When Northern Trust executives think about smart contracts, they see better products and money saved.
The blockchain-based contracts partly cut out the role of third parties in enforcing legal contracts, boosting productivity by around 20% on simple deals and up to 70% on more complex ones, said Justin Chapman, Northern Trust's head of digital assets and financial markets. What's more, the programs allow the Chicago-based bank to store and repurpose data from past transactions. That helps make other deals happen seamlessly, he said.
Northern Trust is part of a trend: JPMorgan Chase has incorporated smart contracts in
Todd McDonald, co-founder of the enterprise vendor r3, said that he has yet to find a sector in the financial services area without an internal use case for smart contracts.
"This is part of a broader discussion on the future of finance," said R.A. Farrokhnia, a professor at Columbia Business School who studies fintech. "Who's going to be left behind, who's gonna do it right — and what it takes for you to disrupt your own organization."
The contracts cut out middlemen. That's why they became central to the decentralized finance, or defi, movement that
"The entry point"
The $156.8 billion-asset Northern Trust entered the digital arena in 2017, when it developed a regulator-approved blockchain network for private equity fund administration. Months before it transferred that network to Broadridge Financial Services in 2019, it started using smart contracts to capture and automate the legal terms attached to asset transfers.
"Smart contracts are a representation of a traditional contract," Chapman said. "You are capturing the definition of the asset itself, the issuance of the asset and the issuing process through a smart contract, and you're entering [that information] onto a register for onward transactions to happen on it."
That boosts productivity. But Chapman said the biggest benefit is in research and development.
"What you tend to find is that the insights are stronger," Chapman said. "You see an enhanced product. If we have a business idea or a problem, we can repurpose different types of smart contracts for different purposes."
Another upshot is that deals on shared networks are more transparent to the parties involved, Chapman said, even while that has taken getting clients to understand how to interpret legal clauses in code.
"We don't get as many challenges or questions as we used to," Chapman said. "Smart contracts are just a code conversion from a written set of documentation. They're nothing too complicated."
With the Chicago-based bank
"The smart contract is the entry point to the new ecosystems and environments as we see them," Chapman said.
In 2020, Northern Trust also began exploring bond tokenization and fractionalization agreements, a year before it helped launch the crypto asset custodian Zodia Custody. It has since also become a participant in
Northern Trust had $14.5 trillion of assets under custody/administration and $1.4 trillion of assets under management at June 30. Those client-asset categories are drivers of its largest segment of fee income, the company said in its
"The weakest point"
Smart contracts pose one big problem: They're prone to hacks.
"Historically, we've seen in the industry, [that] the smart contract could be the weakest point, particularly as the code point," Chapman said. "We have taken on additional cadence [to address that risk]."
When the bank first started using smart contracts, most were based on infamously fraud-prone defi protocols. That required them to recode contracts built on public networks, said Arijit Das, senior vice president in digital asset innovation technology at Northern Trust.
"Most public smart contract standards did not cater to the privacy needs of closed networks," Das said. "The implementers of smart contracts had to code these privacy and security needs into the smart contract logic."
Northern Trust soon developed its own system on hyper-ledger fabric technology with smart contracts coded in Golang, Google's open-source programming language. That, along with recent fintech strides to pioneer smart contract languages that are more secure, has made the programs safer. To double-check smart contracts' cyber protections and avoid fat-finger mistakes, the bank has also introduced an internal audit system.
"We see activity in this space as the industry has recognized the need to solve the problem of privacy for all chains," Das said. "A lot more attention is focused on the needs of large, private permissioned systems with institutional participants."
Safeguards needed
But some experts think there may need to be even more protections in place before smart contracts can be safely integrated into traditional financial services.
That includes placing a "pause" button — often called an "article" — in case one party encounters a hiccup or needs to renegotiate the deal, said Hillary J. Allen, professor at American University College of Law.
Other risks involve human error, picking the wrong coding languages, or trouble in sourcing external data, said Monica Summerville, head of capital markets at Celent.
Then there are also unresolved questions over who bears liability for any legal issues the contracts cause. "I would say the safer rule is that if it's your system, you own it," Allen said.
Banks should also beware that smart contracts, while traceable, are irreversible. That means that they can fail to account for unwanted eventualities that leave parties unable to overwrite prior terms. At Northern Trust, there is often no way to reverse smart contracts, though the bank can layer other contracts on top of them to override the previous terms, Chapman said.
"What if these things work exactly like they're supposed to, and we still don't want that?" Allen asked. "Sometimes there will be situations where you want some flexibility and discretion. There's no discretion. That's sort of touted as a feature, not a bug. But I wonder if it's a bug."
Tech tailwinds are nonetheless pushing financial institutions toward the blockchain, and with it, smart contracts.
But the switch to digital assets is going to be harder than the one from fax machines to email servers, Farrokhnia said. That could be a problem for banks with technology architectures that don't integrate with blockchain servers or executives who aren't up to date on the new technology.
"The learning curve was relatively easy, and it didn't require banks to change their entire systems. Blockchain is the exact opposite," Farrokhnia said. "How do you … still, run the company the way you've been running it, but in an alternate universe?"
To avoid being left behind in an advancing tech race, financial institutions may need to start catching up. They can start by watching the fintech scene, Farrokhnia said.
"Ensure that you have your pulse on the market," he said. "Startups are very good at innovation. But big banks are good at distribution. If you marry the two, then you have something powerful."
