This article explains what “smart contracts” are, what they are used for and why they are important in the blockchain universe.
Decentralization and reducing the need for third-party intermediaries are at the core of many blockchain applications. Smart contracts are one of the tools that can help to achieve these goals.
A smart contract is an agreement between two or more parties in form of a computer code. It guarantees a specific set of outcomes.
Once certain conditions of the contract are met, the pre-defined terms are automatically enforced. Thus, there is no need for a third-party intermediary like a bank or a trustee, as there are no issues with trust between the transaction parties. There is no confusion and there should never be any need for litigation.
Furthermore, the contract runs on a blockchain, which means it is stored on a public database and cannot be changed unless the network agrees to new terms.
The term “smart contract” might be misleading
Smart contracts are neither smart, nor a legal contract.
First, a smart contract is only as smart as the people who coded it. It contains all information that the developers had at the time of coding. Certain circumstances might change, but the code remains the same unless it is being changed and the majority of network participants agrees to the new rules.
Second, smart contracts are not legal documents, which means they are not accepted by any court. They do have the potential to become legal contracts if certain conditions are met. But they are not a legal document per se.
Smart contracts are not new, but blockchain is
Do you remember when we were children and we had these vintage bubble gum machines? You’d place a quarter in the coin mechanism, the machine would recognize that you paid enough money for one bubble gum and would dispense it.
In a way, that’s a smart contract. The rule is: Once the customer has paid a quarter, the machine will dispense a bubble gum.
Thus, smart contracts are nothing new and have been around for a long time.
What’s new, however, is the use of smart contracts in combination with blockchain technology. Blockchain adds much greater security to the enforcement of the contract, as information is stored on a public ledger and verified by the entire network.
That could come in handy in many use cases.
Example: Real Estate Transactions
If you wanted to buy a house, traditionally you would have to go through real estate agents and lawyers who handle all the contracts, documentation, escrow services and title transfers.
We can now conduct the same transactions via a blockchain-based smart contract. In this case, the payment for the house as well as the ownership rights will be stored on a blockchain.
Both transactions are automatically executed by a smart contract, based on the pre-defined rules. When the payment is made, the ownership rights will be transferred immediately.
As the transactions happen on a blockchain network, they will be witnessed and verified by all nodes in the network. Fraud will be nearly impossible. Trust between the transaction parties will no longer be necessary, and there won’t be any agency commissions or legal fees.
Smart contracts are already being used in multiple blockchain business use cases and are key to the development of blockchain projects.
As the use of smart contracts increases and the blockchain industry matures, legal standards will become more important. Thus, over the next few years, we will probably experience a fusion of smart contracts and legal contracts.
Smart contracts can automate transactions, create a higher degree of security, limit the risk of human error, increase transaction speed, decrease the need for third party intermediaries and lower transaction costs.
The advantages are obvious. It’s now up to private businesses to use the technology in a smart way.