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Feb 16, 2021

Smart Contracts in Finance: A Guide for Financial Institutions and Fintechs

By: Algorand

Smart contracts are poised to play an integral role in the future of global finance. In this guide, you will discover what smart contracts are, how they work, and how they will be deployed in the future of global finance.

What Are Smart Contracts?

In a nutshell:

A smart contract is a self-executing contract where the terms of the agreement between two (or more) parties are written into code, operating autonomously on a decentralized blockchain network. 

Essentially, smart contracts are computer programs embedded in a blockchain that provide for the transfer of value between parties if the terms of the contract are satisfied

Financial smart contracts are computer code-enforced agreements that function autonomously, executing financial rules without the need for a central authority. Algorand’s blockchain provides a platform enabling fintechs and financial institutions to integrate smart contracts into their operations at scale.

Cryptographer Nick Szabo was the first to raise the idea of smart contracts back in 1994, when he proposed recording contracts by using computer code. While the idea didn’t take off at the time, it became feasible over a decade later with the development of blockchain technology.

Szabo’s idea was based on the efficiency benefits offered by using a computer program to automate enforcement of contract provisions. Automating contract completion in this way provides a secure method of documenting fulfillment of a contract, removing the need to involve a third-party intermediary to validate the process. 

While the technology wasn’t ready at the time, Szabo’s 1996 paper on the subject of smart contracts outlined the potential of the technology to perform basic functions, such as fraud reduction and contract term enforcement, and for more disruptive uses, such as digital cash and smart property. 

Smart contracts represent a logical extension of the use of the blockchain to facilitate seamless, frictionless transactions on a global scale.

How Smart Contracts Work

Smart contracts operate on the same principle as the if/then function of a computer program. If the conditions embedded in the program underlying the contract are met, then the action (or actions) described in the contract takes place. If they are not met, no transaction occurs. 

For instance, if the buyer deposits a specified sum of money by a certain date, the goods being purchased as specified in the contract would be released on that date. If, however, either the money is not deposited or the goods are not made available by the specified date and time, no transaction occurs.

These contracts are enabled by the immutability of the blockchain – the fact that transactions recorded on the blockchain are permanent. Because such transactions are recorded on multiple network nodes, they cannot be retroactively altered by a single participant. 

Smart contracts offer the following benefits: 

  • Trustless: Traditionally, when two parties who don’t know each other want to do business, a trusted third party is enlisted to validate the transaction. Because smart contracts and the records they generate are verifiably stored using encryption on a shared ledger, users who don’t know each other can outsource trust to the blockchain rather than relying on a trusted intermediary. 
  • Autonomy: The contract is executed when one or more of the parties submits proof of the satisfaction of the terms. 
  • Security: The cryptographic design of the blockchain and its use of distributed nodes makes it extremely resistant to hacks or security breaches.  
  • Error minimization: Automated contracts avoid the errors typically associated with human transaction processing.
  • Speed: By avoiding manual completion of forms or the need to wait for an intermediary to verify and process them, rapid processing of transactions is enabled.
  • Cost savings: Dramatically increasing processing speeds reduces the cost of completing transactions.
  • Precision: Using code to implement contract terms avoids ambiguity over contract provisions that can lead to disagreements.

Smart Contract Use Cases in Global Finance

By enabling people who don’t know each other to easily enter into agreements with each other, smart contracts have tremendously expanded the number of potential participants in digital transactions. For example, decentralized applications (DApps) include multiple smart contracts that work together to provide a service, typically with a user interface like traditional apps. 

Smart contracts have found uses in real estate, insurance, healthcare, credit authorization, real estate, legal processes, and online gaming. However, arguably, the most promising area for the use of smart contracts is global finance.  

Blockchains that support the development of DApps offer developers the opportunity to design innovative solutions that put smart contracts to use for a variety of purposes. DApps can offer more complex transactions than an individual smart contract, including services similar to traditional financial offerings.

Some of the most popular uses of smart contracts for financial applications include:

  • Meeting payroll based upon paying employees a certain amount at a certain time
  • Trading in cryptocurrency tokens from anywhere in the world
  • Allowing users to both lend and borrow cryptoassets
  • Enabling users to exchange non-fungible tokens (NFTs) representing physical assets

The following are smart contract-powered applications building on the Algorand network:

  • IDEX: The world’s leading decentralized exchange to support real-time trading and high transaction throughput, IDEX plans to use Algorand’s forthcoming innovative and high performing primitives to offload smart contract complexities onto the Algorand platform’s native features. 
  • Archax: The first trading platform to receive FCA authorization as a digital securities exchange, Archax will be able to use Algorand's recent smart contract upgrade to develop a number of new products, including smart stablecoins and liquid alternative investments. 
  • Cudo: A distributed computing platform that allows businesses and individuals to take advantage of a network of underutilized devices with unused computing power to scale their own business processes, Cudo has been selected as a recipient of an Algorand Foundation Grant, which will provide Cudo with the expertise and funding to build services for the Algorand developer community to offer Turing complete computing. This partnership enables developers building applications for specific blockchains to consume Cudo Compute resources at an efficient cost point, as the deployment of smart contracts will only push the necessary data on-chain for immutability.
  • Stonize: An Italian fintech company focused on transitioning towards a more inclusive financial system with a mission to make securitization accessible and transparent, Stonize leverages Algorand's Atomic Transfers and Algorand Smart Contract in Layer-1 (ASC1) to provide its customers with faster and more secure clearing and settlement processes.  
  • Monerium: A financial technology company with the mission of making digital currency accessible, secure, and simple to transact, Monerium is leveraging Algorand because it incorporates key features for many mainstream use-cases, including stateless smart contracts and scaleable proof-of-stake consensus
  • Blockstack: Algorand and Blockstack are collaborating on an independent, open-source project to support future design and development of the Clarity Smart Contract Language. Clarity is a “decidable” language, meaning developers can know, with mathematical certainty, what a program will and will not do ahead of time. 

Blockchain and Smart Contracts at Algorand: the Future of Finance (FutureFi)

Smart contracts possess immense potential to improve existing business practices and innovate new ones. The inclusivity provided by open blockchain networks makes economic opportunities available to many people who have previously been unable to access them due to structural or logistical barriers. As a result, the new paradigm created by the combination of blockchain and smart contracts can help democratize numerous processes. 

The opportunities for innovation and enhanced efficiency offered by the blockchain and smart contracts are in keeping with the five principles of FutureFi:

  • Decentralization by Design: A distributed network such as a next-gen blockchain is not under the central control of any one entity.
  • Inclusive (Participation, Permissionless): Open access, due to its permissionless nature, promotes a new economy where no parties or groups are excluded.
  • Frictionless (Creation and Exchange): Any exchange of value is seamless between parties, with no barriers to cause friction like lower costs.
  • Interoperable: Multiple systems operating together to allow connection and communication without restrictions.
  • Secure (Transaction Finality): Irreversibility creates confidence that transactions are not subject to reversal.

Smart contracts offer fintechs and financial institutions a source of innovation that can create opportunities to both improve existing processes and develop new products and services. 

Doing so can not only boost these organizations’ bottom lines but also help further the democratization of finance by expanding the pool of potential users of financial products and services worldwide.

The benefits offered by blockchain-powered smart contracts hold the potential to revolutionize global finance, helping bring about a future of finance that offers the potential for significant economic expansion driven by technological innovation.

Algorand: Enabling Financial Innovation

Algorand has developed the world’s first open, permissionless, pure proof-of-stake blockchain protocol that, without forking, provides the necessary security, scalability, and decentralization needed for today’s economy. 

With an award-winning team, we enable traditional finance and decentralized financial businesses to embrace the world of frictionless finance.

We offer:

  • Smart Contracts: Comprehensive smart contract capabilities enable DeFi solutions and DApps that can scale to billions of users, tens of millions of daily transactions, with negligible transaction fees.
  • ASA: Algorand Standard Assets are standard blockchain assets with customizable options, directly in Layer-1. 
  • Atomic Transfers: Secure transfers and immediate transaction settlement for multiparty transactions built in Layer-1.

Algorand is committed to the ongoing development of best-in-class solutions for the future of economic exchange.

Download: The Future of Payments Report

Algorand has recently partnered with OMFIF (Official Monetary and Financial Institutions Forum) DMI (Digital Monetary Institute), Citi, Cypherium, GrabPay, Mastercard, Novi (from Facebook), PayPal and SWIFT - publishing a report about the Future of Payments.

Key findings in this report include:

  • Evaluation of the current payments industry, including services and infrastructure
  • Key trends and innovations likely to shape the way people will pay, save and transfer value both domestically and across borders
  • Insights on the retail payments industry and commentary on wholesale payments
  • Overview of problems in the current monetary set-up
  • Potential for new ways forward

Are you a developer interested in building on Algorand?