The Digital Transformation of Lending

Blockchain technology is poised to transform lending in ways ranging from mortgage loans to syndicated loan structures. Currently, lending transactions often depend on third-party intermediaries and contain costly, antiquated, and time-consuming manual processes that increase the cost and risks of lending agreements. These processes are susceptible to errors and fraud.

For example, mortgage lending is a particularly lengthy process that often spans over 60 days before a borrower’s closing due to an arduous process that involves ascertaining the borrower’s credit score, the transference of title, and the underwriting of the mortgage — just to name a few. Syndicated loans provide clients with the ability to secure diversified financing. Yet, these deals often involve settlement delays, manual review, and verification processes throughout the loan’s life cycle.

Blockchain technology is charting a new path. For years, the potential of blockchain technology to provide fundamental changes to improve lending processes in retail and commercial lending, syndicated loans, and trade finance, have been discussed and analyzed. That’s because many common loan conditions and processes are readily translatable into programmatic rules triggered automatically using Ethereum-based smart contracts, including the disbursement of funds, interest rate charges, or tracking payment performance. The combination of a blockchain and smart contracts could create tamper-resistant records of the parties’ relationship and lending history, increasing transparency for auditors and regulators through accurate and verifiable data.

Through the automatization and decentralization of a loan agreement’s terms and conditions, blockchain technology offers the hope to usher in a new era for lenders, bringing heightened efficiency and security to the lending process, including transparent record keeping and automated lending processes, which should decrease parties’ risk and reduce settlement delays. Blockchain-based smart contracts can provide parties with the ability to automate the selection of loan members, the verification of financial information, the funding of the loan, the disbursement of funds, and loan servicing, each increasing efficiencies and reducing costs.

However, despite this interest, the financial services industry has yet to find a comprehensive way to streamline the lending process. We have seen early experiments with blockchain-based loans. For example, German automaker Daimler AG issued a €100 million corporate bond in a pilot project that was facilitated through the blockchain network. Yet, Daimler’s corporate bond issuance was conducted on a private blockchain network, which takes away much of the transparency, decentralization, and trustless advantages that a public blockchain provides. In addition, its bond was conducted in parallel with non-blockchain bond issuance processes that spanned more than weeks.

A Pathway to a New Era of Lending

Our demo provides the first step in showing how the automatization and execution of loan agreements on the blockchain can vastly improve these processes. We show how a standard loan agreement can be executed using the OpenLaw protocol and an Ethereum smart contract without lengthy loan processes that characterize lending as it is conducted today.

We took a standard loan agreement outlining the type of loan (revolving or term, secured or not), the loan amount, the interest rate, the maturity date, payment installments, security interests, events of default, and applicable remedies.

Through the use of an Ethereum-based smart contract, we demonstrate how a traditional loan transaction can be performed without the need to rely on centralized institutions to calculate and manage the actual flow of funds between the parties to a transaction. For example, once the loan agreement is executed, a borrower can draw against and pays off his or her loan through a smart contract that is automatically executed on the blockchain network.

While there are many technical dimensions to the loan agreement that one might explore, a deeper examination illustrated below focuses on the method of calculating interest charges. Since one objective of blockchain transactions is transparency, we believe that it is important to capture the interest calculations within the smart contract itself, which increases trust among the parties in the absence of a centralized lending institution.

Thus, at the time a loan is created, its interest rate is recorded within the contract itself. Then, upon specific events during the term of the contract, such as a borrower’s monthly interest payment to the contract, the current interest expense is calculated and accrued based on the outstanding principal balance for the prior month before applying the payment. This method is consistent with the written contract on the OpenLaw platform and common commercial revolving loan practice.

Practical Considerations

While the benefits of applying blockchain technology to loan processes carries much promise, there are currently some technical limitations. For example, blockchains do not currently store all data relevant to a loan agreement. Data that is not readily accessible on the blockchain can be obtained through the use of oracles that can verify specific data points. For example, variable interest rates that change with the prime rate or another market benchmark could be implemented in a smart contract through an oracle feed. However, oracle systems, as with any data verification mechanism, must ensure that correct data is being provided to the smart contract. Some oracle feeds average data from various sources to provide more accurate data points. As such, it may be beneficial for the parties involved in loan transactions to ensure that the oracle feed data being used in the smart contract is accurate. As smart contracts are adopted by more companies and additional uses for smart contracts emerge, the market for trusted parties to create these data feeds will drastically increase.

Additionally, the automatization of labor-intensive manual processes that must be conducted to originate loans, verify data, distribute funds, and service loans, comes with certain limitations. For example, a standard term in a commercial lending agreement covers the risk of default in the case of bankruptcy or when a borrower stops its business activities. Until robust oracle systems develop, this type of information cannot yet be tracked via the blockchain.

Looking Ahead

We’re just getting started. OpenLaw and McCarthy Tétrault will continue to iterate on this use case as we develop the OpenLaw’s protocol and start to experiment with more involved loan agreements. Again, we’d like to thank Ana Badour, Ian Mak, and Eriq Yu from McCarthy Tétrault for their interest and continued support.

Along with this demo and our Real Estate and Tax Law demos, we plan on exploring other proof of concepts over the next few months. Plan on visiting our Medium page for write-ups on some of the following demos we’re thinking about working through next:

A tokenized Licensing Agreement,

An automated Advertising Agreement, and

A basic Will and Testament with asset transfer on a life event.

Please reach out to hello@openlaw.io if you have any inquiries or suggestions (demo ideas too!) moving forward. We’re trying to change the future of commercial law, come join us!

— The OpenLaw Team

Disclaimer: The views expressed by the author above do not necessarily represent the views of Consensys AG. ConsenSys is a decentralized community with ConsenSys Media being a platform for members to freely express their diverse ideas and perspectives. To learn more about ConsenSys and Ethereum, please visit our website.