What Is a Smart Contract and How Does It Work?
What Is a Smart Contract?
Smart contracts are magical, self-running computer programs. They check, manage, and enforce deals all by themselves. Unlike regular contracts, **smart contracts** handle transactions on blockchain networks, like Ethereum.
Smart contracts facilitate transactions without a trusted intermediary in between, such as a bank. They automate workflow by initiating the next action when existing conditions are met. These contracts are stored on a blockchain over a decentralized network.
Moreover, a smart contract agreement allows each transaction to be conducted without the need for one party to know the other, eradicating the requirement of a central authority to monitor each transaction. These contracts render transparent, traceable, and irreversible transactions.
How Smart Contracts Work?
Smart contracts were proposed in the early 1990s by an American computer scientist, Nick Szabo. He compared this new technology to a digital vending machine by highlighting the similarity of their functioning.
When you insert some money into vending machines, they can run either of the two tasks programmed into their system. They can provide you with the required item along with your change, or they return your money, allowing you to make a different selection. Szabo attempted to explain how smart contracts work through a simple example.
If a vending machine can automate the process of obtaining an item without a human intermediary, smart contracts deployed using blockchain technology can facilitate transactions in digital form without the need for an intermediary. This is an example of a simple smart contract.
A smart contract code consists of simple statements written in a programming language such as Solidity and Web Assembly. These statements act as a set of instructions, and a smart contract’s terms execute any action when the predetermined conditions attached to it have been met.
Anyone over the blockchain network can deploy a smart contract’s code, which is transparent, allowing easy verification. This feature allows the interested parties to verify the logic a smart contract uses when it receives digital assets.
Each computer on the blockchain stores a copy of all existing smart contracts together with the transaction data. Whenever a smart contract identifies the fulfillment of predetermined conditions, its code controls are activated by all the chain nodes, resulting in a value flow. This mechanism allows a smart contract to make complex transactions between two parties that do not know each other.
Why Smart Contracts Are Important?
Smart contracts enable developers to build a huge range of decentralized applications and tokens, such as the Ethereum smart contracts that are an integral part of the Ethereum network that helps in the automation of several processes that bring about multiple benefits creating an overall positive impact on society.
Moreover, once a smart contract app has been deployed on a blockchain, it cannot be reversed or manipulated in most cases which ensures security and reduces risks involved in different types of transactions.
A smart contract can serve several different purposes, such as exchanging digital money through applications like Uniswap, Compound, and USDC. According to contract law, a smart contract can be used in the judicial system, allowing individual users or organizations to form an agreement. You can do your digital signature using these agreements, which saves time and money.
Benefits Of Smart Contracts
Transparency and Security
Smart contracts ensure complete transparency as they do not need an intermediary to process transactions. Users do not need to worry whether the information has been altered, and these agreements are encrypted effectively to facilitate secure transactions. This reduces the chances of bad actors on the building blocks of a blockchain-based platform.
Cost Reduction
As a smart contract does not require an intermediary to carry out transactions, it significantly reduces transaction costs. Many contracts allow users to process various tasks without the active involvement and at minimal fees.
Savings smart contracts are different from other smart contracts as they track the movement of goods and services over the network and automate payments hence saving up a lot of time and money.
Backup
All the information stored on different blockchain networks is copied multiple times, which ensures no data loss. During data loss, a smart contract can retrieve the original data stored on the entire chain.
Speed and Accuracy
Smart contracts are automated, indicating that the code is executed immediately when the predetermined conditions are met. This removes the time delay in tedious paperwork as no time is spent on rectifying errors that occur in the case of filing documents manually.
Applications Of Smart Contracts
Smart contracts have many use cases in the real world where two anonymous parties perform transactions easily without needing prolonged business processes.
Supply Chain
The supply chain requires a lot of paperwork that passes through several channels, increasing the risk and chances of fraud. Smart contracts automate this process by reducing time delays and carrying out each transaction quickly and securely.
An example of automation in the supply chain using a smart contract can be inventory management and automation of payments such as insurance payments.
Financial Services
A smart contract enables the accurate implementation of financial services such as bookkeeping and funds management. An insurance company can use these contracts for user funds management and identify the conditions when the company is liable to make a specific insurance payment to a customer.
Healthcare
Smart contracts can be used in the healthcare system to store encrypted patient records with a private key. Only the owner of that information can have access to the data eliminating privacy concerns.
Moreover, several research processes can be conducted efficiently without any physical surveys that are time-consuming and can be manipulated. Patients’ information can be stored on a distributed ledger and shared with insurance companies allowing better clarity and transparency.
Government System
Smart contracts introduction to government systems and tasks can improve reliability and save up a lot of time. These contracts can be used in voting systems, reducing the chances of manipulation.
Moreover, these digital agreements will decode sensitive information and state secrets securely, which reduces the risk of a data breach which could result in potential losses for a country.
International Trade
Smart contracts have revolutionized global trade, allowing businesses to pay through digital currency and form trade agreements easily. This increases the trading opportunities for several industries with the advancements in information technology that takes place regularly.
Security Issues With Smart Contracts
Possibility of Loopholes
Although this blockchain-based technology is secure to a great extent, loopholes could lead to potential threats for the concerned parties over a network.
Third-Party Concerns
Although these digital agreements do not require third-party involvement, they cannot eradicate them completely. An example of this situation is that developers must understand the required automation and create the necessary codes for the execution of a process.
Vague Terms
These agreements might sometimes have vague terms that make it extremely difficult for a layperson to understand a situation, thus creating a communication barrier between the parties involved in a transaction.
Final Thoughts
We have tried to capture all the necessary information that will enable just about anyone to understand smart contracts and their functionality. Smart contracts allow many industries that use blockchain technology to automate their processes, increasing the opportunities for scalability.
However, you need to understand the working of smart contracts to make the best use of this technology.
We hope this article will enable people to understand smart contracts that could be beneficial for them in the long term. Just remember that this article should not be taken as financial advice and is targeted only for educational purposes.
Zornitsa is the Editor-in-chief at Coinlabz. She is involved in researching the impact of blockchain technology and the way crypto is transforming peoples’ perceptions of finances.
