Smart contracts — computer programs that automatically execute specific actions — are becoming increasingly relevant to community banks by facilitating payments and other transactions. Here’s a breakdown of smart contracts and how they could ultimately serve community banks.
Decentralized finance, or DeFi, describes blockchain-based applications that provide various financial services in the crypto ecosystem. DeFi applications, or dApps, rely on smart contracts to automatically execute specific actions, such as transferring funds once a certain condition has been met.
Smart contracts are “small applications stored on a blockchain and executed in parallel by a large set of validators.” Despite the use of the word “contract,” however, smart contracts are not always contracts from a legal viewpoint.
Smart contracts have gained traction in recent years due to a growing interest in blockchain-based financial services programs. However, the concept dates back decades to early theoretical work by cryptographer Nick Szabo to combine computer programming with the “common law of contracts” to build more functional digital contracts.
Don’t let the name fool you — smart contracts are not artificial intelligence. Their designs allow them to automate various functions, but they still need humans to develop and maintain the programming. Human intervention may also be required to help resolve disputes or errors.
Today, developers are using smart contracts in a variety of applications on multiple public blockchains. Ethereum, with more than 450,000 digital token contracts, is the most popular blockchain for deploying applications with smart contracts. However, competitors such as Cardano and Avalanche are quickly growing.
Ethereum is popular, in part, because it supports composability, or the ability for smart contracts to interact with one another, which supports the development of more complex programming.
While the technology is still in its infancy, smart contracts may one day yield benefits for community banks and other payment system participants by automating functions that currently involve manual processing. Some have speculated that smart contracts could help support the Internet of Things by allowing machines and programs to transact under certain conditions.
A recent report by the World Bank noted that smart contracts may also help financial institutions reduce costs associated with physical documentation associated with transactions (e.g., agreements) and decrease counterparty risk. The report also describes possible applications, such as servicing mortgage loans. By automating several activities presently tied to complex approval procedures, smart contracts “could fulfill many loan servicing tasks, such as collecting and disbursing payments to loan holders, tax authorities, and insurance companies.”
Will community banks be able to utilize smart contracts soon? It is still too early to tell when they will be more widely adopted, but greater legal and regulatory clarity on cryptoassets and smart contracts may open more possibilities for community banks to partner with technology providers to assess potential uses and spur more consumer interest in participating in crypto ecosystems.
My next ICBA blog post will focus on the challenges and risks of smart contracts—for community banks and other potential stakeholders.
Brian Laverdure is ICBA vice president of payments and technology policy.