Though blockchain is best known as the technology behind cryptocurrency, many see smart contracts as its most promising innovation. But what are smart contracts and how do they work? What are some of the benefits and risks of using smart contracts? One thing we know for certain: They have the potential to impact countless industries and individuals. This user-friendly guide will teach you everything you need to know about smart contracts, and how they could change our world.
They first surfaced in 1994 when a computer scientist named Nick Szabo wrote an essay titled “Smart Contracts.” Szabo wrote:
“A smart contract is a computerized transaction protocol that executes the terms of a contract. The general objectives of smart contract design are to satisfy common contractual conditions […], minimize exceptions both malicious and accidental, and minimize the need for trusted intermediaries.”
Like your typical contract, a smart contract is a signed agreement between parties based on a set of conditions. If either party fails to meet the terms or breaches the agreed upon conditions, the contract is invalidated and the entire agreement can be terminated.
The main difference between a smart contract and a contract as we know it is that the former carries out these operations through a code that exists on a decentralized blockchain. Instead of relying on complicated legal systems, paperwork or third-party intermediaries, here’s how a smart contract enforces an agreement.
Put simply, a smart contract is a piece of code that contains a contract’s terms. That code is then integrated into a blockchain. From there, the code automatically executes the terms of the contract as soon as all parties consent to its conditions and satisfy all qualifications.
The network of computers (nodes) running the blockchain is automatically recruited for this process. In other words, the vast decentralized network of computers that make blockchain secure, transparent and efficient ensures that everyone involved upholds the contract. In this way, blockchain nodes become the guardians and executors of the contract, eliminating the possibility of error or fraud.
Blockchain’s ledger also serves as a built-in, unchangeable history. This record provides objective proof of all details related to the smart contract. This includes when the contract began, its terms and whether the parties involved satisfied their ends of the agreement.
Smart contracts are fully automated. This means that they never require a third-party’s oversight. Once it’s written into the code, which is then added to a blockchain, the terms of a contract are either satisfied or they are not. If they are satisfied, the code instantly executes the transaction. Conversely, if the terms are not met, the code takes no action.
For example, one party has agreed to give the other party a sum of money for completing a task. Once that task is complete, the smart contract is notified and the funds are automatically released. Smart contracts’ terms are clear, objective and ready to be executed at the appropriate time. This leaves no room for debate.
Furthermore, they are much cheaper than your average contract. You don’t need to hire anyone to create, execute and oversee a transaction, which leads to big savings. Automated agreements also save a lot of time. You can access the blockchain on which your contract exists anywhere. Additionally, you no longer need to spend time on paperwork or communicating with a negotiator.
Take the shipping giant Maersk which recently inaugurated its blockchain platform for international shipping. By using smart contracts, Maersk saves on the cost of scheduling shipments, which involves different distributors, freight companies and customs offices. They estimate that they 1/5 on total shipping costs.
In addition to cutting down costs and time, a smart contract makes fraud almost impossible. For starters, it requires fewer people and transactions. This means that there is less potential for error, purposeful or otherwise. Additionally, there isn’t any physical paperwork that someone could forge or alter.
Most importantly, security against fraud or manipulation is built into the mechanism of a smart contract. Since it exists on the blockchain, there is no person or single server to influence. At its core, a smart contract is a simple piece of code that knows two things: the terms of the contract and whether or not they have been met.
To defraud a smart contract, a person would have to somehow slip past the entire decentralized network of computers which made up the blockchain. To do that, one would need more computing power than is realistically possible.
It can be difficult to understand how something works or why it may benefit us until we understand how to implement it. Smart contracts have countless use cases across varied industries. Here are some of the ways that we can leverage smart contract technology:
Imagine if all voting were secure, transparent and digital. When we say transparent, we don’t mean that your name will be attached to your vote. Rather, you and everyone else will be able to see and track the results of an election in real-time. We wouldn’t have to rely on humans to count physical votes and news sources to report them. Instead, we could just see for ourselves.
If a business is looking to raise money to meet a specific goal, they can create a smart contract. In this case, the smart contract would take the place of the third-party website, like Kickstarter or Indiegogo, and carry out the campaign involving only investors and the business. If the goal were met, the funds would automatically be released. If the company did not meet their goal, the investors would automatically be refunded their funds.
Take Uber, for example. The passenger takes a car to a destination, at which point they transfer money from their account to the rideshare company. With a smart contract, a rideshare wouldn’t necessitate a middleman—Uber, in this case. Instead, the passenger could transfer funds directly from their account to the driver. No need for a third-party to profit off the transaction.
Examples abound in supply chain management, real estate, automotive, healthcare and other sectors. Put simply, automated agreements can replace all contractual transactions. In fact, they can cover some we don’t even consider to be contractual.
As more people adopt smart contracts, the scope of what they can accomplish widens. In essence, the more people use them, the more steps within an agreement you can automate.
Though we are already seeing the benefits of smart contracts, the technology behind them is new—and far from perfect.
Although using code to carry out contracts allows for never-before-seen amounts of objectivity and security, it also presents a few problems. Most obviously, bugs. Even if nobody hacks the code, errors or bugs can still exist within the code itself.
Problems could also arise from the fact that many smart contracts monitor physical products and services. Essentially, there is room for error in the interface between digital and physical. Take Maersk as an example. What happens if one customs office decides to seize an international shipment? What if a shipment arrives at the destination but some of the pieces are broken or damaged?
These issues will be rectified once this technology become the norm.
With this said, these sorts of problems aren’t unique. When it comes to damaged goods, it can be difficult to pinpoint who is accountable, especially if the supply chain is long. However, smart contracts could potentially eliminate subjectivity once more individuals and industries adopt them.
A piece of code dictates whether the parties satisfy the conditions or not. In shipping, one of these conditions is, undoubtedly, that goods remain undamaged. If this is not the case, then the last step in the supply chain is accountable. Therefore, there is little room for fraud or interpretation—if the code is comprehensive.
In this way, a smart contract’s code resembles a regular contract: The language, or code, has to be extensive and all-encompassing.
Smart contracts’ strengths can also be weaknesses. For example, they function beyond government oversight, at least in most places. A regular contact relies on the legal system to back it up, which validates government authority. By comparison, automated agreements do not need lawyers or judges, which makes them more efficient and impartial.
Though the benefits of this outweigh their costs from an individual or company’s standpoint, this poses a problem for governments. For example, how can countries collect taxes on a product sold and shipped using a smart contract? Similarly, what if there is some sort of dispute? A smart contract makes it virtually impossible to trick the other party, but disagreements can always arise.
With blockchain enforcement, these agreements essentially exist outside government authority. But who will solve a legal battle? As of this week, California now recognizes smart contracts as legally binding agreements. Hopefully, other states and nations will follow suit.
Individuals and businesses alike are beginning to adopt these agreements in their procedures—and for good reason. Some of the benefits of using a smart contract include:
Control – With a smart contract, you don’t need to rely on third-party lawyers and brokers.
Security – Your code is automatically encrypted and added to a blockchain ledger. It exists on countless computers around the world rather than on one server. This provides an automatic backup.
Immutable History – Since your smart contract is on a blockchain, it has a built-in history of all steps of the transaction that cannot be deleted or altered. Everybody involved in the agreement can see it and review it at any point.
Efficiency – A smart contract lets you cut out middlemen. Not needing an intermediating party isn’t just more efficient in terms of process and logistics; It’s also more cost-efficient. You don’t have to pay for all those middlemen and ancillary actors. Transactions become faster and cheaper with smart contracts. And the bigger your supply chain, the most you save.
Once your smart contract is on a blockchain there is little room for confusion or inaccuracy. There is no need to compose, negotiate and complete forms, thus eliminating human error and fraud. And once you initiate the agreement, you cannot disrupt it.
Smart contracts open the door for endless possibilities, both personal and professional. Furthermore, they make contractual procedures autonomous. Take a moment to reflect upon the many transactions you conduct daily. From start to finish, there are so many hands in each. Why is a third-party required for transactions that only involve two parties? Instead, smart contracts return ownership to the individual.
