What Are Smart Contracts?
What is a smart contract?
A smart contract is a computer algorithm meant for signing and maintaining self-executable contracts in a blockchain.
These contracts are written in a form of code in a distributed ledger, namely a blockchain, that is maintained and governed by a network of computers.
What’s the point of smart contracts?
Smart contracts allow for reliable and confidential transactions without intermediaries, such as banks or government entities. These transactions are also trackable, transparent, and irreversible.
Smart contracts contain information about the parties’ obligations and sanctions imposed for failing to fulfill these obligations. In addition, such contracts automatically execute all the instructions stipulated by the conditions of the agreement in question.
Where did smart contracts come from?
The first concepts of smart contracts were proposed back in 1994 by a cryptographer Nick Szabo. He described a smart contract as a computer protocol that would control the execution of agreements based on mathematical logic.
Szabo’s ideas were first partially implemented in Bitcoin project and the blockchain technology underlying it. However, most of the modern blockchains, including Bitcoin, are not Turing-complete, therefore their contracts, such as multisignature or delayed transactions, are relatively simple and limited.
Smart contracts are widely used since the launch of the Ethereum project. In 2013, the founder of Ethereum Vitalik Buterin concluded that Bitcoin doesn’t exactly fit the role of an underlying protocol for smart contracts since it wasn’t designed for this purpose. Thus, he decided to make such protocol from scratch.
How smart contracts work and what are their key elements?
Typically a smart contract is written in a blockchain. It can receive and send messages that act as inputs and outputs for the code. These messages, also called transactions, can trigger certain actions inside and outside the blockchain, and even in the real world.
The mandatory attributes of a smart contract are:
- Digital signature methods based on public and private keys owned by two or more parties to the agreement.
- A private decentralized environment, such as Ethereum, that hosts smart contracts and supports inputs and outputs for oracles. Oracles are what connects the digital and real worlds.
- An actual subject the instruments needed for the execution of the agreement (cryptocurrency addresses, oracles, etc.)
- Strict and clear conditions of the agreement signed by the parties.
What are the types of smart contracts?
Depending on the extent of automation smart contracts can be split into:
- Completely automated contracts stored in a blockchain in their entirety.
- Contracts backed by a tangible paper copy.
- Paper contracts with certain provisions translated into code and put in a blockchain (such as payments).
- Blockchain-based solutions are currently at their early stage of development. The technologies are being tested and improved, so really complex smart contracts are not yet used for real. As of today, most smart contracts belong to the third type, where only particular aspects of an agreement are automated.
What are the other applications of smart contracts?
There are many areas where smart contracts can be used, ranging from a simple multisignature to operations with financial derivatives.
Multisignature (or escrow) is the simplest classical example of a smart contract. It allows multiple parties to freeze a certain amount of funds in a blockchain in such a way that it would require signatures from the majority of the parties to spend the money.
Smart contracts are widely used for initial coin offerings (ICOs). A smart contract can be programmed so that if a fundraiser fails, all the funds will be paid back to the investors. If the campaign succeeds, the funds will go to the developers, but only after the majority of the participants give their signatures.
The most promising areas for smart contracts include:
- Finance (banking, insurance, derivatives trading).
- Accounting and audit.
- Supply chains and logistics.
- Property rights.
- Digital identity.
What are the advantages of smart contracts over traditional written agreements?
Smart contracts proponents believe that many types of contracts can be made partially or entirely self-executable. Thanks to the underlying cryptography smart contracts are generally more secure than traditional agreements backed solely by law. Smart contracts also allow for lower transaction fees and may completely exclude misinterpretation of the agreement conditions.
Thus, the primary advantages of smart-contracts include:
- Autonomy (no need to find an intermediary to make a deal).
- Reliability and security (a smart contract is encrypted and contained in multiple copies in a blockchain; system security is guaranteed by mathematical logic, while the lack of a single server makes hacking difficult; the properties of a blockchain ledger make it impossible to change information retroactively).
- Economy and speed (there are no intermediaries and most processes are automated).
- Accuracy (automated processes exclude human errors that may sneak in when people fill in forms and process information).
What are the disadvantages of smart contracts?
Smart contracts are not perfect and the blockchain technology is still developing, which may lead to critical errors in the code. There are gaps in the regulatory framework regarding smart contracts. Oracles, which are the algorithms that connect blockchain with the real world events, are underdeveloped as well. There are also problems related to limited scalability and processing speed. These factors make hinder the application of smart contracts in day-to-day operations.
In some cases, smart contracts are less flexible than traditional written agreements. Any information written in a blockchain is there to stay, so it is crucial to avoid any errors in the initial data.
Confidential transactions conducted via public decentralized ledgers are not acceptable for banks and large corporations.
Many projects and individual developers are working. The progress is being made and in the future, we may see entirely digitized contracts.
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