A smart contract is a special program. It is created to perform specific actions in a blockchain. When conditions are met, the transaction happens. It cannot be changed and is easy to track.
To get how a smart contract works, imagine a vending machine. You put in money, press a button, and it gives you an item. The smart contract works just like the machine: automatically.
Nick Szabo, an American computer scientist, first introduced smart contracts in 1994. In 1998, he created an idea for a virtual currency called "Bit Gold," which came 10 years before Bitcoin. Some believe Szabo might be the mysterious Satoshi Nakamoto, the creator of Bitcoin. However, he insists that he is not Satoshi.
Szabo described smart contracts as digital programs. They carry out the terms of an agreement. He wanted to improve electronic transaction systems, such as point-to-sale methods, to enable them to work in the digital world.
What Is a Smart Contract in Blockchain?
Smart contracts use "if/when...then..." rules written as code on a blockchain. Computers on the network handle the tasks once the conditions are met and verified.
These tasks can include sending funds, registering a vehicle, issuing a ticket, or sending alerts. After the task is completed, the blockchain updates automatically. This is why the transaction cannot be changed, and only those with access can see the details.
Smart contracts can have as many rules as needed. To set these rules, participants agree on how the data and transactions will appear on the blockchain. They decide on the "if/when...then..." rules, account for exceptions, and establish how to resolve disagreements.
Once the terms are ready, a developer writes the smart contract.
Smart Contracts in Cryptocurrency
In cryptocurrency, smart contracts help make transactions faster, cheaper, and more secure. They remove the need for middlemen like banks or lawyers. Once a smart contract is completed, it cannot be changed.
For example, every transaction on the Bitcoin network works like a simple smart contract. Each transaction includes a script that allows only the right person to access and use the funds. Without this measure, others could steal Bitcoins from an account.
This basic feature is only a small part of Bitcoin’s potential with smart contracts. Bitcoin's Script language handles many advanced tasks.
Ethereum supports more advanced smart contracts. Developers can use it to build decentralized applications (dApps) that work without central control. Examples include platforms to trade cryptocurrencies, lend money, or host games.
How Smart Contracts Work
Here’s how a smart contract works on a blockchain.
First, both parties agree on the terms of the contract. Then, the terms are written into computer code. The code lists the conditions that show what will happen during the transaction.
Next, the code is saved on the blockchain. It is copied across all participants in the blockchain network.
Finally, the code is executed by computers in the network. If a condition of the contract is met and confirmed by everyone in the network, the transaction happens automatically.
Types of Smart Contracts
There are different types of smart contracts. They are classified based on their use and complexity.
Basic smart contracts are simple agreements with clear terms. They handle transactions and verify identities.
Multi-signature smart contracts require more than one party to approve a transaction before it happens. This ensures that no single person has full control and makes the applications much more secure.
Decentralized autonomous organizations (DAOs) also use smart contracts. Smart contracts allow them to make decisions as a group. This group sets rules, and the contracts automatically execute actions based on those rules.
More advanced smart contracts are created for complex processes. For example, those can be the management of digital assets or even the creation of decentralized applications (dApps). These contracts can handle many tasks and interact with other systems on the blockchain.
Advantages and Risks of Smart Contracts
Smart contracts are fast, efficient, and accurate. When conditions are met, the contract makes an action. No need in paperwork and no time wasted.
Smart contracts boost trust and transparency. Nobody oversees or performs transactions, everything is done automatically. When an action is completed, it is recorded on a blockchain. Everybody can check it.
Each blockchain transaction is encrypted. It means that it is very difficult to change it. If a hacker wants to change a record, he needs to change the entire blockchain which is almost impossible.
With smart contracts, one doesn’t need any intermediaries, so it also helps to save money and time.
Even though smart contracts are beneficial, they have some cons.
A smart contract is very complex. This is why it is difficult to program them correctly. If there is a mistake, a smart contract won’t work or even may become vulnerable to hacks.
How to Minimize Risks of Smart Contracts
To reduce the risks of smart contracts, you shall always review the code and test it. It is recommended to arrange audits with specialized companies and fix all errors.
Use Cases for Smart Contracts
Smart contracts are used in many industries. For example, in the financial field, smart contracts can help manage transactions such as transfers of money, issuing loans, and others. In the legal field, smart contracts can eventually replace paper contracts. This will be a big advancement for the industry because then, there will be no need for paperwork. A contract will be executed automatically as soon as all conditions are met, so, there won’t be a need in courts. Smart contracts can also be used to track performance, which will cut expenses a lot.
In real economy, smart contracts can work, too. For example, in real estate, a smart contract would transfer the property ownership as soon as the payment for the property is made, without additional paperwork and waste of time. In insurance, they automatically process claims when conditions are met.
The Future of Smart Contracts
More fields and industries are adopting smart contracts. Governments are also exploring smart contracts and may apply them to manage daily activities. Moreover, people may start using smart contracts for daily activities.
Technology develops, and over time, smart contracts will have fewer vulnerabilities and problems and offer an even higher security level. They have the potential to be applied literally everywhere.