What are Smart Contracts? Understanding Smart Contracts on Blockchain

Table of Contents

June 17, 2022 6 min read

What are Smart Contracts? Understanding Smart Contracts on Blockchain

In Brief

  • Smart Contracts are self-executing digital programs that run on blockchain networks. A smart contract is an agreement represented as a computer code that enforces itself based on a predetermined set of instructions.
  • Smart Contracts do not require any trusted central third-party to hold and verify data regarding transactions. Instead, a decentralized network of nodes on the blockchain network use the executable program to validate and verify the transaction.
  • 3. Several smart contracts can be integrated to perform complex transactions to form Decentralized Applications, De-Fi Platforms and the like.

Billions of transactions are executed each day on the internet. It can be in-app purchases, online shopping, banking services or numerous other agreements. To complete transactions, several functions are required. For example, a person wanting to purchase a house would require a website that lists available properties, a communication system with the seller, a payment gateway that connects the banks and also a system that registers the transfer of ownership with the government. Each of these functions are supported by centralized servers that are controlled and managed by a few entities.

Across all these functions, one thing is common- a centralized Trusted Third Party.  A single entity holds, verifies and validates your data. What does this mean? Security Holes. This means that your transaction is controlled by such intermediaries and is subject to their actions.

However, smart contracts can perform all the functions required for a transaction, without the involvement of one central trusted entity and much more quickly- thanks to blockchain technology.

What are Smart Contracts?

A Smart Contract is an agreement represented as an executable computer program that runs on top of a blockchain network. The agreement can be a simple transfer of assets, voting system, loan system, and so on.

“The smart contract is essentially a set of instructions written as a digital code using complex logic, programmed to self-execute if predetermined conditions are met. “

Smart Contracts have multiple use-cases ranging from basic financial transactions to complex ones such as loan systems, insurance, healthcare, voting, energy sector, public goods distribution etc.

Smart contracts mainly operate on an if/then logic i.e., if certain predetermined conditions are met, then the contract is executed. Example- If there is sufficient funds in the wallet, then the transfer of assets is initiated. The arbitrary predetermined conditions are written in high-level computer programming language to “set off” specific functions in smart contracts.

Smart Contracts are:

  • Highly secure and transparent because they rely on blockchain networks.
  • Devoid of middlemen that control and monitor your information.
  • Reliable because they are programmed in digital code and there is very low margin for error.

The Past, Present and Future of Smart Contracts

First, let us look at a brief history of smart contracts.

Origins of Smart Contracts

In the year 1994, computer scientist and cryptographer, Nick Szabo used the words “smart contract” in his article which he described as- “a computerized transaction protocol that executes the terms of a contract.”

“Szabo defined smart contracts as promises expressed in a digital form, including a computer protocol, which enables parties to perform their promises.”

Most smart contract evangelists state that several clauses of a contract can be partially or fully converted to digital code for self-execution and/or self-enforcement. Through improved enforceability of contracts using computerized protocols, disputes, breaches, transaction costs and transaction time would decrease.

a
Observability
b
Verifiability
c
Privity
d
Enforceability

Though Szabo proposed the idea of Smart Contracts in the 1990s and recognized its applications in Decentralized Ledger systems, it was never implemented due to the lack of sophisticated technology to support it.

Use of Smart Contracts on Blockchain

Although the concept of a blockchain- a cryptographically secured chain of blocks was introduced way back in 1991, only in the year 2009, through the launch of “Bitcoin”, it was brought to life. Blockchain networks allow untrustworthy parties to transact without the presence of a trusted third party. This is because the blockchain network is a distributed digital ledger that chronologically stores data and does not permit the data to be altered, modified or misused. However, Bitcoin only supported primitive currency transactions and did not support complex transactions on its blockchain.

“Ethereum introduced smart contracts as an added functionality to its blockchain network enabling the growth several DApps and DeFi platforms”

In 2015, Vitalik Buterin, revived Smart Contracts as an additional and separate layer in the “Ethereum” blockchain. With the help of Turing-complete languages, sophisticated logic could be deployed to design smart contracts capable of performing complex transactions on the blockchain network. These smart contracts were then bundled up and integrated to form Decentralized Applications (DApps) that offered several services and utilities. Several blockchain networks have subsequently been released with improved smart contract functionalities and efficiency.

How do Smart Contracts Work?

ere’s an example how a transfer function in a smart contract works:

Transaction- Annie wants to purchase an NFT for 1 ETH from John.

  • A transaction with Annie's unique user signature and input values [Bid Price(1 ETH) and John’s NFT ID] is created that calls for the “transfer function” in the target smart contract.
  • The transaction is broadcast to all nodes on the network. All the nodes eventually process the transaction using the target smart contract’s executable code.
  • The Smart Contract’s code interacts with the distributed ledger on the blockchain to verify whether Annie has sufficient funds in her wallet and whether John owns the digital art.
  • If Annie’s wallet has sufficient funds and John owns the digital art, then the smart contract program sets off the transfer function and the transaction is successful. 1 ETH is deducted from Annie’s wallet and added to John’s wallet.  Digital Art is transferred from John to Annie.
  • If Annie’s wallet has insufficient funds and/or John does not own the digital art. The Digital Art is not transferred from John to Annie. The Smart Contract Program rejects the input and the transfer function is not triggered. The transaction fails.

Most commonly smart contracts work this way, with a few exceptions. In very simple terms, a smart contract program has a bunch of functions it can perform. When a transaction is submitted, it has a user signature and specific input values that “call” a specific function from that smart contract. The smart contract, using its logic, will determine whether the input values “triggers” that specific function to execute the transaction. If the predetermined if/then conditions are met, the function will execute the transaction. If the input values don't meet the predetermined conditions, then the transaction will not be executed. Either way, this action is permanently recorded on the blockchain network.

Few concerns regarding Smart Contracts

One major concern regarding large-scale usage of smart contracts- security risks. These security risks can be operational risks, implementation risks and design risks. Operational risks could mean that some features representing authority could be exploited if the governance mechanism is flawed. Implementation risks arise from errors in a smart contracts behavior and design risks are those features which can be altered to change a smart contracts behavior. However, most blockchain protocols are constantly working to resolve these concerns and improve smart contract security and performance.

“Security threats and regulatory loopholes are concerns that are currently being analyzed and addressed in order to strengthen the smart contract framework on blockchain networks”

Concerns have also been expressed regarding the legal and regulatory uncertainties of smart contracts. As smart contracts enable cross-border transaction, differences in jurisdictions and applicable laws could lead to legal issues that could create complexity. Smart Contracts are novel technology that is still being developed. As such the question of liability in case of negative consequences arising from this technology is also largely unassessed. As such greater effort needs to go into allocating and attributing liability in case of risks in relation to transactions powered by smart contracts.

Are Smart Contracts the future of transacting?

As more and more sectors have started to experiment with blockchain based solutions and participate in decentralized finance, smart contracts have come into the limelight for their effectiveness and accuracy. Smart Contracts interact with the underlying blockchain network to verify and validate information relating to the transactions. As blockchain networks are distributed public ledgers on a digital network, information cannot be altered, manipulated or misused by middlemen once it is recorded in the network.

This allows untrustworthy parties to directly transact with one another without relying on a central trusted intermediary. Removing such intermediaries in transactions reduces the cost of transacting and transaction time. It also leaves no room for human error or ambiguity in interpreting the language while enforcing the agreement. It also means that a single central entity cannot exercise unbridled control over the transaction and its data.

“As smart contracts run on top of blockchain networks, there is improved enforceability, transparency and accuracy.”

Smart contracts on blockchain networks enable borderless transacting allowing two users to easily enter into agreements without facing the issues that arise from geo-political differences. Smart Contracts are here to stay and disrupt the current models of contracting. We are already witnessing the steady rise in the value that is being generated on DApps and smart contracts running on DeFi platforms. Through increased adoption of blockchain, improvements and further technological innovation, smart contracts can reach mainstream adoption on a global scale.

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