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The construction industry is infamous for delayed payments and payment-related disputes. The issues could be significantly reduced by taking advantage of blockchain-based smart contracts. It is a system that not only saves cost and time but also increases transparency and predictability by automating certain aspects of construction project performance.
Numerous contracts are signed between different parties in a construction project. The typical parties involved in a construction project are an owner, main contractor (or general contractor), subcontractors, suppliers, etc. The greater the distance from the owner, the longer the potential payment delay.
Delayed progress payment is one of the major problems in payment arrangements within the construction projects. Difficulties in cash flow, making contractors and subcontractors unable to carry out the work, and bankruptcy of participants are resulted by late and refused progress payments. Besides, the procurement phase of a construction project witnesses high cost and time overruns in the payment process.
The adoption of smart contracts will allow the conditions of a contract to be coded in the system. Clauses in smart contracts are executed only when the coded conditions are fulfilled. The amount to be released is blocked in smart contracts in such a way that no one party can access money. The payment amount is released to different parties only when the coded terms are satisfied.
Smart contracts are digital protocols that would facilitate, verify, or enforce the negotiation or performance of a contract, or that prevent the need for a contractual clause. A smart contract is decisive because of its binary logic, which means that inputs and outputs are the same, and contract conditions function depends on coded scope satisfaction.
Smart Contracts in Construction
- A construction project usually begins with the owner putting together a set of drawings, specifications, and other relevant documents to render or negotiate a particular scope of work.
- Eventually, a contract is signed with a contractor to carry out the works in exchange for a sum of money.
- The head contractor breaks up the scope of works and signs various other subcontractors to perform the works.
- Different arrangements are made between the owner and head contractor, head contractor and subcontractors to simplify work allocation and clarify payment conditions. Based on this, a bill is presented for the part of the construction work that has been carried out. However, these arrangements don’t work in large-scale construction projects.
- If the payment of one party is withheld or not paid at all due to any discrepancy, other associated parties get affected by it. This severely affects the project.
- Consider the scenario where the owner could embed the contract value in a construction contract. By embedding, it means that all the transactions would happen automatically once a piece of work is completed.
- The owner, if using a smart contract, can embed digital currencies into the contract together with all the stipulations that have to be fulfilled for the main contractor to be paid. The head contractor just needs to deliver their scope of works to receive the payments embedded in the contract.
- This would give a sense of assurance to all the parties involved in the project and protection against insolvency.
Note: The transaction of digital data in smart contracts such as payments is not possible without using the cryptocurrency, a digital or virtual currency aiming to be used as a means of payment. It makes use of cryptography to ensure secure and verified transactions as well as control of the regeneration of new forms of cryptocurrency.
Smart contracts, together with cryptocurrencies, will allow for the preparation of contracts with embedded funds to protect all the associated parties (head contractors, subcontractors, and suppliers) against the insolvency of the owner or late payments. The same technology can also be employed in contractors between the head contractor and subcontractor, subcontractor and suppliers, subcontractors and laborers.
Contracts related to the same project, but different parties, could be linked together in order to create a web of payments. Payments can be self-enforceable and self-executable, only dependent upon the execution of the works as per the contract conditions.
Benefits of Smart Contracts
- Smart contracts reduce the transaction cost and bolster the trust between the working parties. Furthermore, smart contracts and blockchain technologies are unalterable. So, tampering or modifying the codes at a later stage in smart contracts is almost impossible.
- The overhead costs and transaction costs are significantly decreased as there is no need for intermediary involvement. Also, the administration and notary costs regarding the process of chasing payment are mitigated.
- Smart contracts execute exactly the coded condition of contracts, so there is no place for ambiguity in smart contracts. In addition, since smart contract is defined in the blockchain, which is a distributed ledger, whole data such as transaction amount, payment reasons, date of the payment are recorded in a node of the blockchain, which causes the reduction of the disputes and obscurities.
- The encoded contract clauses in smart contracts are stored in the blocks. Only the parties of the contract can access contract clauses, so changing the code, respectively, modifying the contract conditions is impossible. As a result, smart contracts establish a secure and private environment, which results in the reduction of contract frauds.
- Reduction of cost and time, increasing trust among parties, payment guarantee, high speed of execution, and elimination of intermediaries in transaction arrangement are some of the other benefits of smart contract application in the construction industry.
- Since smart contracts are a computerized and code-based system, the need for physical presence is eliminated for drafting the clauses regarding payments, and the virtual presence of parties is adequate. Also, a digital signature is replaced with a wet signature to confirm and sign the contract clauses.
- With smart contracts, payment between different parties would occur at “speed of thought,” eliminating many of the cashflow issues often experienced by companies operating in the construction industry.
A smart contract can make real-time data accessible to the owner, lender, suppliers, general contractor, subcontractors, and architect, and all the stakeholders involved in a project. Apart from the progress of the project, they can monitor the flow of funds with full trust in the truthfulness of details.
Stakeholders could verify the owner’s availability of funds at the start of a project and the list of conditions that would lead to payments. Parties would know the funds are available and that they only need to complete their part of the contract for payment to be automatically released. This saves all of the parties’ time and money, and increases trust between them.