Functionality & advantages of smart contracts in the blockchain explained simply

Distributed ledger technologies (DLT) are considered key technologies. Blockchain technology is the focus of experts. This could optimize numerous processes in the future and place decentralization at the center. Such a blockchain is a kind of decentralized and forgery-proof database. The use cases of such a register are diverse, but a particular focus on the part of companies is on the automation possibilities. With the help of smart contracts, companies can automate numerous processes and thus create added value.

What are smart contracts?

A smart contract is based on computer protocols. This is a type of digital contract based on blockchain technology. The terms of the agreement between “buyer” and “seller” are written directly in lines of code. Smart contracts are self-executing contracts, which means that they come into effect independently when certain predefined events occur and therefore do not require human supervision. If these entry conditions are met, the algorithm automatically initiates a transaction, which is then validated and stored in a block. Smart contracts thus enable the execution of trustworthy transactions and agreements between different parties. These digital contracts are quite comparable to classic contracts – for example, a sales contract or the conclusion of an insurance policy. Since such a smart contract is processed without human intervention, typical sources of error can also be eliminated.

Probably the best-known blockchain platform for developing these digital contracts is Ethereum. But with Tezos, a second blockchain is already available that provides extensive functions. The programming of such a contract can be handled with the help of Solidity, a specialized programming language for Ethereum.

Are smart contracts legally binding?

A contract is an agreement between several parties. Accordingly, a contract always contains the legally binding declarations of intent of the contracting parties. In principle, contracts can be concluded in writing, orally or by conclusive behavior. Due to legal certainty, contracting parties usually opt for a written form. Consequently, such a contract must always contain the general conditions in addition to the explicit naming of the contracting parties.

A smart contract also follows this principle and contains the relevant contractual information. However, this information is already defined in the programmed code during development. Consequently, the following applies to smart contracts: Code is law. Simply put, such a contract is an if-then rule that contains all the information needed to conclude the contract.

How do smart contracts work technically?

Simply put, a smart contract is a small programmed that runs on a blockchain and executes simple if-then rules. The developers define conditions and actions in advance, which are then executed automatically.

Here, the smart contracts benefit from the blockchain and are transparent, irreversible, and traceable. Since these small programmed are based on a blockchain, no intermediary can influence the execution. Instead, all transactions take place on the blockchain – this reduces costs. Due to the decentralization, smart contracts function independently and do not have any time delays.

Within the distributed ledger, these digital contracts are treated like a separate account with a public address, without this account having one – and thus no one has the private key. Once created, external access is excluded. The contract contents are to be defined in the form of actions and conditions so that the account can execute them automatically. In this way, it can connect and interact with other accounts.

What are the special advantages?

Compared to classic contract forms, smart contracts offer several advantages. These include:

  • Security
    Smart contracts are based on blockchain technology and are consequently secured by cryptographic encryption methods. Accordingly, no one can change the negotiated contract terms afterwards.
  • Efficiency
    The programming of a smart contract takes very little time and subsequently the processing is automated. Classical contract forms are more extensive in terms of both creation and processing, so time and cost savings result from automation.
  • Reliability
    Correctly programmed smart contracts almost completely exclude interpretation gaps in the contract terms. In addition, all documents are documented on the blockchain, so that loss is impossible.
  • Decentralization
    Due to the decentralized organization of a smart contract, third-party parties such as banks or notaries are not necessary. Instead, the blockchain takes over the validation of the transaction. The principle of “code is law” applies – the validity of the contract depends exclusively on the fulfilment of the contract conditions.

What are the disadvantages of smart contracts?

Even if the advantages of these digital contracts are convincing at first glance, their concept is not yet fully developed. Consequently, it is also possible that errors will occur using the programmed. Due to the characteristics of the blockchain, transactions that have already been executed are irrevocably documented on the blockchain. Consequently, a subsequent correction is no longer possible.

For example, an error in a Decentralized Autonomous Organization (DAO) enabled the theft of 50 million US dollars on 17 June 2016. Due to the underlying error, the developers of the Ethereum blockchain had to perform an update, which resulted in a hard fork, the forking of the actual blockchain. The direct result was the cryptocurrency Ethereum Classic, which was based on the forked blockchain.

Furthermore, it is possible that the developers implement backdoors in the programmed code. This circumstance shows that not only the underlying blockchain is relevant, but that trustworthy developers are necessary. Finally, a functioning internet connection is required to execute a smart contract. Currently, this requirement cannot be fulfilled worldwide, so that a global use of the technology is not possible.


It is not particularly surprising that smart contracts are considered one of the most important functions of blockchains. With the help of these small programmed, contracts can be fully automated. In addition, these programmed offer a high degree of legal security, so that attacks are almost impossible.

From the point of view of companies, the functions are interesting. Insurance companies, financial service providers and utilities can benefit from the use of this technology. However, now there are still few examples that illustrate successful use.

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