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What Is A Smart Contract And How Do They Work?

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A smart contract is a term widely used in the blockchain world but it has existed before the advent of blockchain technology or cryptocurrencies. Smart contracts were first proposed in the 1990s by Nick Szabo, a cryptographer and computer scientist who others believe that he is the mysterious Satoshi Nakamoto. He has vehemently denied this claim.

Bitcoin, the first and most well-known cryptocurrency supports basic smart contracts although they are limited in nature. Vitalik Buterin later created Ethereum, a blockchain protocol designed specifically for smart contracts and addressing Bitcoin’s limits. The Ethereum platform has gone on to become one of the world’s most used smart contracts platform.

Buterin is regarded as the pioneer of smart contracts while Szabo is the visionary.

What is a smart contract?

In the traditional world, lawyers draft contracts which are then signed by the transacting parties, and enforced by law. Smart contracts are more like normal contracts except that there are no third parties and the conditions of the contracts are written into the code.

Smart contracts are basically self-executing contracts in which the terms and conditions between the concerned parties are written into the code. The contracts are only executed if the pre-determined conditions are met.

The code of the contracts is written and stored on a decentralized blockchain network. One of the most important features of smart contracts is that it eliminates the need for third parties and allows two parties to directly transact with each other.

Smart contracts can work independently or alongside each other. This means that a smart contract can be triggered once and the transaction is complete while in some instances, the execution of one smart contract could trigger a chain of other smart contracts until the transaction is complete.

When smart contracts are mentioned, the next thing people think of is blockchain technology. This is not always the case as it is possible to develop smart contracts without using a blockchain API.

Benefits of smart contracts

Smart contracts wouldn’t be widely popular as they are today if they did not offer users some benefits or advantages over normal contracts. Here are some of the benefits of using smart contracts.

Autonomy – smart contracts function very well without the need for a third-party intermediary. It gives the transacting parties complete control over the agreement.

Trust – smart contracts provide a trustless environment for parties to carry out transactions. As the data is mostly stored on a distributed, secure, and shared ledger. No documents can be lost, stolen, or tampered with. Using smart contracts does not require you to trust people you are dealing with or them trusting you. The platform is unbiased and facilitates fair transactions.

Efficiency – using smart contracts allows you to save a considerable amount of time that could have been spent on redundant and manual tasks such as printing loads of documents, transporting, and storing them in specific places.

Savings – traditional smart contracts make use of estate agents, notaries, advisors, and even consultants who charge a lot of money for their services – maybe rightly so. However, with smart contracts, their services are not needed and their fees can be avoided.

Safety – smart contracts are not easy to hack if they properly implemented. The contracts are secured by cryptography and can potentially keep your documents safe.

The negative side of smart contracts

Smart contracts are inherently still in their infancy. There is still a lot of research that needs to be done. Although they have a lot of promise, smart contracts have also proven to be problematic. The code that underlines the smart contracts need to be flawless and free from bugs.

This may not always be the case and vulnerabilities found in the contracts can be exploited by hackers. In 2016, the DAO, a decentralized autonomous organization, that had just raised nearly $150 million was hacked after cybercriminals exploited a bug in one of the smart contracts. This raised questions about smart contacts’ safety standards and exposed their immaturity at the time.

Other issues such as government regulation can arise in the future as the technology evolves. These challenges have existed only due to the young age of the industry but there is hope that it will evolve over time.

Who and how to use smart contracts?

It should come as no surprise that smart contracts are widely used in the crypto industry but just like blockchain technology, they are also finding great use in other industries.

Initial coin offerings (ICOs)

Many blockchain projects have been launched on the Ethereum (or similar) blockchain networks due to smart contracts capability. How does this happen?

An ICO is a crowdfunding exercise you use to raise money (mostly Bitcoin or Ether) for your blockchain project. You will need to create a smart contract and a token for the smart contract.

In your smart contract, you write code that stipulates how many tokens you are going to sell. You will specify the number of tokens you will release to a wallet address if certain Bitcoin or Ether tokens are deposited into your project account.

This automates the entire process.

Insurance

A number of insurance companies now utilize smart contracts. Two insurance companies in Malta and France developed smart contracts prototypes that compensate airline passengers if they experienced delays with their flights.

Healthcare

Healthcare systems can utilize smart contracts to record and transfer sensitive data. Smart contracts give patients complete control of their data. A new startup allows patients to sell their medical data to researchers.

Governments

Governments can make use of smart contracts in elections. This reduces election fraud.

Smart contract and lawyers

Many people believe that smart contracts will replace lawyers the same way that cryptocurrencies will replace fiat currency.

However, this will not happen any time soon. The best option might be for the two to work together. Instead of lawyers being threatened by smart contracts, they should at least try to utilize them.

Smart contracts are only code (and not the law) that automates the execution of a contract. They are not yet legally binding.

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