Blockchain technology has reached all corners of business—money transfers, retail loyalty programs, legal contracts, copyright protections. This technology serves as the foundation for smart contracts, which brings a new level of transparency and security to business-to-business transactions.
Paper contracts can take weeks to move from one party to another, and digital documents can, unfortunately, be easily forged. Smart contracts become a viable solution to tackle these problems. They can be used to transfer goods, services, shares—all without a middleman. This minimizes the legal and administrative fees, creating a true peer-to-peer marketplace. But, like any new technology, smart contracts come with its limitations: lack of legal structure, ease of use, and uncertainty.
What is a smart contract?
Smart contracts (also referred to as blockchain contracts) are self-executing contracts between two or more parties. Blockchain is the technology behind smart contracts, which is a distributed record of transactions maintained by a decentralized computer network (it’s also the technology behind cryptocurrency).
Experts believe smart contracts and blockchain technology could save investment banks $12 billion per year. Banks could reduce infrastructure costs by an average of 30 percent and reduce compliance-related costs by 50 percent. However, banks are not the only ones to benefit from smart contracts.
In the B2B world, the terms of the agreement would be drawn up between you (the seller) and your buyers. The terms would then be written into lines of code to form the smart contract. The code and agreement are stored in a decentralized blockchain network and only accessible to you and the other parties involved in the contract.
Your B2B company could use smart contracts to exchange money, services, property, shares—anything that has a clear-cut value. Because banks and governments do not regulate blockchains, you wouldn’t need to involve a middleman to create, enforce, or execute the contract. According to PwC, smart contracts will be used to transfer physical goods in addition to digital goods by 2020.
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How do smart contracts work?
Ben Lamm, co-founder of AI solutions agency Hypergiant, says, “Essentially, smart contracts are just software built on blockchain protocols that ensure that certain actions take place once certain conditions are met. Because the program is built on a decentralized ledger (a blockchain protocol), they enable less risk held by one party, and they cannot be altered by a single party or central authority. Metaphorically speaking, smart contracts play the role of a neutral third party, like an escrow service would.”
The contract is stored in a shared database, accessible to all parties—removing the need for each party to download and store their own copy. Cryptography coding enforces smart contracts, and the code automatically executes the terms once the parties meet the predetermined conditions of the contract.
What industries currently use smart contracts?
Finance, insurance, real estate, and shipping currently use smart contracts. According to Gartner, more than 25 percent of global organizations will implement smart contracts by 2022. From his perspective, Lamm states, “We haven’t seen a lot of companies using them yet, but we expect that smart contracts will be the application most responsible for driving broad enterprise adoption of distributed ledger technologies.”
For example, insurance claims can take months to process and payout—a problem for both the insurance company and the customer. A smart contract would automatically trigger a claim when a specific event occurred. If an employee gets injured at work, the smart contract would recognize this event and begin the claim.
In a supply chain, the smart contract could record the ownership of goods at any given moment as they move between warehouses, suppliers, and manufacturers. If an item is misplaced or delayed, the smart contract will find where the product should be and notify the affected parties.
What are the benefits of smart contracts?
Minimizes Resources for Transactions
In a recent article, Nick Allen, the Product Director at Zap, a blockchain startup, said “Businesses spend countless hours and immeasurable amounts of money on administrative costs, including escrow, legal fees, time spent negotiating, etc. Smart contracts automate payments, making the entire process much more streamlined.”
If you’re an international business, foreign transaction fees can be a real sticking point. The average international wire transfer costs anywhere between $22 and $50 in addition to the currency exchange fees you have to pay.
By spending fewer resources on legal fees and administrative tasks, you can shift your resources to improving products, customer experience, and marketing strategies.
Transparency and Security
Smart contracts are stored in a shared, decentralized database, which provides easy access for any party involved in the contract. It also ensures each party has the correct version of the contract, rather than multiple version found in an email string.
Because of the nature of blockchain servers, they are extremely secure—it’s near impossible to make changes to the contract after implementation without leaving a digital footprint. Edits to the smart contract can only occur if it was pre-programmed into the smart contract before implementation.
With a smart contract, there are typically only two parties involved: the buyer and the seller. As a result, this reduces the movement of transactions, creating less friction when executing a contract.
Smart contracts can even replace manual purchase orders and other trade documents. Real-time visibility into supply chain and trading data allows B2B companies to make intelligent and well-informed decisions around inventory, procurement, and finances.
What are the limitations of smart contracts?
There’s currently no regulation or legal structure for blockchain—causing many people to view blockchain as a risky way of conducting business.
There’s no federal contract law enforcing and interpreting smart contracts, leaving it up to the states to regulate these types of transactions. This likely wouldn’t be a significant concern if the contract didn’t cross state lines. However, if the parties are from separate states, this leaves the contract vulnerable to different interpretations of the terms.
Lack of Integrations
If you decide to integrate smart contracts into your business model, you might have a hard time finding an integration. Blockchain technology companies like Zap and Jincor are trying to fill this gap. These integrations allow businesses to use smart contracts without any legal, technical or operational complexities.
Difficult to Code Agreements Without a Technical Background
If you don’t have the technical know-how to write code to form a smart contract, then you will likely need to rely on a trusted IT expert to capture the agreement terms and write the code. You may want to consider a written agreement with the programmer prior to creating the contract, stating that the contract will perform as it was agreed upon by the involved parties.
However, as smart contracts increase in popularity, there will likely be more templates available for those individuals that are not technically savvy. In this case, you would want a written agreement as well with the programmer to ensure the template will perform as advertised.
The Achilles Heel: Automation
Automation is both a benefit and a limitation for smart contracts. Yes, it’s great that once the terms are met in a contract, funds transfer automatically. There’s no need for wire transfers, checks, or credit cards and reduces the risk of unreceived funds and fraud.
That said, some scenarios need human intervention in order to maintain the relationship between the buyer and the seller. For example, say a long-time customer is late on a monthly payment for the first time. According to the smart contract, any customer with a late payment is automatically penalized 72 hours past due. However, for this one customer, you may be more forgiving and willing to let the late payment slide in order to maintain the positive relationship you have. With a smart contract, it would be difficult to stop the automatic penalization of the customer—you can’t make edits to a contract post-implementation.
Smart contract technology comes with its own set of limitations and downfalls, but this shouldn’t overshadow the potential of what it can do. Transactions are a significant part of any B2B business model. By streamlining this process, you can shift your resources to other facets of the business.