. Most securities have settlement delays of two days or longer that can be brought down to minutes, which will also reduce working capital requirements for collateral. Other applications include crowdfunding for small businesses, enabling the trading of tokenized equity shares and settlement of syndicated loans between banks.
While permissioned blockchains bring many benefits of a decentralized network, they compromise on the promise of immutability by limiting the nodes in the system. The unlimited nodes in bitcoin make it tamperproof while pre-selected nodes in a permissioned blockchain allow authorities to intervene between transactions and expose the points of vulnerability. It remains to be seen whether banks can provide the same level of data integrity that is guaranteed by permission-less blockchains like bitcoin.
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