A smart contract is a self-executing program that automates the actions required in an agreement or contract. Once completed, the transactions are trackable and irreversible. To picture a smart contract, consider a vending machine: when you insert the correct amount of money and select an item, the program activates the machine to dispense your chosen item.
Smart contracts permit trusted transactions and agreements to be carried out among disparate, anonymous parties without the need for a central authority, legal system, or external enforcement mechanism.
What You Need to Know
- Smart contracts are scripts that automate the actions between two parties.
- Smart contracts do not contain legal language, terms, or agreements – only code that executes actions when specified conditions are met.
- Nick Szabo, an American computer scientist who conceptualized a virtual currency called “Bit Gold” in 1998, defined smart contracts as computerized protocols that execute the terms of a contract.
History of Smart Contracts
Smart contracts were first proposed in 1994 by Nick Szabo, who conceptualized a virtual currency called “Bit Gold” 10 years before Bitcoin was introduced. Szabo defined smart contracts as computerized transaction protocols that execute the terms of a contract. He extended the functionality of electronic transaction methods to the digital realm.
In his paper, Szabo proposed executing contracts for synthetic assets, such as derivatives and bonds. Szabo wrote, “These new securities are formed by combining bonds and derivatives (options and futures) in various ways. Very complex term structures for payments can now be built into standardized contracts and traded with low transaction costs, due to computerized analysis of these complex term structures.”
Szabo’s vision materialized even before blockchain technology emerged, with derivatives trading now conducted through computer networks using sophisticated term structures.
Smart Contract Uses
Because smart contracts execute agreements, they have numerous applications. One straightforward use is ensuring transactions between two parties occur, such as the purchase and delivery of goods. For example, a manufacturer might set up payments using smart contracts, and a supplier might set up shipments. Depending on the agreement, funds could transfer automatically to the supplier upon shipment or delivery.
Real estate transactions, stock and commodity trading, lending, corporate governance, supply chain management, dispute resolution, and healthcare are only a few scenarios where smart contracts excel.
Smart Contract Pros and Cons
Benefits:
- Efficiency: Speed up contract execution
- Accuracy: Eliminate human error
- Immutability: Code cannot be altered
Challenges:
- Permanent: Cannot be changed if there are mistakes
- Human factor: Rely on flawless programming
- Loopholes: May contain vulnerabilities allowing exploitation
What Is an Example of a Smart Contract?
A simple example of a smart contract is a transaction between a consumer and a business, where a sale is made. The smart contract manages the customer’s payment and the business’s shipment or transfer of ownership.
What Blockchain Has Smart Contracts?
Ethereum has inherent smart contract capabilities, while the Bitcoin blockchain received smart contract features after the Taproot upgrade, enabling communication to layers supporting smart contracts.
What Are Smart Contracts in Simple Terms?
Smart contracts are blockchain applications ensuring both sides of a transaction fulfill their commitments. For example, they could trigger fund transfer when an agreement is digitally signed.
The Bottom Line
Smart contracts are coded directly into a blockchain. They perform agreed actions automatically and remove intermediaries, fostering trustless transactions.
Related Terms: blockchain, decentralized applications (DApps), Ethereum, Bitcoin, cryptocurrency, automation
References
- Coinbase. “Who Is Satoshi Nakamoto?”
- Nick Szabo. “Smart Contracts”.
