Smart contracts for dummies

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How can blockchain transform banking?

Blockchain has the potential to transform many industries, including banking. The technology that cryptocurrencies such as bitcoin are based on uses blocks of data connected in a chain. These connections are validated by encryption algorithms, so you cannot change data unless it is data that you are allowed to change.

You can use this technology to create a distributed ledger – a database spread across multiple sites, regions, or participants – in which information can be available in different locations, available to anyone, and people can be confident the information is trustworthy. But while everyone has access to the data, the encryption algorithm means that data is only visible to people who are allowed to see it. To anyone else, it’s just a bunch of meaningless bits and bytes.

Think about smart contracts as viruses. Good ones.
The cool thing about this technology is that it can hold a piece of software as well as data. And software can execute actions that can be used to represent contracts between counterparts. These contracts can be seen by their owners, who can also allow others to see them. They can be trusted not to be corrupted or changed by people who are not allowed to change them.

Confused? I was, too, until I started to think about these smart contracts as benign computer viruses. Let me explain. A computer virus executes actions automatically and spreads itself. Imagine a computer virus that represents a bet that you made with a friend, and that will execute the payment after it checks the outcome of the bet. Make it a football bet. It copies itself in many places, but in such a way that only you and your friend can see it. And no one can change it. But when the game ends, it makes the payment between you and your friend.

Now hold this thought for a moment, and let's talk about how this concept can be applied to banking and finance.

Anything that a bank does has a legal contract behind it
Right now, banks need to manage many financial contracts, which is what their back offices do. Pretty much anything that banks do needs to have a financial contract associated with it, from a simple payment to a complex derivative. Banks need to calculate and make interest (and other) payments, send confirmations, match confirmations that they receive to contracts they have, settle transactions, and a host of other basic administrative tasks.

But is this real banking? The way I think about banking has much more to do with facilitating the transfer of capital and risk. But this transfer is usually done using financial contracts, which creates a great many operational processes. Banks spend around 80% of their revenues on operations and IT. The headache that digital banks are giving to established banks has a lot to do with the way these new financial institutions leverage new technologies to reduce their costs. Players like Revolut and Transferwise can make international payments at a fraction of the cost of high-street banks.

Can you put everything in a smart contract?
In theory, yes. In practice, probably not. Why? Imagine you have a loan for which you need to calculate the interest accrual. Do you want to have that algorithm coded in your smart contract? It is a standard calculation. Maybe it would be best if the smart contract could instead send the inputs to a trusted service and get back the number.

Today, banks can use platforms such as Finastra’s FusionFabric.cloud to consume functionality “as-a-service” in a scalable model using apps. Imagine if you could get the calculation of interest accrual using “risk free rates as a service”. Or risk measures like VaR on a portfolio by just sending the trades on that portfolio. Or have your collateral management function done for you. Today, you can get all of this on FusionFabric.cloud. The RFR Calculator, VectorRisk and CloudMargin Apps are available on our store.

With more and more fintechs joining the platform, this “as-a-service” model means that banks can outsource even complex admin tasks as the number of APIs and data-sharing datasets increases. Banks will become more and more like the auto industry: the brand delivers the customer experience, while the product is made up of myriad third-party, best-of-breed components. Platforms like FusionFabric.cloud can greatly simplify banks’ operations.

Can we go even further?
Yes, we can. Banks still need to store and manage the lifecycle events of financial contracts and this is where smart contracts can help. Pieces of code with a life of their own, they can perform actions and functions based on different inputs and triggers. If they represent the legal commitments of financial contracts, for example, they can execute their own lifecycle events (such as interest calculations and payments). With a rich marketplace for platform-based services using APIs, these smart contracts can use a fintech to get an interest rate accrual by sending the inputs needed to do the calculation.

Where does this leave banks? Potentially, in a very exciting position. Relieved of the need to run complex back-office operations, they can focus on product development and customer relationships, with a highly distributed infrastructure taking care of the administration.

Banking is essential, but I disagree with Bill Gates’ 1994 assertion that banks are not. People need places they trust to have their financial needs taken care of and that is what banks offer. But banks don’t need large back offices to do this. Maybe that is what Gates was referring to.

What banks need to do is to take advantage of these technologies. They need open platforms that can help them augment their operations and increase their efficiency, so the jump to smart contracts and distributed ledger can happen.

At Finastra, we are fully committed to this vision. We are accelerating our platform play so we can meet the needs of the new, disintermediated banking model that as-a-service and distributed ledger technologies are making possible.

The future of finance is indeed open.