The Impact of Smart Contracts on Financial Services and Supply Chain Management

by Sean Affleck on Compliance. Published February 17th, 2022

Blockchain-enabled automated contracts have the potential to transform how organizations conduct business—but their universal use faces some obstacles

Key Takeaways:

A smart contract is a digital program stored on a blockchain (“automated ledger”) that is executed when predefined conditions are satisfied.
The promise of smart contracts is starting to be realized in a broad range of industries, from high-end retail to insurance.
Legal experts and lawmakers are debating whether smart contracts are legally binding, which may slow their acceptance rate.
Both fintech companies and traditional financial services institutions use blockchain technologies, including smart contracts, in their operations.
Smart contracts also show promise in streamlining supply chain management and facilitating cost savings throughout the product cycle.

The rapid adoption of blockchain technology is impacting operations in government, financial services, healthcare, manufacturing, and many other sectors. One application of this technology is the smart contract: a digital program stored on a blockchain (or “automated ledger”) that is executed when predefined conditions are satisfied.

The defining characteristics of blockchain—security, transparency, traceability, and permanence—make it an attractive means of reinventing the traditional contract. Advocates for the universal use of smart contracts claim they will cut organizations’ costs while driving efficiencies and increasing trust between parties. Detractors point to the challenges of blockchains interfacing with outside data and a lack of consistent regulation.

Here is a look at some of the issues surrounding smart contracts, including their legal status, the potential benefits, and how they are being used in financial services and supply chain management.

Smart contracts: A Brief Review

Smart contracts began as an innovation in what can otherwise be a comparatively labor-intensive, slow, error-prone, and paper-intensive process. In 1997, computer scientist and cryptographer Nick Szabo envisioned eliminating the need for third-party, “central authority” involvement in business transactions. He coined his idea of automated contractual documentation using a decentralized approach “smart contracts.”

The growth of blockchain during the past decade accelerated the evolution of Szabo’s idea. Now, smart contracts have been incorporated into leading-edge applications that transform some of the ways people conduct business.

Benefits of Smart Contracts

There is no consensus on an exact definition of smart contracts, but many advocates agree on their benefits:

Smart contracts “formalize and secure relationships over public networks.”
In comparison to traditional processes, using smart contracts cuts transaction costs.
Smart contracts are self-executing and can be used to digitally enforce the terms of an agreement.
They can minimize fraud and theft.
Complex regulatory and procedural guidelines can be “coded into” smart contracts with the ability to flag inappropriate entries.

Smart contracts function using “if/when…then…” statements written into code on a blockchain. When predetermined conditions are met and verified, the computer network sets predefined actions into motion, such as releasing funds or creating a ticket.

A more complex example involves the creation of decentralized autonomous organizations (DOAs), a new type of corporate entity. The US Senate passed a bill in 2017 authorizing the incorporation and management of businesses using blockchain technology. This popularized DOAs, which began using smart contracts to manage sophisticated corporate structures and incentive plans.

However, smart contracts face a significant obstacle to widespread adoption: many question their status as legally binding and enforceable “documents.” They still need to make a complete leap from useful operational tools to high-level contractual agreements that would stand up in every court of law.

While two US states (Arizona and California) have begun allowing the use of smart contracts and blockchain technology for some enforceable legal agreements, the acceptance of a smart contract as a legally binding agreement remains limited and under debate. As of March 2021, 17 state legislatures had introduced bills dealing with blockchain technology. At least five initiatives seek to establish the legality of smart contracts.

Smart Contract Usage in the Financial Services Industry

Blockchain technology has fueled the rise of fintech and decentralized finance (DeFi) companies within the financial services sector. Consumers have flocked to blockchain-enabled apps for personal banking, investing, and trading. Many of these offerings use smart contracts to deliver value to their users through increased transparency and decreased fees.

Within more traditional financial institutions, smart contracts can facilitate real-time, accurate, and transparent fund transfers. Their use can also ease the financial auditing process by automating routine tasks. Blockchain technology is already used for credit checks; the addition of smart-contract functionality may streamline the lending process and optimize communications among parties. In addition, some investment banks are exploring these contracts to reinvent the way they manage derivatives and other financial instruments.

How Smart Contracts are Impacting Supply Chains

Smart contracts used with blockchain technology are reshaping the way many businesses manage their supply chains. Incorporating these innovations can create efficiencies and bring an expanded level of security to a company’s existing sourcing, manufacturing, and distribution networks.

Ways they are being used:

Manage relationships with vendors
Track the status of products during the entire production cycle, from sourcing to delivery
Reduce fraud and costs

Smart contracts work well as operational tools designed to define targets for procurement and production, among other key areas. They can also provide greater transparency into all aspects of the supply chain and a permanent audit trail.

Resolving the “Oracle Problem” of Smart Contracts

Smart contracts that operate within a blockchain are limited to the data shared by other members of the decentralized network. Transactions can only be authorized by “achieving consensus” among the participants of this closed network, a requirement ensuring the security and transparency of each contract.

But before they can become mainstream, a central issue must be resolved: how to efficiently process centralized, “real-world” data so that it will be accepted by the decentralized smart contract “host,” a blockchain. A smart contract transaction relies on the use of an “oracle,” which is a type of “relay” that aggregates data and “cleans” it. Oracles (used generically and not to be confused with the tech company) are usually third-party applications that enable smart contracts to manage “outside” data and transactions.

Many tech companies are rushing to market with software solutions for the oracle problem. Significant advances have been made in this area. But adding another level of complexity to this technology could affect its accessibility and efficiency. When added to the question of legality, they remain promising and valuable—but they still have some hurdles before universal deployment.

The attorneys at Johnston Clem Gifford routinely advise clients on emerging technologies, regulatory compliance, and other supervisory and governmental matters. Contact us online or by calling (214) 974-8000.