Decentralized Financial Contracts v.1

[Introduction]

The purpose of this thesis for obtaining a Bachelor’s degree in Financial Management is to deepen the knowledge and application of financial models in different areas, including the study and analysis of the use of smart financial contracts.

Although the thesis focuses on traditional financial models and their application in different sectors, it also seeks to explore and examine how smart financial contracts can affect and improve efficiency and transparency in financial transactions.

Writing the thesis will allow the student to research and analyze the implications and benefits of using smart financial contracts compared to traditional contracts. This will include evaluating blockchain technology and how smart contracts can automate and guarantee the execution of the terms and conditions agreed upon in financial contracts.

By addressing this idea in the thesis, the student will be able to deepen their knowledge of smart financial contracts, their operation, advantages and challenges, and how they can be applied in different areas of financial management. This will contribute to the student’s comprehensive training as a professional in the field, keeping up with the latest trends and advances in the financial and technological areas.

I. On Financial Contracts

Financial contracts are legal agreements between two or more parties that establish the conditions and terms for conducting financial transactions. These contracts may include loan agreements, derivatives contracts, futures contracts, financial options, among others. Their main objective is to establish the rights and obligations of the parties involved in the transaction, as well as the payment terms, deadlines, interest rates, and other relevant details.

The execution of financial agreements is guaranteed through different mechanisms. In the case of decentralized financial contracts (DeFi), execution is based on automation through smart contracts on a blockchain. Smart contracts are computer programs that execute automatically when certain predefined conditions are met.

These smart contracts ensure compliance with the terms and conditions established in the financial contracts. Being based on decentralized technology such as blockchain, the need for intermediaries is eliminated and the risk of fraud or manipulation is reduced. Once the agreed conditions are met, such as the maturity of a loan or the price of a derivative reaching a certain level, the smart contract is activated and automatically performs the corresponding actions, such as transferring funds or liquidating positions.

This automated and transparent execution of decentralized financial contracts provides trust and efficiency in transactions, as it eliminates the need to rely on third parties and reduces the time and costs associated with traditional intermediation.

According to generally accepted accounting principles, the characteristics that define a right and an obligation of a financial contract are the following:

1. Right: A right in a financial contract implies that one of the parties has the power to obtain future economic benefits as a result of the contract. This economic benefit can be in the form of cash, goods, or services. The right may arise due to a contractual agreement or as a result of applicable laws or regulations.
2. Obligation: An obligation in a financial contract implies that one of the parties has the responsibility to perform a future action or transfer economic resources to another party. This obligation may arise due to a contractual agreement or as a result of applicable laws or regulations. The obligation may involve the payment of cash, the delivery of goods, or the provision of services.

It is important to note that the rights and obligations in a financial contract must be measurable and have a reasonable probability of occurrence. Additionally, they must be properly recognized and recorded in the financial statements in accordance with applicable accounting principles.

Decentralized financial contracts (DeFi) do not imply a different emergence or origin compared to traditional financial contracts. In both cases, contracts may arise in formal or informal markets, and they establish the terms and conditions for conducting financial transactions.

The difference lies in the method of execution. In decentralized financial contracts, execution is based on automation through smart contracts on a blockchain. This eliminates the need for intermediaries and reduces the risk of fraud or manipulation. Smart contracts guarantee compliance with established terms and conditions and are automatically activated when predefined conditions are met.

In summary, decentralized financial contracts do not change the emergence or origin of contracts but rather offer a more efficient and transparent form of execution through blockchain technology and smart contracts.

e.g. 1

The most common financial contract is the loan contract. This type of contract establishes the terms and conditions for lending or borrowing money. It includes details such as the loan amount, interest rate, repayment term, and associated guarantees. Loan contracts are widely used in financial transactions to finance projects, acquire goods, or cover liquidity needs.

A simple loan contract is defined as one that contains the necessary legal elements for the contract’s validity. These elements include:

1. Consent: Both parties, the lender and the borrower, must give their free and voluntary consent to establish the loan contract. This means that both parties agree with the terms and conditions established in the contract.
2. Object: The loan contract must have a determined and lawful object. In this case, the object is the loan of a specific amount of money from the lender to the borrower.
3. Cause: The cause refers to the reason or motivation behind the loan contract. In this case, the cause is the borrower’s interest in obtaining an amount of money and the lender’s interest in receiving repayment with interest.
4. Legal capacity: Both the lender and the borrower must have the legal capacity to enter into the loan contract. This means they must be of legal age and have the mental capacity necessary to understand and assume the terms and obligations of the contract.
5. Written form: Although not strictly necessary in all cases, it is recommended that the loan contract be made in writing to avoid misunderstandings and future conflicts. The written form provides clear evidence of the terms and conditions agreed upon by both parties.

It is important to mention that these elements may vary according to the laws and regulations of each jurisdiction. Therefore, it is advisable to consult with a legal professional to ensure compliance with the specific requirements of each country or region.

In the case of decentralized financial contracts, the written form can be augmented with the programming of a contract on a blockchain. By using smart contracts on a blockchain, the ability to guarantee execution conditions can be enhanced. This is achieved by programming the transfer of assets upon fulfillment of the obligations established in the contract. In this way, the execution of decentralized financial contracts is automated, eliminating the need to trust third parties and reducing the risk of manipulation or non-compliance.

The way this contract is programmed is not the main object of analysis of this text; rather, it seeks to theoretically explain the implications of its use based on how they are observed in practice, and to financially explain how much value it generates compared to a traditional financial contract.