How Do Smart Contracts Work

How Do Smart Contracts Work?

July 1, 2018.
Here’s a beginner’s guide on what smart contracts are, how they work, and how much they will impact the future of the blockchain industry

The blockchain, albeit a relatively new technology, is steadily gaining momentum and its worldwide adaptation is seeping into industries beyond the financial sector. With its decentralized nature, immutability, and transparency, the blockchain is the ideal platform for any kind of transaction requiring stringent security.

The continuing development of blockchain technology has paved the way for more sophisticated technological advancements and innovations that not only revolutionize the crypto industry, but also streamline and automate certain processes. One such development are smart contracts.

The concept of smart contracts, however, is not entirely new. It was first conceived in 1994 by computer scientist and cryptographer Nick Szabo, but it was only recently that the idea was fully implemented and adapted after Ethereum pioneered the smart contract functionality.


What are smart contracts?

A smart contract is computer code that facilitates, executes, and enforces an agreement using blockchain technology. Put simply, is is a digital contract where the conditions of the agreement are stored in the blockchain, and then certain actions are automated when programmed conditions are met.

In essence, a smart contract is analogous to a vending machine. Vending machines are programmed to execute predefined actions (i.e., dispense items) if certain terms are met (i.e., a person puts in an amount of money into the machine).

In a simple example, if Person X puts a dollar into the vending machine and presses a button designated for a can of soda, and if the amount of money inserted corresponds to the value of the soda chosen, the can of soda is automatically dispensed from the machine.


How do smart contracts work?

Normally, with a traditional contract, you would go to a lawyer to have the terms of an agreement or contract drafted and documented—a process that requires high professional fees and lead time for a contract to be signed and legally approved. With a smart contract, the process is digitally simplified and automated. Without getting too technical, here’s how smart contracts work:

1. Terms of the smart contract is coded
The terms of the smart contract are written as code on the blockchain. It should be noted that computer codes behave in pre-defined ways and, once put on the blockchain, it is immutable and extremely difficult to change; thus, it’s crucial to input the proper and exact finalized conditions into the smart contract.

2. The smart contract is introduced into the blockchain network
As with traditional contracts, a record of the contract should also be kept. In the case of smart contracts, these are encrypted and distributed or propagated across the blockchain network. Each contract is represented by its own unique address in the blockchain, rendering the individuals involved in the contract anonymous. The blockchain, on the other hand, which acts as a ledger, is public and can be seen by everyone in the network. To know more about how the blockchain works, download our presentation here.

3. The smart contract is processed and executed
Also termed as self-executing contracts, smart contracts operate within the IF/THEN premise: if the terms of the contract are met, the contract will execute itself. An event triggers the execution of the contract (e.g., an expiration date), and then the desired action is automatically initiated based on the pre-arranged coded terms (e.g., release of funds). All of the computers/nodes (i.e., miners) in the blockchain network must reach a consensus to ensure that the code was executed as initially designed. The blockchain network is then updated to record the execution of the contract.


The future of smart contracts

Smart contracts were not intended to be used solely for contracts. The technology can be used as precursors for the development of decentralized and blockchain-based applications and even decentralized autonomous organizations (DAO).

As smart contracts are essentially lines of computer code that describe conditions and outcomes, the parameters of the code can contain any specific condition; for example, discounts, mortgages, partial payments, and so on.

The applications of smart contracts are varied and versatile. Smart contracts can automate any process or operation—from banking, insurance, healthcare, voting, government, to virtually any other industry. The autonomous nature of smart contracts enables massive improvements to traditional systems in terms of hastening processes, lowering costs, and improving accuracy and transparency.

However, smart contracts are still far from perfect. Its immutability, despite being one of its strongest suits, is also one of its limitations: any changes to the contract, in cases where the initiating person changes his mind, can almost never be made once it’s been encrypted on the blockchain. Additionally, for you to be able to participate in smart contract transactions, a certain amount of programming language is required; otherwise, there is still a need for a third-party, so to speak, in order to have your contract coded properly on the blockchain.


Final thoughts

Smart contracts are just one of many developments springing from the introduction of cryptocurrencies. While it still has issues in terms of scalability and inherits some of the limitations plaguing the blockchain itself, smart contracts may just be the beginning of a disruptive technology that could change the future of the blockchain industry.


– Article written by Tinny

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Categories: Blockchain, Cryptocurrency