In 2023 the global smart contracts market was valued at US$315.1 million and is anticipated to reach US$1460.3 million by 2030. The potential for institutional finance is enormous, and there are already examples of how the technology is being utilized today.
Self-executing agreements embedded within blockchain technology are essential for streamlining and automating complex financial processes. They can reduce costs, increase transparency, and reshape institutional finance in a number of different ways. In this article, we break down the use cases, the benefits, but also the challenges, and what both TradFi and DeFi need to do to ensure the hurdles are cleared.
The advantages of smart contracts
How are smart contracts integral to the modern financial ecosystem?
Some of the major benefits of smart contracts for institutional finance include:
- Democratization and accessibility. Decentralized platforms powered by smart contracts are open - meaning that anyone can access them.
- Automation and efficiency. Smart contracts automate complicated financial processes. Institutional finance can take advantage of the money and time-saving benefits of smart contracts, allowing for quicker transaction settlement times, security protocol checking, and approvals.
- Transparency. The smart contracts processes are fully transparent with all transactions recorded on the blockchain.
- Security. With the decentralized nature of blockchain, transactions are inherently safer without needing to be stored in a centralized location. Fraud detection and safety protocols are automatic, allowing for quicker identity verification and reporting.
Key use cases
Smart contracts have some key use cases for institutional finance.
- Loan approval. Automation and efficiency are key advantages, as we’ve already discussed. This level of automation is particularly beneficial for streamlining the loan process for institutional banks. Smart contracts make it quicker and easier to verify collateral, execute a loan agreement, set conditions accordingly, do the necessary background checks, and disburse the funds when approved. The same advantages extend to insurance offers, and insurance claim processing, where the legitimacy of a claim and validating contract terms can be done through automated smart contract processes.
- Cross-border payments and remittances. The demand for safe, speedy international remittances and cross-border payments is only growing. Smart contracts allow financial institutions to offer real-time fund transfers for a cost far lower than traditional transactions that take days to arrive.
- Trade. Smart contracts’ efficiency and security facilitate trade transactions with a significantly lowered process time. The kinds of forgery possible during the digitization of letters of credit etc are also avoided by using blockchain. For example, Barclays Corporate Bank, partnered with a platform to utilize smart contracts for the safe and easy storing of bill-of-lading documents, allowing a swift and secure change of ownership. Additionally, interest rate determination means a more competitive rate compared to traditional banks.
- Settlement. Money is often held by incumbent banks for an unknown amount of time before settlement. With smart contracts used, settlement timelines are drastically reduced, and the process becomes much more transparent.
Challenges
As with anything in blockchain, the integration of technology such as smart contracts into institutional finance has its challenges. Incumbent institutions require legal recognition and stringent regulations. Data privacy and confidentiality are core benefits of smart contracts. but without industry-wide standards and regulatory frameworks, possible inconsistencies and flaws could be exploited. Without the use of a central authority, determining liability in the event of a data breach can be difficult.
Jurisdictional differences in legal frameworks make it difficult to stitch together a global solution for many financial institutions. With smart contracts being advantageous for cross-border transactions, things become trickier when different international trade laws and regulations have to be taken into account
This goes hand in hand with the issue of interoperability. There are so many different blockchain platforms and protocols in use, opening up a potential pitfall when they do not function together seamlessly.
Addressing these challenges will require a combination of regulatory clarity, the collaboration between DeFi and TradFi, and a comprehensive campaign of education for both institutional finance and end users.
The essential focus for blockchain and financial institutions
Integrating blockchain technology such as smart contracts into incumbent banking systems will be crucial for ensuring that all of the above use cases continue to grow. This integration must be created on the back of partnerships between banks, payment processors, and blockchain innovators. Without those gaps, institutional finance will find it difficult to utilize smart contracts in a manner that benefits end users.
Challenges such as regulation, liability, etc are issues for all financial sectors, institutional or not. These challenges are continually being solved, but are also changing. If financial institutions want to take on those challenges, they will learn a lot from decentralized players already problem-solving with the technology. And if the DeFi industry leaves institutional finance behind by refusing to integrate and learn from one another, they may end up falling at those same hurdles themselves.
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