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How Do Smart Contracts Operate?

By Laxmikant Khanvilkar

The explosion of internet usage and digital technology innovation played a vital role to solve business problems by optimizing processes, improving customer experiences, and delivering new business models. However, it has also brought to fore the vulnerability of being exposed to several technological nuances.

It is here that the importance of “Smart contracts” has been underlined. Smart contracts being a critical component of many platforms, many applications are built using blockchain or distributed ledger technology to facilitate their execution efficiently.

What exactly are “Smart Contracts”?

By definition “smart contracts” are simply programs stored on a blockchain that run when predetermined conditions are met. Simply put they are a self-executing program that automates the actions required in an agreement or contract and once completed, the transactions are trackable and irreversible.

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.

While blockchain technology has come to be thought of primarily as the foundation for Bitcoin​, it has evolved far beyond underpinning a virtual currency.

A Brief History Of Smart Contracts

In 1994, an American computer scientist Nick Szabo proposed Smart contracts for the first time. Nick invented a virtual currency called “Bit Gold” in 1998, 10 years before Bitcoin was introduced.

In fact, it is often rumored that Nick is the real Satoshi Nakamoto, the anonymous Bitcoin inventor, which he has denied.

Szabo defined smart contracts as computerized transaction protocols that execute the terms of a contract.

He wanted to extend the functionality of electronic transaction methods, such as POS (point of sale), to the digital realm. 

In his paper, Szabo also proposed the execution of a contract for synthetic assets, such as derivatives and bonds. Szabo wrote, “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.”

Many of Szabo’s predictions in the paper came true in ways preceding blockchain technology. For example, derivatives trading is now mostly conducted through computer networks using complex term structures.

Use cases of Smart Contracts

Since smart contracts execute agreements, they can be used for many different purposes. One of the simplest uses is ensuring transactions between two parties occur, such as the purchase and delivery of goods.

For example, a manufacturer needing raw materials can set up payments using smart contracts, and the supplier can set up shipments. Then, depending on the agreement between the two businesses, the funds could be transferred automatically to the supplier upon shipment or delivery.

Real estate transactions, stock and commodity trading, lending, corporate governance, supply chain, dispute resolution, and healthcare are only a few examples where smart contracts can be used.

Pros & Cons of Smart Contracts

The benefits of smart contracts are similar to the benefit of blockchain technology—they remove the need for third parties. Other benefits of this technology are:

• Efficiency: They speed up contract execution
• Accuracy: There can be no human error introduced
• Immutability: The programming cannot be altered

Some of the downfalls of smart contracts are:

• Permanent: They cannot be changed if there are mistakes
• Human factor: They rely on the programmer to ensure the code addresses the terms of the contract
• Loopholes: There may be loopholes in the coding, allowing for contracts to be executed in bad faith

Examples of a Smart Contracts

The simplest example of a smart contract is a transaction between a consumer and a business, where a sale is made. The smart contract executes the customer’s payment and the business’s shipment or transfer of ownership.

Blockchain with Smart Contracts:

Ethereum has smart contract capabilities inherent to its blockchain. The Bitcoin blockchain received smart contract abilities after its Taproot upgrade, which allowed it to communicate to layers that have smart contracts enabled on their blockchains.

In simple terms, smart contracts are apps on a blockchain that make each side of a transaction complete its part. For example, a smart contract could initiate a fund transfer with a third party to verify that the transfer took place.

Conclusion:

As we know, smart contracts are code written into a blockchain that executes the terms of an agreement or contract from outside the chain. It automates the actions that would otherwise be completed by the parties in the agreement, which removes the need for both parties to trust each other. Industries such as art, music, real estate, finance, manufacturing, retail, supply chain, and telecom could benefit significantly from smart contracts. The adoption of smart contracts would be hastened if the platforms which host them accepted payments in all currencies instead of just cryptocurrencies, and brought them under the purview of the current judicial system.

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