The dizzying rise in the valuation of bitcoin has created significant buzz in the finance sector. While much focus has centred around the viability of bitcoin in financial systems, the technology that undergirds the cryptocurrency is steadily gaining mainstream acceptance.
Finance professionals were quick to recognise the potential of blockchain technology in making up the various shortfalls of the status quo. Today, we’ve witnessed the emergence of countless fintech start-ups providing services that leverage on blockchain, while banks are quickly working to integrate the technology into various aspects of its operations.
Current financial systems around the world handle throughputs amounting to trillions of dollars on a daily basis, serving billions of consumers worldwide. Despite its importance, our global financial system is surprisingly antiquated.
Many processes rely on legacy systems characterised by high volumes of paperwork and human involvement. This leads to additional costs, time delays, and increased risk in the form of human error and fraud. A PWC study found a boggling 45% of financial intermediaries to have been a victim of economic crime during the survey period.
A key example would be the convoluted IPO process, where the involvement of many third parties raises costs in terms of both money and time. This presents barriers to entry for much needed growth capital as the resource cost is not something every SME can afford.
Spearheading the Blockchain Revolution
Blockchain technology provides a way to structure data and information securely with a digital ledger. Unlike conventional records, blockchain ledgers are not stored with any central authority, but across a network of computers viewable by the public, ensuring transparency and making it impossible for a single person to amend information.
Amongst the most promising and novel uses of blockchain is smart contracts, a use case that stands out as one of the most innovative solutions built on blockchain technology which I foresee to feature strongly in the industry in the years ahead.
Setting a New Standard for Financial Agreements
In a nutshell, smart contracts are programmed contracts that automatically execute a set of pre-defined actions when a set of pre-determined conditions are fulfilled.
Being self-validated, self-monitored, and self-enforced, automation enabled by smart contracts has several immediate benefits, some of which are as follows:
- Risk Management
With smart contracting, the execution of an agreement is taken out of the hands of a single party, relying instead on digital verification within a blockchain before an action is triggered. Any funds involved could be locked in escrow, and only released if pre-determined conditions are met. This helps to facilitate trust between the involved parties by removing any concerns about enforceability.
- Shorter settlement cycles, at lower costs
In traditional contracts, many financial intermediaries can be involved in the settlement process once a contract is concluded. Necessary liaison between the numerous intermediaries serves to lengthen the settlement cycle, and adds on to the total cost.
The decentralised nature of a smart contract reduces the number of intermediaries from the equation, vastly reducing monetary costs and time involved.
- Fraud Prevention
Fraud is a common problem in the financial sector. Smart contracts can reduce the potential for fraud by virtue of having all financial movement and transactions digitally recorded on an immutable blockchain, bringing transparency to the table. Digital records also facilitate easier auditing and detection of suspicious behaviours that could indicate fraud.
A tangible example of how contracts could benefit from the use of smart contracting would be that of companies raising funds on the secondary market. In this instance, the use of smart contracts lowers the risk involved for both parties by shortening the settlement cycle. This reduces the chances of any party experiencing financial distress, leaving them unable to uphold their contractual obligations. Another upside is that the business and investor both get their funds and shares in a shorter period of time, all at a lower cost.
The Future of Smart Contracts in Finance
However, it is important to note that smart contracts are by no means a magic bullet. The digital nature of these contracts mean that any oversight in the text of may have detrimental outcomes, as the terms cannot be freely interpreted unlike in traditional contracts, but only according to literal meaning. A cautionary example would be the Decentralised Autonomous Organization (DAO) case which saw a hacker making off with US$50m by exploiting a loophole in the terms of the smart contract.
While the technology has admittedly yet to reach levels involving contracts of high complexity, its various benefits have the potential to revolutionise the way business is conducted. Smart contracts could definitely be used in instances where the scope or complexity is limited enough, such as sale of securities or insurance where conditions can be clearly defined.
The large-scale adoption of smart contracts across the financial sector would likely require a need for regulatory oversight, which can jeopardise one of blockchain’s major selling points – autonomy from governments. It remains to be seen whether a compromise can be reached.
About the Author
Khai Lin Chua, Co-founder and CFO, Fundnel.
Khai Lin is the co-founder and CFO of Fundnel, a private investment platform that offers unlisted securities in growth and pre-IPO stage companies across industries to a qualified network of investors. She co-founded Fundnel to make a difference to small and medium-sized enterprises that experience insufficient access to growth and expansion funding.
At Fundnel, she is primarily responsible for the company’s financial and operational strategies, whilst providing foundation to a strong team of visionaries with her execution-driven work ethos. More than just a gatekeeper, she fulfils the role of ‘leader-by-example’ with aplomb.
Khai Lin has significant expertise in banking and private investments, having had more than five years of experience working at JP Morgan, Citibank and CIMB-GK Securities. She graduated with top honours from University College London (UCL) with a Bachelor of Science (BSc) in Economics degree.
Out of the office, she is a passionate supporter of animal rights, clocking in hundreds of hours to marine mammal conservation and research projects.