The power of smart contracts in Capital Markets is undeniable. Although definitions can vary, they are essentially programmable contracts defined with computer code that can automatically facilitate, verify, execute and enforce the negotiation or performance of contract terms on a distributed ledger.
So how can firms harness this power? This question has been vexing the Capital Markets industry virtually since blockchain began to enter its collective consciousness.
At this early stage, harnessing the power of smart contracts is akin to harnessing the power of the atom: incredibly powerful yet incredibly dangerous if not treated properly or in the wrong hands. Because while smart contracts can mitigate some risks by automating functions and eliminating “human error”, they cannot eliminate human error in the development of the code or malicious actors attempting to find vulnerabilities to be exploited.
Both of these weaknesses came into sharp focus on June 16th, 2016 when an error in the code of The DAO, a distributed autonomous organization, was exploited and roughly $60m worth of the associated currency, in this case Ethereum’s Ether, was drained into a sub account, or ‘child DAO’.  What has transpired since has raised even more issues, including the legal right to ownership of the diverted assets. We’ll have more on this in our next blog post but first, a little background.
Smart Contract Pros and Cons
In a traditional transaction, proof of ownership relies on a database with a reporting/auditing function that confirms the actual ownership of assets. So if we can describe smart contracts as the process of embedding the business logic of an asset on the blockchain, then essentially a smart contract takes custody over assets in that ledger and the blockchain removes any third party intermediary holding custody on the asset rights.
But in a smart contract, a token would be used to represent any asset. The ability to hard-code transfer of ownership when trading these assets can potentially create “unbreakable” contracts. Of course this is potentially very powerful because smart contracts could automate hundreds, even thousands, of business processes, allowing machines to transact with little or no human intervention, in turn, creating efficiency and lowering the risk of human error.
The flip side for capital markets, however, is—what happens when it goes wrong? The current immaturity of the technology and controls and processes required to handle situations where vulnerabilities are exploited or errors occur make clear that more work needs to be done before smart contracts can achieve their fullest potential.
For example, what happens when a data feed isn’t available? What happens when one counterparty defaults or doesn’t have the funds available for an automatically-executing contract? Who has the right or responsibility to change an existing contract when it needs to be changed if that oversight hasn’t been defined up front? Who can one turn to when there is a conflict or disagreement between counterparties about the agreement? Will smart contracts have the same enforceability and rule of law as traditional contracts? Will regulators accept smart contracts which in some cases is intended to remove third party intermediaries which currently act as backstops against failed transactions?
The standards, laws, processes, and tools to manage when it goes wrong are in development and will require significant maturity before smart contracts can be more widely adopted.
That said, we see great potential with the technology for specific use cases now and on a broader scale in the future. Through our work with clients, our alliances and partners and in our Labs around the globe, we are actively involved in helping solve these outstanding issues.
Interested in learning more about Accenture’s smart contracts research and how it could help your organization? Contact me, Chris Brodersen, via email.