It’s easier to understand what smart contracts are all about by making use of an example. Consider someone who wants to sell their house. Selling a house is complicated – it involves a lot of paperwork, and linking up with many companies and individuals. Most people who want to sell their house therefore choose to work with an estate agent who can handle the paperwork and put the property out there on the market. The estate agent is an intermediary that helps move negotiations along and oversees the entire transaction from start to finish.
Another important role of the estate agent is the escrow service that they provide. The amounts involved in a house sale is very large and it is difficult to establish trust between buyer and seller. Estate agents charge for their services, however – commission could be about 7% of the total price of the house, which is a big amount to pay for the person selling the house.
Now, a smart contract would be ideal for this situation: both the money involved and the rights to own the house would all be stored on an electronic system based on smart contracts, with the rights and funds distributed to both parties simultaneously, once the transaction is complete. What’s more, with a smart contract, the entire transaction is observed and verified by hundreds of people so it is guaranteed that the transaction will be delivered without fault.
Smart contracts remove the need for an intermediary, simply because trust is no longer an issue. The functionality carried out by someone like an estate agent can be programmatically added to a smart contract which in turn means that the buyer and the seller both save a lot of money.
That’s just one example of how smart contracts can change the way business is done. In fact, smart contracts can work anywhere something valuable is exchanged – whether money or physical goods. Smart contracts deliver transparency and removes the need to pay for an intermediary which could prove expensive – smart contracts resolves questions about trust amongst parties. Terms and conditions, normally written into a contract, are coded into a smart contract – and the transaction data itself is all recorded on a decentralised public ledger, called a blockchain.
How does a smart contract function?
You can see a smart contract as something that’s almost like a vending machine – you put in crypto coins (as much as required for what you want) and the smart contract kicks out a product – whether it’s your driving license, the right to own a property or something else. Smart contracts predefine rules for the contracts including penalties, while also acting as an enforcement mechanism.
A key smart contract feature: interdependence
While you can have a smart contract that’s independent, functioning discreetly, most smart contracts usually work alongside a number of other smart contracts – the smart contracts are interdependent. Once one smart contract is completed successfully it could trigger another contract, which in turn triggers the next smart contract.
The theory of smart contracts allow for very complex interactions, in fact an entire company or system could run off the back off smart contracts that facilitate a range of functions. Smart contracts are, of course, already used widely – smart contracts are central to cryptocurrencies. For crypto smart contracts, all the smart contract laws are predefined: it is a network which functions independently and autonomously.
Smart contracts and objects
Every smart contract has three key component parts, these parts are also known as objects. The first part of a smart contract is the signatories to the smart contract: in other words, the parties that are making use of the smart contract. There will be at least two, but potentially many more, signatories to a smart contract. Signatories are able to either agree or indeed disagree with a smart contract’s terms, and they do so using a digital signature.
The next object of a smart contract is called the subject of the smart contract. It’s an object that will only exist within the environment of a specific smart contract. Another way to configure a smart contract is for the smart contract to have direct, and unrestricted access to the subject of the agreement.
This second element of smart contracts, the subject of the agreement, caused a degree of problems when smart contracts were first proposed in 1996 – stalling progress. When cryptocurrency appeared in 2009 it paved the way for progress in this aspect.
The last object of a smart contract is the specific terms to a smart contract. Terms are described using a programming language that can be understood in the smart contract’s environment. Terms include all requirements applicable to the parties of a smart contract plus the rules, punishments and rewards that are linked to the use of a smart contract.
The smart contract environment
Smart contracts require a suitable environment in order to work properly. Certain elements need to be in place – think public-key encryption for example, because it allows users to sign off on a smart contract transaction using a cryptographic code unique to them – which is specially generated. In fact, this is where smart contracts and cryptocurrencies have a strong similarity.
Also, just like cryptocurrencies, smart contracts need a database that is decentralised and open. This database must be trusted by all the parties participating in a smart contract, and the database must be automated. In fact, the entire smart contract environment must be decentralised for a smart contract to work effectively. Blockchains are an obvious choice for database, and the Ethereum Blockchain has been a particularly good option.
Every smart contract also needs to use a digital data source that is fully reliable and secure. Achieving this involve for example HTTPS and the use of root SSL certificates alongside a range of other security protocols which are widely in use – and which can be implemented on everyday software, automatically.
What are the benefits of smart contracts?
Arguably the leading benefit of smart contracts is autonomy. By using smart contracts you eliminate potentially expensive, disruptive intermediaries or facilitators which gives you full control over the contract. As a result, smart contracts can save money because you don’t need to pay parties such as estate agents, notaries or other advisors – saving the high fees charged by these parties.
Smart contracts also improves trust because it’s not possible to lose smart contracts, and you can’t steal a smart contract – it’s all encrypted. Nor do you need to have a degree of trust in the parties to the contract, the smart contract is so unbiased that it can replace trust. In other words, smart contracts are safer because, if correctly implemented, smart contracts are extremely difficult to break into or hack. It’s all covered by a layer of highly complex cryptography.
It’s also worth noting that smart contracts are more efficient too. Smart contracts reduce the need for manual processes or transporting documents. Because intermediaries are removed it also means that there are fewer hoops to jump through to execute a smart contract.
The creators – and users of smart contracts
Like we said, smart contracts date back to 1996 – the person who first suggested it was Nick Szabo. The computer scientist worked on the idea of a smart contract over many years and published his thoughts. This included a description of a way to run businesses practices based on contract law using an electronic commerce protocol – and to accomplish this even though parties to the business were unknown to each other.
For a variety of reasons smart contracts could not really see wide implementation until 2009 when cryptocurrencies became prominent – Bitcoin appeared in 2009, alongside what we now know as a blockchain that drives the transactions. Blockchains and cryptocurrencies in turn provide the type of environment in which smart contracts can function.
Nick Szabo himself had in 1998 developed plans for a digital currency that is decentralised, he called it Bit Gold. He never put it into action but this currency design had a lot of similarities to Bitcoin which came to the foreground ten years later.
Cryptocurrencies and smart contracts won’t exist without each other – smart contracts are in the main used with cryptocurrencies. In essence, a decentralised cryptocurrency protocol is basically a smart contract where the security and encryption is fully decentralised. It’s a widely used approach across the cryptocurrency universe and it is also one of the most important features that makes Ethereum work well.
Smart contracts in action
Regulatory bodies, governments and traditional financial institutions around the world have been cautious towards cryptocurrencies, but it’s undoubtedly true that the technology behind cryptocurrencies is now widely seen as highly revolutionary, with blockchain finding all sorts of roles in diverse businesses.
One example is four banks – BoA, Credit Suisse, Citi and JP Morgan who collaborated with the DTCC (Depository Trust and Clearing Corporation) to use blockchain technology developed by Axoni. The result is the ability to trade credit default swaps using a smart contract system. The smart contracts in this instance stored all the essential individual trade data plus the metrics for counterparty risk. The consortium claims that the approach delivers an unprecedented level of transparency for both consortium partners and for the regulators involved.
Ripple’s blockchain has also been tested by a group of over sixty banks in Japan and South Korea. The goal was to facilitate cross-border funds transfers between the two countries. Another example is Russia-controlled Sberbank which has used Ehtereum’s blockchain and smart contracts for its own trial run, even though the Russian government itself is strongly against cryptocurrency use.
There is, of course, the Enterprise Ethereum Alliance, a group of more than one hundred companies which was joined by Sberbank recently. Other companies in this group include British Petroleum, Microsoft and Cisco. Overall the alliance plans to further develop blockchain applications so that they are business-ready – and to find and development applications for smart contracts where needed.
Smart contracts are currently mainly in use in banking and finance, due to the fact that smart contracts are so closely associated with cryptocurrency use. Smart contracts can, however, be used far more widely. For example, governments around the world could rely on smart contracts to make it easier to vote, and to make voting a more transparent process.
Supply chains around the world could rely on smart contracts to monitor goods shipment and to also make the paperwork behind shipping more automated – from the tasks require to action and clear shipping through to payment. The list goes on and on, with everything from real estate to healthcare set to benefit from smart contracts and their benefits.