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What Is A Smart Contract And How Does It Work?

Updated on :  

08 min read.

Nick Szabo, a cryptographer and legal scholar, introduced the concept of smart contracts in 1994. From there, smart contracts have emerged as the most used and successful application of blockchain technology in the present times. There are significant benefits of using smart contracts in place of traditional ones.

If you are a crypto enthusiast or investor, here’s a basic guide about smart contracts to help you know more about them.

What is a smart contract?

Smart contracts are computer protocols or programs for automated transactions stored on a blockchain and run in response to meeting specific conditions. In other words, smart contracts facilitate the automated execution of agreements so that every participant can determine the outcome at the earliest without any delay or intermediary.

Working on smart contracts

A smart contract is a kind of program that encodes business logic and is operational on a dedicated virtual machine embedded in another distributed ledger or a blockchain.

Business teams collaborate with developers to define the criteria for the desired behaviour of a smart contract in response to some particular circumstances or events. 

Some example of simple events includes conditions like shipment receipt, a utility meter reading threshold or payment authorisation. Examples of more complex operations are automatically releasing insurance payments or ascertaining the value of a derivative financial instrument. The use of more sophisticated logic may help encode it.

Following that, developers create and test the logic using a smart contract writing platform. After the writing of the application is complete, it goes for security testing by a separate team. An organisation or internal expert specialising in vetting smart contract security usually does this job.

Once authorisation is complete, the contract is deployed on another distributed ledger infrastructure or an existing blockchain.

After deployment, the configuration of a smart contract is done to listen for event updates from an “oracle.” This oracle is a cryptographically secure streaming data source. Once it acquires the necessary combination of events from the oracles, the smart contract executes.

Smart contracts: Use cases

The use cases of smart contracts range from simple to complex. From registering property and ownership rights to conducting economic transactions, smart contracts can be used for several use-cases. 

Here’s a look at some of them:

  • Property Ownership

Smart contracts are very beneficial for property ownership. You can use them to record various types of property ownership, including land, buildings, watches, phones, etc. 

In the housing market, these contracts can eliminate the requirement for expensive services. Examples of such services can include those offered by housing brokers and lawyers. Notably, it enables sellers to handle the transaction entirely by themselves. 

  • Supply Chain 

Enterprises and businesses can enhance their inventory tracking by using smart-contract-powered supply chains. Other advantages include improved tracing results and a cut down in the verification procedure, resulting in fewer thefts and frauds. 

  • Trade Finance

It is possible to revolutionise trade finance with the help of smart contracts. By providing international goods transfer, automating approval workflows, and clearing calculations quickly, the finance industry can greatly benefit from smart contracts.

Plus, these contracts improve the liquidity of financial assets. And in return, it improves the financial competencies of buyers, suppliers, and institutions. Besides, financial services, including loans and mortgages, can be enhanced by connecting the parties and ensuring the whole procedure gets completed in a frictionless manner. 

In addition, smart contracts can be beneficial for mortgage systems, clinical trials, crowdfunding, insurance, voting, etc.

Benefits of smart contracts

  • Transparency and trust

There is no involvement of any third party, so there isn’t any risk of information tampering for personal gains. Also, an exchange of encrypted transaction logs takes place among participants.

  • Savings

Smart contracts eliminate the requirement for intermediaries to carry out transactions. It also removes the fees and time delays associated with them.

  • Security

Their encrypted nature makes blockchain transaction records immensely difficult to hack. Moreover, every entry on a distributed ledger connects to the entries before and after. That is why hackers must change the entire chain to a single record.

Challenges of smart contracts

  • Efficiency, accuracy and speed

The contract gets executed immediately when a condition is met. Also, since smart contracts are automated and digital, there is no need for any paperwork. Further, no time is spent on correcting errors, which can occur while filling out documentation manually.Challenges of smart contracts

Similar to any other technology, smart contracts are not free from challenges and problems. The market is evolving, and several organisations are searching for ways to adopt blockchain technology. And blockchain technology is still in its nascent stage. That indeed hampers the adoption of smart contracts.

These are some of the major challenges which plague smart contracts:

  • Regulations

Any smart contract application has to follow the regulations based on the ecosystem and where its execution will occur.

  • Not standardised

There is still no standardisation of smart contracts with the availability of multiple solutions and approaches online.

  • Learning curve

It is difficult to master smart contracts and blockchain. A developer must have the aptitude to understand the legal perspective of the code being written for the contract. In addition, law agencies and judges must be able to understand the code.

  • Adoption curve

Adoption is certainly an issue with smart contracts. As mentioned above, smart contract adoption gets a beating because blockchain technology is in its nascent stage. Besides, businesses must overcome several challenges to implement smart contracts as they first require a decentralised ledger-based network.

Final word

There is absolutely no doubt about the potential of smart contracts. But they are still in their developing phase. And because of that, they may face some vulnerability attacks. Thus, to make smart contracts a part of daily life, cybersecurity practices and platforms for smart contract creation must be updated.