Could smart contracts sideline banks?

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Imagine a world without banks or other financial middlemen.

That's the vision of Andrew Keys, the founder of ConsensSys Capital, a venture capital firm that fosters the development of decentrailized blockchain services and applications, who says smart contracts running on Ethereum could essentially take the place of banks.

He argues the role banks play in providing identity and reputation verification and acting as a trusted third party for entities that don’t trust each other can be handled by software.

“The concept of being a trusted middleman to process payments at, I’d argue, an egregious rate, or to audit transactions — all of that will become automated and commoditized,” Keys said last week at an event called Democratizing Finance held at the Museum of American Finance. “People will still need financial services and people will still need expertise, but the added value will be higher in the stack,” for instance, in providing financial advice or liquidity.

But not everyone is sold on this concept yet.

“For better or for worse, people outside the blockchain bubble have no trust for distributed ledger technology, particularly as it gets confused with cryptocurrency,” said Alex Jimenez, vice president and senior strategist at Zions Bancorp.

Though he agreed with Keys’ overall thesis, he pointed out that blockchain technology has issues around scalability and overcoming inertia that have yet to be addressed.

Firoze Lafeer, chief technology officer at the fintech small-business lender Breakout Capital Finance and former head of Capital One Labs, had a similar assessment.

“While many financial transactions may soon be done with blockchains and smart contracts, intermediaries are here to stay,” Lafeer said. “The move to blockchains and smart contracts does not eliminate all risks in financial activity. There is a role for banks and other companies who understand how to quantify and monetize risk in this commerce. In fact, I would argue that we will discover new and stronger opportunities for intermediaries in this industry.”

Still, a closer look at ConsenSys' ideas and the debate they have sparked may prove valuable to the financial industry. Distributed ledger technology is attracting smart developer talent, corporate sponsorship and momentum. ConsenSys itself, which has grown to more than 1,100 employees, is gaining traction in financial services. In September, it partnered with 15 banks, including Citigroup, ING and MUFG Bank, to create a venture called komgo that is building Ethereum applications to digitize trading and commodities finance.

A world run by smart contracts

Smart contracts are are self-executing contracts with the terms of the agreement between buyer and seller directly written into lines of code. The code and agreements exist across a distributed, decentralized blockchain network. Legal contracts can be turned into smart contracts, with clauses executed automatically by the software: if X happens, then make a payment of Y to Z, for example. One startup creating smart contracts for businesses is

Smart contracts can be audited by software rather than humans.

“Then you don't have to trust these large intermediaries,” Keys said. “You start removing friction and improving liquidity. You could have employment agreements by the minute. You could have a food stamp that users would not be able to use to buy cigarettes or alcohol, because that's embedded into the logic of these smart contracts.”

Theoretically, a smart contract can do some of the work of a bank. For example, to get a letter of credit from a bank to start drilling in a new site, an oil company would need to excavate at the site, send samples to a laboratory for testing, and if the lab verified there was oil in the rock, the firm would then begin to apply to a bank for a line of credit.

“That process would take close to a year, between the excavation, sending the samples to the laboratory, and applying for the line of credit,” Keys said.

Using a smart contract, the lab’s approval could automatically trigger a letter of credit, cutting about six months out of the process. A bank would still be involved, but it would no longer be the middleman. It would be a provider of liquidity.

“Banks will need to soul-search for added values beyond being the trusted intermediary,” Keys said.

Consumers are also part of ConsenSys’ vision. Instead of logging into Facebook, Google, PayPal or online banking, consumers will use personalized open source browsers that will interact with smart contracts. These browsers will be protected with biometric authentication and they will be used to store digital assets like dollars, cryptocurrency, reward points and medical records. They will also store pieces of the user’s digital reputation — their Uber and Airbnb ratings, for instance.

Consumers could decide what to store in their browser, what they want to give to another party for custody, and what data they want to disclose to third parties, such as elements of their digital reputation for due diligence.

Supporters of such ideas maintain that it would give consumers more control while being safer than the current system.

The risks

But smart contracts are hardly risk free. Though no blockchain has ever been directly breached, smart contracts have been compromised. For instance, The DAO was a decentralized, autonomous venture capital fund that ran on Ethereum-based smart contracts. It literally had no employees, no management and no board of directors. Some users exploited a vulnerability in The DAO's smart contract code that let them siphon off a third of The DAO's funds to a subsidiary account.

Keys chalked this incident up to Ethereum software still being “in the early innings.” The software itself and the ability to monitor and audit it will improve over time, he said.

Another issue with smart contracts is that consumers already are struggling to manage their own private keys and passwords. It's hard to imagine the typical American being capable of protecting all their own data and assets with private keys.

For that reason, Keys sees some people paying an intermediary to take custody of digital assets.

There will be a persistent, and perhaps growing, need for lawyers, too, as smart contract disputes inevitably arise. Lawyers will have to understand computer science, Keys said. Already large law firms are hiring people with computer science as well as legal degrees.

Keys predicts smart contracts will make an impact by the first quarter of 2020, and that a tenth of the U.S. gross domestic product will be on a blockchain by 2025.

Others don’t see this happening so quickly.

“Eventually we will see more types of transactions done directly through smart contracts, routed more efficiently and as part of an automated process that will ensure appropriate checks and obligations are completed as funds are transferred,” said Brad Leimer, co-founder of the venture capital and advisory firm Unconventional Ventures and formerly head of innovation at Santander U.S.

“But will it soon dominate monetary movement to disintermediate the existing rails in any particular geography? I don’t see this happening all that soon.”

There are too many players involved, many of them still in the exploratory stage of distributed ledger and smart contract technologies, Leimer said.

“I would expect iterative smart contracts to be simply an evolution of the overall revolution in payments and money movement we are already seeing,” Leimer said. “Global banks and money networks aren’t going to be taken out of this equation any time soon.”

Why Ethereum?

Ethereum is one of several types of distributed ledger technology with which financial services players, fintechs and startups have been experimenting. Others include Hyperledger, which Northern Trust used to build one of the few production financial services blockchains out there; R3; and proprietary technologies like Ripple’s distributed ledger for cross-border payments. All of these have dozens of financial institution members and clients.

One thing Ethereum has going for it is its ability to run smart contracts. Another is that there are standards being built around Ethereum for identity, reputation, digital tokens and exchanges.

Brian Behlendorf, executive director of Hyperledger, unsurprisingly doesn’t see Ethereum as the end-all, be-all. He pointed out the smart contract language used on the Ethereum public chain, Solidity, is still young. Some developers are building smart contracts on more familiar programming languages like Java and Javascript.

Behlendorf sees companies gravitating toward private, or "consortium," blockchains like Hyperledger projects that can adopt regulation and confidentiality requirements rather than public blockchains like Ethereum.

“No one is saying the public ones will go away, they do still have to figure out what the true utility is beyond being a casino, which is kind of what they are right now,” he said.

In Behlendorf’s view, you can’t bet the farm on any one type of blockchain technology yet.

“No one is going to have the right answer out of the gate, nor should anyone be expected to,” he said.

Killing the middlemen

Ever since companies began pondering uses for blockchain technology, it’s been posited that it could be used to knock out middlemen, like exchanges, clearing agents and banks.

But some of the biggest middlemen in financial services, including the Depository Trust & Clearing Corp. and Swift, have been among the first to jump on the blockchain bandwagon. The DTCC is putting its Trade Information Warehouse for credit derivatives on a distributed ledger; this month 15 large, global banks began conducting user acceptance tests of the technology. In March, Swift announced it conducted a proof of concept with 34 member banks for reconciling the Nostro accounts used to facilitate foreign exchange and trade transactions using a distributed ledger.

Keys said these central actors’ roles will evolve.

Behlendorf said that as the use of blockchain technology grows, financial middlemen should expect their margins to be threatened.

“Any place where you’re making money based on you being a central actor will require a dramatic remake,” Behlendorf said. “It is less about rewarding the centralizers, the ones who can run big data depositories or big networks, and more about rewarding networks of cooperative organizations. You’re more at risk if you’re Swift or DTCC than you are if you’re one of their members.”

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