Smart contracts aren’t just buzzwords anymore, reserved for crypto enthusiasts. With use cases in the gaming industry, NFTS, and music, we’re seeing them pop up everywhere. As technology continues to evolve and people become more accustomed to these developments, their presence is likely to become more prominent.
But what are smart contracts? This text will focus on exploring this topic to provide you with a solid understanding, covering what it means, how it can benefit modern transactions, and the limitations currently in place.
What is a Smart Contract?
A smart contract is an agreement created and implemented through the blockchain network. It is built on code that sets the conditions to be met and the resulting outcomes once they have been realised.
Picture a contract that doesn’t need a lawyer, a printer, or a pen—just code, running quietly in the background. In this case, you also don’t need to wait for a series of manual approvals and verifications before anything is enforced. There is also no central authority that compels parties to comply with the terms because the code itself “forces” everyone to follow the terms of the agreement.
When executed correctly, smart contracts can mitigate risk for all parties involved. At the same time, it can lower costs and speed up transactions.
How Smart Contracts Work
The most important thing to remember about a smart contract is that it runs based on if-then logic. As part of creating the agreement, some preconditions can trigger an action. For example, if the value of Token A reaches $1, sell 50% of the assets in Token A.
It doesn’t have to be just one condition for every smart contract created. There can be a lot that is part of one contract, and each condition can trigger different processes. Essentially, this is what happens:
- All parties agree to the terms of the contract.
- The smart contract is created.
- The smart contract is deployed to the blockchain.
What is about to happen next will depend on external conditions. If the triggering conditions are met, the contract is executed. Then, the outcome will be recorded in the blockchain.
A Brief History of Smart Contracts
The smart contract has a relatively short history. It starts in 1994. Let us take a look at the key moments:
- 1994: Nick Szabo first coined the term to refer to computerised transactions that are implemented as aligned with contractual conditions.
- 2009: The Bitcoin blockchain was created and is now considered the first protocol for smart contracts because it involves having the user use a private key matching their public address to satisfy a transaction.
- 2012: The Bitcoin blockchain created the multi-signature transaction, which required a certain number of people to sign the transaction before it was considered valid. In doing so, it enhanced the security of BTC transfers.
- 2013: Vitalik Buterin launched the Ethereum whitepaper in 2013.
- 2015: Ethereum started to support programmable smart contracts, which can create and execute many independent contracts through a “world computer”. This is the closest to our current concept and understanding of smart contracts.
Types of Smart Contracts
Smart contracts in blockchain can be classified based on the smart contract platform used. However, if we’re going to use a function as the basis of our categorisation, there are three types that you should know about:
- Smart legal contract. These are smart contracts that follow the if-then logic. Let’s say that it was created based on paying a minimum debt amount. If the conditions are not met, then there may be legal consequences.
- Decentralized Autonomous Organizations (DAOs). DAOs are like organisations without an executive board or a president. Instead, the smart contract determines operation, asset distribution, and even voting powers. So, the likelihood of a corporate takeover is practically impossible here. Also, it is a compelling model currently applied for social change that can revolutionise philanthropy.
- Application logic contracts (ALCs). ALCs govern other smart contracts. Another distinct characteristic here is that computers or other contracts “sign” an ALC instead of people or organisations.
Key Benefits of Smart Contracts
The concept of a contract isn’t new at all. It helps preserve the agreement and binds people or organisations to it. So, how is a smart contract different? We’ll cover this in detail in the following subsections:
Enhanced Security
Smart contracts have removed the need to trust people or institutions to mediate or enforce an agreement. With this alternative, you can realise a higher degree of security because of these two things:
- It’s tamper-proof: You can’t just change the details of the agreement after the fact, which makes it less vulnerable to corruption. What’s written stays written so that neither any of the parties nor anyone else with potential gain from tampering will be able to modify anything in their favour.
- It’s decentralised: This is one of the core benefits of using cryptocurrency to support transactions. Since the contract is decentralised, there are no intermediaries that can be attacked or bribed.
In a sense, the contract itself is everywhere and nowhere. It’s not stored in one specific place, making it practically impossible to steal or corrupt. Imagine an IOU that has a copy all over the world. The catch is you don’t know exactly where these practically endless copies are. So, the odds of changing or destroying them all are practically impossible.
Transparency and Trust
Parties enjoy transparency using smart contracts because the logic of the transaction can be viewed through open-source code in the blockchain. Still, it’s important to remember that what everyone else can see is only the public key.
Despite the transparency, the private key still protects the sensitive details. So, in a sense, it’s like having a glass mailbox. Everyone can see that there’s a letter inside. However, until they get the key that opens the mailbox, they’ll never know the sensitive details inside that letter.
As discussed, immutability means that the parties cannot alter the conditions of the contract at will. Therefore, all parties to the transaction can trust that they’re operating under the original agreement. There can be no surprise changes, addendums, or secret fineprints that can tarnish the trust among everyone involved.
Cost Efficiency
Legal agreements are usually mediated by lawyers, notaries, escrow services, and other similar entities. The use of their services and expertise comes with a cost, which you can completely dismiss by using smart contracts instead. Since you don’t need these middlemen to facilitate the transaction, you don’t have to pay their hefty fees either.
With fewer touchpoints required for the agreement, the process will be autonomous. Therefore, there is a much smaller opportunity cost involved. Let’s say that because of a smart contract, you will only need hours instead of weeks to iron out the details of a debt agreement. This means you’ll be able to generate passive income more quickly as a lender.
Speed and Efficiency
Smart contracts also accelerate transactions and processes by automating and eliminating manual work. Instead of relying on manual work for administrative tasks, you now benefit from a more streamlined workflow.
With fewer “stops”, the contract can be executed practically instantly. This saves time and effort without compromising the accuracy of the implementation of the conditions. It’s like sending money from your online bank. Even if you don’t physically visit a branch, line up, fill out a form, and hand over the money, the job will still get done.
Common Use Cases for Smart Contracts
Many industries are now starting to recognise the potential benefits that they can obtain from the use of smart contracts. That’s why in just a single decade, many use cases have been developed already. Across these industries, smart contracts on blockchain have enhanced the security of assets, improved workflow efficiency, and increased transparency with relevant stakeholders.
Financial Services
The finance industry is one of the first to see smart contracts come to life. In many cases, they have been used to:
- Automate transactions: A smart contract only requires that the conditions be met. Therefore, a transaction can still be processed even without a bank or payment processor to verify it.
- Manage assets: The smart contract can stipulate the desired mix of investments and enforce entry and exit points for any trade. You can even manage different kinds of crypto assets like tokenised stocks and NFTs in the same portfolio.
- Enforce agreements: It can also be used to enforce agreements exactly as they are written. For example, if a borrower misses two payments, the collateral will be liquidated right away.
Using smart contracts allows you to trim down the labour required to execute financial services while still promoting efficiency, since, unlike a regular bank, smart contracts function 24/7.
Insurance
As part of the financial industry, smart contracts can also be used for insurance products and services. For example, a client holds a travel policy that will pay after four hours of flight delay. So, by having the policy itself linked to real-time flight data, they can receive compensation even without filing a claim.
It can also be used to reduce fraudulent filings. Let’s say that there’s a car accident, and the car insurance policy itself is a smart contract. This can be linked so that it receives real-time data from the car’s telematic device. This way, it can be verified immediately whether the driver is liable for the accident.
In both situations, insurance policyholders may become more satisfied because they don't even have to file a claim to get compensation. With smart contracts, there may be no need for a fraud investigator or claims adjuster. Instead, the terms are simply automatically enforced based on the details of the smart contract.
Supply Chain Management
With so many materials moving around, smart contracts can serve as a reliable way to transparency, traceability, and automation in supply chains. Here’s how:
- Real-time tracking and verification: The smart contract itself can be linked to RFID tags or other IoT devices to create a time-stamped record of the shipment location.
- Automated process execution: Features such as payment transfer and ownership can be integrated as part of the agreement. For example, once the shipment reaches its destination, a certain amount will be disbursed automatically, and the ownership will be transferred.
- Transparent updates logging: All the generated data from tracking is logged on the blockchain itself. Once it’s there, it can’t be tampered with.
Like with other industries, supply chain management benefits from improving efficiency while limiting the required manpower. Here specifically, smart contracts help foster trust because all parties involved can verify data.
However, the benefit in this industry extends beyond the ability to track. Having traceable and reliable information is also useful for identifying the source of issues. For example, if the items come damaged, it will be easier to retrace the steps to determine what happened to the shipment.
Real Estate
Real estate is one of the most important and most expensive purchases that one will ever make. It is also paper-heavy.
There are numerous intermediaries, like real estate agents, lending officers, lawyers, inspectors, and underwriters. All these specialists involved in the transaction don't just delay the process from inquiry to purchase. They also make it more expensive to buy since their professional fees can pad the contract price.
By using smart contracts in real estate, you can automate transactions. For example, under the agreement, the seller can automatically transfer the title once the payment has been verified. If you’re renting, the contract can be designed to automatically deduct the rent amount from your account. And if there’s no damage after the lease ends, it can transfer the security deposit.
Used in the long run, it can also be a valuable source of information. It can hold data on transfer history, purchase price, previous claims, and more.
Challenges and Limitations of Smart Contracts
Although there may be numerous promised benefits, not everyone is convinced. People still see many potential drawbacks that may not make it worth it to use smart contracts.
Technical Complexity
Developing and testing a smart contract is very complex because of the following:
- Need for qualified specialists: Creating smart contracts in blockchain is not something that an average person can do. You need a developer with a deep understanding of blockchain transactions to do the job right.
- It’s immutable: Its being tamper-proof can be a disadvantage as well. If there are errors or bugs in the code, then you can’t change the details of the original agreement. Instead, you’ll have to implement a proxy transaction to indirectly modify the errors in the first one. That means having to pay for a specialist again to create another smart contract.
- Requires optimisation for gas: Technically, even inefficient code can do the job. However, a blockchain transaction comes with gas fees. So, the specialist needs to be highly skilled to bring down gas fees as much as possible.
Security Concerns
All the details in the smart contract are permanent. So, any security loophole or technical issue will be in the blockchain forever for hackers to potentially exploit. This is exactly what happened during the infancy of DAOs.
In 2015, a community created “The DAO,” which handled investment capital worth $15 million (~3.5 million ETH at the time), generated by selling the community token. However, three months after the launch, a hacker drained most of the funds through a reentrancy attack. Essentially, the hacker kept withdrawing the funds before the contract could update its balance. Think of it as being able to draw the same $100 from your PayPal account over and over again. That’s exactly what happened, but on a much larger scale.
As a result, most of the funds were drained. This proves the need to implement rigorous testing and audits. This way, there will still be accountability even though there’s no central authority anymore.
Legal and Regulatory Issues
The first blockchain smart contract is only a decade old. In many parts of the world, the laws haven’t caught up to technology yet. This raises the following concerns:
- Legal issues on the enforceability of the contract: The agreement was not formed under conventional methods. So, there would be a question of whether the contract is even legally binding because different places may follow different frameworks.
- Jurisdictional issues: Smart contracts are designed to be borderless. However, the laws of the land don’t work the same way. So, even assuming full enforceability, there’s still a question of which country’s laws it should follow.
- Regulatory compliance: Although unintentionally, coders may even inadvertently go against established regulatory measures, such as AMLA and consumer protection laws. Even if a country recognises it as legal, this can put into question the enforceability of the overall contract.
The rigidity of a blockchain contract also doesn’t leave room for dispute resolution. Let’s say that the agreement resulted in unfair consequences. There is no room for human discretion in more complex cases.
Conclusion
It’s very likely that this is just the tip of the iceberg, and no one has yet fully realised the potential of smart contracts. Considering how new the concept and technology are, it has already come a long way. This demonstrates that the benefits of cost efficiency, transparency, security, and expediency are attractive to any industry one may be in.
However, to be fully embraced into the mainstream, there is still a lot that has to happen. For example, the gap for smart contract blockchain developers is still huge. More importantly, the laws of the land must keep pace with technology to legitimise smart contracts. Assuming these issues are addressed, we expect even more use cases in the future.
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