Smart contracts: will Fintech be the catalyst for the next global financial crisis?
| DOI | https://doi.org/10.1108/JFRC-09-2018-0122 |
| Date | 09 December 2019 |
| Published date | 09 December 2019 |
| Pages | 104-122 |
| Subject Matter | Accounting & Finance,Financial risk/company failure,Financial compliance/regulation |
| Author | Randall E. Duran,Paul Griffin |
Smart contracts: will Fintech be
the catalyst for the next global
financial crisis?
Randall E. Duran
Catena Technologies, San Francisco, California, USA, and
Paul Griffin
Singapore Management University School of Information Systems,
Singapore, Singapore
Abstract
Purpose –This paper aims to examine the risks associated with smart contracts, a disruptive financial
technology(FinTech) innovation, and assesses how in the future they could threatenthe integrity of the global
financialsystem.
Design/methodology/approach –A qualitative approach is used to identifyrisk factors related to the
use of new financial innovations, by examining how over-the-counter (OTC) derivatives contributed to the
Global Financial Crisis(GFC) which occurred during 2007 and 2008. Based on this analysis, the potentialfor
similar concerns with smart contracts are evaluated, drawingon the failure of The DAO on the Ethereum
blockchain,which involved the loss of over $60m of digital currency.
Findings –Extensive use of bilateral agreements, complexity and lack of standardization, lack of
transparency,misuse and speed of contagion were factors that contributed to the GFCthat could also become
material concerns forsmart contract technology as its adoption grows. These concerns, combinedwith other
contextual factors, such as the risk of defects in smart contracts and cyberattacks, could lead to potential
destabilizationof the broader financial system.
Practical implications –The paper’sfindings provide insights to help make the design, management
and monitoring of smart contract technologymore robust. They also provide guidance for key stakeholders
on proactivesteps that can be taken with smart contract technologyto avoid repeating the types of oversights
that contributedto the GFC.
Originality/value –This paper draws attention to the risks associated with the adoption of disruptive
FinTech.It also suggests steps thatregulators and other key stakeholderscan take to help mitigatethose risks.
Keywords Global financial crisis, Blockchain, Distributed ledger technology, Smart contracts,
OTC derivatives, Digital currencies
Paper type Conceptual paper
1. Introduction
The rise of digital ledger technology (DLT) over the past decade has served as a disruptive
force within financial services and has been driven by financial technology (FinTech)
companies. In simple terms, DLT is a shared distributed database where there is no centralized
data storage or administration. By its design, it well suited for decentralized solutions, which
aim to avoid having any single point of failure. While digital currencies, such as bitcoin
(Nakamoto, 2008), were the first applications to leverage DLT, many other applications,
ranging from land registries to transactional systems for trade finance, are being developed
and undergoing testing. One of the more intriguing and promising DLT-related technologies
are smart contracts.
JFRC
29,1
104
Received4 September 2018
Revised16 June 2019
27September 2019
Accepted28 October 2019
Journalof Financial Regulation
andCompliance
Vol.29 No. 1, 2021
pp. 104-122
© Emerald Publishing Limited
1358-1988
DOI 10.1108/JFRC-09-2018-0122
The current issue and full text archive of this journal is available on Emerald Insight at:
www.emeraldinsight.com/1358-1988.htm
Smart contracts are software-basedagreements that do not involve human mediators for
execution (Szabo, 1997). Currently,they are implemented as programmatic instructions that
are typically storedand executed on distributed ledger technology. Onceparties have agreed
to initiate and participate in asmart contract transaction, the blockchain will automatically
execute the terms of the agreement once relevanttriggering events occur.
The autonomous nature of smart contracts helps mitigate the risk of counterparty default
due to lack of compliance with an agreement. They also can help avoid the risk of non-payment
by putting DLT-based currencies in a form of digital escrow, prior to an event occurring that
triggers a payment. These features hold great value in reducing the trust requirements between
counterparties by lessening or eliminating risks related to enforcement of the agreement and
the creditworthiness of the counterparty (Schneider et al.,2018). Smart contracts also have the
potential to automate and provide greater efficiency and assurance of the execution of
contractual terms, as compared with traditional contracts. By facilitating new levels of trust
and automation in contractual agreements, smart contracts have the potential revoluti onize
how financial processes are implemented for lending, trade finance, and derivatives trading.
What is more, outside of the FinTech context, smart contracts have wide applicability to other
business domains. That said, there is a ways to go before the benefits of smart contracts are
realized on a broad scale. Challenges related to the implementation of technology innovations
and adaptations, such as establishing benefits for key stakeholders and sufficiently aligning
existing processes with new technology approaches, must be overcome (Leonard-Barton, 1988).
As with other FinTech innovations, due to their novelty, the risks related to smart
contracts are not fully understood. Nevertheless, general considerations related to
technology innovation and adaptation,such as the current stage within the overall lifecycle,
are pertinent. For instance, limited use and testing of new technology in real-world
applications may allow flaws and vulnerabilities to persist undetected. As technologies
mature, practicessuch as standardization and monitoring may be adopted, helping to reduce
the likelihood of these risks.
Given the high velocity of innovation and the rapid adoption of FinTech,it is important
to consider the broader risks that could develop. The evolution of smart contracts and a
broad expansion of their use could create systemic risks and threaten the integrity of the
broader financial system, particularly if they become widely adopted infrastructure
components –i.e. mechanisms and technology that underpin business processes and
counterparty relationships. Interconnectedness and dependency on a common technology
also makes it easier for a single attack vector to affect multiple institutions (Warren et al.,
2018). At the present time this risk may sound doubtful. However, it is worthwhile to
consider the impact that another, relatively new financial technology, over-the-counter
(OTC) derivatives, had in the early 2000s. OTC derivatives served as a catalyst for the
Global FinancialCrisis (GFC) that took place during 2007 and 2008.
There are a number of risks associated with DLTs and smart contracts that are
understood at present (Luu et al., 2016;Juels et al.,2016;Delmolino et al.,2016;Atzei et al.,
2017;Weaver, 2018;Kalra et al., 2018),but perhaps the greater risks are those that have not
yet been uncovered. Because of the novelty of smart contracts, there has been limited
exploratory analysis and research of their potential flaws and unexpected behaviour
characteristics. Likewise, the complexity and rapid evolution of the information technology
(IT) that underpins smart contracts makes it likely that structural and intrinsic risks may
persist and continue to be discovered over an extended period. It is not unusual for critical
security vulnerabilities to be found and exploited in decades-old core IT infrastructure
components, such as the 2017 WannaCry ransomware virus that affected old unpatched
versions of the Microsoft Windows operating system (Graham, 2017). Furthermore, smart
Smart
contracts
105
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