A smart contract is a digital contract in the form of computer code that establishes an algorithm for specific actions and governs certain conditions that must be met by the parties entering into the agreement. If the conditions set by the smart contract are observed, a sequence of actions is automatically launched according to the "if…then" principle.
Smart contracts allow strangers from different parts of the world to conduct safe and fast transactions without involving intermediaries or worrying about outcomes, given that mathematical algorithms monitor the fulfillment of all parties' obligations. Transactions based on smart contracts are fully automated: the smart contract is integrated into a blockchain's code, and the algorithm is executed independently if all contract conditions are met.
Why smart contracts are important
Smart contracts are mainly used to ensure the operation of decentralized applications, guaranteeing the parties' compliance with all agreements. Smart contracts are also used in transactions involving cryptocurrencies and NFTs.
Because activities on the blockchain are almost entirely unregulated by government institutions and other state bodies, smart contracts ensure compliance with the terms of transactions and guarantee their security.
Smart contracts: A brief history
Automating transactions itself isn't exactly a novel idea. American computer scientist and cryptographer Nick Szabo developed the concept in 1994. He proposed creating a protocol that would execute transactions automatically and monitor the fulfillment of their obligations by the parties. However, the technological expertise was not yet sufficiently developed at that time to implement his idea. The scientist's concept only became fully operational in 2013 using Ethereum as its basis, when a special protocol was created allowing smart contracts to function fully.
How smart contracts work and what makes them different from standard agreements
Smart contracts are inextricably tied to the blockchain, constituting part of its code. They fulfill the function of the "paper" contracts we're used to, only in digital form. This means the conditions are put in place using mathematical algorithms and programming languages, and the parties sign these agreements with an electronic signature rather than physically.
All the conditions provided for by the smart contract are binding, and the transaction is considered complete only after the parties have fulfilled all of their obligations in full and the participants have achieved the desired result. This could mean topping up a digital wallet with crypto, exchanging one token for another on a DEX, and more.
All smart contracts contain:
- Monitor compliance with the conditions they stipulate.
- Based on the results of this process, make a decision:
- to execute the transaction if the parties have met all conditions;
- impose fines and penalties or even block access to assets if the conditions have not been met.
Activating a smart contract and the execution of its programmed actions begins with a transaction initiated by a user via their crypto wallet or a message from another smart contract.
How does a smart contract differ from a standard agreement?
The following vital differences can be identified:
- all transactions are carried out automatically on the blockchain;
- smart contracts are based on computer code;
- changes cannot be made to contracts after they have been signed;
- information about the parties to the deal is stored on the blockchain;
- no intermediaries are involved in the transactions.
Use cases for smart contracts
Smart contracts are used in several fields. They can help automate many business processes, eliminate the need for transaction intermediaries, and reduce human labor expenditure.
Smart contracts are often used in cryptocurrency, NFT markets, and the metaverse. They can also be used in more traditional fields.
Many different kinds of operations are involved in issuing and repaying loans. Using blockchain technology and smart contracts makes it possible to formalize all algorithms used in a network's code and ensure they cannot be changed. This can significantly simplify security systems, help detect fraud cases, automate loan issuance, and more.
Additionally, using smart contracts in lending makes it possible to optimize efforts to control the movement of assets and monitor the status of assets pledged when applying for mortgages.
The use of smart contracts is also beneficial in insurance. The protocol adopted looks as follows:
- the parties enter into a smart contract, which specifies the terms of the insurance policy;
- an oracle keeps track of the insurable event;
- when the event is confirmed, the algorithm is executed;
- If all conditions are met, the smart contract guarantees the receipt of the insured amount.
An oracle is a data provider that, when it receives a request from a smart contract, provides reliable information received from sources outside the network that is required in order for the programmed protocol to take place.
With the emergence of non-fungible tokens (NFTs), many artists, musicians, photographers, and other creators have begun using the blockchain to host and sell their creations. However, NFTs also require copyright protection, and this is where smart contracts come to the rescue. They stipulate all the terms of the transaction between the purchaser and creator.
Business reputation management
Smart contracts can help agencies compile independent and fair ratings (of companies, people, products, etc.) They ensure that all evaluations of a given topic cannot be changed, meaning that negative reviews will be impossible to edit or delete, and users can see the actual state of affairs.
Logistics always involves a lot of data about shipments, freight routes, suppliers, customers, etc. If all this information is streamlined using the blockchain, it will be much simpler to process, which will help significantly reduce human error along the supply chain.
Smart contracts can also be used to positively affect healthcare, the electoral process, gambling, property rentals, etc.
Smart contracts represent a promising new technology that makes it possible to automate and carry out transactions in complete transparency, not just on the cryptocurrency market but also in many areas of the "real economy." Their key function is to simplify and optimize business processes.
Smart contracts have, of course, revolutionized blockchain technology. Over time, smart contracts and the blockchain have the potential to impact many areas of people's lives significantly.