what is a smart contract

Blockchain is a noteworthy technology for multiple reasons. It’s the backbone behind the most popular cryptocurrencies and enables strategic development across various industries. These industries include web security, logistics, and even trade finance. Do gain an understanding of how blockchains work in these industries, it’s important to have an understanding of what is a smart contract.

Probably one of the best things about public blockchains is that they are decentralized systems. One that exists between all of the people that are participating. Intermediaries (or ‘middlemen’) are not a contributing factor, so it saves you a lot of time and money and prevents needless conflict. Overall, many consider blockchains to be faster, cheaper, and much more secure than most other legacy systems. It is for this reason that various banks and governments are incorporating the technology as we speak.

With all this in mind, this advance is more apparent regarding its growing popularity as an inventive payment method. Arguably the most prominent driving force behind its rapid adoption is the widespread acceptance of ‘smart contracts.’

What is a Smart Contract?

‘Smart contracts’ are a type of self-executing contract with the terms of agreement residing in the lines of code. To be more specific, these agreement terms are those that are between a buyer and a seller. Both the code and the agreements exist across a distributed and decentralized blockchain network.

These contracts allow for the execution of transactions and agreements among dissimilar, anonymous parties. On top of that, it is without a need for a central authority, a legal system, or any external enforcement. They essentially make all transactions traceable, transparent, and above all else, irreversible.

The primary goal of these contracts is to boost the overall transparency of the transaction. All the while it reduces fees and eases any potential for conflict over a lack of performance. Unlike traditional contracts, however, smart contracts have absolutely no room for interpretation. This is due to all of the terms being predetermined and conditions executed automatically. Therefore, there is immediate enforcement by the contract itself.

The benefits that can come from using a smart contract include:

  • Turning legal obligations into more of an automated process
  • Guaranteeing a higher level degree of security for parties involved in a contract
  • Reducing the conventional reliance on intermediates and any other form of middlemen
  • Lowering transaction costs

Pizzeria analogy

Investopedia writer, Joe Liebkind, has the perfect analogy to explain the purpose of smart contracts:

A simple analogy for understanding the purpose would be pizza delivery. In this example, a pizzeria promises 30-minute delivery for a pie or money back guaranteed. The pizzeria would then create a smart contract with a customer ordering a pie. The customer could put the funds in escrow, and if the pizza is delivered within 30 minutes, the funds are released from escrow to the pizzeria. If the pizzeria fails to deliver on time, the money held in escrow is returned to the customer. While overgeneralized, this example readily illustrates how smart contracts can be applied across nearly any activity that requires some sort of contract to establish trust and security between parties.”

Origins of Smart Contracts

In 1994, Nick Szabo, a computer scientist, took note of how useful a public ledger could be for smart contracts. With this format, contracts could go through a conversion to transform into computer code. Moreover, they could be put into storage and go through a replication process on the system. All of this is under the supervision of the network of computers that manage the blockchain. This would lead to ledger feedback, like the transfer of money and receiving the product or service.

Szabo describes smart contracts as being transaction protocols run by computers that carry out the terms of a contract. His desire was to extend the capabilities of electronic transaction methods, such as POS (point of sale), to be more digital. 

Szabo brought up a proposal for the execution of a contract for synthetic assets, like derivatives and bonds. In his paper, Szabo said the following:

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.”

A majority of Szabo’s predictions in the paper came true, specifically in context to blockchain technology. For instance, conducting the trading of derivatives is through computer networks by way of intricate term structures.

Buterin’s explanation

The most famous smart contract application is the blockchain platform belonging to Ethereum. Vitalik Buterin, the head programmer of Ethereum, once spoke about smart contracts at a DC Blockchain Summit. With these contracts, an asset or currency goes through a transfer to a specific program. From this point:

“…the program runs this code and at some point it automatically validates a condition and it automatically determines whether the asset should go to one person or back to the other person, or whether it should be immediately refunded to the person who sent it or some combination thereof.”

For the time being, the ledger additionally stores and duplicates the document. This effectively gives it a specific type of security, as well as immutability.

Apartment rental example

Let’s use a hypothetical scenario to further explain this. Say you want to rent an apartment from me. You are able to do this by way of the blockchain by paying with cryptocurrency. You will obtain a receipt, which the virtual contract is holding. From here, I will give you the digital entry key that will come to you by a specific date. Assuming that the key does not arrive on time, then the blockchain will release a refund. If I send you the key prior to the rental date, the function holds it. Moreover, it will release both the fee and the key to you and me respectively upon the specific date’s arrival.

This particular system operates on the “If-Then” premise. Furthermore, hundreds of people will witness it, so it guarantees a flawless and impeccable delivery. Should I give you the key, I will eventually receive payment. If you send a certain amount in bitcoins, then you will receive the key. The document will automatically experience a cancellation after the specific time. Following this, there cannot be any interference with the code by either of us. That is to say, it is not possible without the other knowing, seeing as how all participants will receive a notification.

There are a variety of uses for it

Smart contracts have the potential to upset a great number of industries. Use cases are often found in fields such as prediction markets, banking, insurance, energy, telecommunications, and education. It can even be found in the art world and both the music and film industry. Smart contracts use is appropriate and beneficial for an assortment of projects, ranging in complexities.

Services that offer to time-stamp transactions are a good example of how smart contracts can be incredibly useful. This would be applicable to art registries and governmental registries that distribute documents. These documents could include birth certificates, land titles, and school and university degrees.

Ranking the types

PricewaterhouseCoopers (PwC) has a chart that ranks each of the types of smart contracts. They rate certain case examples of each from the straightforward to the intricate.

  1. Digital value exchange: The act of sending a certain type of cryptocurrency (ex. Bitcoin) from one family member to another.
  2. Smart right and obligation: When a consumer purchases a digital content stream.
  3. Basic smart contract: A landlord locking out a tenant from their apartment due to the fact that they are not paying.
  4. Multiparty smart contract: When a merchant is looking to sell their house lends the potential buyer the funds.
  5. Autonomous business unit that is distributed: A corporation unit issuing its own bonds and any buyer can monitor the payments by way of a communal ledger.
  6. Distributed autonomous organization: Self-driving trucks that carry out peer-to-peer deliveries, pay the local toll road fees and also purchase local electricity.
  7. Autonomous government that is distributed: Settlers that belong to a once desolate area can code their own self-enforcing government services.
  8. Distributed autonomous society: Multiple groups of settlers hailing from different areas establishing self-enforcing trade agreements.

According to PwC:

Dreamers and visionaries imagine a blue-sky future in which not only entire companies could operate in automated fashion (distributed autonomous organizations), but also a form of government (distributed autonomous government) and some aspects of society could be automated.”

Examples on how you can use them

In addition to the list above, there are several other instances where smart contracts are useful. IBM vice president for blockchain technologies, Jerry Cuomo, believes that the potential uses range from financial services to healthcare.

1 – Government use

If what insiders say is true, then it’s extremely difficult for our voting system to be vulnerable to rigging. Nevertheless, smart contracts would mitigate concerns simply by providing a secure system. Votes under ledger protection need decoding and they require excessive computing power in order to access. As it is, there’s not a single individual who possesses that much computing power.

On top of that, smart contracts could conceivably help with low voter turnout. A bulk of the apathy derives from a convoluted system that includes doing a variety of tasks. These include lining up, presenting your identity, and inevitably completing countless forms. However, with smart contracts, volunteers are able to transfer the voting process to the online world. This simultaneously makes it easier and much more appealing for certain demographics.

2 – Management use

The blockchain provides not just a single ledger as a source of reliance, but it also cuts out possible disruptions in communication and workflow. This is largely due to it being an automated, transparent system that’s distributed across many servers (as opposed to one centralized server).

Most of the time, business operations endure a back-and-forth procedure while awaiting approvals. Moreover, they have to wait for internal and/or external issues to fix themselves. A blockchain ledger will effectively simplify this. Additionally, it will cut out conflicts that regularly occur with independent processing. These conflicts often result in expensive lawsuits, not to mention settlement delays.

An example of this particular smart contract use was in 2015. The Depository Trust & Clearing Corp. (DTCC) utilized a blockchain ledger to process over $1.5 quadrillion worth of securities. This was, in essence, representative of up to 345 million transactions.

3 – Supply chain use

As you may recall, smart contracts typically function on the “If-Then” premise. In the words of the co-founder at blockchain services startup, Bloq, Jeff Garzik:

UPS can execute contracts that say, ‘If I receive cash on delivery at this location in a developing, emerging market, then this other [product], many, many links up the supply chain, will trigger a supplier creating a new item since the existing item was just delivered in that developing market.”

Often times, supply chains will experience restrictions by systems that are paper-centric. This is where forms need to go through an array of channels for approval. This method basically increases exposure, making the chain vulnerable to losses and fraud. The blockchain revokes this by giving a more secure, accessible digital version to all parties on the chain. Moreover, it automates both tasks and payment.

An example of this smart contract use is Barclays Corporate Bank. They employ smart contracts as a way to record a change of ownership. In addition, they use these contracts to automatically transfer payments to other financial institutions as soon as they arrive.

New York Governor Cuomo cautions that some of the more complex contract types will not go to the blockchain in the near future. He says:

There are adoption patterns and business processes that – let’s face it – have been in place for 30, 40 years that involve many diverse sets of rules that are regulated. Those contracts aren’t going to come into play anytime soon.”

However, he believes that there are more basic types of contracts that could go to the blockchain. These types include those that are made to ensure compliance.

what is a smart contract

4 – Automobile use

Think about where we are at this point in time. To be more specific, think about where we stand regarding technology. It’s no surprise that our everyday appliances are evolving into something more robotic; more automated, so to speak. Imagine a future where pretty much everything is run like this.

Google is an enterprise that is gradually reaching that point. They are getting there with the use of smartphones, smart glasses, and smart cars. This is where smart contracts come in. A notable example of this is the self-autonomous – or self-parking – vehicles. Here, smart contracts essentially play the role of an ‘oracle’, detecting who is responsible for a crash. Is it the sensor or the driver? Or was it a number of other variables?

By utilizing smart contracts, an automobile insurance company can charge rates differently. They can draw from where, and under what conditions, the customers are using their vehicles.

5 – Real estate use

An interesting thing to note is that you can obtain more money through smart contracts. In most cases, if you want to rent your apartment to someone, you have to pay a middleman. Such middlemen include platforms like Craigslist or sometimes even a newspaper so that you can advertise. Even then, you would need to pay someone to confirm that the person paid their rent.

The ledger completely cuts your costs. All you have to do is pay with bitcoin, as well as encode your contract on the ledger. Everyone will see this and you will effectively accomplish an automatic fulfillment. The amount of people who can profit from this is massive. Such groups include brokers, real estate agents, hard money lenders, and anyone who associates with the property game.

6 – Healthcare use

There are a number of advantages that smart contracts – and by extension blockchains – can give to healthcare. Personal health records can be put both into code and on the blockchain with the use of a private key. This key will grant only specific individuals with access. A similar strategy could help ensure that one can conduct research via HIPAA (Health Insurance Portability and Accountability Act) laws. Specifically, it goes through in a confidential manner.

Surgery receipts can go on a blockchain and insurance providers can receive them automatically as proof-of-delivery. On top of that, the ledger itself can be useful for basic healthcare management. This includes drug supervision, regulation compliance, results of testing, and handling healthcare supplies.

Additional advantages to blockchain incorporation in healthcare are:

  • Patients can have some level of control over how institutes use and share their medical data. Any party that’s looking to get a patient’s medical data can check the blockchain to obtain the essential permission.
  • An assortment of medical institutes worldwide administer their own research and clinical trials on different new drugs and medications. A blockchain will aid in the creation of a global database, collecting this data and storing it in one place.
  • Pharmacy companies need supply chains that are incredibly secure, due to the kind of product that they carry. Pharmacy drug theft from supply chains is a problem that puts drugs into illegal markets. A transparent blockchain will help enable close tracking of drugs to their point of origin. Therefore, it will help with the elimination of erroneous medication.

Conclusion

Smart contracts are an innovative piece of technology that is basically the by-product of a pre-existing innovation. Its potential for various fields, though primarily hypothetical at this point, is boundless and could benefit society greatly.

If you want to take the next step and learn about smart contract auditing, read “How to Audit a Smart Contract.”

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