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What are Smart Contracts?

You may have heard of smart contracts. They rose to prominence thanks to the cryptocurrency Ethereum.

Smart contracts offer security, efficiency, and accuracy unlike some technologies in the traditional finance industry.

Smart contracts are the “future of cryptocurrency” in many ways.

In this article, we'll find out why.

What is a smart contract?

The concept behind smart contracts is actually fairly simple

Smart contracts are digital contracts created and executed on the blockchain.

They are basically a computer coded contract that has specific terms established in it – like a regular paper contract – that once fulfilled creates an equation, transaction or other result agreed upon by the two parties who’ve created it.

To understand how smart contracts work, just start with thinking about a regular contract.

A contract is:

A document that sets forth an agreement between two parties, with a detailed set of stipulations and rights that dictate how two parties are to engage and act in relation to an agreement.

A contract includes terms that each party is required to fulfill, or the contract or whatever asset or benefit set forth in the contract is voided.

Simple enough.

For example:

You’ve probably signed a lease for a rental apartment or house at some point in your life. The lease sets forth specific terms – the amount of the security deposit, the length of the lease, when the rent is due, late fees for the rent.

If you violate any of these terms – or the landlord violates any of theirs – you might be in breach of the contract.

A smart contract does all the things a paper contract does. But it does it via computer code and on a blockchain. So it is faster, more accurate and more secure than a traditional paper contract.

How does blockchain work?

To understand how smart contracts improve the benefits of the cryptocurrency market and offer those benefits to more people, it’s important to keep in mind the basics of the blockchain.

Along with allowing financial transactions to take place without the aid of a bank, blockchain provides security, efficiency, and accuracy of transactions.

It does this by being operated by distributed computers running specific pieces of software. In addition, it makes up a digital, distributed ledger that tracks all the financial transactions on the blockchain – creating a public record of all those transactions.

Many blockchains then utilize their own digital tokens to value transactions. Bitcoin, of course, is the first and most prominent example of a blockchain.

The limits of peer-to-peer blockchain transactions

In the past, most cryptocurrency blockchains – like Bitcoin – allowed for peer-to-peer exchanges of currency. The ability for individuals to exchange money directly to one another without the assistance of a third party (a bank) is a hallmark of blockchains and the cryptocurrency marketplace.

But there's shortcoming of bitcoin:

it only allows for the transferring of currency.

It does not provide a platform for creating transactions more complicated than the exchange of money.

Smart contracts fill that void.

Unlike a Bitcoin blockchain, a cryptocurrency blockchain that provides smart contracts can be a marketplace where people can buy, sell and provide access to nearly any financial commodity in a way that is more efficient and secure than most banking transactions.

How smart contracts work

A smart contract is basically a digital contract with the security coding of the blockchain. It has layers of detail and permissions written into the code that require a sequence of actions to take place to trigger the agreement of the terms.

For the conditions of the contract to be met, one party likely needs to provide a security key to the other party by a specified date to unlock the conditions of the contract.

Smart contracts can apply to nearly any interaction in which two parties must execute an established set of criteria to formalize an agreement.

Go back to the example of renting an apartment: A user could write a smart contract for the lease of an apartment, writing in various security steps that are required to execute the contract.

The lessor might need to provide the lessee a security key. Once they do, the lessee has access to the contract. Once the lessee pays with cryptocurrency, the lessor must send the keys.

And so forth.

If any one of these steps is not completed, the contract is voided, money is returned to the lessee, the lessor keeps the keys – whatever the case may be.

Ethereum and smart contracts

The cryptocurrency blockchain most frequently associated with smart contracts is Ethereum. This is for good reason. Ethereum was built specifically to create smart contracts.

In Ethereum, developers can write their own contracts for their goods and services. Those contracts then utilize the Ethereum cryptocurrency – Ether – as the method of payment for contracts executed on the blockchain.

Smart contracts are the primary reason for Ethereum’s growth. The possibility for the contracts to provide people in numerous businesses and industries with the ability to create and execute secure, efficient and accurate contracts is extremely valuable.

Smart contracts have been deemed so promising to the corporate marketplace that in 2017, Microsoft, J.P. Morgan, Cisco, Intel, and Mastercard established The Enterprise Ethereum Alliance, which has a goal of creating a standardized version of Ethereum software that business throughout the world can utilize for transactions and contracts.

Downsides of smart contracts

Smart contracts provide tremendous benefits to nearly anyone who executes contracts digitally.

But they do have a few downsides.

They may be bugs.

Plus:

Users need to make sure they send the correct code. The contract itself can’t confirm that the item in the contract is in appropriate standing.

For example: what if somebody is selling a car via a smart contract, and everything in the contract is accurate, but the car itself doesn’t run?

Smart contracts also face challenges in terms of government regulation and taxes.

Since these smart contracts are often not created by third parties – such as a bank or a lawyer – they do not have the inherent regulation that is a part of the contracts created by those entities. In addition, there’s no clear way for governments to tax the financial transactions in a smart contract.

The future of smart contracts

Although there are some downsides to smart contracts, the upsides and clear benefits to many industries and individuals – and the ability for industries to use code to create an accelerated and accurate contractual transaction – offer extraordinary potential.

This can be seen by the creation of The Enterprise Ethereum Alliance.

Those large, powerful corporations see so much value in these contracts that they’re working to develop ways to apply them to many mainstream companies and industries.

Smart contracts – like security tokens – are another way the technological, security and efficiency of the cryptocurrency marketplace can converge with and bolster traditional financial and commercial industries.

And when that convergence is possible, the broader digital marketplace sees a great interest and opportunity in cryptocurrency technologies.