We all know what a “contract” is. A contract is an agreement between two parties, who may be individuals, groups, or companies. Despite the fact that traditional contracts have countless problems, there has been almost no innovation to solve those problems until smart contracts came along.
In this article, let’s learn what a “smart contract” is, in plain English, along with its pros and cons. Let’s dive in.
Take, for example, a bet between John and Joe. John predicts that Real Madrid will win the next match against Barcelona, while Joe predicts that Barcelona will win. The terms of this agreement are straightforward: John pays Joe if Barca wins, and vice versa. But what if John fails to pay Joe after he has lost the bet? Such trust issues are common in traditional contracts. Even if they have an escrow/middleman, the middleman has trust issues as well.
This is where the importance of “Smart contracts” kick in.
Consider John and Joe carrying out this contract on a blockchain. They both pre-lock their bet amounts in a smart contract and set conditions such as “If Barcelona wins, then transfer the full amount to Joe’s wallet” or “If Real Madrid wins, then transfer the full amount to John’s wallet”. When the match is over, the smart contract will automatically transfer the funds to the winner. There are no security or trust issues because once deployed, a smart contract cannot be manipulated by anyone, including its creator.
So, in simpler terms, a “smart contract” can be visualized as a contract carried out on a blockchain with clear-cut conditions and acts as per the condition that becomes true.
Fun fact: Computer scientist Nick Szabo first proposed the concept of “smart contracts” in 1994. He called it a “smart legal contract.”
A smart contract is a computer program that is stored on a blockchain and executes contract terms automatically when certain conditions are met. These conditions are programmed into the contract as “if-then” statements. When the conditions are met, the smart contract executes the specified action, such as transferring assets or releasing funds, automatically. Smart contracts execute themselves and are intended to be transparent, irreversible, and tamper-proof. This means that the contract cannot be changed or altered once it has been executed. Smart contracts are used to facilitate transactions and automate processes in a variety of industries, including finance, supply chain management, and gaming.
Fun fact: There are over 45 million smart contracts deployed on the Ethereum blockchain to date.
Different types of smart contracts
While there are countless applications that smart contracts can offer, they are mainly categorized into three types based on their applications:
Smart legal contracts
The counterparties of smart legal contracts are legally required to perform the contract’s terms because the contracts are based on properly executed legal agreements. In spite of the fact that not all smart contracts are legally binding, they can perform contractual obligations and execute automatically when the conditions and terms are met. A “Smart Legal Contract” is what John and Joe did in the example above.
Decentralized Autonomous Organizations (DAOs)
DAOs are blockchain-based communities governed by code and rules encoded in smart contracts. These contracts, along with governance systems, replace traditional decision-making processes with automated execution of agreed-upon protocols. DAOs have the potential to disrupt traditional business structures by enabling decentralized, transparent decision-making.
Application Logic Contracts (ALCs)
An Application Logic Contract (ALC) facilitates communication between different devices, such as in the Internet of Things (IoT). Typically, these contracts have application-based code that syncs with other blockchain contracts. The development of ALCs has the potential to revolutionize automated systems and devices.
Fun fact: In 2016, the first Decentralized Autonomous Organization (DAO) was created using smart contracts on the Ethereum blockchain.
Working of smart contracts
Now that you know the basics of smart contracts, let’s look at how a smart contract is created and works. The actual working and creation of smart contracts are highly technical as they involve coding and other technical expertise; this is basically how the process looks like:
A smart contract is initiated by the user by performing a transaction on the blockchain. The transaction contains the conditions and actions to be performed, encoded in it, in an “if-then” format as shown in the first example.
Once this transaction is verified, it is added to a block on the blockchain. This block contains the smart contract’s code, which will be executed by the network nodes.
The smart contract is automatically executed when the contract’s conditions are met. Depending on the action encoded, this could involve transferring assets, releasing funds, or updating blockchain data.
As soon as the smart contract is executed, it is recorded on the blockchain as a new transaction.
In short, the smart contract code is deployed on the network, transactions trigger its execution, the network validates its execution, and nodes store the updated state.
Pros & cons of smart contracts
Now that you are familiar with smart contracts’ workings, let’s take a closer look at their advantages over traditional contracts.
- Cost-effective: As the process is carried out on the blockchain, only the gas fee that’s needed to deploy the smart contract on the blockchain needs to be paid.
- Time-saving: The contract is settled immediately upon the fulfillment of the conditions because there are no middlemen involved.
- Trustless & Secure: Smart contracts, once deployed, everything is automated and tamper-proof so there are no trust issues and security issues.
- Speed & Efficiency: The digital nature of smart contracts means that there’s no paperwork to deal with, and you don’t have to reconcile errors that often occur when manual forms are filled out.
- Availability & Convenience: Smart contracts can be accessed anywhere and at any time, allowing the parties to execute the contract even if they aren’t physically present.
- Precision & Lesser errors: Using software code to automate tasks reduces the chance of manual errors. Additionally, they provide precise and real-time updates.
In summary, smart contracts facilitate a low-cost, secure, fast, and precise alternative to traditional contracts.
Like any technology in its infancy, smart contracts also come with their own flaws when compared to traditional contracts. They are:
- Limited accessibility: Because smart contract technology is still in its infancy, not all people or organizations have the skills or resources necessary to use it.
- Lack of regulation: Many jurisdictions do not yet recognize smart contracts as legal contracts, and it is not always clear whether they can be enforced.
- Complexity: Smart contracts code can be complicated, and mistakes or bugs therein could have detrimental effects. Because of this, it’s critical to thoroughly test and audit smart contracts code before deploying.
- Limited functionality: Because smart contracts have a very limited amount of functionality that they can offer, they might not be appropriate for all kinds of applications.
- Interoperability: Because different blockchains’ smart contracts are incompatible with one another, it can be difficult to use them in a coordinated way.
Even though there are some flaws to smart contract as of now, these flaws can/will be solved as more people and businesses onboard to it.
Use cases of smart contracts
Smart contracts can really become the next billion or even trillion-dollar industry and have the potential to disrupt many other industries, including:
- Voting: Smart contracts can be used to conduct secure and transparent voting.
- Healthcare: Patient data can be protected and shared among authorized parties, including healthcare providers and insurance firms, using smart contracts.
- Real estate: By automating ownership transfer and other legal procedures, smart contracts can be used to simplify the process of buying and selling property.
- Insurance: By automatically triggering payouts when specific criteria are met, smart contracts can be used to automate the process of claims and payments in the insurance industry.
- Banking and Finance: Smart contracts can be used to automate financial transactions, such as the execution of derivatives and other financial instruments.
- Crowdfunding: Smart contracts can be used to automate the process of raising funds for a project, by releasing funds to the project creator once certain conditions are met.
And these are just an introduction to the endless list of industries that smart contracts can revolutionize.
Smart contracts are digital programs that execute automatically on a blockchain when certain conditions are met. They are intended to be transparent, irreversible, and tamper-proof, making them a trustless and secure alternative to traditional contracts. There are three main types of smart contracts: smart legal contracts, Decentralized Autonomous Organizations, and Application Logic Contracts. They are initiated by a transaction, verified, added to a block on the blockchain, and executed automatically when conditions are met. The pros of smart contracts include cost-effectiveness, time-saving, trustlessness, security, speed, efficiency, availability, convenience, and precision. The cons of smart contracts include limited accessibility and lack of regulation.