What are Smart Contracts?

Contracts are legal documents we might come across at one point or the other. Common examples of a contract can be the lease you sign to rent an apartment, the agreement you sign when hired at a job, or even the terms & conditions we agree to when setting up our devices or using a new app on our mobile. Every contract can be boiled down to a set of agreements that both parties promise to abide by. Smart contracts work similarly to basic contracts. Yet to understand exactly what a smart contract is, we need to go a little deeper into what basic contracts are.

To illustrate this point, let’s use the example of a farm insurance contract. With this contract, a farmer agrees to pay a certain amount of money every month to a corporation that, in turn, insures the farmer’s crops. As long as the farmer makes their payments, the contract is considered active. Should something happen to the farmer’s crops, the insurance corporation will cover their losses in the manner that the contract stipulates. For example, if the insurance contract said they would pay up to 80% of the value of the crops should the crops be destroyed by a flood, and a flood were to occur, then an insurance agent would need to verify that the flood occurred and that the farmer had been paying their monthly premiums before sending the insurance payment to the farmer.

In essence, contracts are legally binding contracts that define the relationship shared between two parties. It defines their positions in the agreement; for instance, the farmer is the insured while the insurance company is the insured. It also specifies the conditions in which that relationship exists and may be called off. Each party in the contract has to perform specific actions to enjoy certain benefits. Once a breach of contract occurs, that is an action that isn’t permitted from either party, the contract may be terminated, or a fine may be imposed. For instance, when opening a social media account, you agree to post only contents that don't violate the policies in the terms and conditions you agree to, and you continue to enjoy uninterrupted services if you comply with this. However, once you violate these and post content that isn’t permitted, the content might be deleted, and you may get temporarily suspended from enjoying the services.

Smart contracts drastically simplify this process of contract assessment and execution because it is automated. Contracts like your house lease, employment contracts aren’t often automated and have to go through a process before being executed. For instance, when seeking a loan from a bank, you would have to submit a long list of documents and wait days before you can ascertain your loan eligibility and the amount paid to you. However, when using a loaning app, you discover that the process can be finished in minutes. This is because the system is programmed to automatically check for specific requirements as you upload a few documents to check your eligibility and your loan offer. This is because the computer program that runs the mobile application has been encrypted with certain terms and conditions, which hasten the process. 

A smart contract is a type of computer program that automates contract assessment and execution. Using the above example of a farmer and an insurance company: the farmer and the insurance corporation had a smart contract set up between them. As long as the farmer made monthly payments into their insurance plan, their end of the smart contract would be upheld. Should a flood damage the farmer’s crop, the money would automatically be removed from the insurance corporation’s account and sent to the farmer.

The contract can be executed quicker and more efficiently by cutting out the need for an insurance agent to process the contract and send the payment. However, smart contracts are still dependent on external data to work. For example, somebody needs to prove that the farmer’s crop was damaged by a flood first, which still requires heavy legwork. That’s where something known as an oracle comes in.

Think of Oracles as an external data feed for a smart contract. For example, the smart contract between the farmer and the insurance corporation may have an oracle monitoring the farmer’s payments; so long as the farmer sends his monthly payment, that oracle shows the farmer’s side of the smart contract as upheld. Next, there might be an oracle supplying data from a third-party weather station. If a weather station reported that the geographic coordinates of where the farmer’s crops are located received over half a meter of rain, and a flood was declared, then this part of the smart contract would be considered met. As a result, the combined data from the payments oracle and the weather monitoring oracle would cause the smart contract to execute, sending the insurance payout to the farmer.

As you can see, smart contracts can completely eliminate the need for human interference and judgment in the execution of a contract. This can drastically reduce the opportunity for human errors, intentional contracts breaches, and more when set up correctly. Smart contracts have the potential of disrupting businesses on a global scale, offering massive improvements to operational efficiency across industries.

Smart contracts are digital codes that specify a set of benefits that can be received on predefined conditions defined by the parties involved in the agreement. Essentially, both parties set a condition on which specific actions or series of actions would be performed. Smart contracts can be used in different sectors and are not limited to financial institutions. They operate in real estate, agriculture, education, governance, among several other sectors. 

However, for a smart contract to become active, the contract needs to be digitized. In order to achieve this goal, smart contracts are digitized on blockchain technology, after which both parties can carry out their ends of the deal as specified by the smart contract. The ultimate goal of smart contracts is to automate tasks across networks. Cryptocurrencies like bitcoin, ethereum, ripple, tether operate using a smart contract. That is, cryptocurrencies can operate without the need for a central governing authority because smart contracts exist to enforce contracts.

Smart contracts offer numerous benefits, which makes them integral in developing our social and economic structures. Understanding these benefits would offer a better perspective on how smart contracts operate. Some of the benefits of smart contracts include:

Smart contracts can be built around blockchain technology, allowing the data that is used throughout the smart contract to be stored on a publicly accessible ledger. Numerous cryptocurrency companies build smart contract systems; two of the most notable examples are Chainlink and Band Protocol. Additionally, there are several cryptocurrency companies building projects that leverage smart contracts to solve real-world problems. For example, Etherisc is testing out decentralized farm insurance, much like is described in the illustration above, that would execute smart contracts built on the Chainlink protocol.

However, smart contracts aren’t limited to the crypto space and have several use cases across different sectors. 

Governance

Smart contracts would help automate processes within governmental institutions. It would set a revolutionary change in which government processes are automated, processed faster, and error-free. For instance, taxes could be automated, property acquisition and transfer may also be automated, including election processes among several other institutions within the government.

Finance Sector

The finance sector, including banks, insurance companies, and other financial institutions, would find smart contracts highly effective. Its encryption system provides a system that safeguards funds and financial processes. It also ensures that the transmission of data and enforcement of contracts is conducted faster. This would aid cross-border transactions, which cryptocurrencies aim to attain.

Record Keeping and Tracking

Smart contracts can be an excellent tool for KYC (Know Your Customer) as it helps store essential information that can be shared among similar companies which help with operationality. For instance, research institutions access numerous data that can be easily transmitted to other institutions using smart contracts for other research purposes. In this case, smart contracts allow essential companies learn about the individuals in a community without revealing their true identities. 

Smart contracts can also be an effective tool in shipping and distributions services involved in inventory management. It ensures there is transparency, a lack of fraud, and is error-free. As such, these companies can operate faster once the processes are automated with smart contracts.

While smart contracts are a relatively new technology, they are expected to continue to grow in popularity over the coming years as more and more companies realize their potential to reduce overhead expenses, improve efficiency, and help them become more competitive. Understanding how smart contracts work at this early stage allows you to evaluate companies, choose investment opportunities, and look for new ways to apply this emerging technology.