What are Smart Contracts and How Do They Work?

Discover what smart contracts are and how they function to deliver a result.

A smart contract is a computer program built specifically for an automated transaction. This transaction runs when certain preset conditions are met, maintained on a blockchain. A smart contract automates the execution of an agreement so that all parties involved can ascertain the outcome immediately without the need for an intermediary.

The terms of the buyer-seller agreement are directly inscribed into lines of code that control execution. In doing so, smart contracts enable trustworthy transactions and agreements among disparate, anonymous participants while eliminating the need for a central authority or external governance. Transactions carried out via smart contracts deployed on a blockchain are traceable, transparent, and irreversible.

Popularized by Ethereum (ETH), the world’s second most popular blockchain, smart contracts have brought a variety of use cases to the network, including Decentralized Apps (dApps). Complex transactions that required a third-party intermediary in the past can now be carried out directly through the Ethereum protocol, simplifying the process.

For example, instead of requiring a bank to approve a fund transfer from a client to a freelancer, a smart contract can be used. All that is required is that two parties agree on a single concept.

How Do Smart Contracts Work?

Smart contracts operate by executing simple “if…then…” statements written into code on a blockchain to complete a transaction between two (or more) parties. If or when the predetermined conditions are met, the agreement can be honored, and the contract is considered complete. A network of computers collectively known as nodes executes an agreed action when the conditions have been met and verified.

Once a transaction is complete, it is recorded on the blockchain and all nodes update their copy of the blockchain with the transaction. That indicates that the transaction is final and that only parties who have been allowed access can see the results.

For example, assume a logistics company orders 20 trucks from a car dealership. The company will lock funds into a smart contract that can only be approved when the dealership delivers all 20 trucks. When the dealership delivers the 20 trucks, the funds will be released to its account immediately. However, if the dealership misses its deadline, the contract is canceled, and funds are reversed to the client (i.e., the logistics company).

When establishing the terms of a contract, participants must decide how transactions and their data are represented on the blockchain, agree on the rules that govern those transactions’ execution, look into all potential exceptions, and define a framework to address any disputes.

A developer can then program the smart contract. Most companies that use blockchain for business are increasingly offering templates, web interfaces, and other online tools that assist users in structuring smart contracts.

What Are the Benefits of Smart Contracts?

Autonomous

The main benefit of smart contracts is that they run interruption-free. Automation does away with the requirement for third-party intermediaries to approve contracts. Consequently, this reduces the possibility of manipulation and helps in building trust.

Fast, Accurate and Error-Free

When the agreed-upon conditions are met, the contract is executed immediately. And since smart contracts are autonomous, there is no time spent reconciling errors, as is frequently the case when manually filling out documents.

Cost-effective

Smart contracts reduce the cost of transactions by eliminating intermediaries from the process and, as a result, their associated time delays and fees.

Secured

Smart contracts are encrypted, making them extremely difficult to alter. Cryptography safeguards all documents against tampering. Furthermore, each record on a blockchain is linked to the previous and subsequent records. A hacker would have to change the entire chain to get to a single record.

Trustless and Transparent

As counter-intuitive as it may sound, with smart contracts, you don’t have to trust the other party to transact with them. Because smart contracts operate on a decentralized network, the entire network is trustless, and transactions do not require trust.

Moreover, all relevant parties have complete visibility and access to the transaction’s encrypted records, and therefore, there is no need to wonder whether information has been tampered with for personal gain. Once the contract is signed, no party can back out, which adds to the transparency of smart contracts.

What Are the Applications of Smart Contracts?

Digital Identity

An individual’s identity is one of their most valuable assets. It keeps track of its reputation, data, and digital assets.

Today’s web iteration allows you to connect to various services while unknowingly sharing your identity with companies that profit from the data. In a blockchain-based future, identities will be tokenized and exist in a decentralized environment, protected from malicious actors. Users will regain control as a result, allowing them to share only what they want while profiting.

Real Estate

Purchasing real estate today entails a slew of hidden costs related to closing costs, title transfers, legal fees, and broker fees. Through tokenization a smart contract can replace all intermediaries involved, potentially lowering overall costs.

Assume your house’s deed is tokenized on the Ethereum blockchain. If you decide to sell it, you will enter into a smart contract with the buyer. The title deed would be held in escrow and released when the buyer made full payment —No need for a broker, and the house sells quickly!

Real estate tokenization has already been tried and tested successfully through platforms such as RealT and SolidBlock, which integrate blockchain and real estate.

Insurance

Smart contracts can be applied in the insurance industry to process claims quickly. Essentially, by applying for an insurance policy, a user enters into a smart contract with the provider. The policy will be implemented by a smart contract, which will ensure that all the necessary paperwork, such as driver reports and driving records are present. The smart contract also entails all policy requirements for the user to sign when applying.

Let’s take car insurance as an example. The contract remains open until an accident occurs and the responsible party requires it. The funds are released after they upload the necessary forms proving their need for insurance payment.

Smart contracts are only be executed based on data collected, removing fraud. While the user will probably need minimal paperwork to prove their requirements, the subsequent submission and funding process will be near instant. This type of contract eliminates the need to communicate with insurance companies and individuals.

Escrow

In escrow, a trusted third party manages the exchange of goods or assets between transacting parties. With a smart contract, however, this process can be executed automatically as soon as the service provider submits work.

In the crypto industry, this is already happening on platforms like Ethereum, where businesses are utilizing smart contracts to contract out the services of industry service providers like development teams. Outside the crypto sphere, smart contracts can form a great addition to escrow-based freelancing platforms such as Fiverr.

A Smart Future

With new use cases emerging daily, a future powered by smart contracts appears inevitable. Smart contracts are already being tested in real-world scenarios, and it will only be a matter of time before they become a regular part of our lives. Smart contract platforms will save businesses globally time and money while transforming how they interact with their customers.

Key Takeaways

• A smart contract is a computer program for an automated transaction that runs when certain preset conditions are met, maintained on a blockchain.
• Smart contracts operate by executing simple “if…then…” statements written into code on a blockchain to complete a transaction between two (or more) parties.
• When establishing the terms of a contract, participants must decide how transactions and their data are represented on the blockchain, agree on the rules that govern those transactions’ execution, look into all potential exceptions, and define a framework to address any disputes.
• A smart contracts-powered future seems inevitable. Smart contract platforms will save businesses time and money while transforming how they interact with their customers.

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Author:
Ken Melendez
✍️ Head of Content @ Cindicator
📊 Certified Bitcoin Professional
🔐 Blockchain Chamber - Chapter President

Who is Cindicator?

Cindicator is a world-wide team of individuals with expertise in math, data science, quant trading, and finances, working together with one collective mind. Founded in 2015, Cindicator builds predictive analytics by merging collective intelligence and machine learning models. Stoic AI is the company’s flagship product that offers automated trading strategies for cryptocurrency investors. Join us on Telegram or Twitter to stay in touch.

Disclaimer

Information in the article does not, nor does it purport to, constitute any form of professional investment advice, recommendation, or independent analysis.