A Simple Guide on Smart Contracts: Definition, How They Work, Pros and Cons

Decentralization is one of the foundations of crypto, which aims to eliminate third parties or intermediaries from transactional contracts. Smart contracts, an innovative replacement for intermediaries that use computer codes and blockchain technology, are one of the key blockchain use cases that reflect this characteristic.

This guide will break down what smart contracts are, how they came to be and their development over the years, how smart contracts work, as well as the notable upsides and downsides of using smart contracts.

What Is a Smart Contract?

A smart contract is basically an agreement between two or more parties in the form of computer codes. It is a self-executing contract that includes the terms of a transaction through lines of code rather than requiring intermediaries to facilitate the transaction. 

In crypto terms, smart contracts are programs or applications that run on the blockchain; this means that they are stored on a public ledger which is distributed across the blockchain network. As such, the smart contract codes that execute the transactions cannot be altered or destroyed.

Smart contracts allow for trustless protocols to be built which permit agreements to be carried out between parties (known or anonymous) when predetermined conditions are met and without the need for a central authority or third parties such as banks, legal systems, or governments.

While smart contracts are often related to blockchain and cryptocurrency, the idea of automated transactions did not stem from the expansion of the blockchain into the vast multifaceted system or even Bitcoin.

History and Development of Smart Contracts

Nick Szabo, an American computer scientist and cryptographer, first proposed smart contracts in 1994. Szabo proposed that it should be possible to record contracts in the form of computer codes, which would automatically activate when pre-set conditions are met. The rationale behind this idea was that people would no longer rely on third parties to complete a transaction but rather use self-executing contracts that are hosted on trusted computer networks.

After two years of developing the idea and its possibilities, Nick Szabo released a book in 1996 called “Smart Contracts: Building Blocks for Digital Free Markets” where he defined a smart contract to be “a set of promises, specified in digital form, including protocols within which the parties perform on these promises.” Even though Szabo suggested integrating smart contracts into existing financial tools such as the POS (Point of Sale), as well as invented a virtual currency in 1998 called Bit Gold, the technological structure to make smart contracts workable on a global scale across industries was not available at the time.

The introduction of Bitcoin and blockchain technology many years later finally made it possible to use and further develop the concept. The Bitcoin blockchain has hosted many smart contracts over the years, however, the recognition and popularization of smart contracts can be attributed to Vitalik Buterin and his Ethereum blockchain. Although many blockchains support smart contracts such as Polakadot, Near Protocol, and Cardano, smart contracts that run on the Ethereum Virtual Machine (EVM) are superior versions that have even more notable computational power. In addition, any Ethereum user who wishes to create a smart contract can simply write the codes using the EVM or Solidity.

How Do Smart Contracts Work?

Smart contracts work as self-executing contracts and tasks and automate transactions or agreed-on set actions when certain predetermined conditions are fulfilled. The smart contract can automatically execute the required action or transaction without the intervention of a central entity or third party as a result of computer codes that run on a distributed system, which is the blockchain.

The first step of transacting with a smart contract is to write the contract using Solidity and set it on the blockchain. Smart contracts are often written with if/then statements to ensure that conditions are met before the transaction is completed. Following this, the parties involved in the process can scrutinize and verify that all related terms and conditions are in order before signing to partake or approving the contract. The smart contract goes to work and verifies the conditions using real-time data and once all conditions are met, will execute the underlying action or complete the agreed transaction.

To make this a bit simpler, let’s say Josh wants to do business with Douglas and Jane to the tune of 100 ETH each. Josh can create a smart contract that includes code for something like “if Douglas and Jane complete these tasks then Douglas and Jane will receive 100 ETH each.” To complete this contract and set it on the blockchain, Josh would deposit 200 ETH that would be distributed after the completion of the tasks. Once Douglas and Jane agree to the terms, the smart contract verifies that the tasks have been completed, after which it automatically disburses 100 ETH each to Douglas and Jane.

Advantages and Disadvantages of Smart Contracts

Smart contracts, just like every other blockchain concept have their own merits and limitations. Here are some of them:

Advantages

Trustless system: Smart contracts run on the blockchain where the terms cannot be changed, and all nodes can view and verify the transactions that occur. As a result, parties can have full confidence to enter into those contracts knowing that the outcome is certain upon the completion of all conditions. 

Security: The blockchain where smart contracts are written is also a distributed ledger. This means that someone looking to exploit the contract would need to control more than half of the computer network that makes up the respective blockchain.

Time and cost-effectiveness: Another merit is that smart contracts save you the money required to employ the services of third parties as well as the time needed to carry out many bureaucratic processes. 

Disadvantages

Technicality: While it is true that smart contract creation is open to every user of the blockchain, not everyone is able to do so. Truth is, only a few developers who can write smart contract codes can create standard contracts, and experts such as lawyers may still be consulted in order to properly interpret clauses. 

Scalability: The speed of transactions as well as other scalability features are still dependent on the blockchain that the smart contract is built on. This can lead to users compromising on blockchains with superior smart contracts for blockchains that are faster but not as valuable.

Immutability: The same advantageous feature that makes it impossible to change the terms of a contract can also be a problem if there are errors or bugs in the code of the smart contract after it has been activated.

Bottom Line

It is evident that smart contracts have the potential to revolutionize the way we conduct daily business and transfer value. As more industries begin to explore the use of smart contracts, we can expect to see them being used in a wide range of applications, from supply chain management and real estate to insurance and financial services. 

However, as with any emerging technology, there are still challenges to be addressed. The legal recognition of smart contracts and the need for standardization are important issues that need to be addressed in order for them to be widely adopted. 

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