What Smart Contracts Can Do and How Does It Work?

Smart contracts are growing in popularity, tech majors such as IBM, Google and Microsoft are working on building solutions around it. But what really is a smart contract? How does it work? How can you use it? And what could it mean for businesses and individuals going forward?

Smart Contracts are self-executing contracts with the terms of agreement between buyer and seller being directly written into lines of code. The code and the agreements contained therein exist across a distributed, decentralized blockchain network. Smart contracts permit trusted transactions and agreements to be carried out among disparate, anonymous parties without the need for a central authority, legal system, or external enforcement mechanism. Smart contract technology is like a self-operating computer program that automatically executes when specific conditions are met.

Smart contracts are a concept that was introduced by Nick Szabo in 1994. Imagine the scenario in which you want to buy a car. In order to do that, you need to find a seller, agree on a price and then sign a contract. The contract will include when you need to pay for the car and when will the seller transfer the ownership of the car to you.

Now imagine that instead of getting a contract from the seller, you would have received a small computer program from him/her. This program will act as your contract and even enforce it, without any human interaction. 

Smart contracts are a natural extension of the distributed ledger technology (DLT) used in blockchains. They allow participants to automate part of their business processes and transactions by writing computer code into their blockchain transactions. This code will be executed once the transaction is validated by the network.

Smart contracts are not limited to transactions of money or property. They can be used for other transactions such as exchanging data, providing services, and more. Smart contracts use blockchain technology, which is essentially a decentralized database that is distributed across multiple computers. Because the blockchain is decentralized, this means there’s no centralized server that stores the database; instead, it’s stored on a peer-to-peer network. This means smart contracts are also decentralized and run on a peer-to-peer network.

Because smart contracts are decentralized, they cannot be stopped by any individual party, such as a government or a company. Anyone with an internet connection can participate in the network and execute the contract once all parties involved have agreed on the details.

For this reason, smart contracts are being adopted by international companies and governments because they can serve as an alternative method to traditional ways of doing business that aren’t always reliable or efficient (such as using lawyers to draft legal agreements).

How Does Smart Contracts Work?

The aim of a smart contract is to provide security superior to traditional contract law and reduce other transaction costs associated with contracting. Smart contracts allow the performance of credible transactions without third parties. These transactions are trackable and irreversible.

It is an agreement, the same way as a written contract. This may be done using blockchain technology – it is an immutable public ledger of information. The concept provides an explicit set of promises, to which everyone must adhere, and because they are executed digitally, and independently of the business…

Step 1: Business teams interact with developers to set their requirements for the desired behavior of the smart contract in response to specific events or conditions. 

Step 2: Simple events include things like payment authorization, package receipt, and a utility meter reading threshold. 

Step 3: More complicated actions, such as calculating the value of a derivative financial instrument or automatically disbursing an insurance payment, may be encoded using more sophisticated logic. 

Step 4: The developers next construct and test the logic using a smart contract writing tool. Following the completion of the application, it is forwarded to a different team for security testing. 

Step 5: Use an internal specialist or a business that specializes in smart contract security verification.

Step 6: Once authorized, the contract is implemented on an existing blockchain or equivalent distributed ledger infrastructure. 

Step 7: Once deployed, the smart contract is set to listen for event updates from a “oracle,” which is basically a cryptographically secure streaming data source. 

Step 8: The smart contract runs after it has the required combination of events from one or more oracles.

Smart contracts rely on defined and objective input parameters and execution procedures. However, before the contract can be performed and uploaded to certain blockchains, a transaction fee must be paid. On the Ethereum blockchain, for example, smart contracts are performed on the Ethereum Virtual Machine, and the transaction fee is known as “gas.” As the intricacy of the contract to be performed grows, so does the amount of gas necessary to carry it out. 

The transaction is joined to the blockchain once the transaction fee is paid. This signifies that the transaction is complete and cannot be modified, and only the persons who have been granted permission may see the results. 

What Are the Pros and Cons of Smart Contracts?

These agreements already have a number of advantages over traditional arrangements. This figure is expected to rise in the future as technology advances. For the time being, here are advantages of employing them.

1. Precision 

One of the key criteria of a smart contract is the explicit recording of all terms and conditions. This is required since omissions might lead to transaction problems. As a result, automated contracts avoid the difficulties associated with manually filling out a plethora of paperwork. 

2. Accountability 

These contracts’ terms and conditions are completely open and available to all relevant parties. Once the contract is created, there is no way to contest it. This ensures that the transaction is completely transparent to all parties involved. 

3. Effective Communication

Everything is explicit due to the necessity for precision in contract specification. There can be no space for misunderstanding or miscommunication. As a result, smart contracts have the potential to significantly reduce the amount of efficiency wasted due to communication gaps.

4. Quickness 

These contracts are based on software code and are accessible over the internet. As a consequence, they can complete transactions in record time. Many typical corporate processes may be completed in a matter of hours because to this speed. There is no need to manually process papers. 

5. Security 

Automated contracts employ the strongest degree of data encryption currently available, which is the same standard employed by modern crypto-currencies. This level of security places them among the most secure goods on the internet.

6. Effectiveness

The efficiency with which these contracts function is a natural outcome of their speed and precision. More value-generating transactions are performed per unit of time when efficiency is higher. 

7. Paperless 

Businesses all across the world are becoming more concerned of their environmental effect. Because smart contracts live and breathe in the virtual world, they allow the “go-green” movement. This eliminates the need for large reams of paper. 

8. Storage and Backup

In each transaction, these contracts capture critical facts. As a result, whenever your information is utilized in a contract, it is permanently saved for future reference. These qualities are easily recoverable in the case of data loss. 

9. Financial savings

One of the most notable benefits of automated contracts is that they eliminate the need for a large network of intermediaries. There is no need for attorneys, witnesses, banks, or other middlemen. 

10. Have faith

Smart contracts generate complete trust in their execution. The agreement’s transparency, autonomy, and security eliminate any potential of manipulation, prejudice, or inaccuracy. The network automatically executes the contract when it is solemnized. 

11.  Guaranteed Results

Another appealing aspect of these contracts may be the ability to considerably decrease, if not eliminate, the need for litigation and courts. By employing a self-executing contract, parties agree to be bound by the underlying code’s rules and judgments. 

Where Are Smart Contracts Most Effective? 

As a result of their self-executing character, these contracts are more suited to some sectors than others. Automated contracts are less ideal for companies with high service levels, such as hotels, food, and drinks.

There are various industries that might gain the most from widespread smart contract usage. Various governments throughout the world, for example, have attempted smart contract pilot projects to assist remove the cumbersome manual paper filing connected with dated real estate transactions. Smart contracts might also aid in the protection of sensitive patient data in the healthcare business, while simultaneously maintaining the veracity of the information to avoid erroneous diagnoses. Furthermore, smart contracts have the potential to automate a variety of time-consuming operations in the accounting and finance industries that include figure crunching. 

Smart contracts may also be useful in the following industries: 

  • Startups
  • Venture Capital 
  • Supply Chain Education Insurance Warehouse 
  • Transportation and Logistics 
  • Charities
  • Agriculture Travel & Tourism

Adoption of this technology will assist industries such as banking, insurance, healthcare, and real estate. These industries are based on a set of rules, algorithms, and quantitative parameters of interaction

Limitations / Cons of Smart Contracts

At the moment, there are significant practical constraints to smart contracts that prohibit them from becoming widely used. 

Incapability to Change 

First, changing or cancelling a contract is far more difficult, if not impossible, than it is with text-based contracts. When the law changes or an unforeseen occurrence happens, parties can swiftly prepare an addendum to a text-based contract. However, because blockchains, where smart contracts live, are immutable, changing a smart contract is significantly more difficult. This disadvantage may result in greater transaction costs as compared to utilizing traditional contracts. 

There are little remedies for breach. 

Furthermore, when a contract is broken, smart contracts have concerns with allowing parties to choose self-help measures. 

Negotiation Restrictions

The objectivity and automation inherent in smart contracts can foil how parties actually negotiate contracts. For instance, a party may decide it is beneficial to leave a provision more ambiguous so to later argue that the provision should be interpreted in their favor if or when an issue arises. Smart contracts do not allow for the same level of ambiguity. Smart contracts demand exact parameters. Consequently, parties may elect for text-based contracts for complex agreements due to high transaction costs associated with negotiating those contracts.

Security

As previously discussed, smart contracts also present the added risk that the contract can be hacked and financially exploited. Parties may find added insurance in knowing a text-based contract cannot lead them to financial ruin.

Outside Data

Another technical problem occurs when provisions are inserted into a smart contract requiring the smart contract to receive information from off-chain resources, data from resources not on the blockchain itself. For example, a crop insurance smart contract is programmed to transfer money to an insured party if the temperature falls below 32 degrees. In this case, a significant problem arises because smart contracts cannot pull data from off-chain resources. Rather, that information must be entered into the smart contract.

Oracles, which are trusted third-party information sources, can cure this problem by inputting this information at predetermined times; however, adding a third party to the smart contract process presents the residual problem of diluting the decentralized experience of smart contracts.

Problems That Might Arise with Smart Contracts

According to Sergey Nazarov, CEO of Chainlink, an oracle start-up that leverages many external sources of oracle data, there is no absolutely trustworthy data since oracles have typically conveyed data from a single source. In a white paper, Nazarov stated that data might be “benignly or maliciously contaminated as a result of malfunctioning web sites, deceptive service providers, or honest mistakes.” 

Chainlink has created development agreements with firms in the internet and financial services, such as Google and the Society for Worldwide Interbank Financial Telecommunication (SWIFT), which operates one of the world’s largest clearing and settlement networks.

The way regular contracts function today can be problematic, according to Nazarov, because one party may perform a task but the other party may decide not to pay – likely touching off a legal battle – or there may be assumptions made by one of the parties about a complex contract that may not be true.

“Those contracts are not rigorously enforceable; they can’t be enforced by technology the way a smart contract can.” Nazarov said. “A smart contract is deterministic; it can absolutely be enforced as long as the events related to its contractual clauses happen.

“Smart contracts are contingent on events; they’re contingent on market events, in insurance they’re contingent on IoT data from cars, factories or other equipment,” Nazarov continued. “In trade finance, they’re contingent on shipping data.

In another example, Chainlink created a smart contract for a media company that held in reserve fees to be paid to a search engine optimization (SEO) firm it had hired until news article URLs reached – and then maintained – search engine rankings for a specific period of time.

“That payment wasn’t held by our client or the search engine optimization firm,” Nazarov said. “It was held by this new technology [blockchain and the smart contract] that will programmatically enforce the contract as it was written. That’s the fundamental difference.”

While complicated to develop in the past, constructing smart contracts is becoming easier as new programming tools are emerging that move away from the underlying complexity of smart contract scripting languages, essentially enabling business people to pull together the basics of a smart contract, Bennett said.

“We’re even beginning to see tools that allow business people to pull together the basics of a smart contract,” Bennett said. “That’s only the beginning, though, as some companies have already discovered it can be a challenge to ensure that every network participant runs the same version of a smart contract.”

Final Thoughts

The smart contract has long been considered the main feature of Blockchain, but when the industry declines, many concepts such as decentralization, distributed ledger and so on are gaining popularity. In addition to popularization, blockchain technology has been widely used in various industries and was widely recognized by academia and individuals.  The application of blockchain technology is still expanding, and every field will be affected. Because there is no government supervision and regulatory support for the development of blockchain technology, it is difficult for enterprises to move ahead by themselves. We hope by providing a solid platform for domestic enterprises to build a base of Blockchain applications in China will bring a certain degree of help to them.

To conclude, the world is moving towards a new way of doing things. We are shifting from a “system-driven” culture to an “institution-less” economy. The only way for us to succeed in this new frontier is to build a system that is open, transparent and secure. And the only solution for this decentralization lies in blockchain technology.

Smart contracts can make some processes of doing business online even more efficient. They run directly on top of the blockchain which eliminates the need for a third party to arbitrate failed contracts and disputes. Smart contracts can be used in many industries, and there are now even multi-million-dollar companies working towards unlocking their potential.

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