What is a smart contract?

7 Dec 2021

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What is a smart contract?

A smart contract is a code that automatically executes predetermined actions when the required conditions are met. It brings certainty to the contract's participants while saving time and eliminating the need for third parties.

  • Article Quick Links:
  • How do smart contracts work?
  • The 3 main advantages of smart contracts
  • What are smart contracts used for?
  • What are the 3 main challenges facing smart contracts?
  • The 6 best practices for smart contracts
  • History of smart contracts
  • Future of smart contracts

Let's break it down a bit. A smart contract is

  1. a contract: an enforceable agreement based on certain conditions which can involve two or more parties;

  2. smart: it executes automatically via code when meeting the required conditions;

  3. generally built on blockchain technology to make it secure, permanent, and unmodifiable.

Smart contracts are typically written on a blockchain network because of their security benefits but are not limited to them. If built on a blockchain, the code sits on multiple blockchain nodes. When the code is executed, a new block is added to the network, creating a permanent receipt of every transaction.

Smart contracts are usually adopted by industries with clear rules and quantifiable terms, such as logistics. However, they are not limited to these and their possibilities are almost endless.

How do smart contracts work?

When creating smart contracts, the involved parties agree upon the terms and recruit a development team or work with user-friendly online tools to write the code that will automatically execute the desired actions. This code must integrate one or more oracles (a secure data stream source) to insert live updates. The data stream must then meet the parameters that trigger the code of the smart contract.

Smart contracts work with “if/then” logic. The best way to explain this is with a simple transaction. Imagine you want to change ether (ETH) for Tether (USDT). In this case, if the user deposits X ETH, then s/he will receive Y USDT.

Since smart contracts are generally built on a blockchain, every execution gets recorded in a new block. Because each block is decentralized, the information will be available on multiple nodes of the network, making the execution receipt immutable and accessible to whoever is allowed based on the contract.

The 3 main advantages of smart contracts

Smart contracts bring many benefits. We narrowed them down to three main points to keep things simple.

  1. Accessible (Traceable, transparent & immutable): As smart contracts typically use blockchain technology, the involved parties can find all events and details while being unable to change past activity. It gives the parties a high level of trust, knowing that everything will follow the agreed terms and that there was no tampering with the receipts of past executions.

  2. Autonomous: The stakeholders do not need to interact with one another or with middlemen to verify, control or execute the contract. This characteristic reduces the probability of human error.

  3. Time & cost-efficient: As the actions happen automatically, it saves time and resources for the involved parties. They do not need a lot of manual labour to organize, perform, or monitor the actions.

What are smart contracts used for?

A smart contract can come into play in different life situations. Such DApps are usually adopted in industries with clear rules and quantifiable terms as it is more straightforward. However, smart contracts are not limited to these. Below you will find examples across different fields.

  • Voting: Improving user experience and protecting the count

Smart contracts can significantly improve voting performance. With quick and efficient ID recognition and vote submission, lines speed up. It creates a smoother experience for citizens and an accurate vote count, as every data point gets registered on the blockchain.

  • Real estate: Automatic payments and amendments

Property owners can gain peace of mind and autonomy with smart contracts. When contract conditions are validated, it can automatically insert the new property owner's data and secure it from manipulation. Also, it can be highly beneficial for agreements between landlords and renters as it assures reliable receipts of payments and amendments.

  • Healthcare: Handling sensitive information

Smart contracts could revamp patient record management. Not only that, but receipts, supply management, compliance, and more can be automatically filed and shared with the involved patients and pharmaceutical and insurance companies.

  • Supply chain: Improving forms efficiency

The forms that pass through various supply chain channels and require multiple approvals are susceptible to fraud or loss. With smart contracts, forms like bills of lading are created automatically and made accessible to all stakeholders. Other areas that benefit are inventory management and payment automation.

  • Financial services: Avoiding unnecessary costs

Bookkeeping and securitizing records (i.e. preventing tampering) is more efficient with smart contracts. By automating workflows and calculations, errors such as mistaken payments are reduced.

  • Insurance: Avoiding fraudulent claims

If there is an insurance claim, a smart contract can validate it, check for errors, complete the routing, and transfer payments.

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What are the 3 main challenges facing smart contracts?

Expecting smart contracts to be the ultimate solution right off the bat is unrealistic. The technology is still young and needs to go through various iterations to reach its full potential. We summarized its current challenges to the following points:

  1. Ensuring security: There is good faith from the involved parties that the smart contract is drafted loyally in accordance with what was agreed. However, it is hard to verify this as the stakeholders tend to be illiterate of code language. The harm of a biased code can be magnified if the triggers get out of control. And in this regard, the code of the contracts and oracles needs to be secure enough from hackers.

  2. Difficult to modify: Modifying a smart contract is not like editing a cloud-based text document. The level of coding is quite complex, making it time-consuming and costly to fix changes. However, it is convenient for security purposes.

  3. Third parties still exist: It is impossible to eliminate third parties from smart contracts. While lawyers are not needed to draft contracts, nor finance employees to send invoices, they must get involved to address the necessary legal points and keep track of the executions.

The 6 best practices for smart contracts

According to Harvard, there are six best practices to efficiently create and implement smart contracts. Here is a quick overview:

  1. Hybrid approach: Smart contracts should be drafted in text and code for parties to read and understand the established terms. This has the added benefit of enabling a court to arbitrate should the need arise.

  2. Full visibility: The variables, their definition rationale, and the execution triggers should be clear in the hybrid approach.

  3. Alternative plans for oracles: Smart contracts should mention how they will act in the case of a faulty oracle, be it that it cannot submit the necessary data, gives incorrect data, or does not work at all.

  4. Risk allocation: Risk allocation can help in the case of coding malfunctioning.

  5. Specify terms: The smart contract’s text should mention which law and order of precedence it follows in the case of conflict.

  6. Include representatives from each party: By confirming that a representative of each party reviewed the text and code of the contract, counterparties can defend against unlawful claims e.g. that the code was not reviewed or contains errors.

History of smart contracts

Computer scientist Nick Szabo coined the term ‘smart contract’ before blockchain existed back in 1994. He defined it as “a computerized transaction protocol that executes the terms of a contract.” Doing so, he projected an efficient way to enforce predefined agreements automatically. However, while the contract is ‘smart’, it should not be confused with artificial intelligence because it does not process subjective tasks. In his paper, Szabo used vending machines as an analogy of smart contracts because a simple transaction (releasing candy) gets automatically executed thanks to the data input (inserting sufficient money and making a selection).

Future of smart contracts

Beyond the examples cited above, other futuristic implementations of smart contracts can include IoT devices. When an IoT device registers a certain data threshold, such as a cargo’s temperature rise or security breach, a smart contract with the insurance company could get executed. A simpler example could be a cryptocurrency transaction to automatically receive a good, such as with a soda machine.

While smart contracts must evolve to overcome the challenges mentioned, their implementation could cause significant changes in various industries. The biggest shifts will be in the tasks that professionals fulfil and their dynamic with third parties. For example, lawyers are the main stakeholders when drafting contracts, and they will most likely start creating adaptable templates. It will allow faster implementation of smart contracts from different sectors. And by reshaping the way contracts are handled, new unforeseen possibilities will arise.

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