Removing third parties speeds transactions and reduces their cost.
CFOs and finance departments are always looking for reductions in cost and increases in speed and efficiency in business engagements. One option that’s attracting more attention is the smart contract.
A smart contract is an electronic agreement that uses computer programming and blockchain technology to execute without third parties, such as the banks that verify payments, said Stan Sterna, J.D., a Chicago-based vice president with Aon, which provides the AICPA member insurance programs.
The building block(chain) for smart contracts
Blockchain technology is essential for smart contracts to work. To understand why, it’s important to remember that a blockchain is a distributed, digital ledger to which certain computers, or nodes, are granted access. The first blockchain was set up to record transactions of the digital currency bitcoin. When a transaction such as a bitcoin sale takes place on a blockchain, the details of the transaction are automatically recorded by both sides of the transaction and stored in a block of information that’s immediately shared with and verifiable by all nodes on the blockchain.
In the case of smart contracts, blockchain technology automatically performs contract actions when predefined conditions occur, said Sterna, who has 20 years of experience in consulting CPAs in cybersecurity and risk. The blockchain keeps track of contract terms and enables the automated completion of next steps in the contract process once it verifies that a step is fulfilled.
Let’s say you agree to buy goods from a business using a smart contract. The smart contract holds back payment until delivery is confirmed. “The smart contract then releases payment automatically. This process ensures that the outcome executes correctly,” Sterna said. The process is faster and less expensive than with a traditional contract and removes a lot of human error, he said. In addition, the inherent transparency and immutability of blockchain technology allow all parties in a smart contract to verify transactions and trust that the contract will be kept safe from tampering and fraud.
Smart contracts generally, though not exclusively, pay out in cryptocurrencies, Sterna said. But they also can be used for non-monetary transactions such transferring real property or handling medical records. A smart contract can verify a transaction and call for completion of an action outside the distributed ledger, he added, such as asking a bank to complete a transfer of hard currency.
“Taking a shipping example, the smart contract could verify the transactional process of the shipment per the distributed ledger. Once it is confirmed that the shipment cleared customs, it could message the customer’s bank for payment. If the bank’s internal system determines a valid shipment was made per the agreement, it could create a debit in the customer’s relevant bank ledger and transfer the sum in the customer’s currency,” Sterna said.