Find out what a smart contract is, how it works and how you can program a smart contract yourself. We’ll also show you the top uses and the most popular coins.
Smart contracts, i.e. intelligent contracts, use the advantages of digitization for contract management. With blockchain technology as the basis, they ensure maximum contract security, transparency, and efficiency.
We answer the following questions:
- What are smart contracts?
- How do smart contracts work?
- What are the most famous examples of smart contracts and smart contract coins?
- What are the advantages and disadvantages of smart contracts?
What are smart contracts?
Smart contracts are intelligent, fully automatic contracts.
The term goes back to the American lawyer and computer scientist Nick Szabo, who already described the concept of legally relevant computer programs at the end of the 1990s. The basic idea is to map contracts using web-based computer protocols and to provide technical support for contract negotiations and contract enforcement.
With smart contracts, the entire contract processing takes place automatically according to the following mode:
Receipt of the transaction: triggering of a digitally verifiable event
Checking the transaction: processing the event by the program code
Issue: Taking a legally relevant action based on the event
It is not the mere possibility of automating contract management that makes smart contracts so important, but the connection with distributed ledger or blockchain technology:
Smart contracts are programs on the blockchain that work based on an IF-THEN logic. A previously defined action is automatically carried out when a previously specified event occurs.
Definition according to Wilkens and Falk (2019):
Therefore, the smart contract is a computer program that enables the mapping, execution, and verification of a contract, with the contractual agreements being coded in the form of an algorithm.
Blockchain technology makes this process trustworthy, traceable and transparent, because the blockchain enables forgery-proof and decentralized storage and verification of the admissibility of transactions.
How do smart contracts work?
Smart contracts are based on a blockchain and are executed there on a decentralized basis.
The basic technology for this is distributed ledger. This term describes a network in which data is organized in a distributed manner. The data, including the transaction history, are stored in parallel for all network participants and verified using a consensus procedure.
This approach is in direct contrast to normal databases, where data is stored centrally. With distributed ledger technology, storage is decentralized; central administration is unnecessary. Because of this decentralized storage, the data is forgery-proof and traceable. The system also acts independently of individual participants.
Blockchains are a form of distributed ledger technology. They have a special structure in the cryptographic chaining of data blocks. These are linked in chronological order using specific checksums (“hashes”).
A simplified graphical representation of the blockchain was published in the whitepaper by Bitcoin founder Satoshi Nakamoto.
Smart contracts are software or program codes based on the blockchain and automatically execute digital transactions between participants on this.
In order to be able to carry out these transactions, smart contracts contain status transitions, data, process logics, etc., and thus represent scripted sequences that link at least one result to certain conditions or events.
If the condition specified in the code occurs, an information technology reaction is triggered by the smart contract. This causes virtual transactions. In practice, this means that the program code’s script is digitally signed by the contracting parties and stored on the blockchain. The previously defined event, such as a specific date or market price, occurs, and the contract execution is automatically triggered.
How smart contracts work can be summarized as follows:
Process step 1: The contract terms are recorded in the program code.
Process step 2: The defined event occurs.
Process step 3: The contractually fixed exchange of services is carried out automatically.
Process step 4: The transfer of ownership between the contracting parties occurs digitally or physically.
5 Popular examples of smart contracts
As abstract as the functionality of smart contracts appears at first glance, their application is just as practical. Smart contracts are used in the sense of their original function in contract management and in numerous other areas.
The five most popular examples are described below.
Decentralized finance and smart contracts
There is now consensus that blockchain technology can fundamentally change the financial industry.
This is mainly due to smart contracts, which can make many standardized processes and products more efficient and cost-effective in the future due to the described functionality.
Specific fields of application in the financial sector are primarily the securities and credit sectors.
In a securities transaction, various parties ensure that the transaction can be processed safely and correctly. The volume of data in securities transactions is large; every actor has to process and validate the data within the process of order-clearing-settlement-custody. This leads to long transaction times and high transaction costs.
Smart contracts are a way of automating individual process steps. For example, you can take on the know-your-customer process, i.e. the validation of customer identity, or you can automate the clearing process. Smart contracts can also independently carry out a simultaneous transfer of securities and purchase prices between the custodian banks in the settlement process.
The credit area is also an area of application for smart contracts. Here, interest, repayment, and term conditions can be automatically monitored and processed with the help of smart contracts. It is also possible to include automatic sanctions in the smart contract in the event of a loan default, for example, the automated utilization of security.
Smart contract in logistics
Smart contracts offer interesting fields of application in logistics. For example, sharing concepts, payment or billing systems for connected end devices or peer-to-peer marketplaces can be implemented with smart contracts.
Smart contracts can generate massive increases in efficiency, especially in the supply chain. A digitized supply chain works with much faster transaction processes, which leads to greatly accelerated handling of all processes. Value chains can work faster because smart contracts are replacing intermediaries.
The potential is immense when you consider that a value chain works with many actors, for example, suppliers, manufacturers, dealers, logistics service providers, financial service providers. There are various performance agreements between all these actors that have to be checked and implemented and a massive exchange of data.
Smart contract insurance for insurance companies
The use of smart contracts is also increasing in the insurance industry. A promising field of application is payments in certain damage cases or other events that are carried out automatically by smart contracts.
A successful pilot project in this area was implementing a natural disaster swap in 2016. So-called cat swaps are financial instruments with which certain risks, most natural disasters, are transferred from one insurer to another. The triggering event is previously defined with precise parameters.
Smart contracts in the real estate industry
There are several possible uses for smart contracts along the entire real estate value chain. The use of smart contracts when paying for real estate transactions is obvious.
Smart Contracts also simplify the processing of real estate sales. The law provides that the contract for the sale of a property is signed by the buyer and seller and certified by a notary. After the contract is signed on-site, the notary notes the planned change of ownership in the land register. When the real estate transfer tax and the purchase price have been paid, the transfer of the land register will be initiated.
It is a lengthy process involving various actors that can be significantly accelerated using smart contracts. For example, the smart contract can be provided with the legal purchase conditions that the notary has previously checked. If the land register were to be saved on a blockchain, additional increases in efficiency would be.
Smart contracts in politics and administration
Smart contracts can also bring numerous improvements in politics and administration. This includes the use of digital public services or new forms of registers and, for example, holding elections.
The city of Zug in Switzerland has taken on a pioneering role in this regard and has started various pilot programs for eGovernment.
The use of smart contracts for elections would also be possible, as these can be carried out in a forgery-proof manner.
Pros and Cons of smart contracts
The use of smart contracts has numerous advantages due to the high level of transparency and the general protection against forgery of the blockchain. At the same time, however, the dangers must not be overlooked.
Benefits of a smart contract
Simplification of contract drafting
Transparency and security through the use of the blockchain
Increased efficiency through automated implementation options
High reliability through formalized conditions
Independence from auditing bodies and intermediaries
Disadvantages of a smart contract
Correction and reversal of incorrect contracts
Loss of legal leeway and freedom of interpretation
(for the time being) a lack of legal certainty and standardization
Challenging software development
Blockchain-typical challenges (data protection, usability, energy consumption, scalability)
3 Popular Smart Contract coins
Smart contracts are also made available on the blockchains of various coins. The best-known smart contract coins include Bitcoin, Cardano, and Ethereum. With smart contracts, so-called decentralized applications, or dApps for short, can be implemented.
Smart contracts on Bitcoin
Bitcoin and smart contracts: is that even possible?
In June 2021, after the Segwit update 2017, the first update of the Bitcoin protocol in four years took place. The Taproot upgrade makes real smart contracts on the Bitcoin blockchain possible for the first time, albeit simplified.
The functionality must not be compared with the complexity of Ethereum and its Turing completeness. Nevertheless, projects such as Internet Computer (ICP) or stacks want to build application scenarios such as decentralized finance and smart contracts in general around the Bitcoin blockchain.
Cardano Smart contracts
Cardano is also making efforts to use smart contracts. With the Alonzo update in September 2021, smart contracts will now be made possible after many years of preparation. The focus is on decentralized financial applications, from simple swap apps to decentralized exchanges.
For the update, Cardano relied on the Plutus programming language. The Alonzo upgrade enables Plutus scripts to be written and executed on the Cardano blockchain, enabling the network to become a decentralized application platform for smart contracts.
Ethereum Smart Contracts
While the Bitcoin blockchain is very limited in its functionality, Ethereum sees itself fundamentally as a platform for smart contracts. Accordingly, Ethereum creates all sorts of decentralized applications in that the blockchain allows users to create any function they need themselves. The programming language for this is Solidity.
The specialty of Ethereum and the programmable blockchain is the currency ether, which, unlike Bitcoin, is not intended purely as a currency but also as a fee for the calculations on the blockchain.
Ethereum also uses gas as a mechanism to keep the network running. Every transaction in the network is associated with a fee. If a transaction is to be carried out in the network, the transaction initiator must specify a gas limit. This is the maximum number of gas available for the transaction.
How to Program your own Smart contract
Smart contracts are essentially computer programs. Therefore, anyone who knows a programming language is basically able to program a smart contract. There are numerous tutorials on this on the Internet.
Conclusion on Smart contracts
With blockchains, tamper-proof data structures have been developed, with the further development of which it is also possible to store and execute program codes on the data structure. These smart contracts act like independent actors within the network. They offer numerous possible uses, some of which have already been established. Many are only being considered or are being tested in pilot projects.
What is certain is that smart contracts offer the opportunity to change many areas of our economic life. The extent to which the much-cherished expectations will materialize is not yet foreseeable.