We started to talk about the potential of smart contracts in banking last week. You can read the first part here :)

1. Bonds

Smart contracts are able to execute complex computation, there is the capability to use them to set up and manage “smart bonds”. The coding of the legal requirements in a smart bond would mainly be in the area of permission i.e. to define detailed rules about who is allowed and not allowed to hold this bond.

Smart bond is a financial instrument which automatically pays out at given intervals. Bonds are a good example of a financial instrument suited to smart contracts because they could be backed by other assets that exist on the blockchain, in the case when the bond issuer itself fails to make a payment.

There is one issue with smart bonds that would first need to be addressed and resolved before it becomes functional. If an issuer of the smart bond does not have sufficient funds to pay the bond on time, how can the smart contract coding be written to resolve this type of situation? A smart contract cannot be written so that real world assets are seized or so that the bond issuer is taken to court. Smart contract can only highlight that the payment is overdue and calculate the interest payable. The smart contract would need to be written and managed in a way that, to ensure that funds are sufficient. It could lock up those funds under the control of the smart contract representing the smart bond. To lock up the funds in this way would mean that the issuer could not use them for anything else so there would not be any point to issuing the bond in the first place. This could be a problematic issue to resolve.

2. Clearing and settlement

Global banks have already tested smart contracts for clearing and settlement activity and many of those banks have already progressed to pursuing their own individual further trials. Smart contracts can take over the onerous administrative task of managing approvals between participants, calculating trade settlement amounts and then transferring the funds automatically once the transaction embedded within the smart contract has been verified and approved. For example, in 2015, the Depository Trust & Clearing Corporation (the American post-trade financial services company providing clearing and settlement services to the financial markets) processed over $1.5 quadrillion worth of securities, representing 345 million transactions. Smart contracts have the potential to automate part or parts of this process could generate a substantial saving.

Average settlement time for a syndicated loan in the is US 20+ days, In Europe — 48 days.

3. Distributed Ledgers offer a higher degree of trust and reduced risks

Contracts or records stored on ledgers eliminate the need for a central intermediary to provide trust in the system. For markets that do not use intermediaries, it still a higher degree of trust than current operations:

• Corporate Finance and Investment Banking: Distribution of private equity of small and medium businesses in a crowdfunding or an IPO sale;
• Structured Finance: Trading and settlement of large, collateralized loans such as syndicated loans between a group of banks, mutual funds, and pension funds;
• Insurance: Automated processing of travel insurance claims in case of events that can be automatically verified, such as flight delays or cancellations.

The main issue with implementation of smart contracts in banking right now is legal jurisdiction. But we will talk about legal part of smart contracts implementation in future articles. Stay tuned!