This is the path toward smart financial contracts and more resilient banking

Despite clear signs of inflation appearing as early as the summer of 2021, the US Federal Reserve maintained the key interest rate near zero and kept buying hundreds of billions of dollars of US treasury bonds and mortgage-backed securities each month.

It wasn’t until March 2022 that the Fed’s open market committee took direct, albeit belated, action to quell spiralling inflation. Embarking on an aggressive monetary tightening, the Fed took its Federal Funds rate from near zero in March 2022 to nearly 5% 12 months later.

The speed and magnitude of the Fed’s reversal drove down the value of “safe” financial assets, including US treasuries. Silicon Valley Bank (SVB), which made a name for itself by banking some of the world’s most successful venture capital (VC) firms and their portfolio companies, had parked billions of dollars into long-term US treasuries.

As the Fed began ratcheting up interest rates in the spring of 2022, VC funding rounds became harder to come by and start-ups began to withdraw and spend their deposits. To offset this incremental outflow of customer deposits, SVB sold long-dated US treasuries – which had recently declined in value – at a loss.

Attempts by SVB management to communicate the rationale for the sale, including by maintaining capital adequacy ratios, floundered. Speculation about the bank’s solvency went viral on social media. Spooked depositors withdrew $42 billion in a single day from SVB, making it the second-largest bank run in history.

As US Treasury Secretary Janet Yellen later observed: “No matter how strong capital and liquidity supervision are, if a bank has an overwhelming run that’s spurred by social media so that it’s seeing deposits flee at that pace, a bank can be put in danger of failing.”

The speed and reflexivity of social media have undermined the ability of financial managers and regulators to respond effectively to shifting market conditions. The glacial pace of traditional financial auditing and reporting poses risks for financial institutions in the age of social media and the real-time dissemination of information.

Part of the problem is that financial auditing, risk management and regulation rely on slow and expensive manual reconciliation to make sense of outdated data. In other words, bank runs are happening at the speed of social media, while financial reporting, auditing and compliance still occur at the rate of SEC filings.

To navigate the accelerating rate of change in our data-driven world, financial managers must embrace a digitally-native approach to financial auditing and reporting that incorporates blockchain’s transaction security, verifiability and enforceability.

Managers, investors and regulators could benefit from a near-real-time view of assets, liabilities and cash flows. At the same time, customers (in the case of SVB, its depositors) could benefit from a live and verifiable picture of its financial integrity and liquidity.

Financial institutions and regulators should consider the potential utility of AI-powered analytics, risk management and automation that can be built upon a foundation of machine-readable financial logic and supported by blockchain scaffolding.

Financial contracts, at their very essence, express the intention of the counterparties to exchange cash flows, sums and sequences of payments, which can most effectively be expressed numerically and algorithmically.

ACTUS (Algorithmic Contract Types Unified Standards) is an open-source standard for algorithmic financial contracts. Leveraging the ACTUS standard, Nucleus Finance has built a suite of modular, api-native lifecycle management, tokenization and risk management tools for financial product issuers, investors, custodians and regulators.

There is growing consensus around the potential benefits of tokenization for creating, issuing and managing digital assets. Citi forecasts up to $5 trillion of tokenized financial instruments by 2030, including $1.9 trillion in debt, $1.5 trillion from real estate, $0.7 trillion from private equity and VC and $0.5-1 trillion from securities.

However, most of the financial instruments tokenized to date have been little more than hashed PDFs of term sheets; that is to say, asset tokens representing a claim to future cash flows. The asset token’s counterpart, the liability token, is missing, which expresses the issuer’s payment obligations.

A tokenized financial contract should express the full logic of cash flows between counterparties. One person’s asset is another person’s liability, after all. Representing the whole financial logic of a financial contract means a token must be updated to reflect cash flows and balances between counterparties.

This is why Nucleus Finance has deployed on the enterprise-grade Casper blockchain, as it is the only chain to offer natively upgradable smart contracts. By employing standardized algorithmic logic and real-time updates, a smart financial contract emerges, capable of autonomously expressing its own asset, liability and cash flow state.

The innovations underpinning smart financial contracts can be applied to increase efficiency, liquidity and lower the costs associated with a wide range of financial instruments, including commercial loans, commercial bonds, trade credit and invoice factoring.

In an era where information travels at the speed of social media, financial auditing, risk management and regulation rely on months-old data and manual reconciliation. Solving this means embedding financial contracts with a standardized, machine-readable cash flow logic.

Leveraging blockchain technology to tokenize and update financial contracts based on cash flows can enable managers, investors and auditors to verify balance sheet integrity using automated tools easily. This concept defines the foundation of smart financial contracts, which can autonomously express their asset, liability and cash flow states in near-real-time.