Blockchain in financial services

What are smart contracts on blockchain?

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Have you ever bought a car? A house? If so, you’ve experienced the special type of aggravation that is unique to these types of complex transactions. Many industry leaders have felt that same pain and have been exploring how the use of smart contracts on blockchain can be used to alleviate it. Whether you’ve just learned about the concept or you’re looking for an in-depth explanation, this guide is a great place to start.

What are smart contracts?

Smart contracts are lines of code that are stored on a blockchain and automatically execute when predetermined terms and conditions are met. At the most basic level, they are programs that run as they’ve been set up to run by the people who developed them. The benefits of smart contracts are most apparent in business collaborations, in which they are typically used to enforce some type of agreement so that all participants can be certain of the outcome without an intermediary’s involvement.

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What is blockchain?

Blockchain is a shared, distributed ledger on which transactions are digitally recorded and linked together so that they provide the entire history or provenance of an asset. A transaction is added to the blockchain only after it has been validated using a consensus protocol, which ensures it is the only version of the truth. Each record is also encrypted to provide an extra layer of security. Blockchain is said to be “immutable” because the records cannot be changed and transparent because all participants to a trade have access to the same version of the truth.

What do smart contracts do?

The easiest way to explain what a smart contract does is through an example. If you’ve ever bought a car at a dealership, you know there are several steps and it can be a frustrating process. If can’t pay for the car outright, you’ll have to obtain financing. This will require a credit check and you’ll have to fill out several forms with your personal information to verify your identity. Along the way, you’ll have to interact with several different people, including the salesperson, finance broker and lender. To compensate their work, various commissions and fees are added to the base price of the car.

What smart contracts on blockchain can do is streamline this complex process that involves several intermediaries because of a lack of trust among participants in the transaction. With your identity stored on a blockchain, lenders can quickly make a decision about credit. Then, a smart contract would be created between your bank, the dealer and the lender so that once the funds have been released to the dealer, the lender will hold the car’s title and repayment will be initiated based on the agreed terms. The transfer of ownership would be automatic as the transaction gets recorded to a blockchain, is shared among the participants and can be checked at any time.

How do smart contracts work?

Smart contracts work by following simple “if/when…then…” statements that are written into code on a blockchain. A network of computers executes the actions (releasing funds to the appropriate parties; registering a vehicle; sending notifications; issuing a ticket) when predetermined conditions have been met and verified. The blockchain is then updated when the transaction is completed.

Let’s see how this plays out in a supply chain example. Buyer B wants to buy something from Seller A, so she puts money in an escrow account. Seller A will use Shipper C to deliver the product to Buyer B. When Buyer B receives the item, the money in escrow will be released to Seller A and Shipper C. If Buyer B doesn’t receive the shipment by Date Z, the money in escrow will be returned. When this transaction is executed, Manufacturer G is notified to create another of the items that was sold to increase supply. All this is done automatically.

Within a smart contract, there can be as many stipulations as needed to satisfy the participants that the task will be completed satisfactorily. To establish the terms, participants to a blockchain platform must determine how transactions and their data are represented, agree on the rules that govern those transactions, explore all possible exceptions, and define a framework for resolving disputes. It’s usually an iterative process that involves both developers and business stakeholders.

What are the benefits of smart contracts?

The benefits of smart contracts go hand-in-hand with blockchain.

  • Speed and accuracy: Smart contracts are digital and automated, so you won’t have to spend time processing paperwork or reconciling and correcting the errors that are often written into documents that have been filled manually. Computer code is also more exact than the legalese that traditional contracts are written in.
  • Trust: Smart contracts automatically execute transactions following predetermined rules, and the encrypted records of those transactions are shared across participants. Thus, nobody has to question whether information has been altered for personal benefit.
  • Security: Blockchain transaction records are encrypted, and that makes them very hard to hack. Because each individual record is connected to previous and subsequent records on a distributed ledger, the whole chain would need to be altered to change a single record.
  • Savings: Smart contracts remove the need for intermediaries because participants can trust the visible data and the technology to properly execute the transaction. There is no need for an extra person to validate and verify the terms of an agreement because it is built into the code.

How will you use smart contracts?

Now that you have a better understanding of smart contracts and their benefits, I’m sure you’ve thought of some ways to use them in your company. And with IBM Blockchain Platform, you can get access to development tools, tutorials and a development environment to quickly create your own smart contracts using The Linux Foundation’s Hyperledger Composer. Ready to get started using smart contracts on blockchain?

Connect with me @analyticsbytes on Twitter to continue the discussion.

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