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How Do Smart Contracts Work?

Last updated 30th Nov 2022
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Smart contracts are essentially self-executing computer programs designed on top of a blockchain network that codify the terms and conditions of an agreement between parties, what a traditional contract would outline on pieces of paper. In a smart contract, it is possible to store and verify rules that are self-executable.

Though it’s not been widely adopted, the global smart contract market, led by IBM, AWS, and Oracle, is growing at a rapid speed and is projected to surpass 1.4 billion USD by 2028.

This article will inform the readers about the history of smart contracts, how smart contracts work and why smart contracts are important.

What Is a Smart Contract?

Smart contracts refer to self-executing user-to-user transaction protocols developed within a blockchain with the objective to reduce or eliminate the need for an intermediary to facilitate the conversation between parties while further expediting trust and transparency. The smart contract is written in a virtual language and has the power to execute and enforce itself, autonomously and automatically, based on a series of programmed parameters. Deploying a smart contract is technically a transaction, so you need to pay gas in the same way you need to pay gas for a simple ETH transfer.

Much like traditional contracts, they encompass legally binding terms and conditions and formalize relationships by providing a constitutional basis. Unlike traditional contracts, terms are embedded into a computer code and are executed independently just as the preset conditions are met. They follow simple “if/then…” statements to allow automatic confirmation of fulfillment and execution of outcomes of a contract.

Smart contracts sit at the core of blockchain technology. While its uses in the crypto sphere, such as regulating decentralized autonomous organizations, are enormously valuable, its use stretches beyond overseeing crypto-based transactions. Smart contract solutions may bring a robust twist into key industries like legal, finance, or agriculture, may improve governmental legislation on areas like housing or benefits, and significantly improve supply-chain technologies.

Below, readers can find further information regarding the history and developments of smart contracts, their processes, benefits, challenges, and real-life applications.

How can smart contracts work together?

A smart contract is intended to be used in isolation. Some smart contracts are built to assist other smart contracts.

History of Smart Contracts and Recent Developments

The term ‘smart contract’ was coined by the cryptographer Nick Szabo in the early 1990s to refer to “a set of promises, specified in digital form, including protocols within which the parties perform on these promises”. Szabo aimed to build “standardized contracts” for complex payment terms, which then can be traded at much lower costs.

It was popularized around 2017 by the Ethereum network, the biggest blockchain network designed to support smart contracts.

Why Ethereum smart contracts? The world's first cryptocurrency, Bitcoin, was the first to support basic smart contracts, although they are extremely limited in comparison with Ethereum. However, since every node has the rules baked in via code, all Ethereum smart contracts have the same limitations.

Today, there’s a handful of blockchain networks using smart contracts apart from Ethereum, most notably Binance Smart Chain, Cardano, Avalanche, and Solano.

Smart contracts are recognized by the US National Institute of Standards and Technology, but not recognized as legally binding documents; therefore they are not enforceable. That being said, several states, including Nevada, Arizona, Tennessee, Wyoming, and Iowa, have passed legislation on the use of smart contracts.

Belarus was the first country to legalize smart contracts on a national level, followed by most European countries led by Italy. As of 2021, the UK also joined in the bid to support and facilitate smart contracts across England and Wales.

Characteristics of Smart Contracts

Despite what the name might invoke, smart contracts are not ‘smart’: they are not intelligent tools and they do not go beyond automatically executing pre-programmed steps. At its core, a smart contract is designed to realize agreements such as the following: if Party A pays the price in full, then Party B will deliver the goods. When Party A meets the requirements (pays the price in full), a smart contract verifies the fulfilment and carries out the outcome (delivers the goods). Should Party A fail to meet the terms, the goods will be redirected to Party B.

Two or more participants, individuals or organizations, may enter a smart contract, and terms of which may be elaborated as much as needed to cover the complexity of an agreement.

A smart contract is developed on a blockchain, for that reason, smart contracts are immutable, distributed, and autonomous.

Immutability
Distributed authority
Autonomy

What Are the Benefits of Smart Contracts?

Smart contracts come with a number of benefits for all parties involved, most notably removing the overhead costs and minimizing the human error and delays that are typically associated with traditional contracts. Let's look at how smart contracts are already benefiting certain industries

Benefits of Smart ContractsApplication
Speed and EfficiencyDigitalization and automation
Intermediary FeesNo fees charged by third parties
TransparencyAll records are shared across the network
Security & ConfidentialityAvoid hacks

Speed and Efficiency

Once conditions are met, smart contracts execute the outcomes immediately. Complete digitalization and automation eliminate the need to process paperwork and document filing, along with potential errors that may occur during manual entries. All this results in a significant cut in time spent reconciling contracts.

Intermediary Fees

As self-executing processes, smart contracts reduce or completely waive the need for intermediaries such as solicitors or brokers to oversee the contracts between parties. Subsequently, a smart contract eliminates the intermediary fees and delays that are usually associated with the involvement of third parties.

Transparency

The distributed consensus model smart contracts embrace provides unprecedented levels of transparency. Instead of a centralized authority overseeing the obligations and eventualities, all records are shared across the network and therefore are impossible to be tampered with for personal gain.

Security & Confidentiality

Records on a blockchain network are encrypted and tethered to each other through the hash. Every block has a hash which can also be compared to a fingerprint. Hash identifies a block and all of its content and is always unique, just like a fingerprint. Once a block is created and added to the chain, its hash is calculated.

Every block not only has its own hash but the hash of the previously linked block as well. For example, the first block of the bitcoin blockchain has a hash of 4ft678. Now the second block in the chain has not only its own hash - 75e93p but also the hash of the previous block which is 4ft678. This is how different blocks are interconnected with each other.

Changing or tampering with any record or data in the block will result in the hash of the block being changed. Suppose someone changes the data in the second block. Now in this kind of situation, the hash will no longer be 75e93p but it would become something else, let's say 55c36t. However, the third block would still be reflecting the hash of the previous block as 75e93.

So, if hackers want to corrupt the blockchain network, they would have to change the hash of every single block in the chain which is practically impossible. This implies that a blockchain network is extremely difficult to hack — any attempt to manipulate a block of record results in the breakdown of a whole chain, and thus, very easy to spot.

What Are the Challenges in Using Smart Contracts?

Despite their advantages over traditional contracts, smart contracts also bring about unique challenges caused by their limitations.

Lack of Flexibility

Smart contracts’ immutability almost completely eradicates flexibility as it’s impossible to tweak any terms and conditions laid out in a deployed smart contract. This means that the rules defining the smart contract need to be perfectly defined and agreeable, and the developers of the code must act with utmost caution and care.

Need for a Specialized Skillset

Technical expertise is a key obstacle in the way of the widespread adoption of smart contracts. Parties require an expert with a specific set of skills to codify and read the agreement upon deployment. In such cases, parties may need to rely on the services of lawyers with blockchain specialization to read the smart contract, which brings additional costs.

What Are the Real-Life Applications of Smart Contracts?

What can smart contracts be used for? Smart contacts can be used for any type of transaction, it doesn't have to be financial. Smart contracts’ main functions such as storing data, confidentiality, and autonomous authentication allow the new technology to be used in a variety of areas and industries, despite its relatively limited adoption for the time being. For example, an insurance company could use smart contracts to automate the release of claim money based on events such as large-scale floods, hurricanes, or droughts.

Supply-chain management makes the most realistic and applicable use of smart contracts. An automated triggering model can significantly streamline the shipping and delivery of the goods, and minimize disruptions while prompt responses to unexpected events.

Home Depot has already started using smart contracts to resolve disputes with vendors. The new technology of a smart contract, allows the firm to have real-time communication and greater visibility into the supply chain, strengthening the relationship with the vendors.

Agriculture is another key industry benefiting from blockchain technology to further develop the practice to be more integrated and simplified. Blockchain improves the traceability of information in the food supply chain, and by extension advances food safety and security.

AgriDigital, for example, is a specialized commodity management solution for the grains industry, providing “paddock to plate” transparency for consumers as well as real-time payments to growers and increased efficiency for brokers.

Smart contracts on blockchain also offer a promising future to other key industries, most prominently legal. Despite not being recognized as a legally binding force on a federal level, several states have already allowed standardizing its use for legal documents: California has been issuing marriage certificates via blockchain technology while in Arizona they constitute enforceable documents.

Hundreds of apps that use smart contracts are already up and running.

Future of Smart Contracts

Smart contracts are gaining traction across multiple verticals as industries scale their technological deployments, most notably in supply chain management, while other crucial sectors such as government and utilities are still struggling to undergo a transformative blockchain development due to the aforesaid challenges.

The staggering growth in IoT-connected devices is also expected to incur greater use of smart contracts, making it crucial to address its challenges and define its possible use areas for seamless adoption.

FAQs

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Idil Woodall

Idil Woodall

Idil is a writer with interests ranging from crypto and politics to fintech and media. She spent several years in publishing before becoming a full-time writer in the technology space, and learning the inner workings of an industry she loved ignited her interest in economics. As an English graduate, she cultivated valuable research and storytelling abilities that she now applies to make complex matters accessible and understandable to many. When she’s not writing, she can be found climbing or watching a movie.