The BBVA paper defines smart contracts as any legal agreement capable of automatically enforcing itself with the need for third party intervention. Unlike traditional paper-based agreements, smart contracts are coded scripts, capable of unilaterally applying strict rules and consequences on the basis of fresh data inputs. The blockchain assures that everybody is seeing the same thing without one side having to trust the other side to be honest.

"The ability of smart contracts to alter the way in which many traditional processes are performed is potentially immense," says the BBVA paper, which goes on to outline a host of transformative applications in the financial sector.

Smart contracts can be coded to reflect any kind of data-driven business logic, says BBVA, from actions as simple as voting for a post in a forum, to the more complex such as loan collateralisation and futures contracts, and to the highly complex such as repayment prioritisation on a structured note.

The paper says that while there have been hundreds of proposed use cases for smart contracts, some of the most (directly or indirectly) relevant to financial institutions would include:

• Loans could be stored as smart contracts in the blockchain, together with the collateral ownership information. If the borrower misses a payment, the smart contract could automatically revoke the digital keys that grant his access to the collateral.
• Inheritances could be automated by setting the allocation of assets after death. It might be as simple as moving an adjustable slider that determines who gets how much. Once the smart contract can verify the triggering condition — in this case, death — the contract goes into effect and assets are divided up.
• Escrow. Smart contracts can easily be set up as escrow accounts that monitor an exchange between two parties. The buyer of some goods or services would transfer the payment to the contract account. The contract would monitor external services (i.e. GPS tracking) and, when ownership has been transferred from the seller to the buyer, the contract would automatically release the funds to the seller.
• Cryptocurrency wallet controls. Wallets controlled by contracts could include many different types of complex controls, from daily withdrawal limits to granting and revoking access for specific entities. A generalisation of this will lead to the notion of programmable money, a type of money which can be set up to be spent only on certain kinds of assets, in a geographical area, between two dates, etc.
• Capital Markets. Securities based on payments and rights that are executed according to predefined rules can be written as smart contracts. There are already experiments for the issuance of smart bonds and the management of private stock markets. Contracts that monitor the performance of digital or nondigital assets can also be used as futures, forwards, swaps and options.

Despite the potential, implementation challenges abound, with standardisation issues and wider adoption of the blockchain particular hurdles to overcome.

Says the BBVA paper: "For the foreseeable future, they will not be enforceable in any court and few parties will be able to rely on smart contracts alone to structure all of the terms of a commercial transaction."

From a legal perspective, smart contracts are seen as an evolution of the legal system, not its replacement.

"The role of lawyers might shift from adjudicating individual contracts to producing smart contract templates on a competitive market," states the paper. "Contract selling points would be their quality, how customisable they are, and their ease of use. In the long term, we could see the surge of organized smart contract marketplaces that, in turn, would be fully managed through smart contracts, thus closing the circle."