Why Smart Contracts Will Require Trusted Institutions
Smart contracts, a cornerstone of the digital asset economy and a capability unique to blockchains, are poised to revolutionize finance. In a recent report, S&P Global described how the use of smart contracts in financial services "can improve efficiency and reduce reliance on third parties like asset servicers and custodians, as well as make transaction resolutions faster."
Just as software is "eating the world"—in Marc Andreessen's famous phrase, proponents of smart contracts say this blockchain technology will eat the business world by removing middlemen, reducing fraud, and accelerating transactions. Some decentralized finance (DeFi) advocates predict that smart contracts will make centralized institutions obsolete, with unbiased, impartial code taking the place of human intermediaries.
While smart contracts have the potential to make financial services faster, more efficient, and more reliable, trusted institutions will still be needed. Protego has a unique vision: to harness the power of smart contracts for the future of finance without giving up necessary oversight. To see why, we need first to understand exactly how smart contracts function and what benefits they provide.
The main benefits of smart contracts are speed and automation, along with enhanced integrity and transparency of data. Simply put, smart contracts are built on if/when statements concerning predetermined conditions. When these conditions are verifiably met, the blockchain network hosting the smart contract can take action immediately. This permits autonomous, verifiable settlement, taking third-party custodians, transfer agents, and middlemen out of the equation, while giving participants instant (or near-instant) clarity regarding the outcome.
Smart contracts are a game changer in finance due to their ability to formalize and automatically execute processes that would otherwise require manual input. They can be used to execute "atomic transfers," in which assets are exchanged among multiple parties simultaneously, removing the need for escrow or time-locked contracts.
This works for more than asset swaps. Smart contracts can reference other smart contracts, bundling multiple actions into a single transaction. This process, known as "intra-transaction composability," reduces processing time and virtually eliminates counterparty risk. This has two advantages: it ensures that all parties hold up their end of the deal, and it lightens capital requirements for financial institutions.
When people call public blockchains "trustless," they mean you no longer need to trust the person on the other end of a transaction, because the ledger itself, and every transaction it records, is tamper-proof. Every transaction is also timestamped, ensuring that it is processed in the correct sequence and that all parties to a transaction are working with the same set of facts. This makes it easy to check the integrity of transactional data without relying on middlemen or sacrificing the granular insight they can provide.
Smart contracts promise to cut costs, reduce friction, and mitigate risks that are endemic to traditional finance. They are so powerful, in fact, that any business interaction involving multiple parties could potentially be improved through the use of smart contracts, eliminating the fallible and costly human element in order to execute complex operations transparently and at lightning speed.
Smart contracts do have some drawbacks. Unlike ordinary software, smart contracts deployed on public blockchains can't always be updated once they go live. Immutability cuts both ways. While it prevents tampering with the agreement and empowers financial institutions to record accurate transaction data, it also means that any flaws baked into a smart contract can have serious, even disastrous, consequences.
In the near term, smart contracts won't replace trusted institutions. The more a smart contract has riding on it, the more important a reliable audit of its quality and validity becomes. Investors and stakeholders are counting on it. Counterparties that know the perils and pitfalls, as well as the numerous advantages, of this brave new world will be indispensable.
With the right support, smart contracts can benefit financial institutions while allowing them to retain control over their proprietary data and internal processes. Without trusted third parties to engineer and guarantee the reliability of these new applications, however, smart contracts will likely continue to have what S&P Global calls "slow and limited adoption" in traditional finance.
No matter how much software you have at your disposal, expert guidance will never be obsolete.
Protego Trust Bank N.A (in formation) is a purpose-built, conditionally federally chartered trust bank, exclusively serving the needs of institutional clients. With a firm belief that the future of all assets is digital, Protego Trust is defining the next generation of financial services by providing regulated infrastructure, advanced technology and safeguards that allow institutional clients to securely participate in cryptocurrencies and digital assets. In 2021, Protego Trust received a conditional federal charter from the U.S. Office of the Comptroller of the Currency, in addition to its Washington state charter. It plans to launch in 2022. Learn more about our institutional custody solutions today.