What is Smart Contract? Beginners Guide

Smart contracts are digitally signed and self-executable agreements between two or more parties that are stored on a decentralized ledger

By · Jul 30, 2020 . 18min read

What is Smart contract

Quick Takes:

In this piece, you will learn 

  • What smart contracts are
  • How a smart contract works with illustrations
  • The specific application of smart contracts 

Let’s dive in. 

Introduction

The concept of Smart contracts dates far back even before the Blockchain technology was created, and the Bitcoin network launched. Without any doubt, the most attractive benefits of blockchains are its decentralized nature, the transparency it facilitates as well the time and other resources it saves users by cutting away intermediaries from transactions it facilitates.

Nick Szabo, a brilliant computer scientist, lawyer, and cryptographer in the year 1994 after a careful study observed something striking. After the examination, he concluded that any decentralized ledger could be used as self-executable contracts which he called Smart Contracts. These digital contracts could be converted into codes and allowed to be run on a blockchain.

Before the blockchain, everything ranging from buying and selling, transfer of wealth and properties if it ever occurred on the internet must pass through a third party. If not, parties must meet in-person to carry out that transaction which is always fraught with many risks. The presence of a third-party entity meant associated costs. It also implies more time is needed by the third party to verify the claims of the participating entities. With a smart contract, the game was changed as it quickly in a trustless manner, facilitated transactions efficiently and transparently.

“Did you know digital contracts can be converted to codes and run on the blockchain as smart contracts?”

What are Smart Contracts

Smart contracts are digitally signed and self-executable agreements between two or more parties that are stored on a decentralized ledger for verification between transacting parties.

These agreements are codes that have been pre-programmed with a set of definitive rules and regulations and will self-execute, without the need for intermediaries. It works on the If This, Then That (IFTTT) basis.

How Do Smart Contracts Work?

A perfect example is the Vending Machine scenario given by the cryptography czar; Nick Szabo, in his explanation of how smart contracts work.

Expounding on it further, take a typical vending machine stuffed with cans of Coke, with a slot that accepts coins. This slot has various verification technologies running at the backend. This is to ensure the right coin and not just anything with the shape of a coin is slot in. Otherwise, anybody can cart away with a can(s) of Coke even if they did not do the right thing. So, a typical vending machine while preventing fraud removes the need for an attendant to receive money. This also helps to remove any delay a human intermediary might introduce into the system. With the right monetary amount, the vending machine delivers the Coke right into the hands of the buyer.

Linking this analogy to smart contracts, the picture comes quite clear. A smart contract is an equivalent of an application programming interface (API) in websites and other centralized applications. The Vending machine is the decentralized application (Dapp). This is the interface between the blockchain and an interacting user. The decentralized or distributed ledger records the user’s transactions for all to see. The technology that ensures the right coins and not just any metallic substance are the digital codes. These are agreements that have been written in the form of codes and embedded in a smart contract. The Coke that the vending machine releases are equivalent to anything of value. These ranges from financial benefits to information or digital documents. As the equivalent of an API, the smart contract ensures dapps users have their transactions recorded on a public ledger.

“Did you know that transactions facilitated through smart contracts are automatic and irreversible?”

Why are Smart Contracts Relevant Today?

The smart contract is an innovation that brings massive value in a world with increasing digital transactions. This also means transparency issues and rising costs between transacting members. In the explanation earlier, smart contracts allow the transfer of anything of value in a cheap but efficient manner. All these without the need for a third party. It presents the following advantages.

Advantages of Smart Contracts

Immutability

They facilitate transactions which are automatically recorded on a public blockchain; therefore, it cannot be altered. This is one of the critical benefits of the blockchain.

Trustless

It does not require transacting parties to trust or know each other. Smart contracts execute autonomously as soon as the pre-set conditions coded into the contract are met. It then automatically records the outcome onto a blockchain. As trust is expensive, smart contracts remove the associated costs to attaining trust, which may have to involve intermediaries.

Security

It is an interface between parties and a decentralized, distributed ledger. Unlike a centralized database vulnerable to attack by an intruder, the blockchain records transactions across a network of nodes. These nodes must have the copies of the entire transaction on that network. This, in turn, makes the single point of failure or vulnerable difficult from happening.

Speed

All the required processes for facilitating transactions are automated with codes and embedded in a smart contract. This removes the cumbersome process that is time-consuming, bringing about efficiency.

“Did you know elections can be held on the blockchain using smart contracts?”

Applications of Smart Contracts

Governance

The use of smart contracts comes in handy here for transparency in the voting process. With a smart contract, the government of nations can securely conduct its elections and have the results recorded on a public ledger. This removes the bottleneck and risks of election rigging, ensuring democracy as a superior system of government continues. Sierra Leone conducted a Blockchain-based voting system on March 7 and became the first country to become so.

Health Management Systems

With privacy issues growing constantly, patients can have full control of their medical data preventing unauthorized use. This also helps to protect medical data records that may be vulnerable in a centralized database. Estonia is one country that has successfully transferred citizens’ data records on the blockchain. Asides data provenance, it also helps to forestall medical emergencies such as pandemics as through data distribution. This ensures uniformity when making changes in one copy of a distributed ledger. Other copies in every different location are simultaneously updated, bringing about a swift and decisive decision-making process with utmost transparency.

Corporate Management

A smart contract system can take care of corporate issues. Issues such as time waiting for signing documents, layers of hierarchy, and other management system practices. With its automated systems, it facilitates workflows and provides an immutable ledger as a source of trust which invariably brings about speed in decision-making.

Insurance Sector

The insurance sector requires insured parties to meet certain conditions before claims payout by the insurance companies. This takes a lot of vetting and is time-consuming in the process. Insurance executives can employ smart contracts for claims-payout. This helps to cut down time spent on claims recovery. It, therefore, results in an efficient insurance sector where the insured are happy with the speed of payouts.

Crowdfunding

This has been one of the revolutionary applications of smart contracts, especially during the ICO boom of 2017. Through smart contract technology, individuals can contribute to any project of their choice and receive almost immediately tokens. These tokens are held for financial considerations. The DAO program of the Ethereum Network is also another example. More than 18,000 individuals invested in supporting the project. Participants contributed around $200 million worth of Ether while the initial target was just $20 million. 

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