Smart contract applications, limitations and future outlook

Smart contract applications, limitations and future outlook

January 28, 2021

Blog

Smart contract applications, limitations and future outlook

Head of Blockchain Competency Center

With blockchain hype being over, its scope of applications has gone way beyond cryptocurrency. Smart contracts, which have to be initiated on a blockchain, have the potential to significantly reduce transaction costs, minimize the need for intermediaries, and largely automate contracting processes. Let’s figure out the most prominent smart contract use cases in different industries and discuss their limitations.

What is a smart contract?


A smart contract is a programmable electronic protocol that automatically enforces itself when certain conditions embedded in its code are met. While this may sound complicated at first, the concept of smart contracts has been around for 20 years.

The growing interest in this technology can be largely attributed to the implementation of smart contracts on distributed ledgers, like blockchain. Until blockchain, autonomous contract execution wasn’t possible, because parties would often share separate databases. With smart contracts in place, blockchain becomes more than an immutable record-keeping system, transforming into a full-fledged transaction platform. This allows multiple parties to automatically and securely execute the agreed terms and get rid of intermediaries.

Here are the main benefits of smart contracts:

  • Faster and more accurate execution. Smart contracts don’t rely on a mediator to be enforced and are automatically executed with software code. This significantly increases contract completion speed and reduces the risks of human error.
  • Trust. One of the most attractive benefits of blockchain implementation is its inherited transparency and transaction irreversibility. The decentralized nature of blockchain ensures that only one definitive contract version is shared with all the involved parties. This significantly decreases the risks of fraud and manipulation.
  • Cost reduction. Given that smart contracts imply less reliance on intermediaries, the operational costs are reduced.

Now let’s look at how smart contract consulting can benefit different industries.

Trade settlement

The efficiency of transactions today is hindered by costly and risky settlement processes. In very simple terms, the purchasing party will always face the risk of fraud, as it can never be sure that the selling party will fulfill its obligations.

Currently, there is a number of cost-ineffective and time-consuming sequential practices that comprise trade approval workflows. For example, the settlement period for leveraged loans can be as long as 20 days. This factor alone makes the leveraged loan market highly unattractive due to liquidity-related challenges. Additionally, parties often use different IT systems, which causes disparities and extends settlement times even further.

In the trade finance context, smart contract technology is a missing piece: a transaction won’t execute until predefined settlement conditions are met, significantly decreasing associated risks.

With smart contracts, the majority of processes related to paperwork, KYC, and AML can be done autonomously. This greatly reduces a wide array of operational costs, decreases settlement times, and makes particular markets more liquid. All parties can see if there are any updates to the smart contract conditions, and any such changes are immutably recorded on the blockchain, providing a trusted historical record.

Smart contracts for trade finance

Smart contracts for trade finance

Mortgage

Similar to trade clearing, mortgage lending still relies on mostly outdated frameworks. Loan approvement involves bank employees and third-parties reviewing an avalanche of financial documents and then manually sharing them via email. Each document needs to be signed to be tracked, making this process extremely laborious and vulnerable to human-related mistakes.

With smart contracts, the entire process can be digitized and largely automated. All involved parties will have access to the digitized versions of documents, and payments will be automatically completed upon collecting electronic signatures.

Construction

The use of contracts is firmly embedded in the construction industry. Everything from the delivery of materials to payment transferring to performance measurement is usually done through established contracting procedures. As the industry is becoming more fast-paced, the inherited flaws of conventional contracting are becoming more apparent, though. By their very nature, these contracts can always be interpreted differently and typically take an inordinate amount of time to be managed, which hampers productivity and increases the likelihood of disputes.

In combination with IoT data analytics, smart contracts can help the construction industry to streamline productivity and speed up payment processing. For example, by using computer vision-enabled cameras, the system can detect when a supplier delivers materials and automatically transfer funds to that supplier. This effectively eliminates intermediaries and frees up employees from doing manual work.

Smart contracts can streamline construction invoice processing, too. One of the most persistent struggles of construction companies is the verification of subcontractor amounts payable. Margin, tax, and union fee overstatement have become an industry staple at this point. This causes project teams to be plagued with cascades of manual work, reviewing thousands of vaguely defined contract obligations and thus delaying the payments.

While smart contracts can’t entirely automate the invoice verification process, they can make it significantly more efficient, secure, and transparent. This can be achieved by matching the invoice with the scope of work and the list of completed tasks recorded to the blockchain. In this case, a contractor’s manager validates the completion of tasks, and smart contracts automatically ensure that the task has been completed within the parameters specified in the invoice.

When implemented for large construction projects, such initiatives become breakthroughs. This way, compliant spending gets ensured, work optimized, and all the contractors can check the progress in real time.

Land registry

Currently, land title recording is often risky, fragmented, and cumbersome. The process involves real estate agents examining piles of documents regarding mortgage confirmations, construction-specific data, and buyer-seller agreements. These manual processes are often the reason for document alteration and, consequentially, fraud.

A designated blockchain token can contain all the relevant information about the particular property including the owner and buyer IDs, legal description, third-party testimonials, etc. In order to verify IDs, the seller simply rehashes the digital file and the buyer easily verifies it with his or her public key. By the very nature of blockchain, such process of property transfer makes fraud almost impossible as the wrongdoers would need access to the public keys in addition to injecting the malware into every digital copy on the ledger simultaneously.

Georgia, for example, has successfully piloted a blockchain-based land registry for over 1.5 million land titles. The whole process can now be done in ten minutes and operational costs can be decreased by 90%. It should be noted, however, that with such large-scale blockchain projects, energy consumption can become an issue. In Georgia, the proliferation of blockchain is largely fueled by low energy prices. 

However, when it comes to real estate, outstanding benefits brought by smart contracts can still fade in the face of legal stipulations. As an example, despite a persuasive proof-of-concept, Swedish Consortium has prohibited the tokenization of property even in a prototype. When it comes to government-wide blockchain integration, turning land titles into digitized assets can indeed be a hard initiative to carry out.

Smart contracts for land registry

Smart contracts for land registry

Insurance

Similar to the aforementioned use cases, the insurance industry’s main challenges revolve around trust, slow claims processing, and high operational costs.

Smart contracts can be used to partially automate and speed up transactions. To make this happen, parties can still use a written agreement but place specified triggers that initiate funds transferring on a blockchain. These triggers need to be connected to the real world to validate that a specific event has happened. This can be done with the help of dApps and various IoT devices.

For example, smart sensors can be placed in homes and vehicles to transfer real-time data about accidents like gas leaks and trigger automated claim processing. Beam Dental, a dental benefits provider, takes IoT-based connectivity even further and drives down insurance rates with the help of algorithmic underwriting. Beam’s customers get a connected toothbrush, which shares data with the app, which is then used to adjust premium rates. In a nutshell, the more you take care of dental hygiene, the lower the premium you get.

In another example, if a flight is delayed for more than a specified period, a blockchain-based application could source this information from the airline system and automatically transfer a refund to the passengers.

These smart contract initiatives have already proven to be beneficial in simple insurance scenarios, but few can scale in the long term. For example, in 2017, AXA has launched Fizzy, a flight delays smart contract platform, which provided automatic compensations to clients whose flights were delayed. Unfortunately, the product has been discontinued in 2019. Most importantly, AXA cites disinterest and insufficient demand as the main reasons for scrapping the project.

Interestingly enough, in 2020, Laurent Benichou, Head of Blockchain at AXA, wrote in his Medium blog: “Unifying Insurance and Blockchain has so far been the most difficult task of my entire career”. While blockchain seem to be a good fit for insurance, Benichou cites that these two concepts are fundamentally different in how they approach risks, trust, regulations, and compliance. Moreover, the blockchain interoperability problem is still prevalent, as legacy frameworks used by insurance companies are often hard to merge with blockchain.

Limitations

Although the advantages and possibilities of smart contracts generate much interest across a number of industries, the feasibility of applying smart contracts may significantly vary by business case. Let’s explore some of smart contract limitations.

Inflexibility

The interest in smart contracts among enterprises can be largely attributed to the automation capabilities that this technology implies. In a perfect world, smart contracts are a fully self-operating mechanism that doesn’t require any human intervention after being deployed on a blockchain. However, the majority of commercial relationships are very complex in nature. Accounting for all possible contingencies and nuances in a contract is impossible both in written and digital agreements. Conventionally, parties are forced to seek judicial assistance to help them resolve contractual issues that are often imposed by unforeseen circumstances.

While this problem can’t be completely mitigated regardless of the type of contract, smart contracts can automatically reference an external arbitrager when unanticipated factors come into play. Other than that, we can expect AI to greatly enhance the contract drafting and enforcement by covering a bigger scope of possible contingencies.

Admittedly, AI still won’t be able to adjust contract agreements in compliance with principles of fairness, at least in the nearest future. Currently, most smart contracts applied in commercial relationships would need to be open-ended and rely on the intermediary to be effective.

Link to the real world

Many contractual agreements require some sort of a link to the real world, which hinders the promise of smart contracts to be fully autonomous.

In some cases, it’s possible for a blockchain to effectively handle off-chain data if it’s publicly available and can be universally trusted. For example, stock prices or weather conditions can be easily verified from multiple trusted sources.

However, there is a number of cases when information is publicly available but requires one’s physical presence to be verified. For example, the ecommerce sector could immensely benefit from smart contract implementation, but goods delivery verification is currently not possible without human intervention. It can be argued that this challenge can be overcome with the proliferation of IoT, but the lack of standardization and overall immaturity of this technology makes it feasible only in the very distant future.

Moreover, many contractual obligations that fall into the off-chain category can’t be objectively measured and computationally verified. For example, while in theory you can verify product delivery, the validation of the product’s features can’t be captured by binary logic.

Closing thoughts 

Undeniably, smart contract is a transformative opportunity for many industries. However, any serious implementation initiatives must stem from a solid understanding of this technology’s legal and technological possibilities. While there is a number of unsolved legal issues that need to be addressed, judicial reforms never fail to happen when the wide-scale demand for a technology becomes obvious.

However, it’s worth noting that the media often tends to portray blockchain as a technology that exists in a legal vacuum. It’s critical to realize that the present conventional contract limitations imposed by law will inevitably apply to smart contracts as well. Depending on the jurisdiction, this may significantly limit the self-enforcement capabilities of smart contracts. This technology should be perceived as an advanced piece of software that reaps the benefits of distributed environments, and not as an abstract concept posed to cut off contractual relationships from the real world.

Currently, the greatest obstacles for widespread smart contract implementations are technical. The most potent and feasible smart contract use cases revolve around simple payment transactions. As soon as a particular smart contract application requires linkage to off-chain events, the promises about the independence from intermediaries and self-enforcement often become irrelevant. Moreover, in this case, the main blockchain benefits also largely disappear, as the level of security would now be dependent on an oracle, be it an IoT device or a human. In a nutshell, smart contracts unleash their truly revolutionary potential only when they operate within a blockchain.

Contrary to the well-established approach of applying emerging technological solutions only in case of a valid problem, smart contracts can rarely solve an issue with a sufficient ROI. From a business standpoint, blockchain and smart contracts deserve all the criticism they receive. 

Nevertheless, with smart contracts slowly getting more attention, many decades-old hurdles of commercial relationships are getting exposed. This, in turn, fosters a very important but cumbersome and lengthy process of reevaluating and updating the current administrative mechanisms. We urge blockchain enthusiasts, technology observers, SMBs, and large enterprises to continue researching and experimenting with smart contracts.