If you want to know what a smart contract is, congratulations. You’ve made the first step to learning more about the technology behind blockchain and cryptocurrencies.
And after reading this article, you’re going to know more about smart contracts (and their potential) than 99.9 percent of people in the world.
In this article, we’re going to answer the following questions:
- What’s a smart contract and how is it first created?
- How do smart contracts work (and what’s their purpose?)
- When should individuals and businesses use smart contracts (and when should they avoid them?)
Let’s get started.
The first concept about a smart contract was proposed by Nick Szabo over 20 years ago.
Szabo is a cryptographer and legal scholar, and he’s known for laying the foundation for digital currencies. Back in 1994, when he proposed the notion of the smart contract, there was little interest in them as a whole because there was no digital platform or one single distributed ledger technology that could actually support them.
Back in 2009, the Bitcoin cryptocurrency was first launched on a blockchain network with a distributed ledger tracking all monetary transactions. This innovative combination of technologies enabled the development of smart contract code that is used to enter the individual terms of each contract into the blockchain.
Many platforms now use smart contracts as a standard, including Ethereum, Tezos, Corda, and Hyperledger. Today, with the continuous growth and adoption of Bitcoin and the ongoing support of blockchain technologies, smart contracts are making a run into the mainstream.
So the question remains — what is a smart contract exactly, and why should *you* care about them?
A smart contract is a piece of code, a program, that executes business logic when certain conditions are met.
The execution of smart contracts can result in the exchange of money, unlocking of content protected by digital rights, delivery of services, or other types of data manipulation such as changing the owner of a given property on documents.
Smart contracts can also be used to assert privacy protection through the facilitation of privacy-protected data in response to a specific request.
There is a wide variety of infrastructures, architectures, and platforms that underpin the ways smart contracts are developed, distributed, managed, and then updated. Then can be stored on a distributed ledger or as part of a blockchain, as well as integrated into various other payment mechanisms and digital exchanges that include cryptocurrencies.
Despite the word “contract” included in the term “smart contract”, they’re not actually legally binding documents. Their purpose is to programmatically execute sets of business logic that performs various tasks and processes transactions that have been built into them as a response to a series of conditions. If you want to actually legally bind the two agreeing parties, other legal steps must be taken.
Smart contracts encode logic that is executed and run on a virtual machine baked into a blockchain or another type of distributed ledger.
How do you start making a smart contract? The process starts with a business team coming together with a team of developers to describe their requirements for the desired behavior, which the smart contract will execute in response to certain events or circumstances.
Simple events could be the conditions such as authorizing the payment, receiving the shipment, or even reaching a specific threshold in a utility meter.
More complex smart contract logic can include calculating the value of, let’s say, a derivative financial instrument and then processing the trade of that derivative, or automatically releasing a form of insurance payment in the event of an accident or tragedy.
The developers will then work inside the platform, allowing them to write the logic behind the smart contract, so they make sure everything works as intended. After the application is written and the code is secured, it’s handed off to another team for a security review.
This could either be an external firm that specializes in smart contract security or an internal expert. Once the contract has been approved, it’s free to be deployed on an existing blockchain or another distributed ledger infrastructure.
Once the smart contract is deployed, it will be configured to listen to event updates from what’s called an “oracle”, which is basically a streaming data source secured by cryptography
The smart contract will execute once it receives the appropriate mix of events from either one or more than one oracle.
Blockchains are ideal for the storage and execution of smart contracts because of the security and immutability that are the prime characteristics of blockchain technology.
The smart contract data is encrypted inside a shared ledger, so this makes it virtually impossible to lose the information stored inside a block.
Smart contracts that are blockchain-based are helping make transactions and business processes safer, more efficient, and more cost-effective, all while reducing transaction costs.
The most popular smart contract platform out there happens to be Ethereum, a widely used cryptocurrency platform. With the Ethereum community developing the Solidity programming language, developers can write smart contract applications designed to run on the EVM (Ethereum Virtual Machine) execution environment.
Other popular programming environments include DAML (Digital Asset Modeling Language) and WASM (Web Assembly).
The former is focused on enterprises, and it’s designed to model various business use cases.
The latter allows developers to create smart contract that can basically run in a web browser while also being integrated into blockchains and other distributed ledgers via JavaScript, C, and TypeScript.
Think about it — how could a business benefit from programs that execute logic when predetermined conditions are met?
They could automate processes, manage transfers of funds, and execute agreements in which all participants are immediately aware of the outcome.
But what makes smart contracts the perfect way to do all of this?
They’re cost-efficient. Smart contracts are able to automate certain business processes that span even past the boundaries of the organization. This can basically eliminate a lot of operational expenses and allow businesses to save resources, including the management required to oversee these specific processes.
They’re fast. Smart contracts can help improve the processing speed of certain business processes.
They’re autonomous. Smart contracts are executed automatically by the network so they can reduce the need for a third party to manage these different transactions between businesses.
They’re reliable. Or, in other words, trustless. They take advantage of blockchain ledgers and other tech to maintain a record of all activity that can be verified at any time. They support the automated transactions that remove the possible human error that could lead to lower accuracy.
They include:
Bad security. With any new technology, hackers will continue to identify new attack surfaces that could allow them to compromise smart contracts by exploiting loopholes in the code. The IEEE has even documented their concerns about the inconsistencies found throughout different tools that are used to detect vulnerabilities in the security of smart contracts.
Poor management. Smart contracts are difficult to manage and implement. They will, most of the time, be configured in ways that make them difficult (or even impossible) to change. Although this could technically be considered a security advantage, the contract parties cannot make any changes to the smart contract agreement or even incorporate new details into it without developing an entirely new contract.
Smart contracts are a new and complex tool, and their potential goes far beyond the transfer of money and assets. They can execute transactions throughout different industries from insurance premiums to legal processes to financial derivatives.
Smart contracts have the potential to remove intermediaries inside financial and legal fields by automating routine tasks and automating repetitive processes for which people currently pay lawyers and banks massive fees.
In the legal field, for example, the role of lawyers could shift in the future as smart contracts gain various capabilities, including adjudications from traditional legal contracts and ready-for-use smart contract templates.
Additionally, the ability smart contracts have to not only automate processes but to also control behaviors and responses, can be beneficial when it comes to compliance.
Smart contracts are also a promising feat in automating processes that run on IoT as well as edge computing devices. For example: an energy company could easily develop a smart contract that executes in response to the changing electricity rates while coordinating that with the current electrical output of your household. This means that when prices reach a specific threshold, the contract could automatically turn off the most power-consuming appliances in your house, such as air conditioners.
And finally, imagine smart contracts in a supply chain scenario, in which funds get unlocked as soon as a cargo container has arrived at its destination and the IoT sensors inside it decide that everything is in perfect condition.
The possibilities are endless when it comes to creating automated pieces of code that can run logic.
Where this will take smart contracts, we’ll just have to wait and see.
- Smart contracts are pieces of computer code kept in public databases which facilitate the execution of an agreement when a set of conditions are met.
- Smart contracts are fast, cheap, and a much more reliable way to execute and manage agreements.
- There are technical difficulties when it comes to making changes to smart contracts, and the technology is still developing past the point of simple transactions.
