In simple terms, a smart contract is a piece of computer code based on a blockchain according to predefined terms that contracting parties have agreed to.
Smart Contract: term and meaning
The Smart Contract contains the terms of the agreement between parties and a set of predefined rules that execute themselves when certain conditions are met, such as the release of funds to one of the parties under certain pre-agreed rules.
Under a smart contract, two or more unknown parties can execute a transaction without the need for intermediaries such as lawyers, banks, or central authorities, which should reduce costs.
Smart contract: possible applications
Smart contracts allow these parties to exchange funds, property, shares, or other items of value on a decentralized basis, making transactions traceable, transparent and immutable.
They reduce the cost and time required to establish, formalize, and enforce agreements in what is known as a “trustless environment.”
How Smart Contracts Work
Smart contracts work by simple “if…then…” instructions written into the code of a blockchain. A network of computers performs the actions when predefined conditions are met and verified. These actions can include releasing funds to the appropriate parties, registering a vehicle, sending notifications, or issuing a ticket. The blockchain is then updated when the transaction is completed. This means that the transaction cannot be changed and only the parties who have been approved can see the results.
In a smart contract, as many conditions can be set as necessary to convince participants that the task will be completed satisfactorily. To set the terms, participants must determine how transactions and their data will be represented on the blockchain, agree on the “if…then…” rules that govern those transactions, explore any possible exceptions, and define a framework for resolving disputes.
The smart contract can then be programmed by a developer. However, companies using blockchain for business purposes are increasingly providing templates, web interfaces and other online tools to simplify the structuring of smart contracts.
Advantages of smart contracts
Speed, efficiency, and accuracy
Once a condition is met, the contract is executed immediately. Because smart contracts are digital and automated, there are no paper-based processes to deal with and no time spent reconciling errors that often occur when documents are completed manually.
Trust and transparency
Since there is no third party involved and the encrypted records of transactions are shared by all participants, there is no need to question whether the information has been altered for personal gain.
Blockchain transaction records are encrypted and therefore very difficult to hack. Because each record is linked to previous and subsequent records in a distributed ledger, hackers would have to alter the entire chain to change a single record.
Smart contracts eliminate the need for intermediaries to process transactions, and with it the associated time delays and fees.
How is a smart contract executed?
There are several types of smart contracts. Ethereum is considered the best-known platform. There, smart contracts themselves are treated like an account that acts autonomously. In other words, there are no single individuals who have access to this account. Instead, the actions to be executed are carried out in the network. This account can be thought of in simplified terms as a set of instructions (program code) that are executed. These include performing computation, storing information, and sending transactions to other accounts.
While smart contracts are written by humans and stored on the blockchain, after that, execution is the sole responsibility of the network and the user no longer has the ability to make changes. This means that errors can still occur due to incorrect programming.
How reliable are smart contracts?
It is important to differentiate between the virtual execution of the contract and its significance in the real world. After all, only the actions to be executed are stored on the blockchain. This does not mean that they are valid in the real world. From a purely technical point of view, it can be executed correctly, but it cannot automatically serve as evidence in court to prove a certain claim.
“Code is Law”
Another aspect to keep in mind about smart contracts is the authoritativeness of the program code. Solely the program code of the contract is decisive for the execution. The DAO – a kind of decentralized investment platform – had collected investor funds via a smart contract at the time, for example. There was a bug in the code that a hacker could exploit to his advantage and thus steal the Ether. Even if it had been known who was behind the attack, apart from a hard fork (in this case a reset to an earlier point in time) there would have been no chance to reverse the attack. This is because the hacker merely executed the code stored on the blockchain. In the real world, however, legal action could have been taken to hold the hacker accountable. Therefore, one should always be aware of the maxim “Code is Law” (only the code decides).
Applications of smart contracts
Smart contracts give rise to numerous areas of application, including the following, among others:
- Government – Elections could be simplified using voting systems via the blockchain. Votes stored on the blockchain would first need to be decoded, which would require large computing capacities to manipulate.
- Supply Chain – Supply chains based on many successive agreements can be automated through smart contracts.
- Real Estate – By eliminating the need for intermediaries in rental payments, the process can be done more cost-effectively. In addition, land can be sold in smaller portions.
- Healthcare – Healthcare data can be stored on the blockchain – in insurance claims, the data can be easily referenced.
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