Like any other contract, smart contracts establish the terms of an agreement or a deal, but instead of paper documents drafted by lawyers, smart contracts take the form of a self-executing code running on blockchain, like Ethereum. These pieces of code codify business logic and consequently facilitate three important functions – they store rules, verify rules, and as mentioned, they self-execute. No intermediaries involved.
A short throwback
In 1994, Nick Szabo, an American computer scientist, law scholar, and cryptographer, proposed the use of a distributed ledger to store contracts, because he wanted to extend the functionality of electronic transaction methods to the digital space. He defined it as computerized transaction protocols that execute the terms of a contract – the so-called “smart contracts”. In 1998, roughly 10 years before the invention of bitcoin, he invented a virtual currency called “Bit Gold” and is still often rumoured to be the real Satoshi Nakamoto, which he has denied.
It is clear today that Szabo’s predictions preceded blockchain technology in many ways.
A closer look into smart contracts
The best way to define smart contracts is to look at their two basic characteristics.
- Smart contracts are immutable.
They run on blockchain, which means that they can never be changed. Even if they contain a bug or turn out to be inefficient, the only solution is to create and start using a new one.
- Smart contracts are distributed.
Like any other transaction on a blockchain, smart contracts are being validated by all participants in the network. This distribution makes it impossible for an individual to tamper with funds, as all other participants would notice such action and mark it as invalid.
These immutable, distributed lines of code support storing and verifying rules and executing them. They are specifically designed to remove human error and issues. To explain this, let’s borrow a simple analogy – imagine a secure vending machine.
You insert a dollar into a vending machine to get the snack of choice. The vending machine will take your dollar and verify its amount. Once the amount is verified, the dollar is safely stored, and the vending machine delivers your snack.
The ‘If this, then that’ rule
These tiny programs that run on blockchain, store rules for negotiating the terms of an agreement. Their concept could be simplified to “if this, then that”, meaning they automate a workflow, triggering the next action when conditions are met. They don’t rely on any third parties so the involved participants can transact directly with each other – no intermediary, no broker, no government, or lawyer needed.
The beauty of a smart contract is in the fact that it can check itself; it can run a simulation of what it is programmed for and can see if that is possible to achieve.
The most used example of this is the well-known crowdfunding platform, Kickstarter.
Kickstarter acts as a third party between product teams and investors. Both sides need to trust the platform and pay an additional fee to Kickstarter to serve as the middleman. But with smart contracts, the platform itself would become obsolete. Let’s say that a person wants to write a book about smart contracts, and he needs $5000 to kickstart his project. He asks the community for donations. To every donator who invests more than $50 into his project, he promises to send a free copy of his book. The blockchain program would set the rule that if $5000 is raised, the author will receive these funds, while his investors (who contribute over $50) will receive free copies of the book. If the amount in question is not raised, all donators will get their investments paid back.
Deployed to blockchains, smart contracts are completely traceable, transparent, and irreversible.
Smart contracts already permit trusted transactions and agreements to be conducted among anonymous parties without the need for a central authority or a legal system.
They play a key role in decentralized applications (DApps). Developers use smart contracts to build apps covering everything from loans and insurance to logistics and gaming. They are used for crypto lending and borrowing, token swapping, farming, and staking to name a few. These codes provide the advantage of blockchain security, reliability, and accessibility while offering sophisticated peer-to-peer functionality.
Even the world of business is starting to accept these contracts. We can expect numerous applications in IoT, the financial sector, supply chain, healthcare, etc. Many promising use cases already exist in the field of insurance and real estate. But the most exciting thing about them is that they hold the potential to solve world problems that have never been solved before. Their power of storing data, facilitating trust among individuals, and performing authentication in a transparent way, accessible to the world, will surely prove to be a core solution in the years to come.
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