When learning about cryptocurrencies you're likely to come across the term "smart contracts". First popularised by Ethereum, smart contract functionality is now a regular feature among platforms that allow developers to build decentralized apps (dapps).
In this article, we're breaking down what smart contracts are, how smart contracts work, and where they came from.
What is a smart contract?
A smart contract is a digital agreement that executes based on the terms of the agreement. The terms are predetermined and written into the smart contract's code, ensuring that no edits can be made once the smart contract has been executed. As the smart contract is written using blockchain, the transactions are transparent and irreversible.
Due to the nature of these digital agreements, they can be carried out by two anonymous parties without the need for a third party/ central authority.
Smart contracts generally require payment for their creation, as the execution of the smart contract will require energy from the network. Ethereum smart contracts, for example, require gas fees in order to be created and executed, which are paid directly to the platform. The more complex the smart contract, the higher the gas fees. Other smart contracts will require payment in the digital assets utilized by the platform.
Smart contracts work because they are automated and utilize powerful decentralized technology.
Benefits of smart contracts
First and foremost, the biggest benefit of smart contracts is that they are trustworthy as they cannot be tampered with, nor can a third party intervene. So smart contracts cannot be hacked as they use blockchain technology to encrypt the information.
Smart contracts are cost-effective as they eradicate the middleman and save the users both time and fees that would otherwise come with them. Once certain criteria are met, smart contracts automatically execute, requiring no time delays, paperwork, or room for error. A smart contracts accuracy is determined by the accuracy of the coding used to create the smart contract.
many industries including insurance companies are using smart contracts to streamline and automate their business processes, including fulfilling legal obligations and managing financial transactions. By utilizing if-then statements, the insurance company can create smart contracts that automatically execute the insurance payment to policyholders when certain conditions are met. This can be used to process claims, pay out benefits, and manage other contracts in the same way.
How do smart contracts work?
Smart contracts are digital agreements built using blockchain. Developers looking to create a smart contract will need to utilize a blockchain platform that provides such functionality.
Determine agreement terms
Developers will first need to determine what the agreement terms are as well as the desired outcome. For example, one might create a smart contract that stipulates when 0.5 BTC is received by a certain digital assets wallet the code to a keypad on a property will be sent to the renter.
Determine conditions of agreement
Establish the conditions of the smart contract such as payment authorization or shipment receipt.
Write code
Using a smart contract writing platform, developers will write the code. This will then be sent to another team, such as an internal expert, for security testing.
Smart contracts deployed
Once approved, the code is then deployed on the blockchain platform. The smart contract will then be alerted to any event updates.
Smart contracts executed
Once the terms of the agreement are met and communicated to the blockchain through an oracle (a secure streaming data source), the smart contract will then automatically execute the desired outcome.
One might liken a smart contract to a digital vending machine. The terms of the agreement are understood by both parties involved prior to the transaction. Through an automated process, one party will input the initial criteria (the funds) and the predetermined outcome will be executed automatically (the selected goods will be released).
History of smart contracts
Smart contracts were first conceptualized by American computer scientist, Nick Szabo, the creator of the first digital money "Bit Gold", in 1998. He created them with the intention to digitize transaction methods to replace traditional contract and defined these smart contracts as "computerized transaction protocols that execute terms of a contract."
"These new securities are formed by combining securities (such as bonds) and derivatives (options and futures) in a wide variety of ways. Very complex term structures for payments can now be built into standardized contracts and traded with low transaction costs, due to computerized analysis of these complex term structures."
Szabo's concept remained purely theoretical until the invention of public blockchain technology, which provided the necessary infrastructure for storing and executing smart contracts. In recent years, smart contracts have been used in a variety of industries, including finance, real estate, and supply chain management. While there are still some security concerns with the technology, the use of smart contracts could further increase the efficiency and reliability of transactions.
Conclusion
Smart contracts are digital a contracts between two parties that are automatically executed once certain conditions are met without time delay. Built on the blockchain, smart contracts are immutable, irreversible, and transparent, and require no third parties. Smart contracts are written in varying programming languages dependant on the blockchain network on which they are created. This technology ensures that the smart contracts are implemented correctly.