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What is a Smart Contract?

Henning Taeger
Henning Taeger
Henning is a writer and editor here at Dollargeek who is passionate about personal finance and cryptocurrency. He enjoys sharing his knowledge about financial management and cryptocurrency with readers, helping them make informed decisions about their money. In his spare time, Henning can be found playing the latest video games or jamming on his guitar. He is constantly on the lookout for new ways to improve his financial literacy and stay up-to-date on the latest trends in the world of cryptocurrency.

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What is a Smart Contract?
Table of Contents

Introduction

First, a contract is a term used in referring to an agreement between two or more parties. It is the seal or oath that binds and compels each member of the party to perform by the provisions of the contract.

Take, for instance, Mr. A approaches Mr. B to help him paint his car. They both agreed on a particular amount Mr. A would pay in exchange for the service Mr. B would offer.

If Mr. B does not finish the painting according to Mr. A’s demand and requests payment, Mr. A has the right to refuse to pay, as Mr. B has not satisfied the terms of the agreement in the contract.

In the world of cryptocurrencies, this same concept of contract has been adopted and adapted to fit the ecosystem of the crypto blockchain. The adapted version of the concept of contract is referred to as a ‘smart contract.’

What is a Smart Contract?

It is a computer program, which is stored on the cryptocurrency blockchain and wired to run after certain conditions have been met by operators on the blockchain.

They can be seen as a set of instructions on the blockchain that digitally facilitate the control, verification and execution of transactions. They are majorly based on the Ethereum blockchain.

Smart contracts are decentralized and possess several capabilities that we have been able to explore at this time. They are highly beneficial in ensuring the security of transactions and exchanges on the blockchain without the interference of a third party.

A typical model of a smart contract in action is the ‘escrow.’ However, smart contracts executed on blockchain networks are a bit different from the typical escrow mechanism, in that, the smart contract code is programmed and embedded in the blockchain itself. Hence, no third-party agent is in possession or control of any items of the contract.

The code is such that, certain pre-conditions for the release or exchange of tokens or valuables on the blockchain have been stated. Once the conditions have been met by both parties, the smart contract authorized the transaction (without any bias) and saves both parties the time needed to execute the contract.

Many ERC-20 and ERC-721 contracts are executed based on smart contract provisions. These transactions are known to be swift, secure and reliable. This application is only the tip of the iceberg in the application of smart contracts.

Advantages of Smart Contract

The following are some advantages of the smart contract concept in blockchain:

  • Clarity of transactions: Both parties engaged in the transaction are fed with same information about the progress of the transaction and prompted to take effect when necessary. Since the code is situated on blockchain technology (which is highly immutable and secure), no party to the contract can change the set terms of the agreement
  • It gives autonomy to users: Users engaging smart contract on blockchain are free from third-party influence. Hence, they can easily reach a consensus on how their transaction is / should go.
  • Reduces cost of transaction: There is no need for payment to transaction intermediaries and other related agents.
  • Swift transactions are ensured: Once the conditions are met by both parties involved in the contract, the project or transaction is executed immediately.
  • Self Update: The code controlling he smart controlling the smart contract is unique in the sense that it automatically updates and performs based on the most current blockchain’s terms of co tract and agreement. Hence, users need not be bothered about the version of the smart contract handling their transactions.

Limitations of Smart Contracts

  • High resistance to change: Smart contracts can be a complex body of codes. Hence, they might be very difficult to edit in cases of malfunction.
  • Loopholes might surface: Some unscrupulous individuals use smart contracts to their advantage. They find means of making the smart contract default slightly in its intermediary function.
  • Remote influence from Third-Party agents: While a third party’s influence is not really felt in the smart contract’s execution phase, it is still the brainchild of third-party agents. Hence, it functions just as they would want it to function.
  • Inability to handle vague terms: They are known to be unable to handle / process the vague terms often found in conventional contracts. Hence, they might be a bit difficult to utilize in enforcing the exact terms of a contract, as the typical contract would have done.

Kinds of Smart Contracts

There are three major kinds of smart contracts. They are:

  • Decentralized Autonomous Organizations (DAO)
  • Smart Legal Contracts
  • Application Logic Contracts (ALC)

Here’s a brief description of each:

  • Decentralized Autonomous Organizations (DAO): These are open-source, smart contracts that are governed by highly intelligent and self-enforcing codes aimed at ensuring transparency and protecting transactions on the blockchain.
  • Smart Legal Contracts: These types have a serious legal backing. The terms of agreement and duties of each party must be satisfied to avoid the institution of action on either party.
  • Application Logic Contracts (ALC): This allows devices on a blockchain to perform transactions anonymously and securely, while ensuring cheaper transactions and automation.

How do Smart Contracts work?

Basically, smart contracts can be thought of as a set of automated business rules. These rules of engagement are translated into computer code, usually to oversee an ‘if / then’ situation in the exchange between parties. These codes ensure the integrity of the process.

Smart contracts see to the details of the transaction or requests regarding the transfer of ownership of a cryptocurrency, token or physical asset from one party to the other.

The smart contract programmer would have set several ‘if/then’ conditions into the controlling computer, which would eventually guide the parties through the transaction without wasting time or money while the request is being handled.

The blockchain on which the code is placed keeps an open ledger to record each move involved in the transaction. Hence, transparency of the contract and engagement of each party is maintained.

Therefore, smart contracts hold and screen the actions of parties to a contract against a set of conditions. Once conditions are met, the transaction or exchange goes on as planned and vice versa.

However, in the world of blockchain, transaction fees, commonly referred to as ‘gas fees’ must be paid before the smart contract would be utilized on the blockchain. The gas fee increases the complexity of the agreement to be made increases.

Benefits of Smart Contracts

Smart contracts are highly beneficial to the parties involved. They give a lot of protection to the transaction than would have existed if they were not present.

The following are some benefits of Smart contracts:

  • Decreased risk of breach: Smart contracts utilize the highest known level of data encryption. Hence, the likelihood of being breached is very low.
  • Accuracy: Human record keepers tend to lose or forget to properly document information which is highly vital to ensuring the success and integrity of a contract. However, smart contracts are highly efficient at ensuring detailed documentation of every single transaction involved in the contract.
  • Saves cost: Since intermediaries are not involved in the transaction/exchange, the cost of the transaction is seriously reduced.
  • High efficiency: Unnecessarily long and windy processes characteristic of bureaucracy is successfully removed by the introduction of smart contracts. Hence, the exchanges handled by smart contracts are highly efficient.

Where do Smart Contracts apply?

Smart contracts have a large field of application. They can be applied in the following aspects:

  • Financial solutions in borrowing, trading, lending and investing money and other valuables
  • They can be used in registering property ownership
  • They can be used in maintaining records in healthcare and accounting organizations
  • It can be used to record property ownership. Here, the application of smart contracts could be considered useful in simply recording the ownership of buildings, lands, phones, watches, etc. It can also be used to record property ownership without being specific about the details of the property
  • It can be used in supervising the payment of mortgages
  • Placing and ensuring insurance claims are allocated to the right person at the right time. It really reduces the time and cost of processing
  • Keeping the data of patients who have volunteered to particular in a medical research
  • Voting: This goes a long way in reducing election fraud to be the barest minimum
  • Institution and maintenance of peer-to-peer transactions
  • Ledger documentation of the various stages of product development
  • Stock taking in supply chain management

While the above is not an exhaustive list, it covers major areas to which smart contracts can be applied. Scientists and researchers, however, are still on the lookout for more areas to which smart contracts can be applied.

Some interesting areas are being explored at the moment.

Conclusion

Smart contracts are a set of computer programs or digital instructions which ensure the integrity and smooth flow of any transaction or exchange between parties.

They save time, reduce cost and ensure the efficiency of the exchange. While cryptocurrency and the blockchain are the most popular application, smart contracts can be applied to several other fields and problems, as highlighted above.

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