What are smart contracts in blockchain and how do they work?

• Toshendra Kumar Sharma
• December 27, 2022

Blockchain can provide the ultimate solution with its feature of Smart Contracts.

One of the biggest problems of modern business is trust. With each passing day, we lose faith in big companies and even other humans. Without the trust factor and transparency, we are always advised to dread slowly. We take much more precaution, and this comes at the expense of flexibility that modern business requires.

To solve this problem, we depend on third-party intermediaries. But that also demands a certain level of trust. What if the intermediary embezzles our funds or goes bankrupt?

Here, blockchain can provide the ultimate solution with its feature of Smart Contracts. Let us see what it is and how it works. By the end of this article, you will be an expert on how it works and maybe apply it in your real life.

Let us dive in.

What are Smart Contracts?

Well, smart contracts are just simple computer codes that are run on the blockchain, and they are self-executable when we meet certain conditions. They are immutable, transparent, and, most importantly, they are decentralized. Clearly, this gives them an edge over traditional contracts. 

Nick Szabo introduced the term smart contract in 1990. He described a smart contract as a digital form of a set of promises, and when these promises are met, the users are guaranteed a specific outcome.

Additionally, all of these premises of smart contract are possible because of blockchain. Smart contract found recognition due to its induction in the Ethereum blockchain, where anyone can code a smart contract using the Ethereum Virtual Machine or Solidity.

Smart contracts are one of the safest modes of transaction today. Though a crude version of the Smart contract existed in the Bitcoin blockchain, but Ethereum with Turing Complete language introduced a superior version of the smart contract, which has even more incredible computation prowess.

Today, there is no limit on what a smart contract can do. We will talk more about this later in the article. Before that, let us see how it works.

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How do smart contracts work?

A smart contract, as we mentioned above, is self-executable. So, let us see the basic principles.

Offer: The transaction is initiated by the first part. The first party writes a contract with an if-then statement using Solidity. Then the agreement is passed to the blockchain.

Negotiation: After the contract appears on the blockchain, the contract is open for all the related parties to see. The parties can negotiate on the contract terms. Make sure that you verify all the terms in this step because once it is signed, then there is no going back.

Approval: Once all the parties have approved the contract terms, then triggering events are put into place. Triggering events can be expiry date, due date, strike pass/ stop-loss, or other conditions the parties see fit. After that, the contract is approved, and it becomes immutable.

Self Satisfying conditions: After approval. It can self verify the conditions inside the contract using real-time data from Oracles or IoT devices like sensors or cameras.

Triggering event: The smart contract is triggered when the conditions are met, Then the assets are transferred, or the underlying outcome occurs.

Undoubtedly, this might sound confusing. 

Let us better understand it with an example.

Suppose a person called A wants to buy a house from B. To do that, A will write a smart contract on the Ethereum blockchain. Then negotiations will occur, and the final agreement is approved between both parties.

Let us assume the contract says that when B pays A 500 Eth (Eth is the native token of the ethereum blockchain), that is the triggering condition. After which, the contract will transfer the house’s deed to B. Thus, B is getting ownership of the house.

All of this sounds simple, isn’t it? 

Yeah, it is that simple. While doing this, both the parties made the transaction without intermediaries like Banks, lawyers, or brokers. Thus, both parties uphold ultimate trust while saving both time and money.

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Benefits of Smart Contracts

• Save Money and Time

Smart contracts are self-executing. That means you do not have to depend on your lawyer or bank to set up appointments and handle the transactions. The contract can do all of this by itself. Thus, you end up saving lots of money and time required to fulfill manual work.

• Trust and Transparency

Since smart contracts are written on the blockchain, that means no one can change them after the contract has been written. Moreover, every node on the blockchain can verify the contract. If someone tries to pass on a fraudulent transaction, then it would be immediately rejected by the other nodes. The cryptocurrency trading will either revert to its initial state or be penalized.

• Accurate

The smart contract depends on real-time data from Oracles. That means they have a 100% strikethrough triggering rate once they meet all the conditions. Here, you do now have to worry about technical errors that are involved with manual work.

• Security

The smart contract we write on a blockchain is a distributed ledger. That means every set of entries is connected with previous and subsequent entries. To change a particular entry, hackers need to change all the data in that specific blockchain. This is next to impossible as hackers will need over 51% of all the computers running that blockchain.

• Backup

All the contracts uploaded on a blockchain are present in every computer on the network. So, even if you lose the contract, you can gain access to it from a computer that has access to the blockchain. This makes sure that there is no loss of data. You can even use other contracts available on the blockchain as a template or inspiration to create your contract.

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Applications of Smart Contract

Let us see how a smart contract is used in blockchain-based solutions. All of these solutions are not only for individual use, as the example we used above. But everyone from big to medium to small industries can apply this in their business processes to improve their overall business flexibility.

• Insurance

Insurance-based blockchain services are already a winner. We expect the global market to be $1.4 Billion in 2023, with a staggering year-on-year growth rate of 85%. 

Let us understand how a smart contract will apply to insurance. Suppose you have insurance that you will be paid a certain sum of money in case of a flight delay. Now, the smart contract is linked to real-time flight data. In case of delay, the trigger event occurs, and the contract automatically credits the amount to your wallet. 

Sounds interesting, doesn’t it? Well, AXA is doing the same with its insurance product called FIzzy. Other companies are also introducing smart contracts in their services. You can check them here.

• Supply Chain Management

Supply chain management is the management of goods from raw materials to the final products. With smart contracts and IoT, we can track the exact status of our product until it reaches the final destination. IoT with sensors can give real-time data. When the product reaches its destination, then automatic payment will be processed.

Using smart contracts eliminates a lot of guessing work, and businesses can efficiently plan out when they will receive the product. Thus, streamlining the supply side of a business. The smart contract can also have penalties and bonuses. This will further incentivize the delivery process.

• Copyright

Copyright owners can ensure that they are not cheated of their royalties by including a digital ID in their digital assets. So, automatic payments will occur whenever they are used or royalty is due. Thus, safeguarding the owner’s monetary interest. This can be a big game-changer for artists.

• Games

Believe it or not, but you can use smart contracts in games. One such example is CryptoKitties. Here you can buy and sell cats using Ether. Each kitty is an NFT. Thus each one is unique. Even if the company goes bankrupt or bans your account, you can still be the owner of the NFT. Recently crypto kitties made headlines as one of its NFT was sold for $170,000.

There are other use cases for smart contracts. Here we are just scratching the surface. Soon, you will find more uses for smart contracts as they are bound to be an essential part of our future lifestyle.

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Downsides of Smart Contracts

Like everything else, even smart contracts have some downsides. Let us look into them.

• Immutable

You can say this is a double-edged sword. For starters, being immutable is excellent, as it stops people from changing the terms after the contract is signed. But what if there is some error on the contractor when the code is riddled with bugs? 

Well, in that case, we cannot do anything once they are on the blockchain, so we cannot change them. So, parties need to draw up another contract which can be time-consuming and expensive.

• Third-Party

Smart contracts aim to remove third parties. But, you cannot 100% remove them as they play a vital role. For example, you can draw up a contract without a lawyer. But a developer who will write your smart contract will need to consult a lawyer to understand the clauses and how they will function.

• Speed and Scalability

Since smart contracts are passed to a blockchain, the speed of transactions depends on the blockchain. Like Bitcoin does 7 transactions per second, whereas Ethereum does 13 transactions per second. This speed is significantly less for mass adoption. Yes, there are other blockchains with far greater speed, but developing smart contracts on them may not be as easy as they are on Ethereum.

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How can you use a smart contract?

Firstly, you should have the native token of the blockchain you intend to use. For example, in Ethereum Blockchain, we use Ether tokens. A large number of Decentralized apps are built on ethereum, and you will have specific instructions on how to use them and their underlying smart contracts.

You can use these contracts for various reasons, from posting uncensorable posts to lending money. The use case is endless. One can take up a Cryptocurrency course for better understanding.

What is the cost of running a smart contract?

Thousands of computers validate smart contracts, and this does not come cheap. There is also the risk of the ballooning of Ethereum’s fees. The more the Ethereum network is congested, the greater will be the fees and cost of running the Network.

Are Smart contracts legally Enforceable?

Smart contracts are self-executable. That means when the contract is triggered. Then the contract is enforced automatically. If they work like they are supposed to, then the users do not have to go to court for settlement.

In a study conducted by the Harvard law school in 2008. It was found that the USA legally recognizes some smart contracts. But, not every country has the same legal approach towards cryptocurrencies and blockchain. So, make sure to check its legality in your country.

Final Thoughts

If you have gone through this whole article, then you must know that Smart contracts have both advantages and disadvantages. Some of which can be tackled with improvement in blockchain technology. Ethereum 2.0 will address the issue of scalability and transaction fees, and it will be introduced sometime around mid-2022.

We can also implement a Smart contract with AI. One such way is to let AI analyze previous smart contracts between parties. This way, the AI can propose possible clauses which will help strengthen the contract. AI is also essential in transferring data from IoT devices such as sensors and cameras. Thus offering the contract with accurate information to act on.

Another potential downside is millions of people will lose their jobs. Jobs like that of lawyers or manual clerical jobs and even middlemen may lose their source of income. But, with advancements in blockchains and their products like DAO and smart contracts, many smart contract developer courses, doctors, and even lawyers are excited about the prospects smart contracts will provide in the future. 

Let us adopt smart contracts course with open hands and see what the future has in store for it.