The financial services sector is changing at a dramatic pace thanks to the introduction of blockchain-enabled, decentralized finance technologies. One of the most disruptive applications of blockchain technology across the industry is smart contracts.
The global smart contracts market size is expected to reach a smashing $345.4 million by 2026, growing at the CAGR of 18.1% between 2021-2026. This should be enough for you to get interested in this area of finance.
What exactly are smart contracts? Where are they already being applied in the real world? Keep on reading this article to learn everything you need to know about smart contracts technology.
What is a smart contract? Smart contracts explained
A smart contract is a self-executing contract that includes the terms of an agreement between the buyer and seller written directly into the code. The code and agreements included in it are placed in a distributed and decentralized blockchain network (distributed ledger technology).
The interesting part? It’s up to the smart contract code to control its execution. This also makes all the transactions on smart contracts irreversible and trackable.
Smart contract code allows trusted transactions and agreements to be carried out among disparate or anonymous parties without having to rely on a centralized authority, legal system, or any kind of external enforcement mechanism.
How does a smart contract work?
Traditional computerized agreements usually involve parties that may not know each other, and this introduces the risk that one of the participants doesn’t meet their commitments. To address this risk, digital agreements may be hosted and executed by larger and centralized institutions – for example, a bank. The bank is responsible for enforcing the contract terms.
Digital contracts can be made directly between users and a company or involve a company acting as a trusted intermediary between two users. This dynamic allows contracts that otherwise would’ve never existed due to the high risk. However, a larger and centralized institution may exert asymmetrical influence over the contract in this context.
In practical terms, a smart contract is a computer program hosted and executed on a blockchain network. It contains code that specifies the predetermined conditions that – once met – trigger specific outcomes.
Since it’s running on a decentralized blockchain instead of a centralized server, a smart contract allows multiple parties to get the same output in a tamper-proof, accurate, and timely manner. This is why smart contracts offer such a powerful infrastructure for automation. No central administrator controls them, so they aren’t vulnerable to single points of attack from cybercriminals.
When applied in the context of digital agreements between multiple parties, a smart contract application reduces risk, increases efficiency, lowers costs, and offers excellent transparency into the transaction process.
Benefits of smart contracts
When running the smart contract on a decentralized blockchain infrastructure, you can be sure that there is no central point of failure that cybercriminals can attack. Moreover, by getting rid of the centralized intermediary, you also make sure that no one can be bribed or threatened. And there is no mechanism whatsoever for either party or the central administrator to tamper with the smart contract outcome.
You get a solid, tamper-proof, and correct execution with excellent uptime by processing the smart contract logic redundantly and getting it verified by the centralized network of nodes. You can be 100% sure that the smart contract is executed on time and in line with its terms.
By using a decentralized network to host the smart contract and enforce its terms, you reduce the potential of a for-profit middleman to use their position of privilege to impact its value or rent-seek.
Automating processes such as maintenance, execution, escrow, and settlement have a massive impact on contract efficiency. Smart contracts perform really well. No party needs to wait for any manual data to be entered, for the counterparty to fulfill their obligations, or for the middleman centralized authority to process the transaction.
What are smart contracts used for today?
Rights management (tokens)
Companies and individuals use token smart contracts to create, track, and assign ownership rights to digital tokens that exist on blockchain networks. A token smart contract programs all the functionalities into the token that it issues.
As a result, holders are provided with features like utility insurance in a decentralized application (utility token), voting weight in a protocol (governance token), equity in the company (security token), or ownership claim to a real-world asset (nonfungible token). All of these tokens would be impossible to deliver if not for a smart contract functionality.
Decentralized finance (DeFi)
Decentralized finance is an umbrella term for a range of applications that use smart contracts for re-creating traditional financial products and services such as options, exchanges, stablecoins, asset management, and more.
They often bring together multiple services to build new financial primitives using a smart contract. A smart contract can hold your funds in escrow and distribute them between users based on some predefined conditions. For example, a company can use smart contracts to streamline the lending and borrowing process in a decentralized and permissionless manner.
Nonfungible tokens (NFTs) and gaming
Blockchain-based games are a really interesting use case for smart contracts. In gaming, the idea is to allow a smart contract execution of in-game action.
PoolTogether is a good example of a blockchain-based game. It’s a no-loss savings game where you get to stake funds in a shared pool routed into a money market where it can earn interest. After a predefined time period, the game ends, and the winner is randomly awarded all the accrued interest, and everybody else can easily withdraw their original deposit.
Limited-edition nonfungible tokens (NFTs) also use smart contracts to ensure that each user has a fair shot at getting their hands on such a digital asset.
Smart contracts come in handy to insurance companies for parametric insurance, where the payout is directly connected to a specific predefined event. Smart contracts offer a tamper-proof infrastructure for creating such parametric insurance contracts that are triggered based on data inputs.
For example, a company can provide crop insurance using a smart contract where users purchase a policy based on specific information about the weather – for example, seasonal rainfall in their geographic location.
At the end of the policy, the smart contract automatically pays out if the amount of rainfall in that location exceeds the original stated amount. Thanks to the smart contract, end-users receive a payout on time with less overhead.
Smart contract examples
Automating a business process between multiple parties
One good use case of smart contracts is automating a particular business process happening between a distinct group of entities. These entities come into an agreement on all of the terms in the smart contract, such as process flow, payouts, and dispute resolution.
Such a smart contract may have the following terms:
- If the product arrives on time, then execute a payment from the retailer to the supplier in full amount.
- If the product arrives one day late, then execute the payment from the retailer to the supplier for 98% of the full amount.
Public decentralized applications (dApps)
Practically anyone can interact with these decentralized applications without having to get any permissions. They often use open source technologies so practically anyone can inspect exactly how they work before deciding whether or not to interact with them.
A good example of a decentralized public app is a lending and borrowing market. It can include the following terms locked in the smart contract:
- If the user deposits collateral into the smart contract, they can receive a loan up to 50% of the value of their collateral. That way, by depositing $100, the user can borrow up to $50.
Challenges of smart contracts
While smart contracts open the doors to incredible innovation in the financial services sector, they also come with limitations. One of the most serious inherent issues of smart contracts is that they run on blockchains which are isolated networks.
Blockchains don’t have a built-in connection to the external world. And without that external connectivity, it’s impossible for them to communicate with external systems and confirm whether a real-world event occurred or not. They’re like a computer without the internet.
Lack of real-world connectivity means that a contract can’t know the price of an asset or check the average monthly rainfall before paying out that insurance claim we mentioned before. It’s impossible to verify that a product has arrived on time before carrying out the settlement with a supplier.
That’s why significant advancements in the smart contract space are about connecting them with real-world data and traditional systems outside of blockchain technology. This means expanding the inputs and outputs used within the smart contract logic.
Such hybrid smart contracts use an oracle as the middleware that combines blockchain code with other infrastructure. It can trigger a smart contract with external data or settle a contract on a traditional payment rail. Oracles are becoming a key solution to connecting emerging blockchain networks with legacy systems used by financial institutions.
In the near future, we will get interconnected, high-performing, and highly secure smart contracts that retain all the reliability and security of the blockchain network without getting cut off from the real world.
The future of smart contracts
Smart contracts need to evolve before they become widely adopted for production to use in more complex commercial transactions. Many companies are now considering how the existing concepts and structures in the financial world could be transported over to this brand-new contract technology.
At the same time, many innovators envision how smart contracts will enable the development of new financial products that are currently outside of our financial paradigms.
Are you looking for an expert to help you develop a decentralized application or develop a smart contract for your project? Get in touch with us. At 4Soft, we work with applications based on blockchain technology and smart contract implementation for clients in the financial services industry and beyond.