What are Smart Contracts and How do They Work?

Smart contracts are self-executing agreements built into the blockchain-network which allow conducting transactions directly without any third parties participation. That is, it’s an opportunity to exchange existing assets (money, shares, and other property types) without any intermediaries.

As a matter of fact, a smart contract is a program code that contains information about a transaction in the “if… then” format. Using this mechanism makes transactions traceable, transparent, and irreversible.

Smart Contract code example

The concept itself is not new and was introduced by cryptography experts 20 years ago. But the realization of these ideas in practice became possible only with the development of blockchain technology, which is compatible with all the necessary conditions for their execution.

How Smart Contracts Work

To date, the primary platform for the implementation of smart contracts is Ethereum, as it provides the most opportunities for their realization. Using this system as an example, the way smart contracts work can be explained as follows:

  • The asset is introduced into the program and it independently monitors compliance with the contract terms;
  • Upon execution, the seller receives money, and the buyer – the goods.

The structure of any smart contract includes the following attributes:

  1. The contract parties that have accepted the agreed conditions (for this, an electronic signature or multi-signatures, if there are several parties, is used);
  2. The environment in which the contract will be located (for example, Ethereum);
  3. Subject of the contract – namely, resources for exchange;
  4. Terms of contract – a description of the mathematically confirmed conditions under which the contract will be considered as fulfilled.

How do smart contracts work

A smart contract will store all of the listed funds until the set goal is reached. If the goal is not achieved, then the money is returned to investors.

Advantages and Disadvantages of Smart Contracts

This technology has several important advantages that attract entrepreneurs, government agencies, and other participants’ attention. The main ones are:

  • Autonomy and no intermediaries. Transactions can be conducted without involving third parties who act as guarantors. In the chain, only the contractual persons involved are defined in the contract.
  • Security and confidentiality. All contracts are stored in the blockchain in an encrypted form. Only the parties named in the contract know about the terms and subject of the contract and nobody can make changes to the program code.
  • Implementation speed. If the contract terms are met, the users exchange the assets instantly. No further confirmation is required.
  • Reduced costs. Since additional confirmation and intermediaries’ involvement are not required, considerable cost savings can be achieved, which were previously directed to this area of expenditure.

Difference between smart contracts and traditional contracts
Nevertheless, this mechanism does have its weaknesses, otherwise it would have already been thoroughly utilized long ago. The main drawbacks of smart contracts are:

  • Legal status. Blockchain and crypto-currencies are relatively new tools and in most countries their legal status is not yet completely defined.
  • Creation complexity. They are based on the program code, which already creates difficulties for the average person. Also, when creating a smart contract, you need to provide several conditions and scenarios for the transaction, which is time consuming.
  • No flexibility. The data included in the blockchain can’t be changed during the interaction.
  • Innovative technology. Most people still do not clearly understand what smart contracts are and this prevents them from actively spreading.

Despite all the problems described, most experts agree that smart contracts are headed in a very promising direction and they have great potential to take a foothold in our lives in the future.

Where Can Smart Contracts be Used

The scope of their application is quite extensive but the major distribution of smart contracts is expected in the field of finance, business, and any enterprise related to making payments.
Here are a few of the most obvious smart contract applications:

  • making payments and deposits to banking institutions;
  • payment for delivery by postal or transport services;
  • automatic payment of institution management obligations and/or dividend payments for shares and other securities in the investment sphere;
  • automatic processing of payments on loans or mortgages;
  • trade transactions payment in terms of international settlements;
  • registration of property rights in real estate;
  • voting during elections, etc.

Lawyers will be able to move from crafting traditional contracts to creating model samples of smart contracts. Other industries, such as procurement, lending, and accounting will also use smart contracts – for example, for risk assessment and auditing in real time.

Let’s Summarize

The creation of smart contracts is quite a new direction and this technology has both advantages and disadvantages. But it clearly exceeds those centralized systems that are now used in many economic sectors. The broadsheet ‘The Economist’ referred to smart contracts as one of the most important technologies implemented in the blockchain.

Obviously, such benefits as cost savings, time saving, security, and eliminating the need for intermediaries will contribute to the technology being distributed all over the world in a wide variety of our activity areas.

Volodymyr Fedorychak
Volodymyr Fedorychak
Digital Marketing Specialist at Lvivity