What Are Smart Contracts And How Do They Work?

In business, finance, and healthcare, contracts — particularly written ones — are prevalent and play crucial roles in the effective functioning of their respective ecosystems.

A contract is an agreement between two or more parties that outlines conditions to be adhered to for a specific outcome to be realized. They are drafted to guide the behavior of each party, especially in terms of adhering to the contract's stipulations.

While traditional contracts provide clarity and structure, their written nature doesn't guarantee that the parties involved will adhere to the stipulated terms. This limitation led to the development of smart contracts.

Features of Smart Contracts

Smart contracts are digital agreements stored on the Blockchain. They are programmed to execute automatically once predetermined conditions are fulfilled.

• Programmed Nature: Smart contracts are written in programming languages, not human languages like English. Essentially, they are lines of code designed to execute specific functions.
• Immutability: Once deployed, smart contracts become immutable. This means they cannot be reversed or altered, ensuring trustworthiness and reliability.
• Blockchain Integration: Unlike traditional contracts, smart contracts are stored on the Blockchain. This decentralized storage ensures transparency and security, making tampering nearly impossible.
• Automated Execution: Smart contracts operate autonomously. When predefined conditions are met, they execute automatically without human intervention, reducing the potential for errors or delays.

How to Build Smart Contracts

1. Identify the Parties: Begin by identifying all parties involved in the agreement. This step ensures clarity about who is entering into the contract.
2. Establish the Terms of Agreement: Clearly outline the terms and conditions. This encompasses the duties, responsibilities, expected outcomes, and rules of engagement for each party. Precise identification of these elements is crucial for a successful smart contract.
3. Specify Execution Conditions: Clearly define the conditions necessary for the contract's execution. These conditions determine the contract's validity and need to be explicitly stated.
4. Draft the Smart Contract Code: Write the actual code for the smart contract, detailing the procedures for contract execution once the defined conditions are met. Ensure the use of programming languages compatible with the selected Blockchain network.
5. Deploy the Contract to a Blockchain Platform: Deploy your smart contract to a Blockchain network. This action makes the contract valid since it involves uploading the contract's code to the network, cementing its validity.
6. Automate Contract Execution: With predetermined conditions in place, all that remains is for the parties to fulfill these conditions. Upon satisfaction of these terms, the contract automatically executes, and the Blockchain network activates the corresponding operations.
7. Log Contract Details on the Blockchain Ledger: Lastly, comprehensive details of the contract— including its terms, execution conditions, and timestamp of execution — are recorded on the Blockchain Ledger. Once documented, this information becomes immutable, ensuring it cannot be altered or deleted.

Smart contracts cannot access off-chain data from sources outside the Blockchain network. When real-world input or off-chain data is essential for executing the contract's terms, third-party platforms like Blockchain Oracle come into play. Oracle assists in obtaining the necessary information, enabling the smart contract to enforce its stipulations effectively.

How Smart Contracts Work: An Analogy

Imagine two soccer enthusiasts, Arthur and Alex, journeying from America to Qatar for the World Cup finals between France and Argentina. Passionate about the match, they decide to place a bet. Arthur is confident in Messi and Argentina, while Alex, a fan of Mbappe, roots for France.

Rather than a traditional bet, they opt for a smart contract, with Arthur having expertise in its development. They set clear terms: the loser would transfer 1 ETH to the winner.

The contract, which is written in Solidity and deployed on the Ethereum network, dictates:

• If Argentina wins, 1 ETH goes from Alex to Arthur.
• If France wins, the reverse occurs.

Given smart contracts' inability to access off-chain data, they incorporate an Oracle. The Oracle updates the score as the match ends in Argentina's favor. Consequently, the contract auto-executes, transferring 1 ETH from Alex to Arthur.

This process eliminated middlemen, ensured adherence to the agreement, and provided transparent, indisputable results.

Advantages of Smart Contracts

Cost-Effective: Automation, inherent in smart contracts, significantly saves resources such as time, money, and energy. The immediate execution of stipulated conditions is nearly rapid due to this automation. The principle is straightforward: a corresponding action follows when a specific condition is met. Drawing from our earlier analogy, as soon as France lost the match, 1 ETH was seamlessly transferred from Alex to Arthur. Also, here are notable savings in potential intermediary costs. For instance, in the aforementioned story, Arthur didn't have to invest time, energy, or even money to ensure Alex honored the bet or to hire a mediator to oversee its fulfillment.

Efficiency: Smart contracts are highly reliable and unaffected by external conditions that typically impact human operations, such as weather disruptions, illness, or holidays. They operate around the clock, offering an uninterrupted 24/7 service. Being self-executing, they eliminate the need for intermediaries or human oversight, as their actions are pre-programmed. This increased efficiency makes them a great choice for businesses, particularly large-scale operations. Traditional methods of confirming payments or receiving supplies can be cumbersome, costly, and error-prone. Smart contracts streamline these processes, allowing for effortless payment and supply confirmations. This seamless operation diminishes the typical buyer-seller friction often experienced in conventional business transactions.

Sustainability: Smart contracts present a more sustainable solution than their traditional counterparts. One immediate benefit is the significant reduction in paperwork, which conserves resources and streamlines documentation processes. This digital approach saves substantial space that paper archives would otherwise consume. Also, the energy required for manual record-keeping is greatly reduced, and the risk of human error is minimized, thanks to the automatic nature of smart contracts. This automation ensures no room for inaccuracies arising from human factors like fatigue or procrastination. Every transaction executed through a smart contract is accurately recorded, ensuring a detailed history is maintained. This provides an invaluable resource for future reference, as each transaction retains comprehensive details, making the overall process sustainable and efficient.

Immutable: Once a smart contract is deployed on the blockchain, it becomes unchangeable. This immutability significantly diminishes the potential for fraudulent activities or any attempts by a party to alter the contract for personal benefit. Such immutability eliminates many risks associated with breaches that are often a concern in traditional contracts.

Transparency: Smart contracts champion transparency. All information related to the agreement is accessible and transparent to all involved parties. No party has an advantage in terms of access to data, ensuring everyone operates with the same set of original information. The clear stipulation of terms, conditions, and associated consequences ensures that all participants are well-informed, making any covert contract manipulation virtually impossible.

Disadvantages of Smart Contracts

Susceptibility to Hacks: While smart contracts aim to bring security and transparency, their human creation introduces potential vulnerabilities. Hackers can exploit loopholes in the coding. A notable instance was in 2020 when a hacker manipulated a flaw in Harvest Finance's smart contract, making away with $24 million in cryptocurrencies. Such incidents spotlight the risks associated with coding oversights.

Dependence on Third Parties: The primary vision behind smart contracts is the elimination of third-party intermediaries. However, certain limitations in their functionality make this goal challenging. Specifically, smart contracts cannot independently access real-world or off-chain data. They often rely on external systems like Oracles to bridge this gap and reintroduce a third-party element.

Lack of Flexibility: Immutability, while a core strength of smart contracts in preventing manipulation, can simultaneously pose challenges due to its inflexibility. Technologies aiming to enhance human experiences should possess some level of adaptability. Given that humans inherently make mistakes – "to err is human" – the inability to amend smart contracts in case of errors becomes a notable drawback. Making corrections or adjustments is either extremely difficult or outright impossible.

Future of Smart Contracts

Smart contracts are foundational to achieving a truly decentralized world. They were originally designed to facilitate swift, reliable transactions without intermediaries, but their influence has now expanded due to ongoing research and widespread adoption.

Today, their impact resonates across diverse sectors, including decentralized applications, insurance, supply chain management, politics, and many areas yet to be explored.

Despite certain challenges, smart contracts remain central to the evolution of decentralized technologies envisaging our future. Ensuring rigorous smart contract auditing is essential to bolster their adoption, as it mitigates risks and strengthens the decentralized ecosystem.