Blog Post
Understanding the Functionality and Benefits of Smart Contracts for Corporations
Until recently, the term “smart contracts” was little more than a buzzword. As part of the rising hype within the blockchain and digital assets arena, smart contracts have been of interest to many but understood by few. That’s beginning to change as a wide range of real-world, practical smart contracts use cases are gaining momentum and proving results for business operations within a growing number of enterprises. Many organizations have started to digitally map workflows, improve processes and achieve faster, more transparent and reliable transactions with the help of smart contracts. This article discusses the key features of smart contracts, leading use cases, functionality and benefits.
Defining Smart Contracts
First of all, smart contracts are not contracts in the legal sense. Smart contracts are digital, immutable, automated contracts based on blockchain technology, in which the contracts’ rules and execution instructions are written directly into self-executing programme code. Predefined processes ensure that corresponding transactions are automatically triggered when certain events occur. These transactions, in turn, are stored on a blockchain and run in a decentralised manner.
Smart contracts thus guarantee all contracting parties involved the intended and, above all, complete execution of all contract contents. Human supervision is no longer necessary, which reduces errors and provides immutability of the data and transactions executed.
Understanding how smart contracts work requires a baseline understanding of how blockchain works, which remains a closed book for many. While the backend infrastructure is highly complex and technical, the functional model is relatively simple: a series (blocks) of information that are stored on a public, decentralised chain of servers.
The cryptocurrency Bitcoin, for example, consists of these blocks:
- Transaction information (date, time, value, ...).
- Digital signatures of the people involved in the transaction
- A hash value to distinguish the blocks
Blockchain applications are in a state of permanent development. First was the introduction of cryptocurrencies (Bitcoin), followed by a surge of smart contracts implementation within the financial sector (initially prompted through Ethereum, the first blockchain with smart contract capabilities) and leading to the launch of the DeFi space. In the next wave of this space, blockchain and digital assets technologies are expected to achieve widespread adoption, across numerous use cases, with the aim of enabling faster, cheaper and more efficient transactions and a higher degree of automation.
Smart Contracts in Practice
Smart contracts offer a number of benefits in an enterprise setting: speed, fewer intermediaries, more efficiencies, reduced risk and streamlined costs. Real estate transactions offer a prime example of the advantages smart contracts can deliver. Traditionally, contracts in real estate sales are signed by the buyer and seller and certified by a notary. Once the purchase price is transferred and the tax office has received the land transfer tax, the notary initiates the transfer in the land register, for which the notary receives a fee (typically 2% of the purchase price).
On the blockchain, this process can be simplified and made more transparent and secure. A smart contract would first require the decentralised storage of the land register on the blockchain. Then it would be checked whether the digital signature of the seller matches the signature of the owner in the land register. After the purchase price and the property tax have been transferred to the tax office, the new owner would automatically be entered into the land register. The entire process would be automated and documented and could be completed instantaneously.
At the moment, it is mainly banks that are using these methods. But logistics, trade, manufacturing and many other industries stand to benefit as well, as illustrated in the following findings and graphics from a recent Fraunhofer report.
Another field of opportunity is the public sector, which in most countries is in need of digital transformation. Numerous administrative processes could be automated and made more efficient with smart contracts. For example, once the identity of an applicant has been verified, numerous manual administrative procedures could be eliminated: the registration and re-registration of a vehicle, the issuing of firearms licences, applications for citizen benefits such as Bundesausbildungsförderungsgesetz (state student finance), unemployment and sickness benefits, the transfer of fees via e-payment and elections/counting of votes.
Key Considerations
As with all new technologies, there are potential drawbacks to consider.
Data protection is one important consideration. Many transactions are publicly visible in the blockchain. With off-chain programming, however, it is possible to store blocks on a kind of “side-track” and reunite them with the main chain when needed. This is used in some scenarios to create a private blockchain that cannot be viewed by the public. Data protection will certainly play an important role in connection with smart contracts, and organizations looking to implement them must conduct a thorough assessment of the privacy, security and regulatory risks that may arise and proactively identify them before launching a new process using smart contracts.
Smart contracts must also be standardised and legally certified. Patterns and templates are to be created for frequently used transactions. In addition, the use of marketplaces and libraries for smart contracts may become a future requirement that legislators introduce as the market evolves.
Organizations looking to implement smart contracts will also need programmers to design, test and maintain them and the underlying blockchain infrastructure. In addition to programming the digital contracts, the implementation of warning systems will also be necessary here to detect weaknesses or other errors before they result in a data breach or other disruption to the system. Many organizations will find it more practical and cost-effective to outsource such tasks vs. establishing fully functioning internal teams to do so.
Future regulatory decisions will also play a decisive role in determining the extent to which the use of smart contracts will be permitted in private and public sectors. Legislators will likely be addressing the evolution of blockchain, digital assets and smart contracts in future regulatory frameworks. As this takes shape, organizations will need to ensure their smart contracts deployments can stand on the legally secure ground and are designed to prevent malicious or illegal activity.
What Will the Future Bring?
Smart contracts have the potential to become a success story. In the private and public sectors, almost all processes concerning business transactions or administrative matters can be mapped digitally: contracts, insurances, orders, supply chain management, licensing and more.
With smart contracts, processes can be significantly simplified and optimised. The number of parties necessary to complete processes and transactions can be greatly reduced. Organizations and agencies across the public and private sectors have the opportunity to save time and money. Transactions can be completed faster, easier and more cost-effectively for all parties involved.
This changeover will also require trust. Operators must therefore ensure that blockchain technology and transactions remain secure and adequately protected against attack or manipulation.
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The views expressed herein are those of the author(s) and not necessarily the views of FTI Consulting, its management, its subsidiaries, its affiliates, or its other professionals.