Project manager 16 min read 01/21/2022

Smart Contract - Overview & How It Works (2022)

Smart Contracts are becoming a hot topic for discussion in the world of blockchain technology, and the benefits that they bring to the table are increasingly being recognized. But what exactly is it? In today's post, we look under the hood and explore all you need to know about smart contracts.

Nick Szabo first proposed the concept in 1994 — Szabo is also credited with coining the term "smart contracts." He formalised the concept in a 1997 paper titled "Formalising and Securing Relationships on Public Networks."

What are smart contracts? 

Smart contracts are computer protocols intended to facilitate, verify, or enforce the negotiation or performance of a contract. Proponents of smart contracts claim that many kinds of contractual clauses may be made self-executing and self-enforcing - – i.e., without intermediaries. The aim of smart contracts is to provide security that is superior to traditional contractual practises and to reduce other transaction costs associated with contracting.

The main purpose of a smart contract is to give users the tools they need to do business on the blockchain without worrying about things like trust issues or censorship. 

So how does it work?

How Smart Contracts Work 

The basic structure of a smart contract looks like this: two people enter into an agreement, which is then verified by some kind of arbitrator. If both parties want to go through with it, they can sign off on it and proceed with their transaction. Once everything is signed, sealed, and delivered, they can't go back on their word.

Smart contracts in blockchain technology are executed by digital nodes rather than people and thus require no human intervention to remain in force. The result of this is that smart contracts can execute autonomously and exactly as programmed without any possibility of downtime, censorship, fraud, or third-party interference. Smart contracts allow fair exchanges to occur directly between parties by eliminating the need for a go-between to oversee everything.

The best way to understand smart contracts is by example. A smart contract could be compared to a vending machine. Ordinarily, you'd have to go to the company's headquarters to drop off your money or send a check or wait around for them to mail you a refund (or all three). But with a vending machine, you insert money, press some buttons, and receive your snack immediately.

Characteristics of a smart contract:

Whether you're interested in smart contracts as a potential disruption of cloud computing, or you're more focused on what smart contracts mean for the future of law and business practice, it's helpful to understand their core features:

  • Self-enforcing: smart contracts automatically execute obligations when the specified conditions are met. As soon as the contract terms are defined, both parties can rely on it being executed by using automatic triggering mechanisms that enforce the contract's clauses. Once the code is written and deployed, nobody can change it. And this is not only about money transfers but also about anything else that has value: property rights, shares, and so on.
  • Transparency: All smart contracts are visible to all blockchain network users due to their decentralised nature. However, privacy can still be maintained via encryption techniques.
  • Immutability: The program code cannot be modified or altered once coded. It means that a contract can be executed exactly as planned with no outside interference that can cause unexpected outcomes. Following deployment to the blockchain, a smart contract will run forever unless it's explicitly changed by its creators or someone else who has access to it.
  • Programmable: Smart contracts are created on programmable blockchains that enable developers to create various applications that would not otherwise be possible with conventional technology in areas like property law, loan agreements, and many more.

Why use smart contracts?

The main benefits that smart contracts bring to the table:

Speed and efficiency

With traditional contracts, there is usually a large discrepancy between the time it takes to draft an agreement and the time required to finalise it. Additionally, once an agreement has been made, both parties have to rely on each other to uphold their end of the bargain. However, with smart contracts, these tasks can all be completed at once because they are automated and distributed across networks through blockchain technology.

Smart contracts reduce costs associated with transactions.

There's no need for lawyers or notaries with smart contracts because all of the information is accessible via a computer program. This also makes transactions faster and cheaper than they would be otherwise. 

Reliability

Smart contracts are said to execute transactions 24 hours a day, seven days a week, and 365 days a year without any possibility of downtime. Smart contracts also remove the need for a third party as they can be programmed to complete transactions without the interference of human beings. The programmable nature of smart contracts means that they can be used to achieve several different business goals. They allow people to trade anything from currency to shares and work across different blockchains.

Security

The use of blockchain technology also means that smart contracts tend to be highly secure by design since all transactions and agreements are recorded on a blockchain network that is highly secure by default. Smart contracts rely on cryptographic security models which use digital signatures and hash functions to verify the authenticity of all participants and their transactions over the blockchain network and ensure safe and secure transactions.

Practical uses of smart contracts

Some of the use cases of smart contracts include:

Peer-to-Peer/ cross-border transactions

Another practical use of smart contracts is money transfer and payments. Consider cross-border payments (or even intra-country), which are often delayed due to intermediaries that clear the transactions—and charge you for doing it! Smart contracts resolve these issues.

Record keeping

Smart contracts make it possible to create a permanent ledger where all sorts of transactions can be securely stored. They can help reduce fraud by ensuring that all transactions are transparent, traceable, and irreversible.

Escrow services

Smart contracts can be used to create escrow services. This is done by implementing a smart contract that holds the funds while the parties involved in an escrow service trade goods or services. In this way, it can prevent fraud and scams, making smart contracts very useful in situations involving digital goods or digital currency. 

Protect digital rights management (DRM)

A tokenized licence can be issued to a user that gives them access to a specific piece of media or software. In this way, creators can protect their property from unauthorised duplication, and users can ensure they get what they pay for.

Build decentralised autonomous organisations (DAO)

A DAO essentially replaces traditional business management structures, such as a board of directors, automating decision-making and eliminating the need for centralised leadership roles. 

Insurance Industry

Automated transactions could also be used for payment processing in insurance claims. The ability to process transactions on the blockchain is extremely promising for the insurance industry, where payments are often complex and involve a lot of paperwork. Smart contracts could help automate some of these processes, streamlining claim payments and reducing costs considerably.

Supply chain

Smart contracts can help manage supply chains as payments between parties can only be made if each party has fulfilled its obligations.

Government

Smart contracts are an ideal use case for governments as they can automate processes such as social security and tax payments.
 

Smart Contracts for Real Estate

Smart contracts can be used for many different aspects of buying or selling real estate. Smart contracts allow you to do everything from storing ownership records, making payments for insurance, taxes, and maintenance, to receiving the deed once all payments have been made.

Voting Systems

Smart contracts can be applied in elections where every vote is recorded transparently and securely. Votes cannot be changed or tampered with because they are recorded on a blockchain and tied to a specific person through their wallet address. This creates a much more secure system than any other voting system in place today.

Conclusion

Smart contracts are a new and exciting opportunity. They can truly disrupt transaction processing. Smart contracts have the potential to transform business-to-business (B2B), business-to-consumer (B2C), and consumer-to-consumer (C2C) transactions by eliminating the need for a third-party arbitrator or middleman. Smart contracts use "if this then that" logic to verify transactions. Constantly evolving in complexity and capability, smart contracts unlock new opportunities in many industries.

Overall there are a lot of attractive benefits to smart contracts. They bring efficiency and immutability to the contracts. They will allow us to carry out more business in a trustless environment, where we don't need to rely on private intermediaries to guarantee our transactions. In the end, they are a powerful concept with great potential, even though they represent an entirely different way of carrying out commercial activities than what we've used so far.

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