Whether it is due to layers of middlemen or archaic practices, consumers and businesses suffer from unnecessarily high transaction costs in a wide range of legacy businesses, from insurance sales to home buying to international wire transfers.
But what if there was a technology that could help reduce this complexity, potentially removing layers of middlemen and vastly improving the customer experience? One solution that is getting a lot of traction is the use of smart contracts based on blockchain technology.
The Power of Smart Contracts
Smart contracts originated in the 1990s, when cryptographer Nick Szabo saw the opportunity to turn a contract as a set of promises into an algorithm. To begin, the contract terms are turned into a series of if/then code functions. Once a condition is met, the smart contract takes the next step necessary to execute the contract. However, smart contracts only really became practical with the recent development of blockchain technology and the need to create a format to facilitate business transactions.
One of primary benefits of a smart contract is the speed with which business transactions can be enabled. By building smart contracts into existing processes that might include multiple intermediaries and discrete tasks, businesses can improve existing services as well as create new products or services.
For example, in the insurance industry, certain policy agreements could be automated. A smart contract for travel insurance can be automatically triggered once a flight is cancelled. Once the cancellation is posted, the smart contract makes a payment directly to the policyholder, thereby bypassing the claims process. In manufacturing, smart contracts may replace current supply-chain processes such as bills of lading, proof of origin or quality control.
According to Capgemini Consulting, the deployment of smart contacts can provide real value savings to businesses. In its report on financial services, it estimated that smart contracts could reduce settlement times of leveraged loans from 20 days to six days, which would allow the lending industry to generate an additional $149 billion leveraged loan volume growth. Meanwhile, U.S. banks would be able to cut up to $6 billion from their back-office costs of initiating a home mortgage.
However, smart contracts do have considerable limitations, primarily due to security and scalability. Perhaps the most famous security issue was the hack that enabled $150 million of funds stolen from the Decentralized Autonomous Organization (DAO). The security vulnerability was not in the blockchain platform but rather in the smart contract. According to Gartner, Ethereum “had done exactly what it was supposed to do, but a loophole in the smart contract code exposed the organization to a hack.”
Despite these challenges, the expectation is that smart contracts will start off addressing standardized and explicit agreements. Gartner estimated that by 2022, ratified unbundled (that is, defined impact) smart contracts will be in use by more than 25 percent of global organizations. Here, “unbundled means closely defined and with narrow impact, rather than complex nested contracts where the outcome permutations become nearly impossible to test.”
Putting Theory Into Practice
For a company wanting to optimize their legal agreements, there are a number of companies building solutions that use smart contacts to cut back on legal costs and processing time.
Smart Contract, a San Francisco-based startup, has created middleware technology to link smart contracts to third-party data and processing libraries (e.g., Wells Fargo’s banking API). This simplifies the ability of developers to create smart contracts that can reduce processing times, for example, confirming a payment is received at Wells Fargo as an automatic trigger in a smart contract to open up property title deeds that are in escrow.
Meanwhile, ConsenSys has recently launched OpenLaw, which enables anyone to be able to wrap logic and other contextual information around traditional legal prose. This means that off-the-shelf legal agreements (e.g., conveyances) can be quickly turned into documents with automated, legal, executable code within them and an immutable record of the agreement that is retained by all parties.
There are certainly a lot of limitations with smart contracts as they currently exist. However, the technology keeps evolving, and it is very feasible to see the majority of the templated documents created by lawyers charging upward of $250 per hour becoming an anachronism.
Beyond just reducing processing time in the lending industry, smart contracts provide the opportunity for any industry to more efficiently manage the legal contracting and executing process. A good first step for a company thinking about beginning this transition to using smart contracts is to determine what agreements are repeatable among the same set of trusted parties, and then consider turning these into smart contracts. By calculating the reduction in execution and processing time, a strong business case can be made to start using smart contracts for a broader selection of agreement stakeholders and increasing the complexity of the agreements.
As companies become more comfortable about using smart contracts, the trickle-down benefit to the consumer will be more efficient services.
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