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If you’re new to the decentralized apps and blockchain space, you must have heard the term “smart contract” floating around many times. But what exactly is a smart contract? In this beginner’s guide, we’ll explain everything you need to know about smart contracts in an easy-to-understand language. So, let’s get started!
What is a smart contract?
A smart contract is a digital contract that is stored on a blockchain, or, in other words, a computer protocol intended to digitally facilitate, verify, or enforce the negotiation or performance of a contract.
What this means is that it permits allows credible transactions without third parties.
That is the textbook definition of a smart contract and fundamentally explains how and why they exist. Let’s take a deeper dive into the technology that has the potential to put lawyers out of a job in the coming years.
Understanding the importance of blockchains
In order to understand smart contracts, we must first understand the technology behind them.
A blockchain is a decentralized, distributed ledger that is used to record transactions across many computers so that the record cannot be altered retroactively without the alteration of all subsequent blocks. This essentially means that it is a secure and transparent way of recording data that is not subject to manipulation or tampering.
One of the most exciting things about the advent of blockchain technology has always been the fact it is a decentralized system that exists between all permitted parties. There’s no need to pay middlemen to perform simple operations.
It’s true that blockchains have their problems, but they are undeniably faster, cheaper, and more secure than traditional systems, which is why banks and governments are turning to them more and more.
What does Vitalik have to say?
For those not familiar, Vitalik Buterin is the founder and leader of the Ethereum project. The blockchain where smart contracts first became a reality and where the vast majority of dapp activity is taking place.
Vitalik Buterin explained smart contracts at the DC Blockchain Summit, saying that;
“In a smart contract approach, an asset or currency is transferred into a program, and the program runs this code. At some point, it automatically validates a condition, and it automatically determines whether the asset should go to one person or back to the other person, or whether it should be immediately refunded to the person who sent it or some combination thereof.”
In the meantime, the decentralized ledger also stores and replicates the document, which gives it a certain security and immutability.
Ok, Vitalik, so what does that mean?
How do smart contracts work? A real-world example
Suppose you rent a house. This action can be performed through the blockchain by paying in a cryptocurrency such as Bitcoin or Ethereum.
You would get a receipt which is held in a virtual contract; the seller would then give you the digital entry key, which needs to come to you by a specified date.
If the key doesn’t come on time, the blockchain will release a refund. If the seller sends the key before the rental date, the function holds, and both the fee and key would be released to you and the seller, respectively, when the date arrives.
The system works on the If-Then premise and is observed by hundreds of people, so you can expect a faultless delivery. If I give you the key, I’m sure to be paid. If you send a certain amount in Ethereum, you receive the key.
The document is automatically canceled after the time, and the code cannot be interfered with by either party without the other knowing since all participants are simultaneously alerted.
You can use smart contracts for all sorts of situations that range from financial derivatives to insurance premiums, breach contracts, property law, credit enforcement, financial services, legal processes, and crowdfunding agreements.
The 7 main benefits of Smart Contracts
Smart contracts provide many advantages to users and are facilitating a powershift allowing users to not rely on ‘trusted’ middlemen anymore and, as a result, avoid the fees associated with using them. Here are just some of the clear advantages:
Manually processing documents is time-consuming. Smart contracts use code to automate tasks and can save hours in a wide variety of everyday business processes.
Smart contracts save you money since they remove the need for an intermediary. You would, for instance, have to pay a notary to witness your transaction. Or pay a lawyer to prepare the documents for the sale of a house or car, for example.
Your documents are encrypted on a shared ledger. There’s no way that someone can say they lost it.
You’re the one making the agreement; there’s no need to rely on a broker, lawyer, or other intermediaries to confirm. Furthermore, this also removes any danger of manipulation by a third party. Since execution is managed automatically by the network, rather than by one or more, possibly biased, individuals.
Imagine if your bank lost your savings account. On the blockchain, your documents are duplicated many times over and can be recovered with ease.
Cryptography is a complex and solid form of safety that is used for the encryption of websites. In short, it keeps your documents safe.
Automated contracts are not only faster and cheaper but also avoid the errors that come from manually filling out heaps of forms.
How are smart contracts being used?
Its important with any new technology to achieve adoption and integration to everyday processes. A few industries have been quick to employ the benefits offered through smart contracts. Let’s look at a few of the major industries leading the way.
One of the major benefits of using smart contracts is the removal of middlemen, and that means you get to keep more of your money.
Normally, if you wanted to rent your house to someone, you’d need to pay a middleman such as an estate agent or advertising website. On top of that, for the luxury of knowing the renter is paying, landlords need to pay someone to confirm that transaction took place. These are called admin fees.
The ledger cuts your costs. All you do is pay via cryptocurrency and encode your contract on the ledger. Everyone sees, and you accomplish automatic fulfillment. Brokers, real estate agents, money lenders, and anyone associated with the property industry can profit.
Personal health records can be encoded and saved on the blockchain with a private key that would grant access only to specific individuals.
Receipts of surgeries could be stored on a blockchain and automatically sent to insurance providers as proof of delivery as one example.
The digital ledger could be used for more general healthcare management, such as supervising drugs, testing results, and managing healthcare supplies.
Interestingly, once the network is well enough connected, it would be possible for a doctor in a village in Northern India to access your personal medical history documents from your private doctor in New York. No more medical cards, no more confusion. Just efficient healthcare provision.
The music industry and surrounding creative services have long struggled with accurately and fairly distributing wealth accumulated through joint creative projects. Many bands have broken up over disputes around money and rights.
Using smart contracts, artists can ensure they set out the terms of their work in advance and be sure of payment as the process would be autonomous and automatic.
Furthermore, smart contracts could make the purchasing and use of licensed and royalty-protected sounds much easier as a central database could exist, allowing users to simply find the sample or sound they desire and pay the artist directly for the use.
Supply chain management
Supply chains are often slowed by reliance on paper-based systems, where actual written documents have to pass through many sets of hands for approval. This increases exposure to loss, fraud, and inaccuracies resulting in lost stock.
The blockchain nullifies this by providing a secure, accessible digital version to all parties on the chain and automates tasks and payment.
Another advancement made possible here is the traceability of produce. The smart contract cannot be tampered with, and therefore destinations and origin locations would remain factual. In simple terms, a smart contract could ensure that a beef steak claiming it was from an organic farm in Brazil actually was that.
This area is one that has quickly adopted the technology as the overall efficiency benefits are clear to see.
The downsides of Smart Contracts
Smart contracts are far from perfect, and it is important to note that at this stage in their existence, a lot of the operations being performed on the blockchain can be considered Beta tests.
The main questions arise around the code. What if bugs get in? And how do governments and financial institutions regulate and tax these contracts?
Thinking back to the example given earlier around buying a house. What happens if the seller sends the wrong code, or, as lawyer Bill Marino points out, the right code is sent, but the house is condemned before the rental date arrives?
If this were the traditional contract, I could rescind it in court, but the blockchain is a different situation. The contract would still execute.
The list of challenges until smart contract mass adoption is still long, but there are countless early adopters and developers working to create what will surely be the future of contractual operations worldwide.
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