What are Smart Contracts?

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6 mins read July 28, 2023

What are Smart Contracts?

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.

What are smart contracts?

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.

What is an Oracle?

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.

How do Smart Contracts Operate?

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.

Benefits of smart 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:

  • Automated
    One of the major benefits of smart contracts is that it is automated. This means that it reduces the influence of third parties in the execution of contracts. As such, set conditions rather than emotions or biases guide the contract implementation. It is integral in large organizations to ensure a hassle-free operation.
  • Security
    An integral benefit of smart contracts is the security that it provides. Data is encrypted in a smart contract, and it is immutable. This means it cannot be altered to change preferences or manipulated at will. This is essential for financial organisations where issues of embezzlement and misuse of funds might be a problem. The information is secured and operates interruption-free. This means once a contract is being executed based on set conditions, it cannot be manipulated or stopped.
  • Cost-Effective and Faster
    Smart contracts are cost-effective in that they eliminate the need for intermediaries. Contracts can be executed at a faster pace while still being cost-effective.
  • Trustless Process
    Smart contracts create a trustless system; that is, you do not have to trust the other parties you are entering into an agreement with. Several contracts fall apart because of the inability or refusal of one of the parties to meet their end of the bargain. This results in a lot of conflict between parties and even losses in some.
    As such, people are conservative about who they enter into a contract with, only entering contracts with persons they consider trustworthy and possessing integrity. However, this slows down several processes and makes us lose certain opportunities because of trust. However, this problem is eliminated with a smart contract. The whole system is rigid and ensures that the contract is enforced even when the parties try to go against it. This makes it easier to complete transactions and enforce contracts across the globe. 
  • Elimination of Human Error
    Another essential benefit of smart contracts is that they eliminate human error, creating an accurate and fast process. The data is fed into the system and can process accurate results due to its automated design. However, the data needs to be coded correctly to produce an error-free procedure.

Use cases of smart contracts

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.

Conclusion

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.

Disclaimer: This article is meant to provide general guidance and understanding of cryptocurrency and the Blockchain network. It’s not an exhaustive list and should not be taken as financial advice. Yellow Card Academy is not responsible for your investment decisions.

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