What is a smart contract?
A smart contract is one where an agreement between the counterparties is automatically executed based on the terms or rules embedded in the code. It can be described as the digital version of a standard written contract that automatically verifies, enforces and executes the terms of the contract. Smart contracts have the potential to save time and money for businesses as processing transactions is made more efficient, transparent and anonymous. The American researcher and computer scientist of digital currencies, Nick Szabo, introduced the concept of smart contracts back in 1994.
Smart contracts in Blockchain
The smart contract program runs on a blockchain, which enables traditional contracts to be converted into digital contracts. Similar to what we see with crypto wallets, smart contracts have a balance which allows them to send transactions throughout the network. The only difference is that once a smart contract is deployed, it runs as programmed and cannot be reversed. They require rules to be established, which the system can then enforce through a code.
Smart contracts are used to automate the process of agreement execution. All participants on the blockchain network can access and verify the smart contract code without any third-party involvement, which saves time and money. Additionally, workflows can be automated using smart contracts to trigger an action once conditions are met. Blockchains like Ethereum and Hyperledger are some examples of smart contract platforms.
How do smart contracts work?
Smart contracts follow simple “if-then” statements that are embedded into the code on a blockchain. In simple words, e.g. “If” task A is completed, “then” object “B” will be transferred to you. There is no limitation on how much “if-then” can be included in the contract. These actions could include the transfer of funds to the granted parties, sending notifications, issuing a ticket or registering a vehicle. Once the transaction is complete, the blockchain is updated and cannot be changed. Only the parties who have permission can view the results.
The working of a smart contract can be broken down into a few steps:
- Identify parties and establish the terms of the agreement
In the first step, the parties involved in the agreement should be identified, after which the terms of the contract are finalised. The terms, obligations of parties, and standards for the execution of the contract are all described here.
- Set the conditions
The second step involves specifying the conditions to be met for the contract to be executed. These conditions are stated as rules or criteria that must be satisfied to validate the contract.
- Write the code
Thirdly, the code has to be written for the smart contract. This code specifies the exact steps to be followed for a contract to be automatically executed once the conditional parameters are met.
- Deploy to the blockchain platform
In the fourth step, the smart contract is stored on the blockchain and replicated among its participants to validate the code of the contract.
- Execution
Once consensus is reached and verification is completed by the participants of the network, the fifth step, which is execution begins. The contract is automatically executed when the predetermined criteria are satisfied.
- Record network updates
Lastly, in the sixth step, after the execution of the smart contract is complete, the information on all the nodes on the blockchain network is updated. This information, once recorded and verified, cannot be changed or deleted, making it immutable.
Benefits of smart contracts
- Security
Smart contracts are known for their security, as these run on blockchains. In a blockchain, all transactions are encrypted, making it incredibly difficult to hack. The data is stored in blocks that are linked to all previous and subsequent blocks forming a chain, all of which are immune to alterations. Hackers would have to modify the entire chain to change a single record.
- Real-time execution
When conditions are met, execution of the smart contract happens almost immediately and simultaneously for all parties involved across the network. Smart contracts eliminate paperwork and errors because of their digital and automated nature.
- Transparency
An environment of trust and transparency is created as the information and logic in the contract are shared across all participants in the network.
- Savings
As there is no need for an intermediary in a smart contract, commissions or fees, and delays are eliminated, resulting in reduced costs.
Limitations of smart contracts
- Human error
A smart contract is a computer program that requires the terms and conditions of the contract to be coded by a programmer. Since they are developed by humans, they are susceptible to human errors such as misinterpretation and omission.
- Permanent
Smart contracts that are coded correctly do not create any issues. However, the problem arises when there are errors or flaws in the coding of the contract, as they cannot be changed.
- Unreliable
There is a possibility of inputs of the contract being unreliable, leading to false or non-execution of the contract. Most attorneys are unable to read smart contracts as sophisticated coding knowledge is required to read and write these contracts. Its legal validity is still being debated.
Some applications of smart contracts
- Insurance
With the help of smart contracts, a trigger can be set up to resolve a claim right after an accident occurs. This saves businesses millions spent on processing and handling claims every year.
- Loans and mortgages
The financial industry has significantly improved with the help of smart contracts, with one of the areas being loans are mortgages. It helps track payments and release the property once the loan payment is complete. It ensures a smooth and error-free process.
- Government
Smart contracts help the government manage its operations more efficiently. It assists in activities like land title recording that help with property transfers. Additionally, in voting, the voter’s identity is validated, and their vote is safely recorded. Auditing expenses are cut, and transparency is improved.
Future of smart contracts
Smart contracts have the potential to revolutionise the way international businesses and trade are executed due to their efficiency. It reduces paperwork and increases transaction speed, thus making it cost-effective. Several industries like finance, supply chain, real estate, and more are already benefiting from adopting smart contracts as individuals and decision-makers are freed from mundane administrative tasks. Its uses and applications in real world events are rapidly increasing, and it wouldn’t be long before they become a part of our everyday lives. Before adopting such technologies, you must leverage the resources out there to deepen your understanding of smart contracts and blockchain technology and how they work, so you and your organisation can make the right choices.
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